CONDUCT OF MONETARY POLICY: OBJECTIVES AND STRATEGIES

1
Lecture 9

• CONDUCT OF MONETARY POLICYOBJECTIVES AND
  STRATEGIES

2
The monetary policy goals of the ECB

• The primary objective of the European System of
  Central Banks (ESCB) is to maintain price
  stability.  
• Without prejudice to the primary objective of
  price stability, the ESCB shall support the
  general economic policies in the Community with a
  view to contributing to the achievement of the
  objectives of the Community.
• In pursuing its objectives, the ESCB shall act in
  accordance with the principle of an open market
  economy with free competition, favoring an
  efficient allocation of resources.

3
Transmission processes of policies

• Central banks, cannot control the price level
  directly. They face a complex transmission
  process from their own monetary policy actions to
  changes in the general price level.
• These transmission mechanisms are characterized
  by the existence of several distinct channels,
  each with long, and variable reaction lags.
• Moreover, the transmission mechanisms themselves
  are continuously evolving over time due to
  behavioral and institutional change.

4
Policy goals and targeting

• The strategy of central banks is to aim at
  variables between the goals to be achieved and
  the tools available
• Intermediate targets. These can be monetary
  aggregates (M1, M2, M3) or interest rates (short,
  long).
• Operating targets (or instruments) They can be
  directly adjusted (monetary base, reserves,
  minimum bid rate of the main refinancing
  operations).

5
What instruments has a central bank?

• Open market operations. Purchases in the open
  market causes the short-term interest rate
  (federal funds rate) to fall.It affects the
  supply of reserves

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What instruments has a central bank?

• Discount lending. It also raises the quantity of
  reserves supplied which causes the short-term
  interest rate (federal funds rate) to fall.

7
What instruments has a central bank?

• Reserve requirements. It increases the quantity
  of reserves demanded which causes the short-term
  interest rate (federal funds rate) to increase.

8
Advantages of OMOs

• OMOs are under the full control of a central
  bank. This is not the case for discount
  operations.
• OMOs can be carried out in small quantities to
  smooth developments.
• OMOs can easily be reversed (repos).
• OMOs can be implemented without delays.

9
Characteristics of discount policy

• The main advantage is that the central bank can
  use it in its function as lender of last
  resort.
• But there are three main disadvantages
• The announcement of a discount rate change can
  create confusion if it contradicts the policy
  stance.
• If the discount rate is set at a given level,
  the spread between id and the market interest
  rate can vary wildly.
• Discount operations are difficult to reverse.

10
Characteristics of reserve requirements

• The advantage is that they affect all banks
  equally and have an effect on the supply of
  money.
• But reserves requirements are hard to engineer
  because of multiple deposit contractions
  (expansions).
• Raising reserve requirements can cause immediate
  liquidity problems.

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Reserve requirements in the Euro area
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Should reserve requirements be reformed?

• Should they be abolished?
• Reserve requirements should be retained to
  produce a more stable money multiplier, which
  facilitates monetary control.
• Reserves should bear interest.
• Should the reserves be 100 percent?
• It would allow to strictly control the money
  supply.
• But banks can no longer make loans.

13
Targeting the NASA strategy

• By analogy, NASAs strategy of sending spaceships
  to the moon also works through operating
  targets.
• The pace of spaceships is continuously adjusted
  to intermediate targets, and finally to the
  goal.

14
Example of central bank strategy

• Suppose the central banks price-level goal is
  consistent with a nominal GDP growth rate of 5.
• The bank may then feel that this goal can be
  achieved
• by a 4 growth rate for M2 (intermediate target),
  and
• by a 3.5 growth rate for the monetary base
  (operating target tool).

15
Adjustments of central bank policy

• After implementing the policy, the central bank
  may fine-tune, for instance
• because the monetary base may be growing too
  slowly (which calls for an increase of OMO
  purchases)
• or M2 may not grow in line with the monetary base
  (which also requires an adjustment of policy
  instruments such as OMOs).

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Types of target variables

• The central bank has the choice between two
  different types of target variables
• monetary aggregates (monetary base, reserve
  requirements, M1, M2, M3, etc.)
• and interest rates.
• Can a central bank pursue both targets at the
  same time?

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The answer is no! Why?

• If a monetary aggregate is used, the control of
  the interest rate is lost

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Quantity-oriented strategy problem

• If the money demand curve shifts unexpectedly,
  the interest rate will fluctuate

Ms
Md
M
Quantity of money
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Interest rate-oriented strategy problem

• In order to keep the interest rate at a given
  level (target), the central bank must accept
  variations in monetary aggregates

Ms
Msl
Msu
Mdu
Targetrate
i
Md
Mdl
Quantity of money
20
What criteria to decide on the target?

• There are three criteria for choosing an
  intermediate target
• It must be accurately measurable, and the
  indicator should be available rapidly
• it must be controllable by the central bank
• and it must have a predictable effect on the
  policy goal.

21
Measurability

• GDP figures and price indices become available
  only after a time lag, and they are often
  revised.
• Monetary aggregates are obtained quicker (2
  weeks), but are often revised.
• Interest rates are obtained instantly and are not
  revised.
• Are interest rates the best target?

Be careful What we need are real interest rates!
22
Controllability and predictability

• A central bank has the ability to exercise a
  powerful effect on the money supply, although
  control is not perfect.
• Although it appears that the central bank can
  also control interest rates, it cannot fully
  control inflationary expectations.
• The linkage between intermediate targets and the
  policy goal is controversial, so the
  predictability issue is highly contentious.

23
A historical perspective the Fed

• When the Fed was created in 1914, the discount
  rate was the primary tool.
• OMOs were not yet discovered, and the Federal
  Reserve Act had no provisions to change reserve
  requirements.
• The policy was based on the real bills doctrine
  (loans only for productive purposes) ? which
  papers are eligible.

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The Fed after World War I

• By the end of World War I, the (re-)discounting
  of eligible papers (including Treasury bills) had
  led to inflation, and the real bills doctrine
  became discredited.
• The Fed abandoned its passive role, and it
  increased the discount rate from 4.75 to 7 in
  1920, which (after a short recession in 1920-21)
  brought inflation under control.
• This paved the way for the Roaring Twenties.

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The discovery of OMOs

• The Fed discovered open market operations by
  accident
• It revenue (mainly from discount loans to member
  banks) shrank during the 1920-21 recession, so
  the Fed was under pressure.
• It reacted by purchasing income-earning
  securities to compensate for the losses.
• It then discovered that reserves in the banking
  industry grew (credit multiplier).

26
World War I and the Reichsbank

• In 1914, the Reichsbank had suspended
  redeemability of its notes in gold.
• Much of the government borrowing was discounted
  by the Reichsbank.
• At the end of the war, money in circulation had
  increased four-fold.
• The consumer price index had risen 140 by
  December 1918.
• Yet floating debt of the Reichsbank had increased
  from 3 to 55 billion marks.

27
The Reichsbank After WW I

• Inflation was fueled by
• Germanys reparation payments, which triggered a
  devaluation of the mark.
• A decline in confidence in the mark.
• Hoarded savings entered the market place.
• By February 1920, the price index was 5 times as
  high as at armistice, but it held almost stable
  for 15 months.
• This chance of monetary policy was spoiled.

28
The pace to hyperinflation

• During these fifteen months the government kept
  issuing new money.
• The currency in circulation increased by 50 and
  the floating debt of the Reichsbank by 100,
  providing fuel for a new outbreak.
• In May 1921, price inflation started again and by
  July 1922 prices had risen 700.
• After July 1922 the phase of hyperinflation began.

29
The German hyperinflation 1922-23
30
Stabilization program of 1923/24

• In November 1923, a currency reform was
  undertaken.
• A new bank, the (private) Rentenbank, was to
  issue a new currency the Rentenmark.
• This money was exchangeable for bonds backed up
  by land and industrial plant
• A fixed amount of 2.4 billion Rentenmarks was
  created, and each Rentenmark was valued at one
  trillion old paper marks.
• The Rentenmarks held their value. Inflation
  ceased even for the Reichsmark.

31
Completing the 1923 reform

• In August 1924 the reform was completed by the
  introduction of a new Reichsmark, equal in value
  to the Rentenmark.
• The Reichsmark had a 30 gold backing. It was not
  redeemable in gold, but the government undertook
  to support it by buying in the foreign exchange
  markets as necessary.
• The Reichsbank became independent from the
  government and government loans were limited.
• Drastic new taxes were imposed, and with the
  inflation ended, tax receipts increased
  impressively. In 1924-1925 the government had a
  surplus.

32
The Roaring Twenties and the Fed

• The stock market boom of 1928/29 created a
  dilemma for the Fed
• tempering the boom would have required a higher
  discount rate
• the Fed hesitated to do that because of
  legitimate credit needs
• When the discount rate was finally raised (August
  1929), it was too late.

33
The Bank Panics of 1930-33

• Substantial withdrawals from banks ended in a
  full-fledged panic at the end of 1930.
• One bank after the other closed, but the Fed did
  not perform its role as lender of last resort.
• It did not understand the impact of bank failures
  on money supply and economic activity.
• Moreover there was political haggling that
  entailed policy inactivity.

34
The switch to monetary targeting

• In the early 1970s (Arthur Burns), the Fed
  adopted a policy of monetary targeting, but its
  commitment to the new policy was weak.
• (The Bundesbank followed in 1974.)
• The policy was to pre-announce target ranges for
  the growth rates of money aggregates.
• However the Fed continued to use the federal
  funds rate as an operating target.
• In 1979 (Paul Volcker) the Fed officially changed
  its policy, using reserves as the instrument.

35
Returning to interest-rate policies

• Once inflation was checked, the Fed deemphasized
  monetary aggregate targets and returned to a
  policy of smoothing interest rates.
• In 1993, Alan Greenspan testified in Congress
  that the Fed would no longer use monetary
  targets.
• During the 1990, with strong growth and low
  inflation, the Fed focused on interest rate
  policies, with a defensive stance.

36
The ECBs monetary policy strategy

• The ECB's stability-oriented monetary policy
  strategy consists of three main elements a
  quantitative definition of price stability, and
  the two "pillars" used to achieve this objective.
  
• These two pillars are
• a prominent role for money, as signaled by the
  announcement of a quantitative reference value
  for the growth rate of a broad monetary
  aggregate
• and a broadly based assessment of the outlook for
  price developments and risks to price stability
  in the euro area as a whole.

37
The definition of price stability

• The Governing Council of the ECB has adopted the
  following definition
• Price stability shall be defined as a
  year-on-year increase in the Harmonized Index of
  Consumer Prices (HICP) for the euro area of below
  2.
• Price stability according to this definition is
  to be maintained over the medium term.

38
Quantitative reference value

• To signal the prominent role it has assigned to
  money, the Governing Council announces a
  quantitative reference value for monetary growth
  as one pillar of the overall stability-oriented
  strategy.

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Reference value problems

• First, to ensure that the reference value is
  consistent with the maintenance of price
  stability, money must have a stable relationship
  with the price level. The stability of this
  relationship is typically assessed in the context
  of a money demand function.
• Second, substantial or prolonged deviations of
  monetary growth from the reference value signal
  risks to price stability over the medium term. It
  requires that monetary growth is a leading
  indicator of price developments.

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Money demand (velocity) in the Euro area
41
The broadly based outlook for prices

• It is based on a large number of indicators.
• The range of indicators includes many variables
  that have leading indicator properties for future
  price developments.
• They include, inter alia, wages, the exchange
  rate, bond prices and the yield curve, various
  measures of real activity, fiscal policy
  indicators, price and cost indices and business
  and consumer surveys.