chapter 10...10.2.1 frictions in credit markets ch 10–new keynesian models of monetary policy...

Chapter 10

New Keynesian Model of Monetary Policy

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Learning Outcomes

➢New Keynesian Model

➢ IS-PC-MR Model

➢Implications of the model in the event of a shock

➢Financial Accelerator models

➢ Bernanke asymmetric info models

➢ Simple monetary policy rules

➢ Taylor Rule

➢ Friedman rule of constant money growth

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10.1.1 IS-PC-MR Model - Introduction

▪ Lucas & Prescott – The theoretical foundations of Keynesian models were

weak

▪ In the last 20 years the focus turned to DSGE models which incorporate RBC

models with the dynamic optimization decisions of households

▪ There was a need to move away from the standard IS-LM-AS approach to

better represent the decisions of the Central Bank

Ch 10– New Keynesian models of Monetary Policy

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10.1.1 IS-PC-MR Model - Introduction

Assumptions

▪ Inflation is persistent – Captures empirical evidence

▪ Time lag – There is a time lag between when the economy faces a shock and

the response of the Central Bank is fully felt

▪ Imperfect competition in goods market & Nominal rigidities – No attempt to

change real wage or prices in the short run


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10.1.2 IS-PC-MR model – CB decision


▪ When setting the rule, the Central Bank needs to forecast the inflation and

output gap for the next period

▪ According to the rule, interest rates need to increase whenever actual

inflation exceeds target inflation and vice versa.

▪ Even though the Central Bank can take action after observing a shock at

period 0, due to lagged effect of interest rates on aggregate demand it cannot

fully offset the impact of the shock in the current period.

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10.1.2 IS-PC-MR model – CB decision


Timing

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10.1.3 IS-PC-MR model – Model setup


The model consists of three elements – Carlin & Soskice (2005,2006)

▪ IS Curve

▪ New Keynesian Phillips Curve (PC)

▪ Typically IS & Phillips curve are forward looking

▪ For simplicity we use backward looking IS & Phillips curve

▪ Monetary Policy rule (MR)

▪ Similar to a Taylor rule function

▪ Central Bank uses it to decide on the optimal policy action

▪ The central bank, is forward looking when deciding the level of short-

term interest rates by taking the Phillips and IS curves as constraints.

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10.1.3 IS-PC-MR model – Model setup


IS Curve

Phillips curve

MR function

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10.1.4 IS-PC-MR Model – monetary Policy

rule


▪ Monetary Policy must choose the optimal level of Inflation versus

unemployment

▪ The Central Bank chooses the policy rate in order to minimize the cost of

achieving its objectives given the constraints it faces from the private sector.

▪ The MR line shows the level of output the Central Bank will choose, given the

Phillips curve constraint that it faces.

▪ The model is setup such that it is optimal for the Central bank to carry out its

policy after having formulated expectations

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10.1.4 IS-PC-MR Model – Taylor rule


▪ Monetary policy is conducted by means of short-term rates that can be

effective to stabilize inflation and real output in the short run.

▪ In this framework, the real interest rate is the short term interest rate. rs is the

stabilizing rate of interest

▪ The Central bank sets the nominal short term interest rate and since inflation

is given in the short run, the Central Bank is said to control the real interest

rate indirectly

▪ The central bank will adjust interest rates downwards as inflation falls

11Ch 10– New Keynesian models of Monetary Policy

10.1.4 Key assumptions in MR rule

▪ Inflation inertia

▪ Time lag for interest rate to take effect

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Hawks Versus Doves



10.1.4 IS-PC-MR Model – Monetary Policy

decision


10.1.4 Formal treatment of MR

The monetary authorities set interest rates based on Taylor rules

Taylor rules in practice

http://www.federalreserve.gov/Pubs/feds/2007/200718/200718pap.pdf

http://www.federalreserve.gov/Pubs/feds/2007/200718/200718pap.pdf


10.1.4 Formal treatment of MR

The monetary authorities chooses (r0 – rs) in order to minimize their loss function.

It is clear that a positive inflation gap necessitates an increase in interest rate above

target and vice versa

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10.1.5 Graphical representation - equilibrium


▪ Equilibrium output level is where both wage-setters and price-setters make no

attempt to change the prevailing real wage or relative prices

▪ Each Phillips curve is indexed by the pre-existing or the past rate of inflation,


10.1.5 IS-PC-MR model – Monetary policy

mechanism

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10.1.5 Graphical representation – Demand

Shock


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10.1.5 Demand Shock - Outcomes


▪ Permanent Shift in IS – Stabilizing rs will be higher

▪ Temporary shift in IS – Stabilizing rs will be the same

An aggregate demand shock can be fully offset by the central bank even if there is

inflation inertia if the central bank’s interest rate decision has an immediate effect

on output

The more timely and accurate are forecasts of shifts in aggregate demand, the

greater is the chance that the central bank can offset such shocks and prevent the

impact of inflation from being built into the economy.

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10.1.5 Graphical representation – Supply

Shock


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10.1.6 Demand & Supply shock outcomes


Conclusions

▪ Positive demand shock – Leads to a procyclical inflation revision

▪ Demand shock temporary – Same real interest rate

▪ Demand shock permanent – Different real interest rate

▪ If there are no time lags, the economy can immediately jump to the final

outcome where output is at the full employment level

▪ Positive supply shock – Leads to an anti cyclical inflation revision

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10.1.6 IS-PC-MR Model – Key conclusions

▪ A forward looking IS curve when combined with a MP rule dampens the

response of the economy to a shock

▪ In the long run monetary policy is still neutral – Classical Dichotomy still

holds


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10.2 Financial Accelerator models


▪ These are modifications to the basic new Keynesian model in order to take

into account some real world constraints

▪ They are known as accelerator models as they aim to show that endogenous

development/fictions in particular markets amplify and propagate shocks to

the macroeconomy

Examples of constraints

▪ Kiyotaki & Moore (1997) – Collateral constraints

▪ Aksoy, Basso, Coto Martinez (2013) – Lending relationships

▪ Bernanke et al – Asymmetric information

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10.2.1 Frictions in Credit Markets


▪ RBC & IS-LM model implicitly imply an economic structure similar to thee

Modigliani Miller theorem which implies that financial structure is both

indeterminate and irrelevant to real economic outcomes

▪ In this framework everyone who is credit worthy and who requires funding for

positive NPV projects will receive the necessary funding

However in reality, credit markets are affected by two key frictions

▪ Asymmetric Information

▪ Agency Cost

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However in reality, credit markets are affected by two key frictions:

▪ Asymmetric Information – Akerlof’s Lemons

▪ Hence there is a cost to verifying the credibility of borrowers

▪ Financial contracts reflect the costs of gathering information about the

quality of borrower's investment

▪ Agency Cost

▪ The presence of external funding means that there may be divergences in

the objective of borrowers and lenders.

▪ This would lead to an increase in cost of funds

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▪ In general deteriorating credit-market conditions - sharp increases in

insolvencies and bankruptcies, rising real debt burdens, collapsing asset

prices, and bank failures - are not simply passive reflections of a declining real

economy, but are in themselves a major factor depressing economic activity.

Informational asymmetries together with agency costs leads to fewer projects get

external funding and hence there is real effects in the economy

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10.2.2 Bernanke Asymmetric info model


▪ This framework attempts to explicitly capture the impact of asymmetric info

and other frictions in credit markets and its impact on the wider economy

▪ The framework exhibits a "financial accelerator“ in that endogenous

developments in credit markets work to propagate and amplify shocks to the

macro economy

Key concepts

▪ External finance premium – Difference between cost of funds raised

externally and the opportunity cost of funds internal to the firm

▪ Net worth of Borrowers – Borrowers liquid assets plus tangible and intangible

assets less obligations

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Key result

▪ Standard models of lending with asymmetric information imply that the

external finance premium depends inversely on borrowers' net worth.

▪ This inverse relationship arises because, when borrowers have little wealth to

contribute to project financing, the potential divergence of interests between

the borrower and the suppliers of external funds is greater, implying increased

agency costs

▪ In equilibrium, lenders must be compensated be higher agency costs by a larger

premium.

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The accelerator effect

OutputFirm

profits

Net worth

Finance premium

New Projects

Output

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10.2.3 Bernanke asymmetric info model


Model Setup

SavingsLendings

Labour

Wages

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Model Setup

▪ There are three types of agents

▪ Households

– They supply labour and supply funds to financial institutions

- Households are risk averse

▪ Entrepreneurs

- Risk neutral individuals who live for a finite period

- They acquire fixed capital by risking their net wealth

- Any shortfall is met y borrowing from financial intermediaries

▪ Retailers/ Banks

- Must choose between lending to the entrepreneur and investing in a riskless

return – Retail assumed to hold a diversified portfolio

- The retailer bears the cost of verifying the entrepreneurs credit worthiness

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Results

▪ The borrowers raises funds from the bank when his/her net worth is insufficient to

purchase the necessary capital

▪ The bank evaluates the return generated by this investment against the riskless

return which is the floor return that the bank must receive in order to be willing to

lend.

▪ The bank must pay some “auditing cost” in order to verify whether the entrepreneur

is credit worthy

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Results

▪ The lender will lend at the point where the return to capital will be equated to the

marginal cost of external finance

▪ The external finance premium entrepreneurs have to pay is inversely related to the

proportion of the capital investment that is funded by the entrepreneurs own

wealth – S can be interpreted as the Finance risk premium

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10.3.1 Approaches to monetary policy


From Ch 9 – Monetary authorities decision rule

Broadly theorists talk about two approaches to carrying out monetary policy

1. Rules

2. Discretion

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10.3.2 Discretion


A conversation on Central Banking

Link

https://www.youtube.com/watch?v=qHM1vfQWaIg

https://www.youtube.com/watch?v=qHM1vfQWaIg

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10.3.2 Rules - Taylor Rule


▪ prescribes how a central bank should adjust its interest rate policy instrument in a

systematic manner in response to developments inflation and macroeconomic

activity.

▪ Following such a rule is transparent and is used by major Central Banks in the world

▪ By committing to follow a rule, policy makers can communicate and explain their

policy actions easily and should at least in principle enhance the accountability and

credibility of the central bank.

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10.3.3 Taylor Rules in practice


• The coefficients g and h are expected to be positive

• The coefficient h should e greater than unity in order for the model to be stable

Transmission mechanism

>0

< 0

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10.3.2 Approaches to monetary policy


The Fed awakens: StarWars and Jedi Janet

Jedi Janet battled to balance the dual mandate of inflation and employment, and then awakened the Fed to raise

rates for the first time in nine years, abandoning the dark side of a non-rules based monetary policy.

Web Link - CNBC

http://www.cnbc.com/2015/12/31/the-fed-awakens-star-wars-and-jedi-janet-commentary.html

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10.3.2 Rules Vs. Discretion


Discretion Rules

Decision Maker

Individual - Governor & DeputyGovernor

Collective – Monetary Policy committee (MPC)

Time to make decision

Shorter as gives no thought to future

Longer – takes into account past and future implications

Timing of decision

Unplanned – could take place on any day, any time

Fully anticipated – Date and timing of the decision is known

Accountability None or very little need to explain decision

Oversight and accountable for actions

Effectiveness Stronger in short run More long term impact on market expectations


10.3.2 The Last Jedi?

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10.3.3 Empirical evidence of monetary approach - Taylor (1993)


In support of rules-based approach

• Alleviates the problem of time inconsistency

• Leads to more predictable and more stable policy outcomes

Challenges to rules-based approach

• Becoming increasingly more difficult to formulate policy in terms of a simple policy

rule in the face of increased complexity in the macroeconomic environment

• The incidence of shocks and special events has been on the rise due to global

interconnectedness of world markets and hence the need to respond quickly to

shocks

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10.3.3 Empirical evidence of monetary approach - Taylor (1993)


▪ “Advantage of rules over discretion is similar to the advantage of a cooperative over a

non-cooperative solution in game theory”

▪ Simple algebraic formulations of such rules cannot and should not be mechanically

followed by policymakers

▪ Hence there is still a need for discretion in the operation of policy rules

▪ Systematic and credible features of “rule like” behavior improve policy performance

and effectiveness

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10.3.3 Friedman rule of constant money

growth


▪ A shortcoming of monetary policy is the time lag between when a shock takes place

and when they react to it

▪ The reason central banks cannot quickly react is because of uncertainty with regard

to the data that is observed – Is this a growing trend or due to measurement error?

▪ However once the decision has been made the economic situation may have altered

such that the action taken is inadequate or even unsuitable

▪ Hence Friedman argued that monetary policy should not be used to combat output

fluctuations, not because of neutrality arguments but because of the long and

variable lags involved with such an activist policy.

chapter 10...10.2.1 frictions in credit markets ch 10–new keynesian models of monetary policy...

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