Slide.

2ème année de la Grande Ecole de l’Institut de Rabat

Semestre 3

Monetary and Financial Economics

The Conduct of monetary policy: Strategy and Tactics

1st Term 2017-2018

Slide.2

Plan for today

• Define and recognize the importance of a nominal anchor.
• Identify the six potential goals that monetary policymakers may
pursue.
• Summarize the distinctions between hierarchical and dual mandates.
• Compare and contrast the advantages and disadvantages of inflation
targeting.
• List the four lessons learned from the global financial crisis and
discuss what they mean to inflation targeting.
• Summarize the arguments for and against central bank policy
response to asset-price bubbles.
• Describe and assess the four criteria for choosing a policy instrument.
• Interpret and assess the performance of the Taylor rule as a
hypothetical policy instrument for setting the interbank rate.

Monetary and Financial Economics

Slide.3

The Price Stability Goal and the Nominal Anchor

• Over the past decades, policy makers throughout the world have
become increasingly aware of the social and economic costs of
inflation and more concerned with maintaining a stable price level as
a goal of economic policy.
• The role of a nominal anchor: a nominal variable, such as the
inflation rate or the money supply, which ties down the price level to
achieve price stability
• The time-inconsistency problem

Monetary and Financial Economics

Slide.4

Other goals of monetary policy

• Five other goals are continually mentioned by “some” central bank

officials when they discuss the objectives of monetary policy:

1. High employment and output stability

2. Economic growth
3. Stability of financial markets
4. Interest-rate stability
5. Stability in foreign exchange markets

Monetary and Financial Economics

Slide.5

Should Price Stability Be the Primary Goal of Monetary Policy?

• Hierarchical Versus Dual Mandates:

– Hierarchical mandates put the goal of price stability first, and
then say that as long as it is achieved other goals can be pursued
– Dual mandates are aimed to achieve two coequal objectives:
price stability and maximum employment (output stability)
• Price Stability as the Primary, Long-Run Goal of Monetary Policy
– Either type of mandate is acceptable as long as it operates to
make price stability the primary goal in the long run but not the
short run.

Monetary and Financial Economics

Slide.6

Monetary Policy Strategies

• Main monetary policy strategies (characterized by different nominal

anchors) are:
– Monetary Targeting (MT): use of a specific monetary aggregate
(e.g. M1, M2 or M3) as intermediate target.
– Inflation Targeting (IT): use of a specific medium-term numerical
target for inflation.
– Implicit Nominal Anchor.
– Exchange Rate Targeting.

Monetary and Financial Economics

Slide.7

Monetary Targeting
• Adopted by several countries in the 1970s and 1980s (Germany,
Switzerland, Canada, the U.K., and the U.S.)
• Advantages
– Almost immediate signals help fix inflation expectations and
produce less inflation
– Almost immediate accountability
• Disadvantages
– Rely on stable relationship between inflation and targeted monetary
aggregate
– Must have full control over monetary aggregate

Monetary and Financial Economics

Slide.8

Inflation Targeting

• First introduced by New Zealand in 1990, then Canada (1991), the U.K.
(1992), Sweden and Finland (1993), etc.
• Main elements of IT:
– Public announcement target for inflation (e.g. 2% or between 2-3%)
over the medium-term (e.g. 2 years).
– Institutional commitment to price stability as the primary, long-run
goal of monetary policy and a commitment to achieve the inflation
goal.
– Information-inclusive approach in which many variables are used in
making decisions.
– Increased transparency through communication.
– Increased accountability for obtaining the inflation goal.

Monetary and Financial Economics

Slide.9

Inflation Targeting

• New Zealand (effective in 1990)

– Inflation was brought down and remained within the target most of
the time.
– Growth has generally been high and unemployment has come down
significantly.
• Canada (1991)
– Inflation decreased since 1991; some costs in term of unemployment
• United Kingdom (1992)
– Inflation has been close to its target.
– Growth has been strong and unemployment has been decreasing.

Monetary and Financial Economics

Slide.10

Inflation Targeting

Inflation Rates and

Inflation Targets for
New Zealand,
Canada, and the
United Kingdom,
1980–2014

Monetary and Financial Economics

GMM (2013)
Slide.11

Inflation Targeting

• Advantages
– Does not rely on one variable (e.g. monetary aggregate) to achieve
target as in MT.
– Easily understood by public.
– Reduces potential of falling in time-inconsistency trap.
– Increased transparency and accountability force a better.
communication (e.g. Inflation Report and Fan Charts).
• Disadvantages
– Delayed signaling about achievement of target.
– Could impose too much rigidity.
– Potential for increased output fluctuations and low economic growth
if sole focus on inflation.
– Low economic growth during disinflation.

Monetary and Financial Economics

Slide.12

BKAM Monetary Policy : Goal

• Price stability, defined as “…a year-on-year increase in the Consumer

Prices Index (CPI), close but below 2%”
• “ …maintained over the medium term”(roughly 2 years)
• in Article 6: "In order to ensure price stability, the Bank sets and
implements monetary policy instruments ... To this end, the Bank
operates in the money market by using appropriate instruments ..

• Without prejudice to the objective of price stability set in consultation

with the Minister of Finance, the Bank discharges its mission in the
context of the economic and financial policy of the government". In
other words, and in the absence of pressures on prices, the Bank may
use its instruments to support growth or contribute to the achievement
of other economic objectives.

Monetary and Financial Economics

Slide.13

BKAM Two Pillar Strategy

• First pillar: Real Pillar (Economic Analysis)

• a thorough review of recent economic developments both
internationally and nationally.
– Monitoring of indicators (wages, energy prices, exchange rate, yield
curve, etc) to assess the short to medium-term risks to price stability
• Second pillar: Monetary Pillar (Monetary Analysis)
– Money stock is ‘reference value’ to assess the medium to long-term
risks to price stability
– M3 reference value: 4.5% (consistent with 2% inflation in the long
run)

Monetary and Financial Economics

Slide.14

Analytical framework of BKAM’s monetary policy

Source: BKAM
Monetary and Financial Economics
Slide.15

Functional scheme of the monetary policy model

Source: BKAM
Monetary and Financial Economics
Slide.16

Information mechanism of monetary policy

Source: BKAM
Monetary and Financial Economics
Slide.17

Decision-making process

Source: BKAM
Monetary and Financial Economics
Slide.18

Strategy with Implicit Monetary Anchor

‘just do it’ strategy based on achieving price stability in the long run
(with no explicit target) but also maximum sustainable employment ⟹
dual mandate (FED)
•Advantages
− Uses many sources of information
− Demonstrated success over the years
•Disadvantages
− Lack of transparency leading to higher uncertainty on future
inflation and output
− Low accountability
− Strong dependence on the preferences, skills and trustworthiness
of the individuals in change

Monetary and Financial Economics

Slide.19

Strategy with Implicit Monetary Anchor

• Tools (directly controlled by the CB)

− Open market operations
− Standing facilities (lending rate and deposit rate)
− Reserve requirements
• Policy instrument (operating instrument): variable that responds to
tools
− Reserve aggregates (R, NBR, MB, MBn)
− Short-term interest rates (e.g. interbank interest rate)
− Question: Can the CB target the reserves and interest rates at
the same time?

Monetary and Financial Economics

Slide.20
Linkages Between CB Tools, Policy Instruments, Intermediate
Targets, and Goals of Monetary Policy

Tools of the Policy Intermediate Goals

Central Bank Instruments Targets

Open Market Operations Reserve Aggregates Monetary Aggregates Price Stability

(reserves, nonborrowed (M1, M2, M3)
Interest Policy High Employment
reserves, monetary base,
Reserve Requirements nonborrowed base) Interest rates Economic Growth
(short-term and
Interest on Reserves Interest rates long-term) Financial Market Stability
Large-scale Asset (short-term such as Interest-Rate Stability
Purchases interbank rates)
Foreign Exchange Market
Forward Guidance Stability

Monetary and Financial Economics

 Slide.21

Result of Targeting on Nonborrowed Reserves

Targeting non-borrowed reserves leads to fluctuations in the interest rate because of
fluctuations in the demand for reserves (between Rd’ and Rd’’)
Interbank
rate i

il Rs

i2 Step 1. A rightward or leftward shift

in the demand curve for reserves …

i Step 2. leads to fluctuations in the

Interbank rate between i1 and i2

i1 Rd′′

Rd*
id Rd′

NBR* Quantity of
Reserves, R
Slide.22

Result of Targeting on the interbank rate

Targeting the short-term interest rate leads to fluctuations in non-borrowed reserves because
of fluctuations in the demand for reserves (between Rd’ and Rd’’)

Interbank
rate i

id
Rs Step 1. A rightward or leftward
shift in the demand curve for
reserves…

Step 2. lead the central bank to

i * shift the supply curve of reserves
ff interbank
so that the interbank rate does
Rates Target, iff*
not change…

Step 3. with the result that non-

R d ¢¢ borrowed reserves fluctuate
ier between NBR′ff and NBR′′ff.
Rd *
Rd ¢

NBR ¢ NBR* NBR ¢¢ Quantity of

Reserves, R
Slide.23

Criteria for Choosing the Policy Instrument

Observability and Measurability: policy instrument should be

quickly observable and measurable
•Controllability: policy instrument should be fully controlled with
tools

•Predictable Effect on Goals: policy instrument must have a stable

and predictable relationship with goal
Nowadays , most central banks target short-term interest rates as
policy instrument
But how should this target be chosen?

Monetary and Financial Economics

Slide.24

The Taylor Rule

𝑖 = 𝑒𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑟𝑒𝑎𝑙 𝑖 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 + 1/2 (𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑔𝑎𝑝) + 1/2 (𝑜𝑢𝑡𝑝𝑢𝑡 𝑔𝑎𝑝)

• Inflation gap = (inflation rate – inflation target)

− If inflation rate above target, CB should increase i
• Taylor principle: if inflation rate increases by 1% , then CB should
increases i by 1.5%
• Output gap = (% deviation of real GDP from its potential level)
• Stabilizing real output is an important concern
• Output gap is an indicator of future inflation

Monetary and Financial Economics

Slide.25

The Taylor Rule

Monetary and Financial Economics

Slide.26

The Taylor Rule

Source: GMM, 2013

Monetary and Financial Economics

Slide.27
Lessons for Monetary Policy Strategy from the
Global Financial Crisis
• Developments in the financial sector have a far greater impact on
economic activity than was earlier realized.
• The zero-lower-bound on interest rates can be a serious problem.
• The cost of cleaning up after a financial crisis is very high.
• Price and output stability do not ensure financial stability.

How should Central banks respond to asset price bubbles?

− Asset-price bubble: pronounced increase in asset prices that
depart from fundamental values, which eventually burst.
− Types of asset-price bubbles
− Credit-driven bubbles : (Subprime financial crisis)
− Bubbles driven solely by irrational exuberance

Monetary and Financial Economics

Slide.28

Should central banks respond to bubbles?

How should Central banks respond to asset price bubbles?

• Strong argument for not responding to bubbles driven by irrational
exuberance
• Bubbles are easier to identify when asset prices and credit are
increasing rapidly at the same time.
• Monetary policy should not be used to prick bubbles.

Monetary and Financial Economics