class 10- Central banks & monetary policy.

What are the 3 functions of central banks?

STATE INSTITUTIONS=

• manage finances of state

• manage currency to allow economic activity

• unique lender of last resort to banks, governments & economy.

Central banks and emergency finace:

• try to prevent emergencies instead of reacting.

  • signaling to markets that they will not be able to make money by selling off a currency on financial markets:

    • 3 examples: 2008, 2012, 2020.

On an international level?

• provider of last resort= hegemon’s central banks

What do central banks engage in when the manage the economy?

• MONETARY POLICY.

  • ensure enough loney in circulation.

  • ensure banks have enough

  • ensure governments have acces to finance.

• act through primary interest rate

What are the 3 main goals of the central bank?

• PRICE STABILITY= low inflation

• ECONOMIC STABILITY= smoothing

• FINANCIAL STABILITY= preventing economic crashes.

What is the fisher equation?

real interest rate= nominal interest rate- inflation rate

What is disinflation?

= decrease in the rate of inflation

Who are the winners & losers from inflation?

winners=

• anyone earning money

• debt payers

losers=

• anyone who has money

• investors, savers, creditos

• pensions (fixed benefits)

who are the winners & losers from deflation?

winners=

• anyone who has money

  • investors, savers, creditos

  • pensions (fixed benefits)

    • real value of assets increase

losers=

• anyone earning money

• debt payers

• society= consumption drops → delays.

If inflation is too high…

If unemployemt too high

→ central banks can…

• too high → raise interest rate.

• unemployement → lower interest rates

The measurement approach: (pros/ cons)

• Central bank pays attention to prices in order to change interest rates. (rise when prices rise…)

PRO: evidence based, works without paying attention to money supplu.

CON: suffers blind spots (didnt think housing was part of inflation)

The WS/ PS model approach:

• Central bank think inflation caused by how workers and firms bargain over prices.

PROS: goes beyond economic shocks to look at how firms and workers react

CONS: suffers from blind spots: ignores financial markets = unrealistic

How can firms & workers cause inflation?

• baraganing power of firms increases over consumers= greedflation.

• of workers over firms: wage increase that doesnt result from increased productivity.

When increase in price of oil:

• downwards shift PS curve

• prices rise

• real wages fall

• positive baragaing gap

• peristently higher inflation

Inflation can be caused by supply and demand shocks:

• supply shock ?

  • solution= windfall taxes on firms

• demand shock =cannot boost production → rise prices.

  • solution= fiscal policy investments to increase supply or higher interest rates

Philipps curve

inflation and unemployement curve

• moderate inflation is okay as long as employement goes with it

baragining power and inflation:

• bargaining power can increase inflation over time

How does the central bank stimulate investment?

• lowering real interest rate.

• AD curve shifts upwards

Transmission mechanisms

• asset prices: interest rate goes down → asset prices go up

• Exports: interest rate goes down → exports go up

  • expensive imports drives up inflation.

Can interest rate go below 0%?

• no “zero lower bound”

  • should use fiscal policy

  • if not use quantitative easing

Do Monetary and fiscal policy work together?

Ideally yes → work in same direction as they share the same path.

• created success in US.

What does the effectivness of central banks depend on?

• transmission mechanisms

• interaction with fiscal policy

• capacity constraints (zero lower bound)