MONETARY POLICY 1

1
MONETARY POLICY - 1

• In this lecture I (a) summarize the UK monetary
  policy framework, (b) consider the appropriate
  level of the inflation target, (c) consider the
  logic of central bank independence.
• Elements of the UK regime
• 1. Inflation target, based since 2004 on the
  consumer price index, of 2
• Undefined horizon
• Requirement to support the general economic
  policies of the government
• Open letter if inflation outcome deviates by
  more that 1 from target
• Monthly meeting of the Monetary Policy Committee
  to set the short rate of interest

There is, therefore, constrained discretion,
notably as regards how quickly a given shock will
be counteracted. Bean1999, equation 10, is a
concrete example of this.
2
Level of the inflation target At what level
should the target be set - 0, 5, 10? Analyse
costs and benefits of anticipated
inflation Costs of higher inflation Good
discussion in Mankiw, 5th ed. ch.4.6. So-called
shoe-leather costs and menu costs.
Shoe-leather costs. How much M0 will an agent
hold, on average? There is a tradeoff. Infrequent
trips to the bank mean high average M0 holdings -
shoe-leather costs are low, but foregone interest
is high. Cost-minimizing agents strike a balance
between these costs. Higher inflation means a
higher nominal interest rate, and this (it can be
shown) induces agents to make more frequent trips
to the bank, incurring more shoe-leather costs.
To put it more informally, high inflation means
that the transactions costs benefits of a
monetary economy tend to be lost.
3
Milton Friedman took this argument to the limit
by pointing out that, since real money balances
can be produced at (essentially) zero marginal
cost, it would be optimal to arrange that their
marginal benefit was also zero. This would imply
a nominal interest rate of zero. If the long-run
equilibrium real rate of interest was, say 2,
this would imply an optimal inflation rate of
-2. The diagram below illustrates this idea.
i
marginal benefit
i0
(M/P)0
M/P
At interest rate i0 real money balances are
(M/P)0 and there is a consumers surplus loss
equal to the triangle to the right of (M/P)0.
4
Menu costs. These are simply the direct costs of
changing prices. Benefits of higher inflation
(1) Reduced likelihood of liquidity traps, since
the floor on the real interest rate is lower.
Consider the current (2005) case of the Euro
area inflation target below, but close to, 2,
short interest rate 2, fiscal deficits in
France and Germany that exceed 3 of GDP,
unemployment in France in excess of 10. (2) If
nominal wages are sticky downward, then real wage
flexibility is raised by higher inflation
(Akerlof et. al.). Empirics Simple plots of
GDP/head growth against the inflation rate, for
what little they are worth, suggest that
inflation starts to matter above about 8. E.g.
Sarel, IMF Staff Papers 1996 chart below.
Akerlof et. al, 1996, give direct evidence of
nominal wage rigidity.
Growth
Inflation
8
5
Central Bank independence (CBI) Summary. 1. CBI
has become common in recent years. Not the same
as inflation targetting! In UK, inflation
targetting started in 1992 and CBI was
implemented in 1997. 2. Logic of CBI based on
dynamic inconsistency of optimal monetary
policy. That is, governments may be tempted to
spring inflationary surprises on the economy in
order to lower unemployment. We will see that
this can produce a worse equilibrium than could
have been achieved if commitment to low inflation
had been possible. Barro-Gordon model. 3. Why
does CBI make a difference? Why, in other words,
is a central banker any more likely to respect
commitments than a politician? Three possible
reasons (a) conservative central banker theory,
(b) incentive payment theory, (c) delegation is
enough theory. (c) is probably correct (Bean
1999). 4. Has CBI worked?
6
The Barro-Gordon model the dynamic inconsistency
of optimal policy Basic idea. Zero inflation is
best, but if workers set zero wage inflation, the
government will be tempted to set positive price
inflation and force real wages down. Workers,
anticipating this, set positive wage inflation in
such a way that the government can do no better
than set price inflation equal to wage inflation,
holding the real wage constant. Formal model.
The underlying tension between workers and the
government arises because their desired positions
on the aggregate economys labour demand function
are different - points U and G in the diagram.
Real wage
It is easiest to imagine that there is a union,
which cares less than the government does about
the unemployed. So the union prefers a higher
real wage and a lower employment level than the
government does.
U
wu
G
wg
Lu
Lg
Employment
7
So the preferences are as follows. The union
wants wwu (LLu) and doesnt care about
inflation. The government wants wwg (LLg) and
p0. Its utility function can be written U(L, p)
-(L-Lg)2-a p2. What this utility function
implies is that if the government cannot achieve
both of its goals, it will compromise between
them. The parameter a is a measure of how much
the government dislikes inflation relative to
unemployment. The constraints are (a) that we
assume that we start with the union getting what
it wants (this will be justified), (b) that then
the union chooses the rate of growth of money
wages, denoted g(W), (c) that the government then
chooses p. What is going to happen? This
problem is best analysed with the use of reaction
functions, which you may have seen before in the
analysis of duopoly in microeconomics. So we
first think of how the union would react to given
p. Clearly, it would just set g(W) p, since that
would keep the real wage, w, and employment, L at
the original values, as the union wants. How
would the government react to given g(W)?
8
That is more difficult. Suppose g(W)0. Then if
the government sets p0, it is hitting its
inflation objective exactly, but missing its
employment objective. Suppose wg is 5 lower
than wu. Then if the government sets p5, it
misses its inflation objective, but hits the
employment objective exactly. Plainly it is going
to compromise and set p between 0 and 5.
C
The diagram shows the govt. reaction function BC,
intermediate between the extremes BO and BD,
which would achieve p0 and LLg respectively .
The bigger is a, the utility weight on inflation,
the steeper is the line BC.
g(W)
D
pg(W)5
O
p
E
5
45o
B
9
We can now put the model together. The union
reaction function is just a 45 degree line
through the origin, so the time-consistent
solution is at T. We get there because the union,
as first-mover, just picks its preferred point on
the governments reaction function, BC.
The union gets what it wants, justifying what we
assumed at the outset, and the economy suffers
inflation pT. Now suppose that the government
moved first it would now choose its best point
on the unions reaction function, the point O.
The union still gets what it wants, but now there
is zero inflation. So its definitely a better
outcome.
C
g(W)
U
T
45o
O
pT
p
R
5
B
10
This is the punch-line of the Barro-Gordon model.
We get inflation because unions dont trust the
government. If governments could somehow commit
themselves to zero inflation, the equilibrium
outcome would be better. What has this got to do
with Central Bank Independence? We now return to
reasons a, b and c on slide 5.
A conservative central banker BC rotates round
to BC this is equivalent to a rise in a.
Inflation falls in equilibrium. Incentive
payments to central bankers, proportional to the
inflation rate. BC shifts left, parallel to
itself, and with a big enough payment, it could
go as far as OC, lowering inflation to zero.
C
C
g(W)
U
C
T
45o
O
pT
p
R
B
11
How good are these explanations? Bean does not
like them. First the conservative central banker
theory. We have not proved this, but the theory
does not only imply that inflation will be
reduced. If there are supply shocks, that occur
after wage-setting, but before inflation-setting,
it can be shown that a conservative central
banker will let these shocks fall predominately
on output rather than on inflation. This should
mean that as inflation falls with CBI, output
variability should rise. There is no evidence
that this has happened (King 1997, table 2). What
about the incentive payment theory? Here it is
simply that such incentive systems have not been
used, except in one case. So why has CBI worked?
Beans delegation is enough story can be seen
via a reinterpretation of the utility function
(he makes it a little more complicated, in fact).
According to him, governments simply want high
output and low unemployment for electoral reasons
(so that Lg is just full employment), rather
than because they want to correct union-caused
labour market distortions. If that is so, then
delegating monetary policy to an independent
central bank may solve the Barro-Gordon problem,
simply by taking employment out of the utility
function. The reaction function is then the
y-axis and equilibrium inflation is zero.