Monetary Policy

Question 1

What are the Goals of Monetary Policy?

Answer 1

• Price Stability: Nominal anchor ties down the price level to achieve price stability
• High employment and output stability: Achieve the natural rate of employment {full employment}
• Economic Growth: Encourage investment to boost productivity
• Stability of Financial Markets: Promote stable financial markets to increase investment
• Interest-rate stability: Volatile interest rates creates uncertainty
• Stability in ForEx markets: Supports competitive exports and reduces import inflation

Question 2

Why is price stability preferred to other objectives?

Answer 2

• Time inconsistency: ST and LT conflict, thus the price stability should be preferred, as it has the highest violations: i.e. Phillips Curve
• If Inflation gets too high, people’s expectations change- meaning the central bank loses credibility
• In the LR, Unemployment is fixed, but at a higher inflation rate (NOT GOOD)

Question 3

What is the transparency function of the Central Bank?

Answer 3

• Absence of Asymmetric Information
• Transparency reduces uncertainty in the private sector
• Improves the C.B. incentive

Question 4

What is the independence function of the Central Bank?

Answer 4

• Freedom of policymakers from political parties
• Politicians have incentive for SR prosperity due to the political
• Bank has politcial and economic independence
• FOR: political bias reduce and could be used to facilitate treasury lending (HUGE deficit)
• AGAINST: Undemocratic, distributional issues, unaccountable, Co-ordination challenges

Question 5

What is inflation targeting?

Answer 5

• Framework aiming to preserve price stability and keep inflation in a desired range (2%)
• Achieved using a monetary policy rate
• Medium-term target -> increases transparency and accountbility
• ADV: No time inconsistency, increased transparency, consistent with democratic principles, C.B. perform better
• DISADV: Delayed signalling, too much rigidity, potential for larger output fluctuations, lower economic growth

Question 6

Should there such a strong committment to the nominal anchor?

Answer 6

• Different nation suse different weighting due to LR neutrality
• UK has hierarchical mandate; prioritising a ‘primary target’
• US has a dual mandate; calling 2 targets equally as important

Question 7

What are the tools and instruments that can occur in monetary policy? How can these impact the economy?

Answer 7

• TOOLS: OMOs, Reserve Requirement, QE, Forward guidance
• Tools are how we inject/withdraw liquidity
• INSTRUMENTS: Reserve aggregates or IRs
• Instruments are variables that respond to tools
• Tools -> Instruments -> Targets -> Goals

Question 8

How can you choose policy instruments?

Answer 8

• MEASURABILITY / OBSERVABILITY: Fisher equation
• CONTROLABILITY: IRs can be controlled easier than others
• PREDICTABILITY: Link between IR and goals

Question 9

What is the Taylor Rule?

Answer 9

• If there are two goals that are equally valued, how should a balance be reached?
• RULE: i = π + i * + 0.5(π - π * ) + 0.5(Y-Y * ). This is a weighted average of the inflation and output gap
• i * is the equilibrium FFR, keeping u fixed and π stable
• Illustrates that Real effects aren’t the same as nominal effects
• Taylor Principle- C.B. should raise i more than π- therefore, there is instability if δi < δπ, as r falls

Question 10

What are some lessons learnt from the GFC?

Answer 10

• ZLB for interest rates- as shown by the fisher equation
• Cost of clearing up a crisis is substantial
• Price and Output stability is not financial stability
• Unconvetional policies such QE (Asset Purchasing)
• Under QE: C.B. increase balance sheet, increase price pressure on LT bonds, reduces the long term IR, increases liquidity
• Portfolio rebalancing: investors look towards to riskier assets

Question 11

Should a Central Bank respond to bubbles?

Answer 11

• Asset bubbles are departures from the fundamental values of an asset- which will eventually burst
• CREDIT BUBBLE: GFC, WSC
• SPECULATIVE BUBBLE: .com, Cryptocurrencies
• VERY tough to identify given the CAPM
• Monetary policy effects all prices, not just that asset
• Raising IR could be useless given the abnormal conditions

Question 12

If direct intervention should be avoided, what approach should a central bank take?

Answer 12

• Macroprudential looks more appropriate
• Automatic Stabilisers ‘Lean against the Wind’
• Should establish capital requirements, monitor FI risk, respond to wider conditions