Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Spring 2012 Advanced Workshop on Global Political Economy, Institute for Global Law & Policy, Harvard Law.

Transcript Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Spring 2012 Advanced Workshop on Global Political Economy, Institute for Global Law & Policy, Harvard Law.

Institutions of Macroeconomic Policy

Jeffrey Frankel

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

Lecture I, May 30 Monetary 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.

Monetary ease in 2003-05 was excessive

(at least in retrospect) Source: Benn Steil, CFR, March 2009 US real interest rate < 0

•

(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.

2008-09 1930s

Source: IMF,

WEO

, April 2009, Box 3.1

• 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).

peak: early 80s

≈

peak: 1990 Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University peak: early 90s

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 6 th 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.

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 bank might as well give 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.

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 2. Money growth 3. Exchange rate 4. Price level 5. Nominal GDP 6. Inflation rate

Addressing the time-inconsistency problem (continued)

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.

•

Delegation

Alesina & Summers: Central banks that are institutionally independent of their governments have lower inflation rates on average .

Transition economies

“Central Bank Independence, Inflation and Growth in Transition Economies,”

P.Loungani & N.Sheets, IFDPS95-519 (1995)

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.

Addressing the time-inconsistency problem (continued)

2) Reputations

• 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.

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

6 proposed nominal targets and the Achilles heel of each:

Monetarist rule Targeted variable

Vulnerability

Velocity shocks

Example

US 1982

Inflation targeting

CPI Import price shocks Oil shocks of 1973-80, 2000-08

Nominal income targeting Gold standard Commodity standard Fixed exchange rate

Nominal GDP Price of gold Price of agric. & mineral basket $ ( or €) Measurement problems Less developed countries Vagaries of world gold market Shocks in imported commodity Appreciation of $ (or € ) 1849 boom; 1873-96 bust Oil shocks of 1973-80, 2000-08 1995-2001 Professor Jeffrey Frankel

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

uropean

onetar y

nion 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.

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

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

Countries adopting IT experienced lower inflation

Gonçalves & Salles, 2008

, “

Inflation Targeting in Emerging Economies…”

JDE

I nflation 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 $.

End of Lecture I Monetary Policy Institutions: Central Banking Jeffrey Frankel

James W. Harpel Professor of Capital Formation & Growth http://ksghome.harvard.edu/~jfrankel/ Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

Appendix 1: Dynamic inconsistency

• Assume governments, if operating under discretion, choose monetary policy and hence AD so as to maximize a social function of

π.

– => Economy is at tangency of AS curve & one of the social function’s indifference curves.

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

• Assume

–

π e &

  setters have rational expectations

E π

–

=> π e = E π = π

on average.

shifts up • •  economy is at point

on average . Inflationary bias:

π e =E π > 0

• Lesson: The authorities can’t raise

anyway, so they might as well concentrate on price stability at point

3. But π e adjusts upward in response to observed π>0.

The LR or Rational Expectations equilibrium must feature π e = π. π π e Result: inflationary bias π>0, despite failure to raise

4. The country would be better off “tying the hands” of the central bank. Result:

(no worse on average than under discretion), and yet π=0.

● ● ●

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

2. If π e would stay at 0, then to get the higher

it would be worth paying the price of π>0.

1. Barro-Gordon innovation: It can be useful to think of society’s 1 st choice for output as

Y= Y

ˆ (& π=0), even if it is unattainable.

Time inconsistency of non-inflationary monetary policy, continued



  (   

) + Policy-maker minimizes quadratic loss function:   1 2 (



ˆ ) 2  1 2

(  ) 2 , where the target

ˆ 

=>   1 2 (

  (   

)  ) 2  1 2

(  ) 2

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



  (

  (   

) 

ˆ )  

(  )  0 .

Take the mathematical expectation: (

 

(   

)  )  

(  )  0 .

    

(

ˆ 

)  0

 the inflationary bias.

Appendix 2: Seignorage

is another reason for inflation, including hyperinflation 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.)

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,

must go up more than

The real economy plummeted in 2008

Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Spring 2012 Advanced Workshop on Global Political Economy, Institute for Global Law & Policy, Harvard Law.

Transcript Institutions of Macroeconomic Policy Jeffrey Frankel Harpel Professor Spring 2012 Advanced Workshop on Global Political Economy, Institute for Global Law & Policy, Harvard Law.

Institutions of Macroeconomic Policy

Jeffrey Frankel

Lecture I, May 30 Monetary Policy Institutions: Central Banking

Institutions

Central Banking

(1) Stable money

(2) Financial stability

• UK

The famous bank run in

It’s a Wonderful Life

The bank run in

Mary Poppins

• US –

A true bank run, NYC, ≈ 1931

Monetary ease in 2003-05 was excessive

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

The Fed let M1 fall after 1929,

The formal retreat from activist monetary policy

The Mexican sexenio

Addressing the time-inconsistency problem

1) Delegation

2) Reputation

3) Binding rules

1) Delegation

2) Reputations

3) Rules

Fashions in choice of nominal anchor

The exchange rate anchor

End of Lecture I Monetary Policy Institutions: Central Banking Jeffrey Frankel

Appendix 1: Dynamic inconsistency

Appendix 2: Seignorage

Hyperinflation in Zimbabwe

Directory