Leeds University Business School Advanced Macroeconomics 2024-2025 Lecture 9 PDF

LEEDS UNIVERSITY BUSINESS SCHOOL Advanced Macroeconomics LUBS 3505 2024-2025 Lecture 9. Monetary Policy II Shocks, Inflation Aversion, and Limitations Outline - Recap of the full IS-PC-MR model - When to change interest r...

LEEDS UNIVERSITY BUSINESS SCHOOL Advanced Macroeconomics LUBS 3505 2024-2025 Lecture 9. Monetary Policy II Shocks, Inflation Aversion, and Limitations Outline - Recap of the full IS-PC-MR model - When to change interest rates? Why? - An increase in inflation - What factors determine by how much? - CB’s degree of inflation-aversion - A critique of the NCM model - Assumptions - Practical or implementation - Empirical - Vevox: 123-485-896 (ID) Recap: Full 3 equations model (IS-PC-MR): We can now put together the IS-PC MR model: The CB is targeting inflation (𝜋 𝑇 ) 𝑟−1 and keeps the economy at IS-output gap form potential output (𝑦𝑒 ). (3) 𝑦1 − 𝑦𝑒 = −𝑎(𝑟0 − 𝑟𝑠 ) 𝑟𝑠 It is aware of the policy lag: 𝑟0 t=0 t=1 𝜋1 𝑦1 𝑦𝑒 y Hence, the CB is constantly Inertial Phillips PC thinking forward (MPC) to check if 𝜋 (4) 𝜋1 = 𝜋0 + 𝛼(𝑦1 − 𝑦𝑒 ) its current 𝑟0 can deliver 𝜋 𝑇 and 𝑦𝑒. 𝑉𝑃𝐶 PC ‒ If so  no intervention. MR PC (𝜋 𝐼 = 𝜋 𝑇 ) ‒ If current 𝒓𝟎 cannot deliver 𝝅𝑻 and 𝒚𝒆  CB intervenes (change 𝑟y (min its loss given 𝜋𝑇 MR, Monetary Rule conditions)). Then the CB will try (6) (𝑦1 − 𝑦𝑒 ) =-𝛼𝛽(𝜋1 -𝜋 𝑇 ) to stabilize inflation and output and return to 𝜋 𝑇 and 𝑦𝑒. 𝑦𝑒 y To illustrate this, let us simulate a shock… When and why? A rise in inflation 𝜋 𝑦 𝑟 CB decisions 𝑟−1 Pre-shock 𝜋𝑇 = 2 𝑦𝑒 𝑟𝑠 Point (A) 𝑟0 t=0 𝜋0 > 𝜋 𝑇 𝑟1 𝑟𝑠 Inflat.expect↑: CB knows PC shift-left in t=1: 𝜋0 𝑦𝑒 𝜋1 = 𝜋0 + 𝛼(𝑦1 − 𝑦𝑒 ) IS Point (B) 𝑦 = 𝑦𝑒 What to do? Set 𝑦 in t=1 that min L s.t. PC 𝑦1 𝑦1 𝑦𝑒 𝑦2 y 𝑦1 < 𝑦𝑒 : cooling down 𝜋 𝑟0 How? IS  𝒓𝟎 𝑉𝑃𝐶 PC (𝜋 𝐼 = 𝜋0 ) PC (𝜋 𝐼 = 𝜋1 ) t=1 𝜋1 𝑦1 𝜋1 > 𝜋 𝑇 Point (C) Inflat.expect↓: CB knows MR PC (𝜋 𝐼 = 𝜋 𝑇 ) B PC shift-right in t=2: 𝜋0 𝜋2 = 𝜋1 + 𝛼(𝑦2 − 𝑦𝑒 ) 𝜋1 C 𝑦1 < 𝑦𝑒 𝜋2 D What to do? Set 𝑦 in t=2 that 𝑇 𝜋 =2 E A min L s.t. PC 𝑦2 𝑟1 𝑦1 < 𝑦2 < 𝑦𝑒 How? IS  𝒓𝟏 t=2 𝜋2 𝑦2 𝜋2 > 𝜋 𝑇 𝑦1 𝑦𝑒 y Point (D) Inflat.expect↓: … 𝑦2 The same process will repeat D  E until the CB stabilizes the economy back at A. When and why? A rise in inflation What’s happening? 𝑟−1 CB reacts by increasing interest rates: 𝑟 𝑟1 𝑟0 Thereafter, CB reduces 𝑠 interest rates: 𝒓′ → 𝒓𝒔 IS A B C D E A 𝑦1 𝑦𝑒 𝑦2 y 𝜋 𝑉𝑃𝐶 Cools-down economy, reduces output: BC MR PC (𝜋 𝐼 = 𝜋 𝑇 ) 𝜋0 B A B C D E A 𝜋1 C Shock: 𝜋2 D Economy 𝑇 E 𝜋 =2 A jumps AB 𝑦1 𝑦2 𝑦𝑒 y A B C D E A Guiding the economy along the CB’s MR towards (𝜋 𝑇 , 𝑦𝑒 ): C  D  E  A Source: Fig 3.9 C+S’15, p.100 By how much? Degree of inflation-aversion by the CB We have argued that 𝜷=1  CB attributes equal weight to output and inflation. Why? With 𝜷=1: (5’) L=(𝑦1 − 𝑦𝑒 )2 +(𝜋1 − 𝜋 𝑇 )2  Circumference Graphically: When solving the CB’s optimization problem: In a circumference all radius Min L=(𝑦1 − 𝑦𝑒 )2 +𝛽(𝜋1 − 𝜋 𝑇 )2 (5) with 𝛽=1 𝜋 are equal, hence, s.t. 𝜋1 = 𝜋0 + 𝛼 𝑦1 − 𝑦𝑒 (4) 1% rise above 𝜋 𝑇 𝜋 PC’’’ PC’’ 𝜋𝑇 PC’ 1% fall below 𝑦𝑒 𝑦𝑒 𝜋𝑇 y In economic terms, since a circumference is an isoloss  CB is indifferent to: 1% fall in output below 𝑦𝑒 1% rise in inflation above 𝜋 𝑇 𝑦𝑒 y Monetary Rule (MR) CB attributes equal weight to inflation (6) (𝑦1 − 𝑦𝑒 ) =-𝛼𝛽(𝜋1 -𝜋 𝑇 ) and output. By how much? Degree of inflation-aversion by the CB When 𝜷>1 (5’’) L=(𝑦1 − 𝑦𝑒 )2 +𝛽(𝜋1 − 𝜋 𝑇 )2 where 𝛽>1 The loss function becomes an ellipse with a greater radius along the horizontal axis. Graphically: Solving the CB’s optimisation problem when 𝜷>1: PC’’ 𝜋 𝜋 PC’ MR 𝜋𝑇 𝜋𝑇 𝑦𝑒 y MR The CB is indifferent and a smaller than 𝑦𝑒 y between a fall in output 1% rise in inflation of 1% below 𝑦𝑒 above 𝜋 𝑇 MR becomes flatter when the CB is inflation-averse. Intuition: When the CB is inflation-averse CB attributes more weight to inflation it is willing to sacrifice more output to than output: CB is inflation averse. tackle the same inflation rate. Critiques of the NCM approach: Closed economy Critiques of the assumptions: 1. It ignores the possibility of hysteresis effects after a shock, or as a result of monetary policy actions. UK, 1970-1992 26.0 24.0 1975 Monetary policy actions 22.0 20.0 18.0 1980 to control inflation Inflation 16.0 14.0 12.0 10.0 8.0 6.0 1990 4.0 1992 1984 2.0 1970 1988 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 Unemployment Source: OECD (unemployment) and IMF (inflation) 2. Fiscal policy is downgraded to a secondary role in which all it needs to do is to keep its budget balanced. This is based on the assumption that economies suffer from full crowding out - contrary to substantial evidence of the existence of positive multipliers (Hemming et al. (2002)). 3. There is no recognition of the role of the credit market and the importance of the banking system as an intermediary in the financial system (there is only one single interest rate). For instance, the problems that followed the collapse of Lehman Brothers cannot be accounted for. Fontana and Setterfield (2010). Ch. 5 Critiques of the NCM approach: Closed economy Practical problems to conduct monetary policy in the NCM: 4. The central bank has no tool to fight cost-push inflation and asset price bubbles other than depressing the overall level of aggregate demand: Recall inflation rise case… 4 3 inflation 2 1 Int. rates output 0 -1 pre-shock 0 1 2 3 4 -2 -3 -4 This problem has become very apparent since 2007 and CBs have reacted by introducing macroprudential tools: ‒ New Capital Requirements ‒ Maximum Quantities, or loan-to-value, borrowing relative to individual’s income BoE, Quarterly Bulletin 2013,Q3, https://www.bankofengland.co.uk/quarterly-bulletin/2013/q3/macroprudential-policy-at- the-boe 5. The model relies on the capacity of the CB to forecast inflation which has proven to be subject to considerable uncertainty, i.e. http://www.bankofen gland.co.uk/publicati subject to large estimation errors. ons/Pages/inflationre port/irfanch.aspx Fontana and Setterfield (2010). Ch. 5 Critiques of the NCM approach: Closed economy Empirical problems: 6. The goal of price stability is not enough. Periods of price stability such as the “great moderation” of the 1990s and early 2000s were still followed by shocks. Source: Mankiw (7th ed.) Macroeconomics, p. 6. 7. Evidence of the link between Inflation Targeting (IT) and Inflation Moderation is far from unequivocal: i) CB’s simulation models show a modest influence of interest rates on inflation: a 1% rise in the CB’s interest rate reduces inflation by 0.41-0.75% over 5 years. i) Cross-country comparisons also show that countries that have not adopted IT have also enjoyed low inflation during the last 20 years (Ball and Sheridan, 2003). Fontana and Setterfield (2010). Ch. 5 Summary Extensions to the IS-PC-MR model: CB’s Inflation aversion: L=(𝑦1 − 𝑦𝑒 )2 +𝛽(𝜋1 − 𝜋 𝑇 )2 𝜋 MR for 𝛽=1 ‒ MR becomes flatter when the CB is MR for 𝛽>1 inflation-averse (𝛽>1). 𝜋𝑇 ‒ Intuition: When CB is inflation-averse it is willing to sacrifice more output MR for 𝛽