17/10/ XXXXXXXXXXOct-12 The Independence of Central Bank in an open economy. Dr Javier Coto-Martinez. Lect 6 Brunel University Objectives. • The exchange rate as adjustment mechanism. The macroeconomic adjustment in an open economy. • Monetary policy and inflation in an open economy. • Rule vs. discretion: The credibility of the macro policy in a floating exchange rate regime. • Time inconsistency problem and the trade off between inflation and unempl ti oyment in open economy • The Barro-Gordon model. • Solutions to the inflation bias. Inflation targeting in open economy. • References: • Alesina, A. and Gatti R XXXXXXXXXXIndependent central banks: Low inflation at No cost. American Economic Review. 85. no 2 (May): XXXXXXXXXX. • Alesina, A. and Summers, L XXXXXXXXXXCentral Bank independence and macroeconomics performance. Journal of Money, Credit and Banking, 25 no2 (May): XXXXXXXXXXBrunel University 2 ( y) • Barro, R. and Gordon D.B., XXXXXXXXXXA positive theory of monetary policy in a natural-rate model. Journal of Political Economy. 91:589-610. • McCallum, B.T XXXXXXXXXXTwo Fallacies Concerning Central-Bank Independence (in How Independent Should the Central Bank Be?) The American Economic Review, Vol. 85, No. 2, (May, 1995), pp XXXXXXXXXX/10/ XXXXXXXXXXIntroduction: stabilisation policy in UK • Independent Central Bank with the objective of low and stable inflation. • Can an independent central bank stabilize the economy in an open economy?. • Euro vs £, consider the following scenario: a country member of Euro is in recession. There is a low demand for domestic goods. The government has to consid th f ll i ti ider the following options 1. To devalue the currency. It is not an option 2. Expansion in money supply. It is not an option. 3. No policy change and rely on price adjustment over time 4. Fiscal policy: an expansion in government spending and public deficit • To study this problem, we will present a version of the AS/AD in open economy to studies the effect of different macro policies on output and inflation Brunel University 3 • A flexible exchange rate could help to stabilize the economy. • Inflation bias. • A fixed exchange rate as commitment mechanism to avoid inflation Fixed Exchange Rates and the Adjustment of the Real Exchange Rate Aggregate Demand and Real Exchange Rates Equilibrium: Y = C(Y-T) + I(i) + G + NX(Y,Y*,q) Output Demand for Domestic Goods Exports: X = X(Y* q ) P sP q * = •A real depreciation increases exports q ? An increase in domestic price generates a real appreciation Recall: S denotes the nominal exchange rate. Brunel University 4 Imports: M= M(Y,q) (+ , - ) Exports: X = X(Y , q ) (+ , +) •A real appreciation increases imports. q? •A real depreciation increases exports. q ? 17/10/ XXXXXXXXXXThe central bank has to vary the money supply, so that the domestic i t t t i l t i t ti l i t t t With fixed exchange rate: S = S & i = i * interest rate is equal to international interest rate. The AD in open economy , G , T ) sP Y Y( _ * + = P Brunel University 5 How would this open economy, with a fixed exchange rate adjust to an increase in the price level? How does this adjustment differ from the adjustment for a closed economy? Aggregate Demand Given aggregate demand with time: A reduction in price P produces a real depreciation that increases AD , G , T ) sP Y Y( _ * + = Pt Price Level A reduction in price P produces a real depreciation that increases AD. Brunel University 6 Output, Y AD 17/10/ XXXXXXXXXXAggregate supply • Consider that workers commit to nominal contract one period in advance. They need to forecast the future price level. The aggregate supply ( ) * w - p (log) real wage. idd shock XXXXXXXXXXt t t t t z y = y - w - p + z Brunel University 7 Since workers commit to wages, that set output to its natural level ( ) wt = Et-1 pt Aggregate supply XXXXXXXXXX * t t t t t y = y + p - E p + z - If prices are equal to the expect price level the economy is at potential output ( ) * 1 p E p y y t = t - t t = ( ) * If prices are higher than the expect price level the economy is above potential output. The unexpected inflation reduces real wages, the reduction in unemployment increases production. Inflation gap Brunel University 8 ( ) * 1 p E p y y t > t- t t > ( ) * 1 p E p y y t Inflation gap 17/10/ XXXXXXXXXXThe AS is the same in closed and open economy Aggregate supply XXXXXXXXXX * t t t t t y = y + p - E p + z - Yt ? ? ut ? ? Wt ? ? Pt ? Pt e? ? Wt ? ? Pt ? Price Level AS Brunel University 9 Output, Y * y Aggregate Demand and Aggregate Supply vel AS • Short-run equilibrium at A, P, Y • Natural level of output • Economy is in a recession Price Lev A P * y Brunel University 10 Output, Y AD y * y y 17/10/ XXXXXXXXXXFixed Exchange Rates and the Adjustment of the Real Exchange Rate Adjustment without devaluation • With y • AS will shift downward til * • The real exchange rate will rise until • y=y* until y = y* • In the medium run the nominal Price Level A P Brunel University 11 exchange rate is constant, but the reduction in price generates a real depreciation Output, Y AD Y P´ B * y Fixed Exchange Rates and the Adjustment of the Real Exchange Rate Adjustment without devaluation XXXXXXXXXX * t t t t t y = y + p - E p + z - ( ) * 1 p E p y y t Now, workers will adjust the expected inflation, they expected a reduction in the price level, then they reduce the the nominal wages. Then there is an expansion in production and reduction in P Brunel University 12 • In the medium run the nominal exchange rate is constant, but the reduction in price generates a real depreciation and an expansion in NX p P sP q * = 17/10/ XXXXXXXXXXAdjustment with a devaluation • Devaluation shifts AD to AD´ Y is higher given P Level AS A P • New equilibrium at Yn, C • Real exchange rate is adjusted trough the AD´ devaluation Note that C Brunel University 13 Output, Y Price AD Y P Yn B devaluation. Note that the increase in prices P tends to compensate the devaluation AD´ Summary • With a fixed exchange rate, real exchange rate adjusts in the medium run. The labour market takes the burden of the adjustment. • Devaluation is a faster adjustment mechanism. The devaluation reduces the real exchange rate, increasing the AD • But devaluation will likely have a direct effect on the price level. • Credibility problem: in fixed exchange if workers do not believe that the government wants to keep the exchange rate pegged, they will resist any reduction in wages, since they expect an increase in i fl ti Th i ld b it i t t Brunel University 14 inflation. The recession could be quite persistent. 17/10/ XXXXXXXXXXThe Problems of Flexible Exchange Rates: • The exchange rate can move for many other reasons than changes in the domestic interest rate. • Expectations play a large role in the determination of the exchange rate.. • Flexible exchange rate may be subject to large fluctuations which, in turn, require large movements in the interest rate which can make the economy unstable movements in the interest rate which can make the economy unstable. • Time inconsistency problem the government under a flexible exchange they have an incentive to expand the economy to generate a short term expansion. • Euro: • Monetary policy is determined in ECB • The European central bank will reduce the interest rate in the case of European recession. • But countries can not use monetary policy in the case of local recession in country, generated by a asymmetric shock. • Fiscal policy has to be used to deal with asymmetric shock. Brunel University 15 py y • UK: • A flexible exchange rate • An independent central bank to fight inflation: inflation targeting Brunel University 16 17/10/ XXXXXXXXXXCauses of inflation • The central bank can reduce the inflation by reducing the money supply rate of growth. • But we know that in the short run a reduction in money supply reduces output. • The central bank should minimize any negative Brunel University 17 y g effect on output in the short run. Brunel University 18 17/10/ XXXXXXXXXXBarro-Gordon model • Consider that workers commit to nominal contract one period in advance. They need to forecast future price level. The aggregate supply ( ) * w - p (log) real wage. idd shock XXXXXXXXXXt t t t t z y = y - w - p + z Brunel University 19 Since worker commit to wage that set output to its natural level ( ) wt = Et-1 pt Government objective function. • The government try to max the following objective function. • U= ? (y y*) (1/2) p2 • U= ? (y- y*) -(1/2) p2 • Higher inflation reduces utility. • The y>y* the utility increases. • We assume that inflation is determined by money growth, then the Brunel University 20 We assume that inflation is determined by money growth, then the gov. controls inflation. 17/10/ XXXXXXXXXXInflation in open economy. • Consider that the PPP holds. • P=sP* • If P*=1 then the inflation is equal to the depreciation rate ( ) t = t - t -1 = t - t -1 p p p s s In the case of flexible exchange rate the government can control Brunel University 21 In the case of flexible exchange rate the government can control the exchange rate s. They could use monetary policy to generate a depreciation and inflation. Optimal policy • First workers set wages according to expected inflation at t-1. After that, the government set inflation t XXXXXXXXXXwt = Et-1 pt t = fixed by contract wt ( ) t t t t t t w E p U w p XXXXXXXXXX/ 2) = = ? - - - p Brunel University 22 Inflation and expected inflation ( ) p t = pt - pt XXXXXXXXXXt t-1 pt ( )1 ( ) = t - t- t e p E p p 17/10/ XXXXXXXXXXOptimal policy • First worker set wages according to expected inflation at t1. After that, the government set inflation t XXXXXXXXXXwt = Et-1 pt t = fixed by contract wt Inflation and expected inflation and the exchange rate. In this model expected inflation and nominal wages are determined by the exchange t Brunel University 23 ra e ( ) p t = pt - pt-1 ( )1 ( ) = t - t- t e p E s p ( ) t = t - t -1 = t - t -1 p p p s s Optimal policy • First worker set wages according to expected inflation at t1. After that, the government set inflation t-1 t XXXXXXXXXX XXXXXXXXXX/ XXXXXXXXXX/ XXXXXXXXXXe t t t t t t t t U U p p E p p p p ? = ? XXXXXXXXXXBrunel University XXXXXXXXXX/ 2)( )t t e U = ? p t -p - p Important: to control inflation is equivalent to control the exchange rate 17/10/ XXXXXXXXXXEx-ante optimal policy • First workers set wages according to expected inflation at t-1. The government announces the optimal inflation, worker fix wages according with this optimal inflation. t-1 t XXXXXXXXXX/ 2)( )t t t e U = ? p t -p - p ( ) wt = Et-1 pt e Brunel University 25 t p t =p Optimal inflation is zero and output is at the natural level. Is this policy credible? Will the government implement this policy?. Ex-ante optimal policy • First worker set wages according to expected inflation at t-1. The government announces the optimal inflation, workers fix wages according to this optimal inflation. = t = 0 e p t p Optimal inflation is zero and output is at the natural level. A stable h t p t = ( pt - pt-1 ) = st - st-1 = 0 Brunel University 26 exchange rate. Is this policy credible? Will the government implement this policy?. 17/10/ XXXXXXXXXXEx-post. Optimal policy First worker set wages according to expected inflation at t-1. Now the wages are fixed and the government can change the leve o at o . l of inflation. t XXXXXXXXXXwt = Et-1 pt t = fixed by contract wt ( ) t t t t t t w E p U w p XXXXXXXXXX/ 2) = = ? - - - p Brunel University 27 Inflation and expected inflation ( ) t t-1 pt XXXXXXXXXX/ 2)( )t t e U = ? p t -p - p Diagram ( ) * t t e t t y = y + p - p + z AS Inflation Utility Higher utility Brunel University 28 Output, Y * y 17/10/ XXXXXXXXXXEquilibrium.Time inconsistency • Given the expected inflation the government solves the optimal monetary policy XXXXXXXXXX/ XXXXXXXXXX = - = = - - t t t t e t d dU U ? p p ? p p p Brunel University 29 Ex post the optimal inflation is equal to p t = ? Time inconsistency • First worker set wages according to expected inflation at t1. After that, the government implement the monetary policy t XXXXXXXXXXwt = Et-1 pt t = fixed by contract wt The gov. announces zero inflation Is the policy credible? XXXXXXXXXX/ 2)( )t t e U = ? p t -p - p Brunel University 30 Is the policy credible? p t = ? p t = ? e 2 U = -(1/ 2)(?) 17/10/ XXXXXXXXXXEquilibrium The government announces zero inflation .Is the policy credible? No First workers set wages according to expected inflation at t XXXXXXXXXXwt = Et-1 pt = fixed by contract wt p = ? p t = ? t e p t = ( pt - pt-1 ) = st - st-1 = ? Brunel University 31 t y 2 U = -(1/ 2)(?) Diagram ( ) * t e t t y = y + p - p AS p = ? e p = ? Inflation t = 0 e p Brunel University 32 Output, Y * y 17/10/ XXXXXXXXXXTime inconsistency • Ex-ante the government will prefer to announce zero inflation. • If the government implements this policy U=0 If the government implements this policy U=0. • Ex-post, the gov. does not have commitment power to implement this policy. Since wages are fixed, the gov. will try to increase inflation (to depreciate the exchange rate) to increase output and employment above the natural level . Solution: to generate commitment power. Institutional reform: an independent central bank who does not care Brunel University 33 reform: an independent central bank, who does not care about unemployment XXXXXXXXXX/ 2)( )t CB U = - p Ex-ante policy Equilibrium Independent CB Inflation p t = ? ? = 0 p t = 0 p t = 0 Exchange rate Output y=y* y=y* y=y* st -st-1 =0 st -st-1 =? t st -st-1 =0 Brunel University 34 Gov U U= ? (y- y*) -(1/2) p2 U=0 U=0 2 U = -(1/ 2)(?) 17/10/ XXXXXXXXXXCentral Bank Independence 1. Bank of England least independent: Govt. makes policy decisions. 1998 Bank of England Act gives the operational responsibility to set the interest rates. 2. European Central Bank: most independent—price stability primary goal. 3. Bank of Canada and Japan: fair degree of independence, but not all on paper 4. Trend to greater independence: New Zealand, Brunel University XXXXXXXXXXInflation targeting. The Bank of England must keep inflation at a target 2.5%. Empirical evidence Brunel University 36 Source: Alesina, A. and Summers, L XXXXXXXXXXJournal of Money, Credit and Banking, 25 no2 (May): XXXXXXXXXX/10/ XXXXXXXXXXBrunel University 37 Source: Alesina, A. and Summers, L XXXXXXXXXXJournal of Money, Credit and Banking, 25 no2 (May): XXXXXXXXXXBrunel University 38 Source: Alesina, A. and Summers, L XXXXXXXXXXJournal of Money, Credit and Banking, 25 no2 (May): XXXXXXXXXX/10/ XXXXXXXXXXBrunel University 39 Brunel University 40 Source:C Allsopp XXXXXXXXXXMacroeconomic policy rules in theory and practice.MPC.Bank of England, Discussion paper N10 Sept XXXXXXXXXX/10/ XXXXXXXXXX XXXXXXXXXX £ effective exchange rate $ effective exchange rate XXXXXXXXXX Brunel University XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/ XXXXXXXXXX/02/2004 Source: Bank of England Interactive data base. Base year XXXXXXXXXX 140 Euro effective exchange rate monthly average. £ effective XXXXXXXXXXexchange rate m av $ Effective exchange rate Brunel University XXXXXXXXXXDec-00 Apr-01 Aug-01 Dec-01 Apr-02 Aug-02 Dec-02 Apr-03 Aug-03 Dec-03 Source: Bank of England Interactive data base. Base year XXXXXXXXXX/10/ XXXXXXXXXXInflation Targeting • Advantages – 1. Allows focus on domestic considerations, mainly inflation – 2. Not dependent on reliable relationship between M-aggregate and inflation. – 3. Readily understood by public. Focus on transparency and communication – 4. Eliminates time-inconsistent policy – 5. Performance good: p and p e ? , • Disadvantages – There is not a direct control over the inflation Brunel University 43 – Too much rigidity – Potential for increased output fluctuations and exchange rate fluctuations Time inconsistency in open economy. • An independent central bank could produce low inflation, as well as a stable exchange rate. • Ina open economy another instrument is to commit to low inflation is the exchange rate. • Anti-inflation credibility in EMS in 90s. The Bundesbank was the conservative central bank in Europe and the other countries pegged the exchange rate with respect to DM. Brunel University 44 • If you fixed your exchange rate with respect to DM you could not generate inflation. Otherwise the currency will depreciate in long run. (Monetary model). 17/10/ XXXXXXXXXXFigure 20-2 Inflation Convergence Within the EMS, XXXXXXXXXXBrunel University 45 Figure 20-9 Unemployment Rates in Selected EU Countries Brunel University 46 17/10/ XXXXXXXXXXConclusion • The time inconsistency problems: it is difficult for the government to implement a low inflation and stable exchange rate. • An inflation (depreciation) surprise could increase the welfare of the society in the short run. But it will generate inflationary expectation in the future. • Commitment problem: A independent central bank or fixed exchange rate. Brunel University 47 • It is second best solution, we can not use monetary policy to drive the economy towards full employment.