EC2B5 readings Flashcards
(17 cards)
What is Inflation Targeting & Why Adopt It? - Bernanke and Mishkin
Definition & Core Idea:
Inflation targeting (IT) is a monetary policy framework where a central bank announces a numerical inflation target (usually around 2%).
The goal is to anchor expectations, improve transparency, and increase accountability without enforcing a rigid rule.
Why Adopt IT?
Collapse of exchange rate pegs (e.g. UK, Sweden) created need for a new nominal anchor.
Failure of money supply targeting (e.g. Canada) led to policy instability.
IT helps lock in low inflation achieved through prior disinflation efforts.
Supported by theory: monetary policy has no long-run impact on output, but does influence inflation; credibility and expectations matter.
Example:
BoE targets CPI at 2%, writes public letters if off target.
NZ law allows firing the governor for missing target.
IT as a Framework (Not a Rule) - Bernanke & Mishkin
Bernanke & Mishkin’s Main Argument:
IT is not a strict rule like Friedman’s money growth targets.
Best understood as “constrained discretion”:
Anchors long-term inflation expectations
Allows short-run flexibility to respond to shocks, output, or exchange rates
How Flexibility is Built In:
Use of target ranges (e.g. 1–3%) rather than point targets
Excludes volatile items (food, energy) from official CPI
Use of escape clauses (e.g. Bundesbank’s “unavoidable inflation” after oil shocks)
Gradual disinflation paths accepted (e.g. NZ’s slow convergence)
Critique of Rule-Based Views:
IT isn’t a mechanical formula.
Instead, central banks use models, forecasts, and judgment to steer toward inflation goals.
Avoids the rigidity and output volatility caused by pure rules.
Communication, Credibility, and Criticism - Bernanke & Mishkin
Communication & Transparency:
IT improves public understanding and market expectations.
Central banks publish:
Inflation forecasts
Justifications for actions (e.g. BoE fan charts)
Clear link between short-term actions and long-term inflation outlook
Accountability Mechanisms:
Public reporting holds banks responsible (letters, reports, parliamentary scrutiny)
IT helps resist political pressure (e.g. pre-election stimulus)
Criticism & Limitations:
Too narrow? IT may overlook output/employment in crises.
Credibility not automatic: Must be earned through performance.
Sacrifice ratio not clearly improved (IT may not reduce output loss during disinflation).
Expectations only adjust gradually — announcement isn’t enough.
IT vs Dual Mandate:
IT: Single goal (inflation) = clarity + discipline
Dual mandate (e.g. Fed): Inflation + employment = flexibility, but less predictability
Bernanke & Mishkin support formalizing IT to preserve success after leadership changes.
Why Price Stability Wasn’t Enough - Charlie Bean
Main Idea:
Before the 2008 crisis, central banks kept inflation low and stable — this was seen as a big success.
But at the same time, credit and asset markets (like housing) were growing dangerously.
Low interest rates, used to control inflation, may have encouraged too much borrowing and risk-taking.
What Really Caused the Crisis?
It wasn’t just monetary policy — other important factors played a role:
- High savings in countries like China lowered global interest rates.
- Investors felt too safe during the “Great Moderation” and took bigger risks.
- Banks used complex financial products (like securitisation) that hid how risky they really were.
- Bad incentives and weak rules meant banks were not prepared for losses.
Bottom Line (Author’s View):
Focusing only on inflation gave a false sense of security.
The crisis showed that financial risks can build up quietly, even when inflation looks fine.
So central banks need to care about more than just price stability — financial stability matters too.
Leaning Against the Wind vs Cleaning Up After - Charlie Bean
Two Views on Crisis Prevention:
Leaning Against the Wind (Bill White / BIS):
Central banks should raise interest rates above inflation target if leverage or asset prices look dangerous.
Willingness to accept short-term inflation/output volatility to reduce future crisis risk.
Cleaning Up After (Alan Greenspan):
Focus on minimising post-crisis fallout, not prevention.
Saw pre-emptive action as too blunt or economically damaging.
Author’s Judgment:
In theory, leaning against the wind is reasonable.
In practice, it may require very high rates to curb a credit boom → potential recession.
Therefore, we need a second instrument: macroprudential policy.
Macroprudential Policy – The Missing Tool - Charlie Bean
Why We Need It:
With two goals (price stability + financial stability), we need two instruments.
Monetary policy (R) = controls inflation
Macroprudential tools (K) = manage leverage, credit cycles
Types of Macroprudential Tools:
1. Resilience-focused:
e.g. Countercyclical capital buffers → absorb shocks in busts
- Pre-emptive tools:
e.g. Loan-to-value/income caps, sectoral risk weights → reduce risky borrowing
Model Insights:
PS Curve (price stability) is steep → best managed by monetary policy.
FS Curve (financial stability) is flatter → macroprudential tools can handle credit growth with little effect on AD.
Limits & Realism:
Macroprudential tools can be evaded, not yet battle-tested.
Monetary policy “gets into all the cracks” (Jeremy Stein) — may still be needed when K is ineffective.
Hence, UK MPC’s remit now allows temporary inflation deviations if needed for financial stability.
Final Analogy:
Like Joseph in Genesis — prepare in good times for the inevitable bad ones.
Lesson: Future stability requires prudence, not just inflation control.
Why Banks Are Risky – And Why It Matters (The Economist)
Core Argument:
Banks serve a vital function — linking savers to borrowers — but are inherently fragile.
Their assets (loans) are long-term and illiquid, while their liabilities (deposits) can be withdrawn instantly → creates risk of bank runs.
Risks Identified:
If depositors panic (even without cause), they rush to withdraw → leads to forced asset sales and insolvency.
Systemic risk arises from contagion effects — fear spreads from one bank to others, triggering a banking panic.
Author’s Emphasis:
Banks try to protect themselves with liquidity (cash, bonds) and capital (equity), but in crisis, this may not be enough.
Government backstops (like deposit insurance and central bank liquidity) are critical to stop panics.
However, deposit insurance also creates moral hazard — if depositors are always protected, they stop disciplining risky banks.
From Leverage to Crisis – The Root of Instability (The Economist)
Core Argument:
Before the 2008 crisis, banks were highly leveraged and focused on short-term profit.
Example: RBS and Citi had 50:1 leverage — they could only absorb a 2% loss.
Key Issues:
Profit incentives and bonus systems rewarded short-term gains, encouraging risk-taking and low capital buffers.
As asset returns fell in the 2000s, banks boosted profits by:
Reducing holdings of safe (low-yield) assets.
Borrowing more (leverage) to increase returns on equity.
Author’s Conclusion:
This dynamic made banks brittle and vulnerable, with insufficient buffers to absorb even small shocks.
Hence, even a relatively contained problem (like US subprime) triggered a global crisis.
Making Banks Safer – Policy Tools and Trade-offs (The Economist)
Core Reforms:
Basel III: stronger capital rules, liquidity requirements, lower leverage, and countercyclical buffers (more capital in booms, less in busts).
Too Big To Fail problem:
Big banks expect bailouts → take more risk.
Responses include: breaking up banks, Volcker Rule (bans proprietary trading), and ring-fencing of retail banking.
Ongoing Trade-offs:
More equity = safer banks, but bankers argue it reduces lending and profits.
Academics (Admati & Hellwig) disagree: equity reduces risk, doesn’t reduce credit as much as banks claim.
A compromise: CoCos (contingent convertibles) — bonds that convert into equity in bad times.
These:
absorb losses.
Encourage investor monitoring (since creditors bear risk if things go wrong).
Author’s Message:
Reforms must balance stability and efficiency.
No perfect fix — but stronger buffers, better incentives, and smarter oversight are essential to avoid repeating past mistakes.
What is QE and Why Use It? - the economist
Key Context:
With interest rates near zero (e.g. post-2008 crisis), central banks ran out of conventional tools.
QE (Quantitative Easing): central bank creates money to buy assets, especially government bonds.
Main Goals:
Stimulate the economy by:
Lowering long-term interest rates
Raising asset prices (via portfolio rebalancing)
Encouraging borrowing and spending
Boosting confidence through commitment to prolonged monetary support
Authors’ Point:
QE became the most widely used unconventional policy of the crisis era.
Used by the Fed, BoE, and (eventually) ECB, especially when traditional rate cuts were no longer possible.
How QE Works and Where It Helps Most - the economist
Mechanisms of QE:
Portfolio rebalancing: Investors sell bonds to the central bank, then buy riskier assets → raises their prices, lowers yields.
Supports government borrowing: Lower yields = cheaper debt → less pressure for austerity.
Signals commitment: QE shows central banks are serious about keeping rates low, anchoring expectations.
Euro Area Application:
Although the ECB can’t finance governments directly, QE can still reduce borrowing costs and ease austerity pressures.
May also weaken the euro → boost exports.
Could support reform momentum by making recession less severe.
Author’s View:
QE’s effects are most needed — and potentially most powerful — where markets are under the most stress (e.g. eurozone periphery).
Does QE Work? Evidence and Concerns - the economist
Evidence of Impact:
Studies from Fed and BoE suggest:
↓ interest rates
↑ GDP by 2–3%
↓ unemployment by ~1.5 percentage points
↑ inflation (modestly)
QE1 and QE2 in the US possibly added 3 million jobs by late 2012.
Mixed Results:
In Japan (2000s), QE failed to stimulate lending → economy stagnated.
→ Known as the “Lost Decade”.
Risks & Criticisms:
Banks may hoard reserves → no new lending.
Exit risks: unwinding QE (e.g. asset sales) could cause rate spikes or market volatility.
Example: 2013 “Taper Tantrum” after Bernanke hinted at slowing QE.
Critics argue gains are modest, while long-term consequences are unclear.
Author’s Tone:
Cautiously optimistic: QE helps, but it’s no silver bullet. Benefits must be weighed against risks, especially in the exit phase.
Why Grexit Was Back on the Table in 2015 - the economist
Greece, under Syriza, resisted creditor-imposed reforms; bailout talks stalled.
Some argued Grexit could help:
Default would erase unsustainable euro-denominated debt (~180% of GDP).
Drachma devaluation (~50%) might restore competitiveness and boost exports/tourism.
Greece had a primary surplus and current account surplus, suggesting it could manage without external loans.
Advocates saw exit as a way to end creditor control and austerity.
🧠 Author’s View: These benefits are theoretical and overstated — Grexit would trigger deeper damage.
Why Grexit Would Be Costly for Greece - the economist
Reintroducing the drachma = messy and chaotic:
IMF forecast: GDP down 8%, inflation up to 35%, widespread disruption.
Loss of confidence: Investors would view Greece as unreliable, harming recovery.
Debt relief illusion: Greece already benefits from:
Very low interest rates (~3% of GDP).
Long maturities (to 2050s), deferred payments until 2022.
Devaluation benefits limited:
Exports are a small part of GDP.
Internal devaluation (fall in wages) had already improved competitiveness.
Inflation risk and weak central bank independence would undermine gains.
📉 Author’s Conclusion: Grexit would worsen Greece’s economic prospects, not solve them.
Risks for the Eurozone & Final Verdict - the economist
Eurozone risk has decreased since 2012:
ECB’s QE and OMT policies contain contagion.
Greek bond turmoil didn’t spread to Spain/Italy.
Some argue Grexit might help:
Sends a message: rule-breakers can be expelled.
Weakens anti-austerity movements like Podemos.
BUT: Letting Greece go breaks the idea that euro membership is permanent → turns euro into a glorified fixed-exchange-rate regime.
EU might also face higher default losses and potential humanitarian aid costs.
✅ Author’s Verdict: Despite political tension, a deal is better for both sides — Grexit still costs more than it gains.
Suppose you are advising on the negotiations between Greek Prime
Minister Alexis Tsipras and the Troika on the terms of the third bail-out
package to Greece. Discuss the pros and cons of Greece’s option to reject the
terms of the bail-out deal and consequently be ejected from the euro (Grexit),
from the perspective of (i) Greece and (ii) other members of the Eurozone.
- the economist, Carmen Reinhart
(i) Greece
Pros:
* Reintroduction of the drachma is likely to entail sharp depreciation
against the euro, boosting export competitiveness and growth.
* Greece can write off its oppressive debt burden.
* An end to austerity measures and their recessionary impacts (Ricardian
Equivalence does not hold in a financial crisis).
* Supply-side reforms might be more likely to be implemented as (i) they
can be combined with expansionary monetary policy and (ii) the benefits
will accrue to Greece rather than its creditors, thus increasing incentives
to undertake the painful reforms.
Cons:
* Austerity measures might be even worse if Greece defaults – primary
budget deficit would need to be reduced from 10% to 0% almost
overnight, as further bailout loans would not be available. Should be
weighed against generous debt repayment terms enjoyed by Greek
government (very low interest rates and maturity extensions).
* Investor confidence would be shattered if Greece defaults, raising long
term borrowing costs.
* Currency depreciation would increase import prices, leading to surge in
inflation (Bank of Greece does not possess the anti-inflationary track
record and anchoring effect of ECB).
* Gains from boost to export competitiveness could be limited given that
Greek export share of GDP is relatively low, (ii) there has already been
significant real wage depreciation and (iii) high inflation would erode
gains in competitiveness.
* Forcible conversion of euro bank deposits to drachma is likely which
would massively depreciate in value, thus gutting depositors’ savings.
* Could lead to capital flight and surge in risk premia (e.g. Argentina’s
(2002) experience of quitting dollarization).
* Transitional costs of introducing a new currency (introducing new
banknotes, re-denomination of prices and contracts).
* Structural reforms and fiscal discipline might fail without the pressure of
external creditors.
(ii) Eurozone creditors
Pros:
* No more throwing good money after bad.
* Eurozone becomes closer to an optimal currency area.
* A hard-line stance might spur fiscal prudence and structural reform
among the remaining members who want to avoid similar exit.
Cons:
* Grexit might lead to contagion whereby panic in the bond markets pushed
one country after another into default, potentially leading to collapse of
the euro.
* Forfeit of debt repayments, and might also need to provide large amounts
of aid if Grexit led to a humanitarian disaster.
* Membership of the euro no longer seen as irrevocable, making it
vulnerable to speculative attack
The nation of Ireland and the state of Nevada have much in common. Both
are small economies highly dependent on selling goods and services to their
neighbours. Both were boom economies for most of the past decade. Both had
huge housing bubbles, which burst painfully and are now suffering high
unemployment. And both are members of larger currency unions: Ireland is
part of the euro zone, Nevada part of the dollar zone. Which is more suited to
remaining in their respective currency union – Nevada or Ireland? - Paul Krugman
Nevada is more suited to remaining in its currency union, because it has stronger adjustment mechanisms than Ireland to cope with asymmetric
shocks.
Trade integration: Ireland trades relatively little with its Eurozone neighbours - its chief export markets are the US and UK (and trade among euro nations is only 10 or 15 percent larger than it would have been had the euro not been created).
Real wage flexibility: Real wages are relatively inflexible in Ireland (in the
euro crisis, it took Ireland two years of severe unemployment to achieve about a
5 percent reduction in average wages).
Labour mobility: Americans are more mobile than Europeans, due to
cultural integration, a common language and a less generous welfare system.
Fiscal federalism: unlike Ireland, Nevada benefits from a system of fiscal
transfers from the federal government, e.g. social security payments are
increased during recessionary conditions.
Banking union: US states are bound by a banking union with a common
resolution mechanism for dealing with failing banks. Hence, Nevada does not
have to bear the costs of financing bank bailouts, as these are undertaken by
the Federal Reserve. This was not the case for Ireland during the euro crisis,
which therefore entered the “doom loop”. However, the Krugman article was
published before the Eurozone adopted banking union in 2012
