Macroeconomic Themes:31 Contribution of Monetarism in Macroeconomic Policy Supply of money is the determinant of the national income In the long run, the

Macroeconomic Themes:3 1

Contribution of Monetarism in Macroeconomic Policy

• Supply of money is the determinant of the national income

• In the long run, the influence of money is primarily on the price level and other nominal magnitudes. Real output and employment are not determined by monetary factors.

• In the short run the supply of money does affect the output. Money is the dominant factor in causing cyclical fluctuations in output and employment in the short run.

• Private sector is inherently stable and instability is primarily the result of the government policy.


Policy conclusions

• Stability in the growth rate of money supply is crucial for a stable economy. Monetarists favour a constant money growth rate policy rule rather than discretion.

• Fiscal policy does not have any systematic impact on real or nominal income.


The basic mechanism of money supply

Households and firms save part of their income. They also borrowfrom their banks if their savings are not enough to meet theirexpenses.

If deposits are not enough these banks borrow from the centralbank. Central bank lends them by creating reserves at a pre-specified interest rate.

By doing so it adds to the monetary base. Given the moneymultiplier this translates into the overall supply of money.

This supply along with the given demand for money by the privatesector determines the market interest rate as well as the price level.

Households and firms revise demand for loans based on these newinterest rates and prices.


The basic mechanism of money supply

Government similarly can approach the central bank to finance its deficit.Central bank creates reserves while lending to the government. This alsoraises money supply.

A central bank also buys foreign currency and sells domestic currency.Money supply expands when economy activities rise and contracts whenthey slow down.

Central bank alters the interest rate to increase or reduce the liquidityrequired in the economy.


Money Supply

V a r i o u s t y p e s o f m o n e y : M 0 , M 1 , M 2 , M 3 , M 4 ;

M o n e y m u l t i p l i e r : rm 1

I f w e c o n s i d e r i n g a l e a k a g e i n t h e c u r r e n c y h o l d i n g :

crcm

1

CRM 0 ( a )

DCM 4 ( b )

t h e n d i v i d i n g ( b ) b y ( a ) rcc

RCCD

MM

1

04 .

I f p e o p l e h e l d m o r e c u r r e n c y t h e n m u l t i p l i e r b e c o m e ss m a l l e r .


Money Demand

Q u a n t i t y t h e o r y o f M o n e y ( Q T M ) : M V = P T

C a m b r i d g e e q u a t i o n o f m o n e y d e m a n d :

kYPM = > PY

kM

1

K e y n e s i a n m o n e y d e m a n d

trbtYbbtP

M210

F r i e d m a n t y p e m o n e y d e m a n d

kPYM = > PYrDrbrerkM

,,,


Friedman (1968) on Monetary Policy

Given the natural rates of interest and unemployment,monetary policy cannot be pegged to lower the interestrate or the unemployment. Is so it only raises inflationaryexpectation and increase in price level. There will be noimpact on real magnitudes.

Monetary authority can control nominal quantities suchas it liabilities, M0, M3 or M4. By controlling them itcan stabilise the price level.

Price mechanism in the market system works better whenprices are stable and relative prices can adjust accordingto the dynamics of the economic system.


Natural Rate Hypothesis

nte

t uub

UnShort run Phillip’s curve PC

LPC f g

d e PC4 b c PC3

a PC2 u un PC1Natural rate of unemployment and avertical Phillip’s curves


A brief story of monetary policy in the UK and the EU

Fixed peg system in the Gold Standard and the Bretton Woods.Exchange rate was the nominal anchor of monetary policy.

Targeting money supply during 1970s. Stop and Go Cycles.

Monetarism in the Thacher and Reagan administrations.

Inflation targeting during 1980s.

Central bank independence during 1990s.

Euro 1999.


Inflation and growth rate of money supply in the UK 1972-2000

-5

0

5

10

15

20

25

301

97

0Q

2

19

71

Q4

19

73

Q2

19

74

Q4

19

76

Q2

19

77

Q4

19

79

Q2

19

80

Q4

19

82

Q2

19

83

Q4

19

85

Q2

19

86

Q4

19

88

Q2

19

89

Q4

19

91

Q2

19

92

Q4

19

94

Q2

19

95

Q4

19

97

Q2

19

98

Q4

reta

il p

rice

ind

ex

an

d g

row

th r

ate

of

mo

ne

y su

pp

ly

rpi

msgrth

lagp


Growth Rate fo real GDP in the UK

-6

-4

-2

0

2

4

6

8

10

121

97

0Q

2

19

71

Q4

19

73

Q2

19

74

Q4

19

76

Q2

19

77

Q4

19

79

Q2

19

80

Q4

19

82

Q2

19

83

Q4

19

85

Q2

19

86

Q4

19

88

Q2

19

89

Q4

19

91

Q2

19

92

Q4

19

94

Q2

19

95

Q4

19

97

Q2

19

98

Q4

growth rate


How does the Bank of England forecast the inflation?

The economic model of the Bank of England includesa loss function,policy reaction function andintermediate targets.

Core forecasting model that the MPC uses for interest ratedecisions includes 150 variables.

But the model for the pre-MPC briefing is based on charts andtables of more than 1000 variables. Information for this model iscollected from 12 different branches of the bank around thecountry. Inflation target focuses on the domestically generatedinflation (DGI). (John Vickers, Inflation Targeting in the UK,Bankof England Quarterly Bulletin, 1999 pp. 368-375). The forecastingmodel might be summarised in terms of the following diagramfrom the MPC.


Officialrate

Marketrate

Assetprices

Exchangerate

Expectationsand confidence

Domesticdemand

Net externaldemand

Domesticinflationary pressure

Importprices

Inflation

Total demand

Transmission Mechanisms of Monetary Policy-Bank of England’s View

Macroeconomic Themes:3 14B&W Figure 9.7

Percentage increase in prices on a year earlier

Source: Inflation Report, Bank of England, November 2000

Bank of England’s Fan Chart


Effects of Changes in the Rate of Interest

First round effects

Households: saving, housing, wealth,foreign asset, portfolio allocationsFirms: cost of capital, debt-equity,portfolio allocations

Second round effects: consumptionspending, additional demand for goods

Time lags: anticipated and unanticipatedpolicy changes.


Simple Policy Reaction Function: An Example of Interest Determination Rule

Impact of interest rate in output

*

1*titidyty (1)

where ti and *tiare actual and natural level of output,

ti is the actual rate of interest in period t,

i is the interest target of the monetary authority,d <0 is a negative parameter.There is one period lag between the interest rate decisionand the change in the output.


Simple Policy Reaction Function: An Example of Interest Determination Rule

T h e i n f l a t i o n r a t e r e s p o n d s t o t h e a g g r e g a t e s u p p l y

*11

*tytyctt ( 2 )

w h e r e t a n d *t a r e a c t u a l a n d t a r g e t i n f l a t i o n r a t e s .

T h e r e f o r e t h e i n t e r e s t r a t e d e t e r m i n a t i o n r u l e i n s i m p l et e r m s c a n b e w r i t t e n a s

***ttbtytyatiti ( 3 )


Bamplified cycle

A

smoother cycle

Does Policy Work? Lags and demand management policy

Time

Out

put

Businesscycle


Monetarist’s View on Impact of Monetary and Fiscal Policies

Monetarists view of Monetary policy (IS-LM) Monetarist view on Fiscal policy (IS-LM)


Monetary Policy Instruments

Money supply targeting Interest rate targeting


Interest Rate Determination Model: Actual and Predicted Series

0

2

4

6

8

10

12

14

16

18

0 20 40 60 80 100 120TIME

PTBIL TBILLS


Prediction using a Simple ModelInterest Rate Determination Rule : A Simultaneous Equations Estimation

-10

-5

0

5

10

15

20

25

0 20 40 60 80 100 120TIME

PTBIL TBILLS

-6

-4

-2

0

2

4

6

8

0 20 40 60 80 100 120TIME

PDY DY

-10

-5

0

5

10

15

0 20 40 60 80 100 120TIME

PDRPI DRPI


References

1. Ball Laurence and Romer David (1990) Real Rigidities and the Non-Neutrality of Money, Review ofEconomic Studies, 1990 57 183-203.

2. Bank of England (www.bankofengland.co.uk) The Transmission Mechanism of Monetary Policy.3. Barro and Gordon (1983) A Positive Theory of Monetary Policy in a Natural Rate Model, Journal of

Political Economy, 91:4: 589-610.4. Goodhart C.E.A. (1994) What should central banks do? What should be their macroeconomic

objective and operations?, Economic Journal, 104, November, 1424-1436.5. Friedman, M. (1968), "The Role of Monetary Policy," American Economic Review, No.1 vol. LVIII

March.6. Kydland F.E and E.C. Prescott (1977) Rules rather than discrection: the Inconsistency of Optimal

Plans, Journal of Political Economy, 85:3: 473-491.

Documents

Macroeconomic Themes:31 Contribution of Monetarism in Macroeconomic Policy Supply of money is the determinant of the national income In the long run, the