Notes: Monetary Policy

Monetary Policy Overview

• Topic: Political Economics topic 8

• Lecturer: Andrew Pickering

Introduction

• Observation: Changes in monetary policy are inherently redistributive.

  • Borrowers and lenders are affected differently.

  • Thus, monetary policy becomes a ‘political’ decision.

• Purpose of Monetary Policy:

  • Price Stability?

  • Stable Inflation?

  • Minimize Output Variability?

• Who Should Execute Monetary Policy?:

  • Politicians?

  • Delegated ‘independent’ officials?

Politicians as Monetary Policy Makers

• Democratic Accountability:

  • Politicians are democratically accountable but have limitations:

  • Democracy does not guarantee optimal outcomes.

  • Politicians could be incompetent.

  • Politicians may be susceptible to inflation bias.

  • Politicians may be influenced by electorally induced volatility.

Part 1: Inflation Bias

Inflation Bias and Barro-Gordon Model

• Model (Barro-Gordon 1983):

  • Government's preferences represented as:
    $L_G=δ₁π²+(x-x^*)²$

  • Where:

    • $L_G$ = welfare loss to the government

    • $π$ = inflation

    • $x$ = output deviation from the natural rate

    • $x^*$ = targeted output

    • $δ₁$ = government's relative dislike for deviation of inflation from zero.

Phillips Curve Representation

• Output Supply: Given by the Phillips Curve

  • Equation: $x=α(π-π^e)$

  • Where:

  • $π^e$ = expected inflation.

  • Note: When expectations are correct, output equals its natural rate.

  • Wages and prices are set prior to policy decisions, requiring expectations formation about policymaker's actions.

Equilibrium Inflation and Output

• Optimization Condition:

  • Setting the derivative of the government's loss function w.r.t. inflation to zero:
    $\frac{\partial L_{G}}{\partial\pi}=2\delta_1\pi+2\alpha(\alpha(\pi-\pi^{e})-x^{*})=0$

• After substituting the output supply function and setting $x=0$ (for medium-run output), we have:

  • $\pi_{G}=\alpha x^{*}/\delta_1$

  • $x_{G}=0$

• Source of Positive Inflation Bias: Rational expectations.

  • Wages depend on wage setters’ expectations, not merely on announcements by the policymaker.

  • The inflation bias arises from the time-inconsistency of initially optimal policies (as explained by Kydland and Prescott 1977).

Reducing Inflation Bias

• Mechanisms:

  • Rules vs. Discretion:

  • Discretion allows for flexibility, while rules enhance credibility.

  • Divergence from announcements occurs through discretionary implementation of policy.

  • Commitment:

  • If policymakers pre-commit to zero inflation, then:

    • $π=π^e=0$

    • $\left(\frac{\partial L_{G}}{\partial\pi}\right)=2\delta_1\pi=0$

    • Thus, $π_G=0$

  • However, establishing commitment in practice is challenging and can lack credibility.

Policy Rules

• Types of Policy Rules:

  • Friedman Rule: Money growth = $x\%$ perpetually.

  • Taylor Rule (initiated by John Taylor, 1992): $i=r^{*}+\pi^{*}+1.5\left(\pi-\pi^{*}\right)+0.5y$

• General Issues with Rules: Issues of commitment and credibility.

  • Taylor Rule could avoid some credibility issues and is derived from optimization problems similar to Barro-Gordon's.

Independent Central Banks (CB)

Instrument and Objective Independence

• Instrument Independence: Central Banks set monetary policy independently (e.g., FRB, BoE, ECB).

• Objective Independence: Central Banks choose policy goals such as price stability, inflation targets, or output stabilization.

• Rogoff (1985) Model:

  • Considering an independent CB with preferences represented as:
    $L_{CB}=μ₁π²+(x-x^*)²$

  • Where $μ₁ > δ₁$, indicating that the CB is more conservative than the government.

  • Outcomes are:

  • $π_{CB}=αx^*/μ₁$

  • $x_{CB}=0$

Implications of a Conservative Central Banker

• Result: Lower inflation under independent CB than when monetary policy is conducted by the government.

• Evidence: Presented through various statistics and inflation averages from different countries.

Measuring Central Bank Independence

• Use of indices combining legal and institutional aspects of monetary policy by Cukierman, Webb, and Neyapti (1992) and Alesina and Summers (1993).

• Index Evaluation Factors:

  • Tenure length, appointment procedures, dismissal provisions, and ability to hold other government offices.

Extending the Barro-Gordon Framework

Uncertainty Considerations

• Considering shocks to the Phillips Curve introduces dynamics of lower inflation volatility under Central Bank Independence (CBI), but increases output volatility as the trade-off for inflation stability.

Variance Inflation Analysis

• Graphical representation of variance inflation among various countries showing lower volatility levels in CBI contexts.

Summary of Evidence on CBI

Empirical Findings

• CBI appears to reduce inflation drastically in high-income countries.

• Mixed results in less developed countries with no statistically significant relationship often noted between CBI and equilibrium inflation (reference as per Campillo and Miron, 1997).

Why Adopt CBI Worldwide?

• Consensus on high inflation being detrimental spurred CBI demand.

• IMF policies mandated CBI for supported countries.

• Academic backing from time inconsistency and inflation bias frameworks.

• End of institutions like Bretton Woods necessitated alternatives, with CBI presented as favorable.

Central Bank Independence in Post-Crisis Context

Effects of Financial Crises

• Financial crisis challenges consensus surrounding CBI.

• Politicization of monetary policy has been observed; questioned if this reflects independent policymakers adhering to a Taylor Rule.

Part 2: Political Business Cycles

Introduction to Political Business Cycles

• Another rationale for CBI, potentially explaining reduced politically-induced macroeconomic volatility.

Types of Political Business Cycles

• Opportunistic Political Business Cycles:

  • Existence is debated; limited systematic evidence available.

  • Voters show responses to the economy, but in nuanced ways.

• Partisan Political Business Cycles: Impact of the ruling party on macroeconomic outcomes noted (with analysis from articles such as Vox).

Predictions and Implications

• Utilize models forecasting the relationship between wages, expectations, and government preferences.

• Analyze political volatility dynamics through correlation of political cycles with economic output.

Final Considerations

• Arguments against CBI involve concerns over democratic deficits, narrow mandates, misalignment with government policies, biases, and crisis responses.

These notes aim to provide an exhaustive guide to the key concepts discussed in the transcript related to monetary policy and its political implications.