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80 Seiten, Note: 1,3
List of Figures
2 Modelling Inflation Targeting
2.2 Monetary Policy
2.2.1 Monetary Policy Strategies in Theory
2.2.2 Monetary Stability as an Aim of Monetary Policy
2.2.3 Empirical Monetary Strategies
2.2.4 Monetary Transmission Mechanisms
2.3 Inflation Targeting as Monetary Policy Strategy
2.3.2 The Origins
2.3.3 On Transparency
2.3.4 Form of the Target and the Policy Horizon
2.3.5 Asset Price Bubbles and Rapid Expansion of Credit
2.3.6 Critical Discussion
2.4 The Instrument Rule Model
2.4.1 Modelling Inflation Targeting
2.4.2 Kydland and Prescott’s Time Consistency Problem
2.4.3 Barro and Gordon Introduce Reputation to the Game
2.4.4 McCallum and the Monetary Base
2.4.5 The Taylor Rule For Interest Rate Setting
2.4.6 Asymmetric Preferences and Non-linear Taylor Rules
2.5 The Target Rule Model
2.5.1 Svensson’s Model in the New Keynesian Framework
2.5.2 Some Aspects in Critical Discussion
3 The Process of Inflation Targeting in the UK
3.1 Some Historical Issues
3.1.1 Development of the Bank of England
3.1.2 Previous Monetary Policy Regimes
3.1.3 Adoption of Inflation Targeting
3.1.4 Operational Framework from 1992 - 1997
3.1.5 Bank of England Operational Independence
3.2 Present Monetary Policy Framework at the Bank of England
3.2.1 Core Purposes and Monetary Strategy
3.2.2 The Bank’s Publication Policy
3.2.3 Forecasting Inflation at the Bank of England
3.3 Bank of England Transmission Mechanism
3.3.1 The Transmission Mechanism in Overview
3.3.2 Interest Rate Setting Process and Quantitative Effects
3.3.4 From Changes in Spending Behaviour to GDP and Inflation
3.3.5 The Role of Money
3.3.6 Relationship between Inflation and Inflation Expectations
3.4 Effects of Inflation Targeting in the United Kingdom
3.4.2 Basic Economic Developments After Inflation Targeting
3.4.3 Inflation Targeting and the Exchange Rate
3.4.4 Empirical Evidence of a Non-linear Taylor Rule
3.4.5 Efficacy and Impact on Social Welfare
3.4.6 Inflation Targeting and The Household Sector After the Financial Crisis
3.4.7 Expected Inflation as a Metric of Heightened Credibility
3.5 Concluding Remarks
2.1 A Real Taylor Rule
3.1 UK Leaving the ERM
3.2 Bank of England Structure
3.3 Stylised Forecast Sequence
3.4 Bank of England Transmission Mechanism
3.5 Bank of England Official Bank Rate
3.6 UK Inflation Rate
3.7 UK Gross Domestic Product
3.8 UK Unemployment Rate
3.9 UK Inflation Expectations
“[A]n internal standard, so regulated as to maintain stability in an index number of prices, is a difficult scientific innovation, never yet put into practice.“1
Especially since the operational introduction as central bank monetary policy framework in the early 1990s in New Zealand, the United Kingdom (UK), Canada and Sweden, inflation targeting has gained both empirical and theoretical relevance as a monetary policy strategy. In this paper I relate to inflation targeting theory and its framework in the UK. For that purpose I first regard the development of inflation targeting in respect to other monetary policy strategies in sections (2.2) and (2.3). I will answer the question what the actual target variable is and why one would want to have inflation being low and stable. Then there is some complexity because the development of inflation targeting has to be viewed in relation to paradigmatic debates between Monetarist and New-Keynesian insights. In the sections (2.4) and (2.4) I present the two fundamental views of how an inflation targeting framework should be modelled. By stating some equations from basic theoretical literature, I try to give a overview about the different characteristics of that monetary policy strategy and how there is still controversy about the way of modelling. Chapter (3) is concerned with the operational framework in the UK, including statements to historical developments at the Bank of England in section (3.1). In particular, gaining of operational independence in setting interest rates—section (3.1.5)—was an important step for the Bank. The present monetary policy framework will be reviewed in section (3.2), in detail relating to the Bank’s publication policy—section (3.2.2)—and the inflation forecasting process—section (3.2.3). The Bank of England’s model of the transmission mechanism is reviewed in section (3.3). This includes the interest rate setting process, the role of money and the relationship between inflation and inflation expectations. Finally, I discuss some economic effects that changed the British economy since the introduction of inflation targeting—section (3.4).
In this section, I give an explanation of the development of theories relating to modern inflation targeting models. Therefore, I give insights into the main theoretical publications. The aim is to discuss inflation targeting theory in relation to monetary policy in general, and different views within the inflation targeting research, for there is controversy regarding which kind of model suits best.2 I will not be able to discuss the modelling in detail, but I find it useful to quote some of the essential equations. It is unclear what terms actually appear in central banks’ objective functions and what weights each term receives.3 It is also unclear what weights and terms should appear, since there is this professional disagreement over proper model specifications. Later, some empirical evidence from the UK will give a hint in section (3.4.4). First, we will have a look at monetary policy in general and the question what the actual target variable in inflation targeting is.4
While monetary theory is researching the effects of money supply and interest rate variations by modelling, the theory of monetary policy analyses the monetary order including its institutions, aims, instruments and their effects. Then, practical monetary policy is the whole amount of done or foreseen actions to regulate and steer the money supply, interest rates and liquidity of the economy.5 With these actions, monetary policy also influences outcomes like economic growth, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and influence the interest rate. The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.6 The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in base currency entering or leaving market circulation. For the UK, this will be discussed in more detail in section (3.3.2). Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold.7
It is useful to develop a strategy for the application of monetary policy instruments. In monetary policy there are ultimate aims and sub-ordinate targets. Ultimate aims are targets for stability and growth, sub-ordinate—or intermediate—goals are, for example, annual growth rates of a certain monetary aggregate.8 Monetary policy strategies can be categorised as follows:
Discretionary monetary policy leads to monetary policy actions in the case of the occurrence of a certain situation. It is used to harmonise economic cycles by using an anti-cyclical policy.9 A policy regime based on discretion makes no public (or just vague) commitments about its objectives and future actions. It reserves the right to set monetary policy from month to month according to the assessment of current conditions looking at ’everything’.10
Rule-based monetary policy expresses the ’built-in-stabiliser’ that works automatic and without external decisions. Rule-based policies are proposed by the Monetarists (for example Friedman11, H.C. Simon) and by new classics—see, for example, Kydland and Pr esc ott (1977). Discretionary monetary policy has in the eyes of the new classic school an inflation bias which has to be controlled by legislative rules.12
Rules create credibility that the monetary authority will not abuse its powers. On the other hand rules deprive the central bank’s ability to deal with unusual circumstances. Discretion preserves flexibility and enables to respond to new information. But on the other hand the lack of perceived discipline may foster uncertainty in the public mind.13 Being a combination of both concepts, formula flexibili ty means that the central bank sets certain levels of indicators. If they are outrun the bank is allowed to react.14 Besides the analytical story of rules versus discretion, the development of both is also based on a fundamental—paradigmatic—change in views, so that speaking of ’rules’ mostly relates to a more Monetarist view, while speaking of ’discretion’ means kind of a (New-)Keynesian perspective.
While speaking of inflation targeting, we always imply that there are positive effects of low and stable inflation. Monetary stability is viewed as basic condition for a market economy and monetary policy is known as the best instrument for achieving that aim. Economic costs of inflation arise because the functions of money are disabled by certain degree—even if the inflation is correctly anticipated. These costs arise from suboptimal keeping of money by private agents, menu costs and fixed amounts in the tax legislation.15 Relating to baseline discussion, supporters of trading higher inflation rates for positive effects on employment, growth or the states finances are not based on solid theoretical and empirical models, as argued by Bofinger, Reischle and Schächter (1996).16 In addition, the positive relationship between inflation and real growth modelled by T obin (1965) is viewed as dissatisfactory.17 The fact, that the state should finance itself by issuing money is not true in economies with a well-adapted tax system and it is not possible with an independent central bank.18 Contrary, on empirical basis the relationship between inflation and economic growth is viewed as being negative.19 So, with inflation targeting being the explicit effort to reach monetary stability , the inflation targeter’s case rests on these arguments:
In the long run, the inflation rate is the only macro-economic variable that monetary policy can affect. This not because unemployment and related problems have become less urgent concerns, but short-run fluctuations in the economy are seen less easy to influence.
Even moderate rates of inflation are harmful to economic efficiency and growth and the maintenance of a low and stable inflation rate is important for achieving other macroeconomic goals, for example high real growth, low unemployment, financial stability, and a not-too-excessive trade deficit.20
So, price stability as the primary long-run goal of monetary policy provides a key conceptual element in the overall framework of policy-making. That framework helps policymakers to communicate their intentions to the public and to impose some degree of accountability and discipline on the central bank and on the government itselft.21
Besides analytical distinctions one can find different monetary strategies on the empirical level. The exchange-rate focussed monetary policy was practised until the crash of the Bretton-Woods-System in 1973 from most central banks. This system forced the central banks to interventions on the exchange market to keep the exchange rate on a fixed level. The trend focussed policy was introduced under the influence of Monetarist theory by the western central banks at the beginning of the 1970s. They changed to annual money supply measures and, instead of discretionary actions, the policy was focussed on long term trends of the economic capacity, known as the production potential. Although the money supply growth rate stayed the important variable it was, however, not regulated on a legislative basis as demanded by Friedman. Finally, the monetary policy of a direct inflation target was introduced in the early 1990s by Great Britain and Sweden because they had troubles using the money supply rate as an indicator. The central banks of these countries set out maximum inflation targets or were forced to reach a certain inflation rate by their government. The central banks reviewed all indicators that influenced the targeted inflation rate and used all of their instruments to reach that goal.22
The way monetary policy is working through to the real economy is called the monetary transmission mechanism. While the Keynesian —respectively interest structure based— approach leads to a broad amount of indicators, the Monetarist view is in principle a reduction to the monetary base as the relevant indicator and instrument for the expected inflation. Relative to the complex Keynesian transmission model the Monetarist approach is therefore very simple.23 The same is true for the theory of the direct international price relation where the exchange rate is the most important indicator and—again—instrument at the same time. On the other hand, the expectations theory bases on all relevant economic information on which one can develop an understanding of the expectations of the market agents. This is particularly true for wages and nominal interest rates of longterm bonds. The expectations theory bases on the interest rate structure theory and is a key element for inflation targeting. This is because time inconsistencies between the monetary authorities actions’ and their effects lead to an inflation forecast targeting based on agent’s expectations.24 Inflation expectations of the market actors can be used as a link between the central banks instruments and the ultimate target of monetary policy.25 Besides the—additional—usage of traditional intermediate indicators, in an inflation targeting framework the central bank has to be able to adjust its operating target—the interest rate—due to the time-lag by the usage of information about the future. Inflation rate targeting is then practised over the intermediate target of inflation rate forecasts. This implies the communication of these forecasts, which are regularly published in reports of the central bank. So the actual target variable is the forecast of inflation, not the inflation rate.26
Having the frame laid out, we find now that inflation targeting is a rule-based concept27 of monetary policy where the central bank is trying to reach the final target of monetary stability without using traditional intermediate targets as for example exchange rates or the money supply.28 In the words of Cukierman and Muscatel li (2008), the positive theory of monetary policy in developed economies has reached a broad consensus in recent years that conceptualises monetary policy as follows:
“[P]olicy authorities minimise a linear combination of the quadratic deviations of inflation and of output from their respective targets (the inflation and the output gaps in what follows), and the main policy instrument is the short-term rate of interest.“29
The fundamental thought is to fight the insecurities and time-lags between action and effects in the monetary transmission process by the monitoring of a large amount of indicators and to direct monetary policy by the fixation of a target value for the price level respectively the inflation rate. The reason for many countries to develop such a strategy were no theoretical advantages, but the breakdown of traditional relationships between the money supply growth rate or exchange rate and prices. Therefore an intermediate target strategy was made impossible. But with direct inflation targeting is also not able to fully control the price level by its instrument, as stated by Deutsche Bundesbank (2008).30 The inflation target is formulated and communicated over a quantitative value or a target range, which the central bank commits itself to. On the ultimate target level there are two distinct forms of inflation targeting:
Explicit inflation targeting, where countries publish the inflation rate target. This is popular in countries with adverse inflation development in the past because it raises transparency of the monetary policy, especially if the central bank law is not clear in its formulation of a target and if monetary policy is not completely independent. This transparency about the ultimate target of monetary policy is therefore especially relevant for the system’s credibility.31
Implicit inflation targeting, where countries do not publish such kind of targets but express by action their commitment to a goal of monetary stability.32
Using explicit inflation targeting, the central bank is communicating its strategy as well as its targets to explain the monetary policy actions. The commitment of the central bank on an inflation target is mostly institutional initialised with the definition of clear sanctions (in form of personal changes), if the inflation targets cannot be fulfilled. These mechanisms of raised transparency and accountability in management raise the central bank’s credibility in public.33 Disadvantages of this concept are due to a greater amount of complexity, therefore less transparency for the public and the danger of disorientation of monetary policy decisions.34 The instrument in an inflation targeting framework is set after a certain rule. While straightforward in principle, this feedbac k rule —as it was firstly cited by T aylor (1993a)35 —is in practice likely to be quite complex. The feedback variable is the full probability distribution of inflation outcomes, into which will feed a lot of information variables. This complexity confers both costs and benefits. The benefits derive from the rule’s use of a wide range of information variables, as under the optimal feedback rule. The costs are the loss of simplicity and thus transparency about just what monetary policy is doing and why. That cost could well be important if agents believe that complexity is being used as a facade for periodic inflation surprises. An inflation bias might well then obtain. In response to this, most inflation-targeting countries—the UK among them—have made efforts to spell out their reaction functions in clear terms.36
Most of the elements of inflation targeting could be found in the monetary policy of Germany and Switzerland in 1999. The Maastricht Treaty, the basis for the European monetary union, mandates price stability as the primary objective of the new European Central Bank. Most countries either adopted inflation targeting as a response to an unexpected unhinging of an earlier managed exchange rate regime—as in Finland and Sweden; or as a result of the failure of monetary targeting because of the vicissitudes of money velocity during the 1970s and 1980s—as in Canada and New Zealand; or, in the UK case, as a result of both.37 The intellectual roots of inflation targets can be traced back to the last century—to Marshall (1887) and Wicksell (1898). Later, Fisher (1911) and Keynes (1923) both put forward monetary policy schemes which target explicitly an index number for prices. Sweden did an experiment with an explicit price-level standard during the early part of the 1930s.38
As previously pointed out, a key element of inflation targeting is transparency. It is achieved by the communication of goals, targets, strategies and forecasts on a regular basis and the members of the central bank speaking to the public. Reasons for inflation goals can be laid out, the tasks and borders of monetary policy can be explained.39 In the eyes of Mishkin (2004), transparency is firstly effecting credibility of the monetary policy. Is the credibility raising, then inflation targets are easier to realise because inflation expectations are similarly kept to a low level. A high level of transparency can solve the problem of time inconsistency because the control of the monetary policy and its actions is easier. Systematic failures are easier to monitor, their execution by the central bank is less probable. Although central banks raised their transparency by the introduction of inflation targeting enormously, there could be even more. In most cases there are no publications to the form of the target function and the weight factors for the output stabilisation.40 Inflation or monetary policy reports are published by Canada, New Zealand, Sweden and Spain, as well as in the UK. They allow inflation targeting central banks to expose to the wider world the analysis underlying their monetary policy advice. A second are the minutes of the monthly meeting at which monetary policy decisions are made. Third example of greater transparency is the publication of forecasts for inflation (and for other variables). These serve as a summary statistic of the information variables upon which policy is set, thus simplifying monitoring by outside agents.41
Besides the question which variable should be targeted in monetary policy in general— money supply, exchange rate or inflation—one can question the design of the target. Some central banks give a clear numeric value while others just formulate a target range. The huge advantage of a range is its flexibility. The control of the inflation is never completely possible so the target range secures from deviations that occur often in the case of a certain target point. But the publication of a target range also has disadvantages. It can raise insecurities over the inflation in comparison to a precise target value. A narrow target range on the other hand can reduce inflation expectations but brings greater danger of missing the aim. A broad target range can foster insecurities of monetary policy aims and therefore reduce accountability.42 The time horizon within to reach the inflation target also leads to discussions. The delayed effects of monetary policy actions on inflation—two years in recent years—can lead to problems. Is the inflation target given too less time, the inflation cannot be controlled properly. Misses of the inflation target are sincere, even if the central bank’s decisions where right. A too short time horizon can also lead to unnecessary high amounts in the usage of instruments to reach the inflation target.43 Furthermore variations of the output would increase if the inflation was targeted backwards too fast to its target value with a short horizon.44 A horizon of two years seems to be optimal, as stated by Mishkin and Schmidt-Hebbel (2001). It gives the monetary policy the time their actions need to influence the inflation and it reduces output variability to a low level.45
The appropriate response of monetary policy to asset price bubbles and any associated rapid expansion of credit is a matter of debate amongst central bankers and monetary economists. In the aftermath of the collapse of the dot-com bubble and the more recent wider correction to international share values, a number of commentators have argued that the achievement of price stability by central banks may be associated with heightened risks of financial instability , too. They argue that central banks should not focus solely on inflation prospects, but also take account of developments in asset prices, debt and other indicators. They may be symptomatic of incipient financial imbalances which is neatly summarised by Crockett (2003):
“(I)n a monetary regime in which the central bank’s operational objective is expressed exclusively in terms of short-term inflation, there may be insufficient protection against the build up of financial imbalances that lies at the root of much of the financial instability we observe. This could be so if the focus on short-term inflation control meant that the authorities did not tighten monetary policy sufficiently pre-emptively to lean against excessive credit expansion and asset price increases. In jargon, if the monetary policy reaction function does not incorporate financial imbalances, the monetary anchor may fail to deliver financial stability.“46
According to this view, policy should be tightened if the policy-maker believes that an asset price bubble is developing, or if balance sheets show signs of becoming stretched through excessive debt accumulation, even though inflation may be well under control. Failing to do this may raise the likelihood of financial instability. Central bankers should be especially concerned about the broader set of symptoms that usually accompany asset price booms, namely a built-up of debt and a high rate of capital accumulation. During the asset price boom, which may initially be prompted by an improvement in economic fundamentals, such as an increase in total factor productivity growth occasioned by a new technology, balance sheets may look healthy as the appreciation in asset values offsets the build-up of debt. But when optimism turns to pessimism, the correction in asset values results in a sharp deterioration in net worth, stretched balance sheets, retrenchment and possible financial instability.47 This process may be further aggravated if banks respond to the deterioration in balance sheets by restricting lending, i.e. a credit crunch.48 But on the other hand raising interest rates to prick an apparent bubble may simply produce the sort of economic collapse one wants to avoid. So in the eyes of Bean (2003)—a member of the Bank of England—the best that one can do is deal with the consequences as the bubble bursts or financial imbalances unwind. This debate revolves around the desirability and feasibility of pre-emptive monetary policy tightening in order to prevent subsequent financial instability. Much of the growing literature examining this question focuses on stochastic asset price bubbles and analyses the implications in a suitably calibrated macroeconomic model of following either a simple Taylor rule or an inflation-forecast-targeting rule augmented with the asset price. The bottom line of this literature seems to be that the results hinge on the particular stochastic assumptions regarding the asset price (as well as other shocks that might provide a fundamental explanation for the asset price movements) and above all on the information available to the policy maker.49 Bean (2003) and Cecchetti, Genberg and W adhwani (2002) do not see any difficulty in principle in taking on board the implications of concerns about asset price bubbles, incipient financial imbalances, etc., within an inflation targeting framework.50
From an analytical perspective, the differences between inflation targeting and monetary targeting are just semantic. Both regimes shoot for the same end-point: a specified growth path for nominal magnitudes. Given the transmission lags in monetary policy, both rely on a forward-looking inflationary assessment when monetary policy is being set. Haldane (1998) states, that the difference between them hinges on the weights each attaches to different information variables when forming the forward-looking inflation assessment.51 He therefore relates to differences in the foundational paradigm. Contrary to monetary targeting, inflation targeting should be more responsible for real economic values. In theory , pure monetary targeting is a limiting case of inflation targeting.52 The weight attached to monetary variables is unity, and the weight attached to non-monetary variables is zero. Inflation targeting means using an eclectic mix of information variables, with non-zero weights assigned to both real and monetary magnitudes when forming an inflationary assessment.53 In practice , this distinction and these restrictions are largely hypothetical. Studies of the Bundesbank’s reaction function (such as Clarida and Gertler (1995); Mus- catelli and Tirelli (1996); Neumann (1995)) confirm that real as well as monetary variables help to explain its actions over recent years. Actual and expected inflation and output gaps are often found to play a prominent explanatory role with money having a bit part.
As stated above, the time-lag of monetary policy instruments on the inflation and shock effects inside this time-lags lead to an inflation forecast targeting. Published inflation forecasts are used as intermediate targets. Bofinger, Reischle and Schächter (1996) criticised this by pointing to the fact that the inflation rate forecast does not show all characteristics of an intermediate target. It is not well controllable by monetary instruments and it is not showing a stable relationship with the final target, the inflation rate, as it is with exchange rates and money supply.54 Related to the UK, these aspects are further discussed in section (3.3.6). Another criticised aspect is the low inflation rate for the price of output variability. The short-term goal conflict between inflation and output in case of supply shocks makes monetary policy decide between one of these two goals.55 Furthermore there is said that inflation targeting, although it is related to monetary policy rules, provides a too huge space for discretionary decisions . This argument is closely related to the definition of monetary policy rules. Inflation targeting can be viewed as optimising action to achieve fixed targets. It is forming a framework for the central bank to offer sufficient flexibility for optimal decisions, as stated by Bernanke (1999).56 On empirical basis, all central banks who did explicit inflation targeting reached self-made goals. But the 1990s were a phase with low inflation rate and there were a lot of other countries who reached an inflation rate goal of one to four percentage points.57 Last, but not least, a problem could arise from the false impression a central bank establishes: to be able to defeat inflationary tendencies from their beginnings, while this is quiet impossible with the complex structure of the interest rate structure transmission mechanism and the very indirect influence of higher inflation rate expectations on the actual inflation rate. Due to the difficulties of this fine-tuning of monetary policies it would—in the eyes of Bofinger, Reischle and Schächter (1996)—be more appropriate to work with an implicit inflation targeting. To sum it up, in using inflation targeting, there is a trade-off between the transparency relating to the final target and the loss of reputation by missing the short-term inflation target due to exogeneous shocks.58
In the previous sections the discussed inflation targeting characteristics were relatively general. Key element of economic research is the formulation of inflation targeting models relating different economic indicators and instruments, as, for example, inflation rate, interest rate and the production growth rate in mathematical models. Therefore, in the last 40 years different economic models were developed and empirically tested via mechanisms of estimation and correlation analysis; some of them trying to discover the monetary authorities’ policy rules. I relate to a few of them in the following sections concerning the mathematical modelling of inflation targeting. Often the definition of policy rules is viewed very narrow and a decision rule means that a simple reaction function is being followed— which was previously meant by ’feedback rule’ in section (2.3.1). That is mostly called a simple instrument rule. But a policy rule can also be interpreted as a target rule for compliance of the own or external guidelines under discretionary optimisation. Therefore we will make the difference between instrument rules—this section—and target rules—section (2.5). An instrument rule refers to some formula prescribing settings for the monetary policy-maker’s instrument as a function of currently observed variables. Examples include the Taylor rule, Taylor (1993a), several interest rate rules studied by Henderson and McKibbin (1993), and the activist monetary base rules of McCallum (1988) and Meltzer (1987). The rule takes explicit position on the fact which variables are concerned, among them may be expectations (based on current information) of present or future variables.59 The advantage of a simple instrument rule is the possibility of simple implementation and monitoring. In addition it is very easy to understand for the public.60 In the following sections I will discuss its development.
During the early postwar period, macro-economic analysis was dominated by the view marshalled by Keynes (1936) where short-run fluctuations in output and employment are mainly due to variations in aggregate demand. Macro-economic stabilisation policy can, and should, systematically controll aggregate demand so as to avoid recurring fluctuations in output. These ideas largely reflected the experience from the Great Depression. Keynesian macro-economic analysis interpreted these phenomena as failures of the market system to coordinate demand and supply, which provided an obvious motive for government intervention.61 Real-world devolpments in the late 1970s revealed serious shortcomings of this analysis. It could not explain the new phenomenon of simultaneous inflation and unemployment—stagflation—which seemed closely related to supply side shocks, which had played a subordinate role in the Keynesian framework. Lucas (1972) pointet to the fact that the relationships between macro-economic variables are likely to be influenced by economic policy itself.62 As a result, policy analysis based on these relationships might turn out to be erroneous. His conclusion was that the effects of macro-economic policy could not be properly analysed without explicit micro-economic foundation. Using modelling, Kydland and Prescott (1977) first identified this inflationary bias that results when a central bank does not pre-commit to a monetary policy rule.63 That means that in a discretionary regime the monetary authority can print more money and create more inflation than people expect.64 The key insight of Kydland and Prescott (1977) is that many policy decisions are subject to a fundamental time consistency problem . They show that, given a rational and foward-looking government that chooses a time plan for policy in order to maximise the well-being of its citizens, if given an opportunity to re-optimise and change its plan at a later date, the government will generally do so. This result is a problematic logical implication of rational dynamic policymaking when private-sector expectations place restrictions on the policy decisions. It points to the mathematical problem as a game, rather than a control theory model (which would be solved using, for example, dynamic optimisation). Governments that are unable to make binding commitments regarding future policies will therefore encounter a credibility problem . The public will realise that future government policies will not necessarily coincide with the announced policy. Kydland and Prescott (1977) showed that the outcome in a rational-expectations equilibrium where the government cannot commit to policy in advance—discretionary policymaking—results in lower welfare than the outcome in an equilibrium where the government can commit.65 Thus, they laid the foundation for introducing explicit rules into the monetary-policy process.
Barro and Gordon (1983) compared discretion and rules in monetary policy on the foundation of Kydland and Prescott (1977). They introduced reputation to the subject by stating that the government has some sort of reputation in advance for maintaining the true binding to a monetary policy rule in a repeated interaction between the policy-maker and the private agents. Time-inconsistent deviations from that rule would be punished by the loss of reputation and so lowering the output effects of the inflation rate. Mc- Callum (1988) called this approach monetary misperceptions theory .66 Barro and Gor don (1983) set out an example with the policy-maker’s objective involving a cost for each period, zt, which is given by:
Abbildung in dieser Leseprobe nicht enthalten
The cost of inflation is . a .( π )2. These costs rise at an increasing rate with the rate of inflation, π t . The benefit from inflation shocks is b t ( π t − π e ). These benefits could be reductions in unemployment or increase in governmental revenue. The policy-maker’s objective at period t entails minimisation of the expected present value of costs,
Abbildung in dieser Leseprobe nicht enthalten
where r t is the discount rate that applies between periods t and t + 1. The policy-maker controls a monetary instrument, which enables him to select the rate of inflation, π t, in each period. They further researched the temptation to cheat after the implementation of a rule. If the policy-maker engineers today a higher rate of inflation than people expect, then everyone raises their expectations of future inflation.67 They model it by the following form of expectations and reputation (credibility) mechanism:
Abbildung in dieser Leseprobe nicht enthalten
with rule-based inflation, [Abbildung in dieser Leseprobe nicht enthalten], and discretionary inflation, [Abbildung in dieser Leseprobe nicht enthalten], which means that the policymaker optimises without rule-binding.68 The benefits from surprise inflation may include expansions of economic activity and reductions in the real value of the government’s nominal liabilities. But because people adjust their inflationary expectations in order to eliminate a consistent pattern of surprises, this cannot arise systematically in equilibrium. Contrary, in equilibrium, the average rates of inflation and monetary growth will be higher. Enforced commitments on monetary behaviour eliminate the potential for ex post surprises. Such commitments are embodied in monetary or price rules.69 Making rules even more attractive, they stated, that the potential loss of reputation could force the policy-maker to stay within its rule-binding framework.70
Fighting on the Monetarist’s side, McCallum (1988) proposed that there is “very little basis for any predictions concerning the way in which quarterly or annual changes in nominal GNP will be divided between real output growth and inflation. Consequently, a policy rule’s design should not be predicated upon any particular model of that division“,
“Over long spans of time [...] output and emloyment levels will be essentially independent of the average rate of growth of nominal variables.“71
Based on these paragraphs, he developed a target path for nominal gross national product (GNP) that grows steadily at a pre-specified rate that equals the economy’s prevailing longterm average rate of real output growth. He also showed an operational mechanism for achieving this target, thereby specifying the settings of an instrument variable that the monetary authority can control directly. In his opinion, the best instrument variable is the monetary base,
“which is a variable that can be accurately set on a day-to-day basis by the central bank of any nation.“72
With bt = log of the monetary base, xt = log of nominal GNP, [Abbildung in dieser Leseprobe nicht enthalten] = target-path value of
tt, and λ is non-negativ, this rule can be written as:
Abbildung in dieser Leseprobe nicht enthalten
1 Keynes (1923).
2 See, for example, discussions between McCallum and Nelson (2005); McCallum and Nelson (1999) and Svensson (2005); Svensson and W oo dfor d (2004); Svensson (2001).
3 See McCallum and Nelson (2005), p. 599.
4 See section (2.2.4).
5 See Peto (2002), p. 159.
6 See Frie dman (2004), p. 9976ff.
7 The other primary means of conducting monetary policy include discount window lending (i.e. lender of last resort), fractional deposit lending (i.e. changes in the reserve requirement), moral suasion (i.e. cajoling certain market players to achieve specified outcomes), and ’open mouth operations’ (i.e. talking monetary policy with the market). See Frie dman (2004), p. 9976ff.
8 See Peto (2002), p. 186.
9 See Peto (2002), p. 190ff.
10 See Bernanke (1999), p. 5.
11 Being a former adherent of Keynes, Milton Friedman developed his fundamental criticism against anti-cyclical stabilisation policy. In empirical research he found discretionary interventions having destabilising effects due to lags in the transmission process. So he argued in favour of stabilisation policy based on monetary policy. See Frie dman (1948).
12 See Peto (2002), p. 190ff.
13 See Bernanke (1999), p. 5.
14 See Peto (2002), p. 192.
15 For further discussion of these issues see Bofinger, R eischle and Schächter (1996), p. 78ff.
16 Apparently being New Classics, they summarise analyses concerning the long-term trade-off between unemployment and inflation, known as the Phillips-curve to the fact that effects on employment are nothing but short-term and transient. See Bofinger, R eischle and Schächter (1996), p. 39.
17 See Orphanides and Solow (1990), p. 257f.
18 See Bofinger, R eischle and Schächter (1996), p. 76.
19 See Bofinger, R eischle and Schächter (1996), p. 47.
20 See Bernanke (1999), p. 10f.
21 See Bernanke (1999), p. 11.
22 See Peto (2002), p. 193f.
23 See Bofinger, R eischle and Schächter (1996), p. 245.
24 See Bofinger, R eischle and Schächter (1996), p. 245f.
25 See Bofinger, R eischle and Schächter (1996), p. 369.
26 See Mishkin (2002), p. 3.
27 Even when the discussion about discretion in inflation targeting is lasting.
28 See Bofinger, R eischle and Schächter (1996), p. 365ff.
29 Cukierman and Muscatel li (2008), p. 1.
30 See Deutsche Bundesbank (2008), p. 1.
31 See Bofinger, R eischle and Schächter (1996), p. 365ff.
32 See Svensson (2001), p. 2.
33 See Mishkin (2002), p. 2.
34 See Deutsche Bundesbank (2008), p. 1.
35 Which is discussed in section (2.4.5).
36 See Haldane (1998), p. 19f.
37 See Haldane (1998), p. 2.
38 See Haldane (1998), p. 2f.
39 See Mishkin (2004), p. 49.
40 See Mishkin (2004), p. 53.
41 See Haldane (1998), p. 20.
42 See Mishkin (2001), p. 212.
43 See Mishkin and Schmidt-Hebbel (2001), p. 184.
44 See Meyer (2001), p. 7.
45 See Mishkin and Schmidt-Hebbel (2001), p. 184.
46 Italics in original, Cr ockett (2003), p. 1.
47 See Bean (2003), p. 20.
48 Governments all over the world are right now working against a threatening credit crunch.
49 See Bean (2003), p. 21.
50 See Bean (2003), p. 22.
51 See Haldane (1998), p. 3.
52 There is an oppositional meaning to that subject, quoting "... other goals are submitted under the goal of the inflation rate target. Secondary goals—for example stabilisation of the output—are possible in principle and wished but there is not necessarily a numeric value for it." Svensson (2001), p. 2.
53 See Haldane (1998), p. 3.
54 See Mishkin (2002), p. 4.
55 See Bernanke (1999), p. 299.
56 See Bernanke (1999), p. 6.
57 See Bofinger, R eischle and Schächter (1996), p. 373.
58 See Bofinger, R eischle and Schächter (1996), p. 375f.
59 See McCallum and Nelson (2005), p. 598.
60 See Debelle (1999), p. 7ff.
61 See The Royal Swedish Academy Of Sciences (2004), p. 1.
62 See Luc as (1972); See Luc as (1973); See Luc as (1976).
63 See Ir eland (2002), p. 2.
64 See Barr o and Gordon (1983), p. 101f.
65 See The Royal Swedish Academy Of Sciences (2004), p. 2.
66 He pointed out that this view was founded by Luc as (1972) (1973). See McCallum (1988), p. 188.
67 See Barr o and Gordon (1983), p. 108.
68 See Barr o and Gordon (1983), p. 120.
69 See Barr o and Gordon (1983), p. 101f.
70 See Barr o and Gordon (1983), p. 120.
71 Both quotations McCallum (1988), p. 175.
72 McCallum (1988), p. 176f.
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