Finpoly Module 2 PDF

FINPOLY - MODULE 2 - monetary stability - stability of the value of money in general Modern Central Banking Perspectives Terms are often interchangeable since in K...

FINPOLY - MODULE 2 - monetary stability - stability of the value of money in general Modern Central Banking Perspectives Terms are often interchangeable since in Key Central Banking Mandates general it almost has the same root cause Monetary Stability and context - Refers to the stability of the value of the currency, whether in terms of Financial stability domestic or overseas purchasing - At simplest level an environment in power which the financial sector can - Thus encompasses price stability, perform its intermediary function and can be used interchangeably in smoothly and without disruption certain contexts Financial Stability Liquidity shortages - Still no universally agreed-upon - Key players failed to meet their definition, but often refers to smooth short-term financial obligations functioning of the financial system and robustness against shocks Overindebtedness of Economic Agents - Thus encompasses many of the - Economic agents refer to traditional central banking functions, households, firms, and the such as payment system oversight, government lender of last resort, and banking Borrowers unable to repay their supervision loans, lenders would also find Full Employment themselves in trouble - Quite uniquely, the Federal Reserve has “price stability and full Full employment employment” as its mandate - Not a popular mandate of central - Until recently, the Federal Reserve banks as it is controversial in some has underplayed the full employment way mandate, preferring to suggest that - All labor resources are used in most full employment can be achieved efficient way through price stability - Achieving maximum output in the economy with expectations on Monetary Stability boosting the economy - Situation in which the value of money does not fluctuate too much Theoretical Foundations of Monetary (either gaining or losing in value too Policy * quickly) - Central banks often follows credible rules that aims for low and stable Monetary Stability vs Price stability inflation environment Monetary stability is closely related price stability The Quantity Theory of Money - Price stability - refers to domestic purchasing power of the currency  - Describes relationship between money, economic activity and the general price level in the long run - In the long run, total output of the economy depends on non-monetary factors such as capital, labor input, and technology - Represented by the equation of exchange MxV=PxQ M = quantity of money circulating in the economy The Natural Rate of Unemployment V = velocity of the circulation of money - Examines inflation and P = general price in the economy unemployment data in more detail Q = quantity of goods sold and taking into account the role of expectations P x Q = can be considered as GDP - Unemployment rate corresponds to fundamentals of the economy and ⬆️ money circulation = inflation or when the unemployment rate is at a particular rate, inflation rate will not hyperinflation change The Phillips Curve - Natural Unemployment rate exists - Suggests that monetary policy can due to transitory unemployment - be used to directly influence fresh graduates, migrants etc. economic activity and output in the - Also known as Non-accelerating short run inflation rate of unemployment - Uses Inflation Rate and (NAIRU) Unemployment Rate as factors to fine tune the economy NAIRU vs Phillips curve - As prices and inflations adjust in the long run, short run Phillips curve shifts up vertically making the long run Phillips curve vertical at the NAIRU  agents would anticipate the policy and raise their expectations of future inflation accordingly; at the extreme the effects would be that the inflation rate would adjust but not unemployment Time Inconsistency Problem - Points out that without a binding rule, policy maker can just retreat from their announced policies - Tests the credibility of central banks to deliver the announced policies, for Rational Expectations Hypothesis the public to trust such - Developed to address shortcomings announcement in economic theories (or applications - Monetary policy rules should be in of theories) based in adaptive place to make policy actions to be expectations credible and effective since the - Adaptive expectations - public knows that policy makers do expectation of the future value is not have the discretion to easily based on its past values retreat from their actions Has two (2) important implications for - Central bank should be operationally conduct of monetary policy independent from political 1. Lucas critique interference so it can follow its 2. Policy ineffectiveness Proposition chosen monetary policy rule effectively Rational Expectations Hypothesis - Lucas Critique Tools Strategies and Tactics of Monetary - Proposes that the effort to conduct Policies economic policy entirely on the basis There are five (5) key monetary policy rules of relationships observed in highly or regimes that aims to keep inflation low aggregated historical data is futile, and stable to provide the price level and as individuals change their decisions economic stability needed for long run in response to the introduction of the economic growth policy 1. Exchange Rate Targeting - Use of model to the parameters that 2. Money Growth rate Targeting govern individual behavior at the 3. Risk Management Approach microeconomic level 4. Inflation Targeting 5. Unconventional Monetary Policy Rational Expectations Hypothesis - Policy Ineffectiveness Proposition - If central bank attempts to lower unemployment (rate) through a loose monetary policy, economic  - If money supply growth is consistent at a target rate then inflation is low and stable Risk Management Approach - No announced specific targets for monetary supply growth or inflation rate - Closely monitors various economic data and acted in a forward-looking manner, in order to maintain price stability and minimize risks to employment and economic growth - Uses short term policy interest rate Monetary Policy Independence and adjust it accordingly - Central bank does not truly have the independence to conduct monetary Inflation Targeting policy as it sees fit - Aims inflation within a specific target - Central bank may need to vary over a specific time frame money supply to match the changes - Often uses a short-term interest rate in demand for currencies rather than or policy interest rate adjusting domestic money conditions - Extreme form of exchange rate targeting is the use of currency board, where exchange rate are fixed at a particular level the local currency is legally required to be backed up by foreign currencies held by the central bank Impossible Trinity Exchange Rate Targeting, Free Capital Flows and Independent Monetary Policy - Numerous central banks are Unconventional Monetary Policy abandoning Exchange Rate - Central bank has already pushed the Targeting as their monetary policy policy interest rate down to near rule as it is impossible to maintain a xero, but the economy needs further fixed exchange rate while fine tuning stimulus the domestic economy at the same - To compliment, central banks time response may be the following three sets of tools Money Supply Growth Targeting 1. Lending to financial - Setting a target rate for growth of institutions money supply based on quantity theory of money  2. Providing liquidity to key credit markets 3. Purchasing long term securities Providing / Restoring Liquidity - The purchase of government securities from the private banks will put money in their hands to lend to private individuals and spur economic activity Purchasing Long-Term Securities - Often known as Quantitative Easing - Not only adjusting policy interest rates but also easing shortages of liquidity in the economy by injecting quantity of money into the hands of the private sector - Central banks buy up long-term government securities to banks - The private banks uses government yield as a benchmark when calculating interest rates for borrowing and lending