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Monetary Lent Topic4

The document discusses the goals that monetary policy should aim to achieve, including average inflation, inflation stability, and stabilization of output and employment fluctuations. It analyzes considerations for each goal such as the shoe-leather costs of inflation, relative price dispersion from price stickiness, menu costs of price adjustment, and the zero lower bound on interest rates. The optimal monetary policy goals are argued to be zero average inflation and price stability to minimize inefficiencies.

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Sebastian Muñoz
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0% found this document useful (0 votes)
67 views45 pages

Monetary Lent Topic4

The document discusses the goals that monetary policy should aim to achieve, including average inflation, inflation stability, and stabilization of output and employment fluctuations. It analyzes considerations for each goal such as the shoe-leather costs of inflation, relative price dispersion from price stickiness, menu costs of price adjustment, and the zero lower bound on interest rates. The optimal monetary policy goals are argued to be zero average inflation and price stability to minimize inefficiencies.

Uploaded by

Sebastian Muñoz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 45

EC321 : Monetary Economics

Topic 4 — Goals of monetary policy & Optimal monetary policy

Kevin Sheedy

LSE

Lent term 2014

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 1 / 45


Goals of monetary policy

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 2 / 45


Goals of monetary policy

What goals should monetary policy aim for?


1 Average rate of inflation?
2 Stabilization of inflation fluctuations?
3 Stabilization of output and employment fluctuations?
4 Other possible goals:
I Exchange rate stability
I Financial stability
I Avoiding bubbles in asset markets

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 3 / 45


Inflation
Average inflation rate?
Stability of inflation?

Considerations:
Shoe-leather cost of inflation
Relative-price dispersion due to price stickiness
Menu costs of price adjustment
Redistribution of wealth owing to nominal contracts
Distortions resulting from lack of indexation in tax system
Zero lower bound on nominal interest rate
Statistical bias in inflation measurement
Downward nominal wage rigidity

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 4 / 45


Shoe-leather cost of inflation
Increasing amount of money held provides a benefit in terms of
facilitating transactions
Opportunity cost of holding money for individual agents is
positively related to nominal interest rate i
Marginal cost of supplying money ≈ 0
Hence:
With a positive nominal interest rate, agents will economize on
holding money
Inefficient because private cost is really just a transfer
(seigniorage revenues for government)
Social cost of provision is essentially zero
Efficiency requires individual agents to face no private cost of
holding money
Friedman rule: Reduce nominal interest rate to zero
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 5 / 45
Shoe-leather cost of inflation
Demand curve for real money balances represents marginal private
benefit of holding money. With zero social cost, deadweight loss is
area under demand function minus consumer surplus:

i
consumer surplus

dead weight loss


i
M /P
Loss is referred to as a shoe-leather cost (i.e. cost incurred by
holding less money than convenient — going to the ATM frequently
— or equivalently, benefits foregone).
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 6 / 45
Friedman rule

Friedman rule requires it = 0 — hold nominal interest rate


constant at zero
Implications for inflation: use Fisher equation

it ≈ rt + πt+1

Assuming r > 0 on average (as would be the case when


households are impatient, i.e. β < 1) together with i = 0 implies
π < 0 on average
Friedman rule requires deflation on average (goal of negative
inflation)

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 7 / 45


Relative-price dispersion owing to price stickiness
Sticky price model: Only a fraction of prices change in each period.
Demand curve for individual good i depends on relative price p(i)/p:
 −
y (i) = p(i)
p
y.
If π ↑ then:
Firms with unchanged nominal prices: relative prices fall
Firms making price changes: relative prices rise
This relative-price dispersion is not caused by any changes in
preferences or technology → inefficiency
Efficiency requires marginal utilities to move only in line with
marginal costs:
Consumer equates relative prices to marginal rates of
substitution
So relative price changes unrelated to shifts in relative costs lead
to a movement away from the efficient allocation of resources
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 8 / 45
Relative-price dispersion: Implications for inflation

Relative-price dispersion is minimized when π = 0


No need to change price for any reason other than fundamental
factors shifting demand or affecting costs
Implications:
Zero inflation on average is desirable
Price stability (no inflation fluctuations) is desirable

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 9 / 45


Menu costs of price adjustment

If there are resource costs of making price adjustments then it is


efficient to have firms make price changes only for fundamental
reasons.
It may be efficient to incur a menu cost to change price if there
is some shift in preferences or technology that calls for a
different relative price.
It is not efficient to incur menu costs so that individual prices
can track movements in the general price level when inflation is
positive or negative on average.
Implications:
Zero inflation on average is desirable
Price stability (no inflation fluctuations) is desirable

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 10 / 45


Redistribution of wealth: debtors vs. creditors
Consequences of nominal debt contracts and π fluctuations:
When π ↑, debtors gain and creditors lose because the real value
of debt falls
When π ↓, debtors lose.
Debt deflation (credit channel):
I π ↓ → real debt ↑ but net worth ↓
I When borrowing requires collateral, the ability to borrowing is
reduced → investment ↓
I Prices may then decrease further

Implications:
Make inflation as predictable as possible (avoid inflation
fluctuations in response to shocks)
Average (predictable) level of inflation is irrelevant because
nominal interest rate adjusts (Fisher equation)
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 11 / 45
Incomplete indexation of the tax system

Progressive income tax:


I When nominal income increases as π ↑, households have to pay
higher taxes even if real income remains the same
I → distortion of incentive to work
Taxation of capital gains:
I When (nominal) stock price increases following π ↑, households
have to pay taxes even if there is no real capital gain
I → distortion of incentive to invest
Implications:
If tax system cannot be fully indexed, the distortion can be
minimized by targeting zero inflation.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 12 / 45


Zero bound on nominal interest rate
The nominal interest rate cannot be negative. Sometimes, this might
represent a severe constraint on monetary policy, e.g. Japan:

Japanese nominal rate and inflation

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 13 / 45


Zero bound on nominal interest rate
The central bank may sometimes want to generate a negative real
interest rate to stimulate the economy. Fisher equation:

r ≈i −π

i
π* = 2

π* = 0
0 time

Risk of zero lower bound being a binding constraint is lower when the
inflation target is positive.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 14 / 45


Bias in inflation measurement

Example:
Harrods in 1910: Record player £11
2007: £39 (online purchase)
I Price increased by a factor of 3.5, but the quality is obviously
different.
Also, CD players (about £34 in 2007) much more sophisticated
than the record players in 1910.
Price of food: increased by a factor of 48 between 1910 and
2007.
Not clear if the (quality-adjusted) price of durable goods has
really increased by much, if at all.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 15 / 45


Bias in inflation measurement

Insufficient quality adjustment causes upward bias in measured


inflation
US estimate: CPI inflation might have overstated changes in
cost of living by 0.8 − 1%
UK estimate: around 0.6%.

Implications:
Targeting zero measured inflation may mean targeting actual
deflation
→ More appropriate to target positive inflation

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 16 / 45


Downward nominal wage rigidity

Some evidence of downward nominal wage rigidity.


When inflation is zero, it is then difficult for the real wage to fall
(if needed to clear the labour market).
When inflation is positive, the real wage can decrease even if
there is downward nominal wage rigidity.

Implications:
Target a positive rate of inflation on average.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 17 / 45


Output and employment
Another goal of monetary policy may be to influence the level of
output and employment. Why?
Mitigate inefficient use of resources:
I unemployment (or over-employment)
I under/over-utilization of capital
Idea: close the “output gap” — but what target level of output
should be used to calculate the output gap?
Obvious choice is “efficient” level of output ŷt
Another choice is the “natural” level of output yt∗
“Efficient” output will generally be above “natural” output, and
the distance between them may change over time
“Natural” output gap is most informative about inflationary
pressure, though “efficient” output gap is obviously the most
direct way of measuring the inefficiency due to output
fluctuations.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 18 / 45
Efficient and natural output

Efficiency requires P = MC , so monopolistic competition


(MR = MC ) leads to natural output being too low.
Should CB care about this distortion?
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 19 / 45
Central bank’s loss function
In general, the central bank has multiple objectives, but only one
policy instrument. It must make trade-offs:
Need to describe preferences over different objectives to study
these trade-offs
Specify a “loss function” to minimize (analogous to maximizing a
utility function). The loss function measures the distance of the
actual outcomes from what would be best for the economy.
Two objectives (inflation, output gap) and quadratic loss function:
1
(π − π ∗ )2 + a(x − x ∗ )2

L= (1)
2
π ∗ is the target value for inflation π
x ∗ is the target value for the output gap x
The coefficient a represents the importance the central bank
attaches to output gap deviations from target relative to
inflation deviations.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 20 / 45
Inflation targeting

1
(π − π ∗ )2 + a(x − x ∗ )2

L=
2
When a = 0 we have ‘strict inflation targeting’
When a > 0 we have ‘flexible inflation targeting’
I Central banks that adopt inflation targeting arguably do not
completely ignore output fluctuations
I → can interpret as flexible inflation targeting
I a small: CB is very averse to inflation (“conservative” or
“hawkish”)
I a large: CB worries a lot about output (“soft” or “dovish”)

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 21 / 45


Inflation forecast targeting

In reality, there are considerable lags in the transmission


mechanism of monetary policy (see Topic 3) → CB cannot
control current inflation.
Inflation targeting in practice is ‘inflation forecast targeting’:
1 
L = Et (πt+f − π ∗ )2 + a(xt+f 0 − x ∗ )2

(2)
2
Et : expectation conditional on information available at time t
when policy is chosen f : forecast horizon. In UK, f = about 2
years.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 22 / 45


Optimal monetary policy

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 23 / 45


Optimal monetary policy

Model optimal monetary policy as the policy that minimizes the


central bank’s loss function subject to the constraints it faces.
Study this question in the context of the New Keynesian model
we developed in Topic 4.
Consider two objectives:
I inflation
I output gap
What is the optimal monetary policy response to shocks? e.g.
I TFP shock
I cost-push shock

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 24 / 45


New Keynesian model
Work with approximations of equations to keep the algebra simple
(but drop the notation x̃t to denote deviations from steady state).
Indicate expectations of the future explicitly using (conditional)
expectation Et .
Phillips curve:
πt = βEt πt+1 + κxt + ut
where ut = γµ∗t is the cost-push shock.
IS equation:

xt = Et xt+1 − σ(it − Et πt+1 − r̂t )

The output gap xt = yt − ŷt is defined relative to efficient output ŷt .


r̂t is the “efficient” interest rate.
We drop the Taylor rule equation since we are now going to have the
central bank set the interest rate to minimize a loss function.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 25 / 45
Properties of PC and IS
Can express inflation in terms of current and expected future output
gaps and cost-push shocks:
πt = κxt + βEt πt+1 + ut
= κxt + ut + βEt [κxt+1 + ut+1 + βπt+2 ]
= κxt + κEt [βxt+1 + β 2 xt+2 + β 3 xt+3 + · · · ] (3)
2 3
+ ut + Et [βut+1 + β ut+2 + β ut+3 + · · · ]
Can express the output gap in terms of current and expected future
interest rate gaps:
xt = Et xt+1 − σ(it − Et πt+1 − r̂t )
= Et xt+2 − σEt (it+1 − πt+2 − r̂t+1 )
− σ(it − Et πt+1 − r̂t )
= − σ(it − Et πt+1 − r̂t ) − σEt (it+1 − πt+2 − r̂t+1 ) (4)
− σEt (it+2 − πt+3 − r̂t+2 ) − · · ·
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 26 / 45
Loss function
Loss function includes:
Deviation of inflation from target π ∗
I Desirable level of inflation target depends on factors explained
earlier
Deviations of output gap from target
I Which output gap measure to use? — output gap defined in
terms of efficient output
I Average value of actual output is the same as the average of
the natural level of output, which is below the average value of
efficient output.
I Since xt = yt − ŷt we should aim for xt equal to x ∗ > 0.

1
L = [(πt − π ∗ )2 + a(xt − x ∗ )2 ]
2

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 27 / 45


Optimal monetary policy problem

Central bank chooses it to minimize


1
L = [(πt − π ∗ )2 + a(xt − x ∗ )2 ]
2
subject to the structure of the economy:

πt = βEt πt+1 + κxt + ut

xt = Et xt+1 − σ(it − Et πt+1 − r̂t ).

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 28 / 45


An equivalent problem
It is equivalent (and simpler) to think of the central bank as
directly controlling the output gap xt .
1
min L = [(πt − π ∗ )2 + a(xt − x ∗ )2 ] (5)
2
subject to
πt = βEt πt+1 + κxt + ut (6)
Having solved this problem, we then find the explicit value of it
using the IS equation.
Logically, we can drop the IS equation as a constraint because
the interest rate it does not appear directly in the loss function.

From now on, we assume π ∗ = 0 for simplicity.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 29 / 45


Benchmark case: x ∗ = 0, ut = 0

Central bank does not try to close the gap between efficient and
natural output on average
No cost-push shock ut
We will assume CB takes Et πt+1 as given (“discretionary
optimization” — no commitments made for future policy)

1
min L = [πt2 + axt2 ] (7)
2
subject to πt = κxt + βEt πt+1 (8)

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 30 / 45


Benchmark case: x ∗ = 0, ut = 0

Substitute equation (8) into the loss function (7) to obtain an


unconstrained minimization problem:
"  2 #
1 2 πt − βEt πt+1
min L = π +a
2 t κ

First-order condition:
κ
x t = − πt (9)
a

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 31 / 45


Interpretation of the first-order condition

κ
x t = − πt
a
This represents equality between the marginal rate of transformation
(MRT) and the marginal rate of substitution (MRS).

MRT between πt and xt : dx
= κ from the PC.

MRS between πt and xt : dx
= −a πxtt from L.
MRS = MRT gives (9).

Implication of (9): Central bank should decrease the output gap


when inflation rises.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 32 / 45


Equilibrium

Equilibrium is determined by:


κ
πt = κxt + βEt πt+1 , xt = − πt
a
From these equations, xt = πt = 0 is a solution (it is the unique
stable solution), noting that Et πt+1 = 0 with rational
expectations.
The interest rate consistent with this equilibrium can be
calculated from IS:
it = r̂t (10)
Therefore, the central bank should move the nominal interest
rate in line with the “efficient” interest rate r̂t .

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 33 / 45


Graphical analysis
πˆ t

PC when E t πˆ t +1 = 0

xt
0
πˆ t = − ( a / κ ) x t

Phillips curve is a positive relationship between πt and xt (for


given inflation expectations)
First-order condition is a negative relationship
Equilibrium is at intersection.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 34 / 45
Formation of expectations

πˆ t PC when E t πˆ t +1 = π~ > 0

PC when E t πˆ t +1 = 0
π'
xt
x' 0
πˆ t = − ( a / κ ) x t

When Et πt+1 = π̃ then equilibrium is xt = x 0 and πt = π 0 . Then


agents should expect that Et πt+1 = π 0 < π̃ → PC shifts down →
Et πt+1 = 0 is consistent with equilibrium.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 35 / 45


Nature of optimal monetary policy
it = r̂t

As seen in Topic 4, the efficient interest rate r̂t is approximately:

r̂t ≈ at+1 − at

where at is the level of TFP.


Therefore:
Increase in current TFP (positive supply shock): central bank
should cut interest rate
Can extend the model to include other types of shocks:
Government spending (see problem set): Increase in government
spending (positive demand shock) raises the efficient interest
rate, so the central bank should raise the nominal interest rate.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 36 / 45
Case 2: x ∗ = 0 but ut 6= 0

Central bank continues to take Et πt+1 as given (discretion).


Assume Et ut+1 = 0 (cost-push shock cannot be predicted in
advance) and Var[ut ] = su2 .
The minimization problem:
1
min L = [πt2 + axt2 ] (11)
2
subject to
πt = κxt + βEt πt+1 + ut (12)

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 37 / 45


Case 2: x ∗ = 0 but ut 6= 0

Similarly to the benchmark case, we have


"  2 #
1 2 πt − βEt πt+1 − ut
L= π +a
2 t κ

First-order condition is the same:


κ
x t = − πt (13)
a

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 38 / 45


Equilibrium

Complete stabilization of πt and xt is no longer feasible owing to


cost-push shock ut .
From equations (13) and (12) we have

κ2
πt = − πt + βEt πt+1 + ut
a
Conjecture: since Et ut+1 = 0, it must be the case that
Et πt+1 = 0 (we check this later). If this is true, we can solve for
πt and xt :
a κ
πt = 2 ut , xt = − 2 ut (14)
κ +a κ +a
a
We can now see that Et πt+1 = Eu
κ2 +a t t+1
= 0.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 39 / 45


Properties of equilibrium

a κ
πt = ut , xt = − ut
κ2 +a κ2 +a

If ut ↑ then πt ↑ and xt ↓ (inflation-output gap trade-off).


If a ↓ then smaller fluctuations in πt and larger fluctuations in
xt . This is because CB puts less weight on xt fluctuations.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 40 / 45


CB preferences and equilibrium

πˆt
FOC (high a ) PC when u t > 0

FOC (low a )
PC when u t = 0
( Etπˆ t +1 = 0 )

xt
0

More conservative CB obtains smaller π fluctuations by accepting


larger x fluctuations.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 41 / 45


Inflation-output gap variability trade-off

For a particular value of a:

a2
Var[πt ] = s2
(κ2 + a)2 u
κ2
Var[xt ] = 2 2
su2
(κ + a)

CB’s preference parameter a and equilibrium:


As a → 0, we have Var[πt ] → 0 and Var[xt ] → κ−2 su2 .
As a → ∞, we have Var[πt ] → su2 and Var[xt ] → 0.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 42 / 45


Efficiency frontier and optimal monetary policy
Average value of loss function:
1
E [L] = [Var[πt ] + aVar[xt ]]
2
Var[π ]
)

when a = ∞

Efficiency frontier
Trade - off in
social loss
(slope a ) optimal equilibriu m given a

when a = 0
0 Var[ x ]

For each a we can plot a point (Var[xt ], Var[πt ]). Considering the
range of possible a values traces out the efficiency frontier of the
inflation-output gap variability trade-off.
K. Sheedy (LSE) EC321 Monetary Economics Topic 4 43 / 45
Efficiency frontier and optimal equilibrium
Expected value of loss function is
1
E [L] = [Var [πt ] + aVar [xt ]]
2

The central bank’s willingness to accept inflation volatility in


return for lower output gap volatility is measured by the
parameter a.
The straight line in the figure represents the central bank’s
indifference curves (linear because loss function is linear
combination of two variances)
Optimal monetary policy is the tangency point between the
efficiency frontier and the indifference curves.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 44 / 45


Optimal responses to shocks
We can compute the optimal interest rate from the IS curve.
Equilibrium output gap and inflation:
a κ
πt = ut , xt = − ut
κ2 + a κ2 + a
IS: xt = Et xt+1 − σ(it − Et πt+1 − r̂t )
Then the optimal interest rate is:
1 κ
it = r̂t + ut (15)
σ κ2 + a
Response to r̂t remains the same as before.
If ut ↑ then it ↑. CB responds by less to ut as a becomes larger.

K. Sheedy (LSE) EC321 Monetary Economics Topic 4 45 / 45

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