Monetary economics - Appunti

Monetary Economics

First part: Rational expectation and money neutrality

What is money?

Most people believe that money is created in terms of loans, but it is not the same thing. The main feature is its universal acceptance by agents in the economy, and this is guaranteed by the legal value. In the early 20^th century, money was just a representation of gold. Before the 19^th century, it was gold, silver, copper, but basically in the 19^th gold was the basic money (it was paper money, a sign representing a certain amount of gold).

For example, the exchange rate between the pound and the dollar was actually the ratio between the grains of gold in pounds and in dollars, there was an exchange rate of more or less 4, as a ratio between the weights of pounds and dollars. This regime was called the gold standard. It had an interesting implication, it was not only exchange rate determined by the weight in gold between two units of currencies, but also that meant an international payment system based on gold.

It is interesting, because gold is difficult and risky to be transported between countries (stolen from pirates who try to rob the transport of gold), and it is heavy. It also has a cost of transportation. The cost of transportation was almost fixed, considered a sort of fixed cost per kilo or physical amount of gold. This would create a sort of corridor of exchange rates. Suppose the exchange rate between £ and $ was 4.86, and then you have the cost of transport, that would create a corridor between 4.2 and 4.89. It means that, if the pound (valued 4.86 dollars) was going below 4.84, it would be convenient for US exporters to export, instead of British pounds banknotes.

If the pound were further up than 4.89, it would be convenient for British importers to ask gold, instead of US dollars. These percentage points above and below the central parity give a corridor of no arbitrage, according to which if the exchange rate was in the corridor, nobody would ask for gold to be actually transported between US and UK. If the rate moved outside the corridor, it would be convenient to be actually transported.

The link between a currency and its gold content would give rise to an exchange rate and a payment system. It was a fixed exchange rate regime, basically ruled by the amount of gold represented by each currency.

Role of a central bank in a gold standard regime

The Central Bank has basically the role of lending to commercial banks, and lending to the government. There was little to do, except that it could actually move the policy interest rate (at that time was basically the discount rate), in order to keep the exchange rate at its parity level. If too much gold was running out of the country, the central bank of that country could raise the interest rate in order to maintain the parity level (or lower the interest rate with an excess of gold inflow).

Why should CB keep gold inflowing and outflowing? As the quantity of banknotes that could be printed and circulate in a country was determined by the quantity of gold within the country, so by maneuvering the interest rate, the Central Bank was controlling the amount of money circulating in the country. Maneuvering the quantity of gold in the central bank will keep the money in circulation strict, while allowing more gold to enter the country will allow the money to grow.

Why would the central bank try to keep the quantity of gold, therefore of money, at a certain level? It was believed that the quantity of money would determine the price level, and determine then the inflation rate.

Quantity theory of money of the golden standard

M is the quantity of money, D is the loss due to the circulation of money, P is price level and Y is output. This is called the quantity or Fisher equation.

M*V = P*Y

Left side: current value output, its nominal value GDP (PY). Left side: quantity of money (money supply) time its velocity of circulation. The 2 terms must be equal, the reason is that, if too much money is chasing too little output, given the velocity of circulation, that would increase the price level.

M^ + V^ = π^ + Y^

For the quantity theory, the velocity of circulation V is zero, and Y is zero (output is at its full employment level). The velocity of circulation V is equal to 0, because output Y is at its full employment level. Keeping V and Y constant, then an increase (decrease) in money would just imply inflation (deflation).

But this is a simple-minded theory of money:

• The velocity of circulation is not always constant, and it can be empirically improved. When there is an innovation in the payment system, the velocity of circulation does change. The introduction of electronic money changed V, much less money is needed to settle the same number and value of transactions.
• Output is not constant, it is not just the case that output is growing, but if there is a growth rate, inflation could be zero if V is constant, and if M^=Y^, so money could grow with no inflation implications.

The point is that output Y grows at a constant rate. So, there is no business cycle. What you have is that M^ can be higher than Y^ at each point of time, even if, on average, they are equal. You can have inflation or deflation according to the actual business cycle.

Can we assume that Y is always growing at its constant rate? In the late 19^th century, early 20^th, it was made this assumption, which allowed Central Banks to maneuver the monetary policy of the quantity equation, maneuvering the discount rate, in order to have a money growth rate compatible with a constant rate of growth and a zero inflation. With a zero inflation rate, the exchange rate could be constant. If all countries were in a zero inflation regime, the inflation rate could be constant (no pressure to appreciate or depreciate currencies).

Problems with the gold standard

There was another problem with the gold standard, and the quantity of money that each country was able to print was conditioned by the amount of gold printed, that was inflowing. So suddenly, supposing that the economy was growing at a constant rate as the money rate, in order for the money to grow at the same rate as the economy was growing, some gold had to be dug up, and there was no guarantee that gold mines were able to produce gold to the necessary extent. In a sense, the gold standard was implicitly deflationary.

If you look at the equation, suppose V^ is constant; if M grows less than Y, then Y must be negative, unless we have an accelerating philosophy of circulation, or we have deflation in a growing economy.

Conclusion

• The gold standard had its own problem, it was appropriate for a full employment economy, where Y does not fluctuate around its long-run constant growth rate.
• If Y was not fluctuating, the growth rate of money could be lower than the growth rate of output. There is too little money chasing too much output.

So the gold standard was actually abandoned by Great Britain, then by US, and lastly by France. The Italian lira and Deutsch mark were actually out of the gold standard, except the lira came back to the "quota 90" (but hard to be hold and lasted shortly).

Post World War II monetary system

After the 2^nd world war the gold standard was substituted by a new monetary system called “the gold exchange standard”. It was not an interesting, but not actually real, invention: basically even before WW2 it sort of replaced the previous system, but after the war it was official one, with the Bretton Woods agreement in 1944.

The fundamental feature of the gold exchange standard was that we cannot have all currencies and gold to keep the exchange rate fixed and to let the economy grow. The economy will have to grow at an accelerated pace after WW2 because of the disruption of the war itself. Also France and Britain were at the centre of the war for years, it had to be rebuilt. It implies a high growth rate, an accelerated one.

So no anchored gold was actually possible, and indeed there was an agreement to have just one currency anchored to gold (convertible into gold), and it was the US dollar, because US was the most powerful country in the western world. Countries belonging to the soviet block were not belonging to the international monetary system. And the other countries would not be convertible. Their economies were outside the defences of the western economy, there was little trade between western and eastern countries. China was just a rural country, underdeveloped, and under the communist regime was totally isolated from international trade. New Zealand and Canada, for example, were large, but underpopulated. Japan was part of western Europe.

The agreement was that all currencies had a fixed exchange rate with the dollar and among themselves: exchange rate metrics. All the exchange rates were fixed with Bretton Woods (exchange rate of 624 liras per dollar until 1971). Implicitly, you have an exchange rate between each western currency and gold, but at the same time each European/western country was not constrained in its money drifting by the amount of gold. If you wanted to have gold, you had first to exchange money to the federal reserve.

The gold exchange standard was not as deflationary as the gold standard, but still it met a difficulty when the US had the need of printing more dollars (in early 1960s with the Vietnam war). US decided to print money to pay for the war; it implied inflation in US and depreciation of $ on international currency markets. After France and Germany were unhappy about it, and did no longer accept the depreciated US dollar. So the French and German central bank asked for gold to Washington, this depleted the US gold reserve, and there is no upper bound to reserve, but there is definitely a lower bound (no under zero). So after a couple of years of bargaining, depletion of US reserves, the American government said that the dollar is no longer convertible.

Unilaterally, put an end to the gold exchange standard. Richard Nixon in 1971 said that it wouldn’t have given dollar no more to anybody. All money was purely legal money, there was no anchorage to gold. That was the end of fixed exchange rates, there was a tentative of rebuilding it in Europe, but it was restricted to 6 countries in the European market.

At the time the gold exchange standard actually collapsed, the economic theory behind the exchange rate was no longer the quantity theory of money. It had been abandoned in the early 1930s. The gold standard was replaced by the Keynesian theory. Keynes said that the constancy of output at its full employment level, or of the growth rate at the potential level cannot be maintained. This was after the great depression after the Wall Street crash in September 1929.

Monetary policy after the gold standard

Monetary policy that became one of the fluctuation reducing policy instruments. According to Keynes’ monetary policy, it aimed to maintain Y close to full employment, but it admits that it is not always possible. Then fiscal policy must come in.

Apparently, the inflation problem had disappeared, because 1930s were characterized globally by crippling deflation. Monetary policies should not aim to keep inflation at bay (it is not the main problem). It had to keep employment output as much close to full employment as possible.

Characteristic of the Keynesian approach: monetary and fiscal policies should be fine tuning. The CB should use all these discretion in its hands to pursue the targets posed by the governments, and governments should be totally discretionary, there was no rule. The idea was that central bankers, as well as policy makers, would put a wealthy improvement for society. They should use their instruments at their best.

But things have changed by the late 1950s. European economies were growing at an accelerated pace, even France. Full employment was reached with low unemployment rates, and basically no inflation. They were the best example of Keynes’ economy. Paradoxically, no Keynes’ intervention was actually made: small public deficit, in Italy public debt was around 20% in GDP, the economy was growing with employment, low declining unemployment. There was an economic boom (golden age).

Prices were constant (no inflation), output was growing, and all governments had implicitly promised that they would have intervened whenever the economy had fallen into a recession. By doing this, they have strengthened the expectation of entrepreneurs that they could sell all that they have produced (no demand gap below supply to fill up with gold; the gold would just fill it up, but there was no mean to do this, there was no gap).

So Keynesian policy promised (“whatever it takes” in 2012, Mario Draghi: huge Italian spread, promise to buy bonds, but actually nothing was done, didn’t buy gold bonds; it was enough the promise).

In the 1950s happened the same thing, governments promised to implement quantity theory of money, but they were not needed because the promise was enough (expectations are important). If you are able to create a positive expectation environment, that would do probably better than implementation.

The shift in economic theory in the 1960s

By the 1960s, the optimism due to this golden age growth had faded. The Vietnam war on one hand, creeping inflation, disruption (particularly in US, France, Italy, UK, Germany), broke the consensus around the Keynesian path, and the theory of monetary policy was for some extent changed. Changes in economic theory sometimes have a close relation with the historical development; there were people that had never abandoned the quantity theory of money, they were convinced that inflation was always a money phenomenon (too much money chasing too little output), that economy was at its full employment.

The time was right for a U term in economic theory. The leader of this group was Milton Friedman, an American economist who had taught in Chicago, main economist in the post-war era. He was a sort of self-land monetarist. He believed that money was the real point that had to be controlled by CB, particularly the money growth rate. Friedman believed that dubious about discretion would lead to acceptable results. He rather preferred rules, in a pessimistic view of human beings.

So you never surprise economic agents or the markets when rules are followed. But what do we mean by rules? They are a sort of instruction leaflet. There is very small flexibility, it is about to address control out. You have few lines which tell you what to do.

What we can say is that the targets monetary policy debate output inflation reinforces around a few Instruments. Money IS-LM monetarists subjects. They can be divided in four categories with respect to Interest Inflation targeting their targets (output and rate inflation) and instruments (money and interest rates).

In the first quadrant, you have IS-LM, which Keynes developed in 1930 after the publication of the general theory, and developed in the 1950s. it is the version of the Keynesian model.

Interest rate: it is just an inflation targeting. It can be pure inflation targeting (only pursue price stability) or pure output targeting, or it could be a mixture of both targets with different weights.

Transmission channels of monetary policy

• Portfolio channel: Central bank raises overnight rates. Commercial banks raise credit cost and also rate on bonds and other securities will pay a higher interest rate. So, people will change the balance in its portfolio between Money and Investments (Financial Assets), for the advantage of the latter (Interest Rate grows, Financial Investments grow, Real Investments decrease).
• Credit channel: Same initial scenario discourages credit demand and that will cover investments.
• Exchange rate channel: An example is the Quantitative Easing. ECB buys bonds Prices of bonds will go up, yields of bonds will go down, more liquidity in the system, that can be spent to buy foreign bonds (with a higher yield) but that will cause a deficit in the balance and a devaluation of the € commodities of EU country become more competitive.

The exchange rate channel (3) works better than the credit channel (2) because the latter is influenced by the soundness of the bank system. Moreover, it is useless to have a high credit supply if the firms don’t want it (Low Credit Demand). Moreover, commercial banks don’t want to lend because of the risk to incur in a non-performing loan.

The models we are going to examine can fit in this background. Of course, there is another one, which targets captures the actual Independence Dependence debate.

We have dependence Money and independence CB Instruments and interest rate on x-axes, and rules and discretion as instrument on the Y-axes.

Generally, dependence from CB means CB who actually respond to governments, there is a strict accountability of the CB and the government, while independent CB usually act discretionally (IS-LM model), while independent CB are not out of the strict control of government, because they follow rules. An independent central bank cannot accept a non-politically elected body, at discretion.

Rules: If the ECB announces that the money growth rate is π = π + π, that’s a rule.

The Taylor Rule is another rule: π = π + π + ππ (π – π*) + ππ (π – π )_t L_tt L

Rules vs discretion issue is linked to the target vs instrument or the independence vs dependence of the Central Bank.

Dependence/independence of the central bank

A Dependent CB works under the control of the treasury, that can borrow freely or make debt with it. The Central Bank is the Lender of Last Resort: if nobody buys the bonds, the government asks the CB to buy them.

An independent CB cannot be obliged to buy sovereign bonds. It decides the money growth rate, in some cases also the inflation rate (ECB sets it at a lower but close to 2%. Bank of England is Dependent and so inflation target is decided by the English government; it can only decide the instruments to reach the targets. FED instead is semi-dependent by the USA government; it is quite independent in its operations but follows general policy guidelines.