Institutions of Macroeconomic Policy

Jeffrey FrankelHarpel Professor

Spring 2012 Advanced Workshop on Global Political Economy,Institute for Global Law & Policy, Harvard Law School

Lecture I, May 30Monetary Policy Institutions:

Central Banking

Institutions• Economists have begun to pay more attention to “Institutions”

– In such areas as Macroeconomics, Development Economics, – and Economic History: Douglass North (1991) on property rights.

• Example (“Lucas Paradox”): Why does capital often flow “uphill”: to countries that already have a lot of capital, rather than to those without? Answer: Because the former group are the countries that have institutions, such as rule of law, that assure investors they will be able to reap the returns on their investments.

• But we need to get more specific about what sorts of institutions work.

• These 3 lectures will look at institutions in the areas of monetary and fiscal policy, with an application to the current euro crisis.

Central Banking

The three big objectives of central banks:

•(1) Price stability• avoiding inflation.

•(2) Financial stability• avoiding banking panics

and financial crashes.

•(3) Economic stability• avoiding recessions.

(1) Stable money• Objective:

To supply a currency that can be used throughout the country and that will keep its value, i.e., will not be inflated away.

• In the 19th century, the gold standard was the original institution to guarantee (long-run) price stability.

– UK (from 1821)– US (from 1873)

(2) Financial stability

Objective: To act as a Lender of Last Resort in the face of potential bank runs or other financial panics.

• UK -- Bagehot’s rule (1873): In a panic, the central bank should be prepared to lend unlimited amounts to banks

– provided their problem is a liquidity shortage, rather than insolvency,

– against collateral.

The famous bank run in It’s a Wonderful Life

The bank run in Mary Poppins

Financial stability, continued

• US – – American antipathy to eastern banking elites defeated

19th-century attempts to found a national bank.

– In the Panic of 1907, J.P. Morgan had to act as Lender of Last Resort.

– => At Jekyll Island (1910), six conspirators secretly drafted Aldrich Plan for a central bank.

• Congress passed the Federal Reserve Act in 1913• with anti-elite protections,

– incl. 12 Federal Reserve districts.

A true bank run, NYC, ≈ 1931

American Union Bank

• US, continued

– Response to banking collapse in Depression• FDR called national bank holiday,

after which only those banks judged to be solvent were allowed to re-open (1933).

• Financial reform to reduce future moral hazard -- The Banking Act of 1933:– FDIC

» Insurance of deposits (up to $10K)– Matched by requirements that banks hold reserves & capital.– “Glass Steagall”

» Commercial banks, who benefit from safety net, could not also engage in risky investment banking.

• But the “financial stability” goal of central banking had been largely forgotten by the end of the century (or taken for granted)

– with the exception of emerging market crises.

• Lesson that monetary theory should take from the 2007-09 global financial crisis:

– excessive monetary ease can show up in the form of asset price “bubbles”

• leading to crashes & recessions,

– and not necessarily always in the form of inflation• leading to crashes & recessions.

– Von Hayek, Minsky, Kindleberger.

Source: Benn Steil, CFR, March 2009

US real interest rate < 0

Monetary ease in 2003-05 was excessive(at least in retrospect)

(3) Final central banking objective: Stabilize the real economy

• In response to unemployment and lost real GDP in the Great Depression, federal policy was given responsibility for stabilizing economic activity.

• as codified in Employment Act of 1946• and Humphrey-Hawkins Act of 1978, • including dual mandate for Fed:

low inflation (“price stability”) & low unemployment (goal = 4%) .

• Monetary policy mistakes in the interwar years (arising in part from mistaken belief that wages & prices

would adjust rapidly to clear labor & goods markets) had had huge costs:

• UK (1925) returned to gold standard at overvalued exchange rate (despite warnings from Keynes in On the Economic Consequences of Mr. Churchill.)

• US allowed M2 money supply to decline after 1929 (as documented by Milton Friedman & Anna Schwartz, in A Monetary History of the US).

• Premature renewed US monetary (& fiscal) contraction brought back recession in 1937-38,– a mistake we are all in danger of repeating today.

The Fed let M1 fall after 1929,but was careful not to repeat the mistake after 2007.

Source: IMF, WEO, April 2009, Box 3.1

1930s

2008-09

• Monetary (and fiscal) expansion in 1960s was heyday of “Keynesian” policy to stimulate growth.

• Re-thinking then followed, due to ever-rising inflation

– and also due to another consequence of excessive expansion: widening US balance of payments deficit

• which accelerated the end of the Bretton Woods system (ending in 1971 $ devaluation & 1973 floating).

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

peak:

≈ 1990 peak: early 90s

peak: early 80s

The formal retreat from activist monetary policy

• The Phillips curve (1958) had implied that monetary policy could push up employment and output indefinitely, at the cost only of steady inflation

– Samuelson, Solow, • both of whom are Nobel Prize winners.

• It was superceded by the Natural Rate Hypothesis: if unemployment were held below its natural rate, inflation would accelerate without limit

– Friedman and Phelps (1968), another 2 Nobel Prizes.

The retreat from activist monetary policy, continued

• The Natural Rate Hypothesis was followed by the Rational Expectations Hypothesis: – Any systematic pattern of monetary policy

(e.g., expansion in recessions or election years) would be built into expectations.

– Only random monetary changes can have real effects, because only they are unexpected. => Discretionary monetary policy not useful.

– Lucas, Sargent, Barro in mid-1970s.

2 / 3 Nobel Prizes.

• Implication: Discretionary monetary policy is not useful.

The Mexican sexenio

From 1976 through 1994,

inflation would should up and the peso would devalue, every 6th year (presidential election years).

• Then came the Dynamic Consistency Hypothesis:When central banks have discretion, equilibrium entails an inflationary bias.

– They have to print money even just to match the inflation that the public expects,

– with no growth benefits. – Kydland & Prescott, and Barro. 2 / 3 Nobel Prizes.

• Implication: Monetary authorities might as well give up on trying to stabilize the real economy. Instead, commit credibly to low inflation.

– => expectations of low inflation => attain actual low inflation without having to suffer unemployment or lost output to do it.

Copyright 2007 Jeffrey Frankel, unless otherwise notedProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

Addressing the time-inconsistency problem

How can the Central Bank credibly commit to a low-inflation monetary policy?

Announcing a policy target π = 0 is time-inconsistent, because a CB with discretion will inflate ex post, and everyone knows this ex ante.

CB can eliminate inflationary bias only by establishing non-inflationary credibility,

which requires abandoning the option of discretion.

so public will see the CB can’t inflate even if it wants to.

CB “ties its hands,” as Odysseus did in the Greek myth.

If monetary policy cannot have a systematic effect on output anyway, the central bankmight as wellgive up, and attain the only goal it can: price stability.

But only if it “ties its hands” will its commitment not to inflate be credible.

Copyright 2007 Jeffrey Frankel, unless otherwise noted Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Addressing the time-inconsistency problem

1) Delegation. Appoint a central banker with high weight on low inflation, and grant political independence. Rogoff (1985):

2) Reputation

3) Binding rules. Commit to rule for a nominal anchor:

1. Price of gold 4. Price level 2. Money growth 5. Nominal GDP3. Exchange rate 6. Inflation rate

1) Delegation• Legal independence:

– Governors have long terms and can’t be fired.– Central bank has its own budget.– No obligation to buy government bonds,

• “monetization of the debt”,• either directly nor indirectly.

• The original independent central banks:– Federal Reserve, Bundesbank & Swiss National Bank.

• In the 1990s, – independence was also granted the Bank of England,

Bank of Japan, & many others (Korea, Mexico, …)– The ECB was given complete independence.

Addressing the time-inconsistency problem (continued)

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Alesina & Summers: Central banks that are institutionally independent

of their governments have lower inflation rates on average.

• Delegation

Copyright 2007 Jeffrey Frankel, unless otherwise noted Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

“Central Bank Independence, Inflation and Growth in Transition Economies,” P.Loungani & N.Sheets, IFDPS95-519  (1995)

Transitioneconomies

Copyright 2007 Jeffrey Frankel, unless otherwise noted

I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Limitations to the argument for central bank independence

1. Some consider it undemocratic.

2. The argument only works if conservative central bankers are chosen.

3. Although independence measures are inversely correlated with inflation, these measures have been debated and,

4. more importantly, the choice to grant independence could be the result of priority on reducing inflation.

5. As with rules to address time-inconsistency, there is little empirical evidence that it succeeds in reducing inflation without loss of output.

6. As with rules, one loses ability to respond to short run shocks.

Copyright 2007 Jeffrey Frankel, unless otherwise noted Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

• A new Central Banker can act tough in early periods, to build a reputation for monetary discipline,– and can then ease up subsequently

• without reigniting inflationary expectations.

– US examples: Volcker, Greenspan.

– Might explain why the ECB takes a hard line.

Addressing the time-inconsistency problem (continued)

2) Reputations

Professor Jeffrey Frankel

3) Rules

Fashions in choice of nominal anchor

• 1980-1982: Monetarism (target the money supply)

• 1984-1998: Fixed exchange rates (incl. currency boards & monetary union)

• 1999-2008: Inflation Targeting (target some version of the CPI)

Professor Jeffrey Frankel

Targeted variable

Vulnerability Example

Monetarist rule

M1 Velocity shocks US 1982

Inflation targeting CPI

Import price

shocks Oil shocks of

1973-80, 2000-08

Nominal income targeting

Nominal GDP

Measurement problems

Less developed countries

Gold standard Price

of gold Vagaries of world

gold market 1849 boom; 1873-96 bust

Commodity standard

Price of agric. & mineral

basket

Shocks in imported

commodity

Oil shocks of 1973-80, 2000-08

Fixed exchange rate

$ (or €)

Appreciation of $ (or € ) 1995-2001

6 proposed nominal targets and the Achilles heel of each:

The exchange rate anchor

• Many small or developing countries that had very high inflation rates finally achieved price stability in the 1990s by means of new exchange rate targets.

• Increasingly popular were legal/institutional means of committing credibly to a fixed exchange rate:– Currency boards (Hong Kong, Argentina, Bulgaria, Baltics…)

– Dollarization (Ecuador, El Salvador, Montenegro…)– Monetary Unions (particularly European Monetar y Union in 1999);

• especially after weaker exchange rate targets failed in the currency crises of 1997-98:– Band/Basket/Crawl (Mexico, Thailand, Korea, Indonesia, Russia, Turkey).

– But most responded by moving to the opposite corner: floating.

Copyright 2007 Jeffrey Frankel, unless otherwise notedProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

Source: IMF Survey. October 23, 2000. Andrea Schaechter, Mark Stone, Mark Zelmer. Online at: http://www.imf.org/external/pubs/ft/survey/2000/102300.pdf

Inflation Targeting originated in New Zealand in 1990. Spread to northern countries and, starting in 1999, to EM countries.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Countries adopting IT experienced lower inflation

Gonçalves & Salles, 2008, “Inflation Targeting in Emerging Economies…” JDE

Inflation Targeting has taken some heavy blows recently

• The biggest setback came in Sept. 2008:central banks that had relied on IT had not paid enough attention to asset bubbles.

– Central bankers had thought they were giving asset markets all the attention they deserved: housing & equity prices could be taken into account to the extent they carried information regarding inflation.

– But this escape clause proved insufficient: – When the global financial crisis hit -- suggesting at least in retrospect

that monetary policy had been too loose during the years 2003-06 -- it was neither preceded nor followed by an upsurge in inflation.

• The same thing had happened when asset markets crashed in the US in 1929, Japan in 1991, and Thailand & Korea in 1997.

• Also, the Greenspan reliance on monetary easing to clean up the mess in the aftermath of such a crash proved wrong.

Another major drawback of IT: inappropriate response to supply shocks & trade shocks.

• Monetary policy should respond to an increase in world prices of export commodities by tightening enough to appreciate the currency (“accommodating the terms of trade”).

• But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of import commodities -- exactly the opposite of accommodating the adverse shift in the terms of trade. – E.g., it is suspected that the reason for the otherwise-puzzling

decision of the ECB to raise interest rates in July 2008 -- as the world was sliding into the Great Recession -- was that oil prices were reaching an all-time high.

– Oil prices get a substantial weight in the CPI, so stabilizing the CPI when $ oil prices go up requires appreciating versus the $.

Jeffrey FrankelJames W. Harpel Professor of Capital Formation & Growth

http://ksghome.harvard.edu/~jfrankel/Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

End of Lecture IMonetary Policy Institutions: Central Banking

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Appendix 1: Dynamic inconsistency

• Assume governments, if operating under discretion, choose monetary policy and hence AD so as to maximize a social function of Y & π.– => Economy is at tangency of AS curve &

one of the social function’s indifference curves.– Assume also that the social function centers on > ,

even though this point is unattainable, at least in the long run.

• Assume W & P setters have rational expectations– => πe (& AS) shifts up if rationally-expected E π shifts up– => πe = E π = π on average.

• economy is at point B on average. Inflationary bias: πe=E π > 0.•

• Lesson: The authorities can’t raise Y anyway, so they might as well concentrate on price stability at point C.

Y Y

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Y1. Barro-Gordon innovation: It can be useful to think of society’s 1st choice for output as Y= (& π=0), even if it is unattainable.

Y

2. If πe would stay at 0,

then to get the higher Y

it would be worth paying the price

of π>0.

3. But πe adjusts upward in responseto observed π>0.

The LR or Rational Expectations equilibrium must feature πe = π.

Result: inflationary bias π>0, despite failure to raise Y above . Y

π

πe

4. The country would be better off “tying the hands” of the central bank. Result: Y = (no worse on average

than under discretion), and yet π=0.

Y

●

●

●

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Time inconsistency of non-inflationary monetary policy, continued

+ Policy-maker minimizes quadratic loss function:

,

where the target .

=>

)( eyy

22 )(2

1)ˆ(

2

1 ayy

yy ˆ

22 )(2

1)ˆ)((

2

1 ayy e

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Given discretion, the CB chooses the rate of money growth and inflation π (assuming it can hit it) where

.

Take the mathematical expectation:

+ Rational expectations: =>

the inflationary bias.

0)()ˆ)((

ayyd

d e

.0)()ˆ)(( aEyEy e

Ee

0)ˆ( yya

E

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

How do governments finance spending?

• Taxes

• Borrowing

• Domestic

• Abroad

• Seignorage ≡ creating money to finance deficits

(Inflation tax ≡ money creation in excess of rising money demand from real growth.)

Appendix 2: Seignorage is another reason for inflation, including hyperinflation

Hyperinflation in Zimbabwe

The world’s most recent

hyperinflation: Zimbabwe,

2007-08

Inflation peaked at 2,600% per month.

The driving force?

Increase in money supply:

The central bank monetized

government debt.

The exchange rate increased along with

the price level.

Both increased far more than the money

supply.Why?

When the ongoing inflation rate is high,

the demand for money is low, in response.

For M/P to fall, P must go up more than M.

The real economy plummeted in 2008