Central Banks & Monetary Policy

The Central Bank and Monetary Policy

• The study of macroeconomic policy concludes with an examination of the central bank and its role in stabilization through monetary policy.
• Central bank responsibilities include banknotes, money, inflation, modern economies, and monetary policy tools and limitations.

Base Money

• Banks hold bank reserves in accounts at the central bank
• "Paying by card" involves transferring bank deposits via bank money
• Bank money constitutes most of the money in a modern economy
• Notes and coins, or currency, make up the smaller part.
• The central bank supplies two forms of base money, which are currency (notes and coins) and reserves (bank deposits).
• Reserves can be converted to currency on demand, and vice versa.
• If a bank needs more notes, they can convert some of its reserves into notes; if it has too many, they can swap them for reserves at the central bank.
• The central bank supplies reserves by buying assets from banks or directly lending to them
• Money is created when a bank makes a loan, increasing bank money
• The central bank creates money when it buys government bonds from a public entity, which leads to an increase in base money.
• Bank money (deposits) is a collective liability of commercial banks.
• Currency (banknotes and coins) is considered legal tender, meaning anyone selling something is obliged by law to accept it

Banknotes

• Banknotes can be used as a means of exchange for goods and services and to pay off debt
• Upon using banknotes and coins, the central bank's liability to you is transferred to whoever you buy things from
• The entire monetary base of the economy is a form of government debt, with banknotes being signed by the government.
• Banknotes offer a store of value, though imperfectly due to inflation
• Positive inflation progressively decreases the value of a banknote in terms of real spending power.
• In countries with a central bank that succeeds in keeping inflation low, stable, and predictable, inflation reduces the real spending power of currency slowly and predictably.
• The more successful the central bank is at stabilizing inflation, the more reliable its liability is as a real store of value and as a unit of account.
• This activity is referred to as monetary policy.
• The central bank is a government-owned institution with the power to create legal tender, like banknotes and coins.
• Base money (currency and reserves) is its liability.
• Historically (70s-80s), central banks operated under government control to keep inflation low by controlling the money supply, called "monetarism."
• Today (90s-present), central banks are independent authorities responsible for stabilizing the economy by targeting a low, stable, and positive inflation rate.

Inflation Targeting

• Inflation targeting involves using monetary policy to maintain inflation close to a constant target that is consistent with the supply-side equilibrium.
• Demand and supply shocks can create a bargaining gap pushing the economy away from supply-side equilibrium.
• A positive bargaining gap leads to inflation increases, while a negative bargaining gap leads to inflation decreases.
• When the economy is at the supply-side equilibrium, inflation is positive and constant which is typically 2 or 3%.
• The most widely adopted target in advanced economies is an inflation target of 2%.
• When inflation is above target: employment is above equilibrium, there’s a positive bargaining gap, and the economy is in expansion
• Contractionary monetary policy increases the interest rate, which leads to decreased aggregate demand and diminished inflationary pressure.
• When inflation is below target, employment is below equilibrium, a negative bargaining gap exists, and the economy is in recession.
• Expansionary monetary policy decreases the interest rate, which leads to increased aggregate demand and higher inflationary pressure
• AD = 𝑐0 + 𝑐1 (1 − 𝑡)𝑌 + 𝑎0 − 𝑎1 𝒓 + 𝐺 + 𝑋 − 𝑚𝑌 is the aggregate demand formula
• A higher interest rate makes it more expensive for firms to borrow to finance their investments, so aggregate demand decreases.
• A lower interest rate makes it cheaper for firms to borrow to finance their investments, so aggregate demand increases.

Independent Authority

• Central banks had little operational independence until roughly the late 1980s, with national monetary policy being directly controlled by national governments.
• Governments and politicians might exploit the short-run trade-off between inflation and unemployment (the Phillips curve), especially approaching elections, which could generate inflation.
• Countries granted greater independence to their central banks in light of theoretical arguments and evidence.
• Governments set the inflation target, but central banks were given the task of achieving it.
• New Zealand was one of the first countries to make the shift and made its central bank independent in 1990
• New Zealand introduced an inflation target in the range of 1%–3% and inflation fell and remained low.
• The European Central Bank was established in May 1999 to guarantee and maintain price stability

Inflation Targeting in Practice

• The ECB's primary objective is to maintain price stability by keeping the rate at which prices for goods and services change over time low, stable, and predictable
• The Governing Council considers that price stability is best maintained by aiming for 2% inflation over the medium term
• The Bank of England's monetary policy objective is to deliver price stability (low inflation) and support the government's economic objectives for growth and employment
• Price stability is defined by the Government's inflation target of 2%.
• The Federal Reserve Act states that Congress established maximum employment, stable prices, and moderate long-term interest rates as the statutory objectives for monetary policy

Monetary Policy Tools

• Monetary policy involves central bank or government actions to influence economic activity through changes in interest rates or the prices of financial assets.
• In normal times, central banks directly control the policy rate (𝑖𝑃) which is a nominal interest rate
• Ideally, these banks would also like to affect 𝑟, the real interest rate.
• For a given nominal interest rate, higher inflation reduces the real interest rate and the real cost of borrowing
• In general, r = i - π where r is the real interest rate, i is the nominal interest rate, and π is the inflation rate

The Fisher Equation

• For a given nominal interest rate, higher expected inflation reduces the real interest rate, inflation is good for borrowers
• If deflation is expected, the real interest rate increases even above the nominal interest rate, deflation is bad for borrowers.
• In our framework we will assume that the central bank can affect the real interest rate by directly controlling the nominal interest rate : 𝒓 = 𝒊𝑷 − 𝜋 𝑬
• Policy rates across major central banks include Federal Funds Rate (Federal Reserve System), Bank Rate (Bank of England), and Deposit Facility Rate (European Central Bank).
• With expansionary monetary policy, the central bank will want to increase aggregate demand to close the bargaining gap and bring inflation back at target.
• This response includes cutting the nominal interest rate and so the real interest rate will decrease, leading to increased AD and closing the gap

Supply-Side Shock

• A supply-side shock involves an unexpected or exogenous change in the supply side of the economy.
• The increase in the price of imported energy means that production just become more costly and firms will pass, at least partially, the increase in their costs into prices.
• The real wage falls and there is a new supply-side equilibrium.
• AD has not changed, causing a positive bargaining gap of 2%.
• In these instance, workers perceive a loss in their purchasing power (the real wage is lower) but employment prospects are the same.
• This causes workers to require a higher nominal wage to be retained and motivated and HR managers will implement a nominal wage increase.
• Therefore, marketing departments increase prices by 4% and inflation increases above the central bank’s target!
• Policymakers face the dilemma of whether to allow inflation to increase, or intervene to close the positive bargaining gap. But AD will fall and unemployment will in generatation a recession if they intervene
• An inflation-targeting central bank will therefore focus on inflation, and choose to intervene with a contractionary response to increase the policy rate and so increasing real interest rates
• This turns will negatively affect investment and contract aggregate demand, and the output and employment decrease until the bargaining gap is zero, and inflation will be back at target.
• As for every other policy response, the Central Bank must calibrate it properly by either reducing rates too much, or not enough

Risks

• Timing is crucial, as failing to intervene promptly risks workers adjusting their inflation expectations upward, leading to the central bank only being able to bring inflation back at 5%.
• If the central bank intervenes it may have to generate another recession to bring the inflation back down at 2%.
• Central bank credibility stresses the importance of avoiding a potential wage-price spiral where inflation expectations remain anchored to the target
• A monetary policy committee meets regularly (monthly) to adjust the policy interest rate and can set any policy interest rate
• Mechanisms need to be in place to implement the announced policy rate throughout the economy
• The central bank can reduce the policy rate, boosting aggregate demand and bringing inflation back at target in response to negative aggregate demand shock
• The larger the negative AD shock, the greater the nominal interest rate cut to stimulate demand.
• The policy rate cannot be set lower than zero, as people would simply hold cash rather than put it in the bank, because they would have to pay the bank for holding their money.
• Macroeconomists refer to this situation as the zero lower bound (ZLB) so rZLB = 0% − πE
• The central bank would like to cut the nominal interest rate low enough to bring the economy back at the supply side equilibrium and like to achieve 𝑟 𝑜𝑝𝑡𝑖𝑚𝑎𝑙
• However because the bank can only cut the nominal interest rate to the zero lower bound and achieve 𝑟𝑍𝐿𝐵 > 𝑟 𝑜𝑝𝑡𝑖𝑚𝑎𝑙, so AD increases but not enough so there is still a negative bargaining gap and inflation will keep falling
• If that continues, inflation becomes negative (deflation), and with adaptive inflation expectations it may cause The real interest rate is increasing, and AD decreasing again.

Unconventional Monetary Policy

• Macroeconomists and policymakers have returned to look at Fiscal Policy for stabilisation as monetary policy can be ineffective
• Banks and central banks have had to expand their policy tools in new directions.
• These tools are unconventional monetary policy tools like quantitative easing, forward guidance and negative interest rates