Description
"It explains
Monetary policy: what should the goals be?
How should central banks achieve those goals?
The role of expectations and the implications for monetary policy
What should be the relationship between central banks and the government?
How should monetary policy adjust to international economic forces?
What is Philips Curve? RBI monetary instruments, Direct instruments, indirect policy instruments."
Monetary Policy
Narasinha Sawaikar
Summary of Lecture
? ? ? ?
Macroeconomics and macroeconomic policy Role of monetary policy within macroeconomic policy Goals and instruments of monetary policy Monetary policy in an open economy
Macroeconomics
?
?
?
Macroeconomics looks at the economy as a whole unlike microeconomics which looks at a firm or industry. Variables that are of interest in macroeconomics are GDP and GDP growth, inflation and employment. These variables often tend to move together in the form of business cycles
Macreconomic Policy
? ? ? ?
?
?
Expansionary policy seeks to stimulate the economy and raise GDP growth Contractionary policy seeks to slow down the economy and lower growth Expansionary fiscal: lower taxes, higher government spending Expansionary monetary: lower interest rates Contractionary fiscal: higher taxes, lower spending Contractionary monetary:higher interest rates
Monetary Policy
? ? ? ? ?
Monetary policy: what should the goals be? How should central banks achieve those goals? The role of expectations and the implications for monetary policy What should be the relationship between central banks and the government? How should monetary policy adjust to international economic forces?
Goals
?
?
?
Among the main economic variables, growth and employment are desirable and often move together especially in the short run. However inflation is undesirable thus there may be a trade-off between low inflation and low unemployment. Earlier economists and central bankers believed that there was a menu of choices between inflation and unemployment defined by the Phillips curve This meant that central banks could perhaps increase growth and reduce unemployment by stimulating the economy at the cost of some inflation
Phillips curve
Problems with “moderate” inflation
? ? ?
Once inflationary expectations are built into the economy it becomes very hard to control inflation In practice the trade-off between inflation and unemployment was only temporary and once expectations had adjusted it was no longer valid. To maintain the benefit of lower unemployment you need higher and higher inflation. High inflation introduces uncertainty into economic decisions and distorts allocation of resources High inflation tends to hurt weaker sections of society since they are less able to hedge against inflation Empirically the trade-off between inflation broke down in the 70’s. You had both high inflation and high unemployment
? ? ?
Phillips Curve breaks down
Phillips Curve Discredited
? ? ?
?
Because of the events of the 1970’s the theory behind the Phillips curve was discredited. Economists still believed that there was a short-run trade-off between inflation and unemployment However in the medium to long run as inflation expectations adjusted the trade-off broke down. In the long run there was no trade-off A policy of using inflation to reduce unemployment would be counter-productive as it would only produce higher and higher inflation in the long run.
New Consensus: Low Inflation
? ? ?
?
Today major central banks tend to have inflation targets of around 2-3%. Why not zero? Conventional inflation measures may overstate real inflation. One of the reasons is that it is hard to incorporate quality improvements in inflation measures. It allows real interest rates to fall below zero which is not possible with zero inflation because nominal interest rates generally don’t go below zero. This allows central banks more freedom to fight recessions.
Inflation and growth
?
?
?
?
While central banks have become more and more concerned about inflation, economic growth is also important and typically cited as a twin goal. In practice major central banks will try to pursue the maximum economic growth consistent with low inflation. Thus if inflation is low and the economy is sluggish they will loosen monetary policy to stimulate growth. However if inflation is rising they will generally focus on reducing inflation even at the cost of some growth.
What causes inflation?
? ?
?
? ?
Broadly inflation depends on the balance between aggregate demand and aggregate supply AD: Private Consumption, Business Investment, Government Spending, Net Exports AS: Output that all the factors of production in the economy: land, labour,capital etc are capable of producing if fully utilized. AS shocks may come from weather, oil price shocks etc. Policymakers have to anticipate AD, AS over 1-2 years while framing monetary policy Monetary Policy infuence AD though it has to take AS into account
Monetary Policy Channels
? ? ?
?
Interest Rate channel: Changes in interest rates affect investment which changes AD Wealth Effect Channel: Changes in interest rates affect the value of assets which affects consumption Exchange Rate channel: changes in monetary policy influences exchange rates which change aggregate demand Credit Channel: Monetary policy affects the availably of credit which affects investment particularly by smaller firms
Why Monetary policy is difficult
? ?
?
? ? ?
Fundamental problems with monetary policy. Long and variable lags: Recognition lag, Execution lag, Impact lag Different channels work over different periods Channels depend on the decisions of private actors: consumers, firms, commercial banks The length of the lags may vary across time Therefore policymakers have to anticipate macroeconomic conditions over period of time
Critical Role of Expectations
? ? ? ?
Inflation depends not just on objective factors but also expectations of inflation Expectations of future inflation become self-fulfilling Will be incorporated into unions wage negotiations etc and may cause a wage-price spiral Credibility of the central bank becomes important because it influences expectations Central banks have to be careful about how they communicate monetary policy decisions and about developing a track record of fighting inflation
?
Central Bank Independence
?
? ? ?
?
Credibility of the central bank is vital because inflation is governed by expectations; expectations of inflation can themselves fuel inflation. Governments often have an interest in loose monetary policy especially before elections If markets factor political pressure into expectations, this may increase inflation Therefore central bank independence may help lower inflation expectations and make monetary policy more effective E.g. Bank of England made autonomous
What should monetary policy target?
? ? ? ?
?
Given the basic goal of keeping inflation low how would central banks achieve this goal? Historically there has been a big debate about money supply targetting and interest rate targetting. Today most central banks target short-term interest rates through their monetary policy. This is because monetary policy is easier to communicate through interest rates Also money supply targetting proved to be ineffective because of fluctuations between the relation between money supply and inflation
Rules versus Discretion
How much autonomy should central banks have? ? One extreme view (Milton Friedman) is that monetary policy should be conducted by predetermined rules leaving very little scope for discretion ? However the prevailing trend is for substantial discretion for central banks combined with greater autonomy from the government ? This autonomy has often been combined with concrete inflation targets which central banks are expected to attain.
RBI monetary instruments
? ?
?
Two broad types of monetary instruments Direct instruments: like CRR,SLR and administered rates are direct interventions by the central bank affecting variables like bank reserves. Indirect Instruments like outright open market operations and repo operations inject and withdraw liquidity into the system and indirectly affect interest rates
Direct Instruments
?
?
?
Cash Reserve Ratio (CRR): The proportion of time and demand deposits that banks need to hold in the form of cash reserves at the RBI. This remains an important monetary policy tool and is currently at 7.5%. Statutory Liquidity Ratio( SLR): Proportion of deposits that banks need to hold in terms of liquid securities like government bonds. This has been a relatively unimportant until recently. In the current crisis there have been calls to reduce SLR. Bank rate: Rate at which RBI lends to banks under various financing facilities. Currently at 6%. In practice there is only limited lending at the bank rate so this rate has become less important.
Diminishing Role of Direct Instruments
?
Over the last ten years the role of direct policy instruments has diminished in line with international practice.
Source:www.equitymaster.com
Indirect Policy Instruments
? ? ? ?
Open Market Operations: Outright operations: Sale and purchase of government securities. Sale of securities withdraws liquidity from the system Purchase injects liquidity
Liquidity Adjustment Facility
? ? ?
?
Liquidity Adjustment Facility (LAF): daily repo and reverse repo auctions Repo/ Reverse Repo: temporary injection and withdrawal of liquidity into the system Repo: RBI buys government securities from counterparty which will buy them back in a short period. In effect the RBI is making a short-term loan Reverse Repo: RBI withdraws liquidity temporarily from the system. Counterparty buys securities from RBI and sells them back in a short period.
Problems with LAF
? ? ?
?
?
Ideally short-term interest rates should fluctuate between the reverse repo rate and the repo rate. However in practice this has often been violated Repo transactions require bonds as collateral and if banks need liquidity above their treasury bill holdings, call money rates may spike On the other side the RBI has limits for liquidity absorbition through reverse repo. If there is greater liquidity call money rates may fall below corridor. Furthermore the gap between the reverse repo and repo, should be narrow enough to pin down a short term rate. Currently at 3% the gap is too large.
MSS
? ? ? ?
? ? ?
Market Stabilization Scheme was started in 2004 as a way for the RBI to control strong liquidity flows into the Indian economy. MSS uses the sale of government securities as a method of absorbing liquidity MSS limit current at Rs. 2 lakh crore MSS is an example of sterilization where a central bank combines an intervention in the forex market with an offsetting transaction in the bond market. E.g. Suppose the RBI wants to intervene in the forex market to prevent the rupee appreciating because of capital inflows. RBI will buy dollars and sell rupees. This will tend to increase the money supply in India. The MSS allows the RBI to offset this by absorbing liquidity by selling bonds
Monetary Policy in a Global Context
? ?
? ?
Global Integration introduces new variables in the conduct of monetary policy Global economic conditions have to be closely monitored for their effect on Aggregate Demand. International capital flows and FFI’s play an increasing role in the financial system There is a greater risk of contagion from the international financial system
Monetary Policy and Exchange Rates
There have been many currency arrangements over the last few centuries ? Broadly speaking they can be divided into three: Fixed exchange rates Flexible exchange rates Managed Floats (hybrid) Each system has its strengths and weaknesses The type of currency regime matters a great deal for monetary policy and each choice has its advantages and disadvantages.
?
Fixed Exchange Rates
?
? ? ?
The government fixes the exchange rate either with an important reference currency or a basket of currencies or an important commodity like gold. The exchange rate doesn’t fluctuate according to demand and supply. Instead the central bank intervenes in the foreign exchange market to maintain the fixed rate In addition foreign exchange controls may be used to allocate foreign exchange
Advantages
?
?
?
A fixed exchange rate reduces exchange risk and the disruptions caused by sudden exchange rate movements By anchoring itself to a more reputable currency, the government can commit to following a sound monetary policy This in turn will ideally lead to lower interest rates
Problems
A fixed exchange rate will make monetary policy less effective especially if you have free capital flows ? A fixed exchange rate will make the currency vulnerable to a speculative attack. ? E.g. ERM crisis in 1992 and the attack on the British pound ? A fixed exchange rate may encourage too much borrowing in foreigncurrency debt E.g. East Asian crisis ? Any rationing of foreign exchange can lead to inefficiency and corruption
?
Britain and ERM
? ?
?
?
ERM was a preparation for the single currency. Currencies fixed within a band In 1990 Britain joined ERM. By 1992 with rising German interest rates, the pound came under serious speculative pressure (eg. George Soros) Bank of England tried to defend the pound but on Sept 16 1993 (Black Wednesday) was forced to withdraw In the process of trying to defend the pound the Bank of England lost 3.3 billion pounds.
Flexible Exchange Rates
?
?
?
a) b)
In a flexible exchange rate, the exchange rate is set by demand and supply in the foreign exchange markets There is no intervention by the central bank or government Some of the factors that affect the exchange rate include: Its attractiveness as an investment destination Its inflation rate relative to trading partners
Benefits
? ?
?
?
?
The main benefit of a flexible exchange rate is that it preserves the freedom of the central bank to conduct monetary policy In fact under flexible exchange rates monetary policy will be extra effective because of the effect of capital movements on the exchange rate E.g. Suppose a government wants stimulate the economy, it will lower interest rates which will lead to a currency depreciation which will add further to total demand (how?) Flexible rates also eliminate the inefficiencies associated with exchange controls Flexible rates should lead to a faster adjustment to economic shocks
Problems
? ?
?
?
Flexible exchange rates add to volatility and increase transaction costs for international business Foreign exchange markets may tend to overreact and move beyond fundamentals The flexibility may tempt policy makers to create more inflationary policies Developing countries may have to pay an excessive exchange premium for international capital
Managed Float
An exchange rate which is flexible but where the central bank intervenes occasionally is called a “managed float” ? Reasons for central bank intervention: a) smoothing excessive fluctuations in exchange rates b) Exchange rates affect trade and aggregate demand ? Two main methods of influencing exchange rates: a) Direct intervention in the forex markets b) Indirect intervention through regular monetary policy which will indirectly influence exchange rates Many central banks including the RBI pursue a managed float. One major problem with this policy is that it makes monetary policy less transparent since there are two goals: keeping low inflation and managing the exchange rate.
?
Real effective exchange rate (REER)
?
?
? ?
?
The REER is a measure for whether a currency is undervalued or overvalued. The RBI has used it as guide to exchange rate management. Effective means that instead of looking at a single exchange rate, a composite is created of the exchange rates of various important trading partners NEER or nominal effective exchange rate is a composite of different exchange rates of a country’s various trading partners. Real means that the exchange rate is adjusted for inflation rates in both the home country and the trading partner. After adjusting the NEER for inflation you get the REER. For example if India has a higher inflation rate than its trading partners but its NEER remains constant then its REER will rise.
RBI and REER
? a)
b)
?
?
The RBI calculates two REER indices: A six-country index with currencies from the USA, Euro zone, Japan, UK, China and Hong Kong A 36 country index which covers around 75% of India’s trade. Both indices use 1993-94 as the base year and use three-year moving average trade statistics to assign weights to the different currencies. In general the RBI has intervened in the market to keep the REER between 95 and 105.
NEER and REER India from 93-94
NEER and REER for India
110 105 100 95 90 85 80 REER NEER
Source:RBI
19 93 -9 4 19 95 -9 6 19 97 -9 8 19 99 -0 0 20 01 -0 2 20 03 -0 4 20 05 -0 20 6 07 -0 8 (P )
Impossible Trinity
The following three are impossible to sustain simultaneously: 1)A fixed exchange rate 2)Free capital flows 3)Independent monetary policy This creates a dilemma for policymakers since all these three are desirable for different reasons Policymakers have to choose which of the two are most important for the economy in question Either they give up completely on one of the three or they partially adjust between the three.
?
Example
? ? ? ? ? ? ? ?
Think of the three legs of the impossible trinity and give them scores of 1-10: Independent monetary policy: 10 being a fully autonomous monetary policy Managed currency:10 being a fully fixed exchange rate Capital flows:10 being a fully open capital account. Then the impossible trinity says that a country can have at most a total score of around 20. One way of achieving this is to give one of the three legs completely and achieve close to full scores on the other two. Alternatively you can achieve a mix of the three: perhaps around 6 to 7 on each. Policymakers may change the mix according to conditions:e.g. going from 7 to 6 on capital convertibility in order to move from 7 to 8 on managed currency. Recent restrictions on PN’s and ECB’s may be viewed as an example of this.
RBI hits impossible trinity
? ? ?
?
?
In recent years the RBI has faced the constraints of the trinity. India has tried to partially keep all three parts It tries to maintain an independent monetary policy with some exchange rate management and some capital controls Compromise means that goals like inflation reduction may suffer Fundamental problem is that one instrument: monetary policy is used to achieve two targets: inflation and exchange rate
Current Consensus
? ? ? ? ?
?
Monetary policy rather than fiscal policy is the main tool for macroeconomic stabilization. The main focus of monetary policy should be low inflation The main tool of monetary policy is targeting short-term interest rates through open market operations Central banks have a fair amount of discretion in the way they conduct policy Central banks should have a high degree operational independence while remaining accountable for achieving low inflation A combination of moderately flexible exchange rates and moderately open capital flows
doc_825259332.ppt
"It explains
Monetary policy: what should the goals be?
How should central banks achieve those goals?
The role of expectations and the implications for monetary policy
What should be the relationship between central banks and the government?
How should monetary policy adjust to international economic forces?
What is Philips Curve? RBI monetary instruments, Direct instruments, indirect policy instruments."
Monetary Policy
Narasinha Sawaikar
Summary of Lecture
? ? ? ?
Macroeconomics and macroeconomic policy Role of monetary policy within macroeconomic policy Goals and instruments of monetary policy Monetary policy in an open economy
Macroeconomics
?
?
?
Macroeconomics looks at the economy as a whole unlike microeconomics which looks at a firm or industry. Variables that are of interest in macroeconomics are GDP and GDP growth, inflation and employment. These variables often tend to move together in the form of business cycles
Macreconomic Policy
? ? ? ?
?
?
Expansionary policy seeks to stimulate the economy and raise GDP growth Contractionary policy seeks to slow down the economy and lower growth Expansionary fiscal: lower taxes, higher government spending Expansionary monetary: lower interest rates Contractionary fiscal: higher taxes, lower spending Contractionary monetary:higher interest rates
Monetary Policy
? ? ? ? ?
Monetary policy: what should the goals be? How should central banks achieve those goals? The role of expectations and the implications for monetary policy What should be the relationship between central banks and the government? How should monetary policy adjust to international economic forces?
Goals
?
?
?
Among the main economic variables, growth and employment are desirable and often move together especially in the short run. However inflation is undesirable thus there may be a trade-off between low inflation and low unemployment. Earlier economists and central bankers believed that there was a menu of choices between inflation and unemployment defined by the Phillips curve This meant that central banks could perhaps increase growth and reduce unemployment by stimulating the economy at the cost of some inflation
Phillips curve
Problems with “moderate” inflation
? ? ?
Once inflationary expectations are built into the economy it becomes very hard to control inflation In practice the trade-off between inflation and unemployment was only temporary and once expectations had adjusted it was no longer valid. To maintain the benefit of lower unemployment you need higher and higher inflation. High inflation introduces uncertainty into economic decisions and distorts allocation of resources High inflation tends to hurt weaker sections of society since they are less able to hedge against inflation Empirically the trade-off between inflation broke down in the 70’s. You had both high inflation and high unemployment
? ? ?
Phillips Curve breaks down
Phillips Curve Discredited
? ? ?
?
Because of the events of the 1970’s the theory behind the Phillips curve was discredited. Economists still believed that there was a short-run trade-off between inflation and unemployment However in the medium to long run as inflation expectations adjusted the trade-off broke down. In the long run there was no trade-off A policy of using inflation to reduce unemployment would be counter-productive as it would only produce higher and higher inflation in the long run.
New Consensus: Low Inflation
? ? ?
?
Today major central banks tend to have inflation targets of around 2-3%. Why not zero? Conventional inflation measures may overstate real inflation. One of the reasons is that it is hard to incorporate quality improvements in inflation measures. It allows real interest rates to fall below zero which is not possible with zero inflation because nominal interest rates generally don’t go below zero. This allows central banks more freedom to fight recessions.
Inflation and growth
?
?
?
?
While central banks have become more and more concerned about inflation, economic growth is also important and typically cited as a twin goal. In practice major central banks will try to pursue the maximum economic growth consistent with low inflation. Thus if inflation is low and the economy is sluggish they will loosen monetary policy to stimulate growth. However if inflation is rising they will generally focus on reducing inflation even at the cost of some growth.
What causes inflation?
? ?
?
? ?
Broadly inflation depends on the balance between aggregate demand and aggregate supply AD: Private Consumption, Business Investment, Government Spending, Net Exports AS: Output that all the factors of production in the economy: land, labour,capital etc are capable of producing if fully utilized. AS shocks may come from weather, oil price shocks etc. Policymakers have to anticipate AD, AS over 1-2 years while framing monetary policy Monetary Policy infuence AD though it has to take AS into account
Monetary Policy Channels
? ? ?
?
Interest Rate channel: Changes in interest rates affect investment which changes AD Wealth Effect Channel: Changes in interest rates affect the value of assets which affects consumption Exchange Rate channel: changes in monetary policy influences exchange rates which change aggregate demand Credit Channel: Monetary policy affects the availably of credit which affects investment particularly by smaller firms
Why Monetary policy is difficult
? ?
?
? ? ?
Fundamental problems with monetary policy. Long and variable lags: Recognition lag, Execution lag, Impact lag Different channels work over different periods Channels depend on the decisions of private actors: consumers, firms, commercial banks The length of the lags may vary across time Therefore policymakers have to anticipate macroeconomic conditions over period of time
Critical Role of Expectations
? ? ? ?
Inflation depends not just on objective factors but also expectations of inflation Expectations of future inflation become self-fulfilling Will be incorporated into unions wage negotiations etc and may cause a wage-price spiral Credibility of the central bank becomes important because it influences expectations Central banks have to be careful about how they communicate monetary policy decisions and about developing a track record of fighting inflation
?
Central Bank Independence
?
? ? ?
?
Credibility of the central bank is vital because inflation is governed by expectations; expectations of inflation can themselves fuel inflation. Governments often have an interest in loose monetary policy especially before elections If markets factor political pressure into expectations, this may increase inflation Therefore central bank independence may help lower inflation expectations and make monetary policy more effective E.g. Bank of England made autonomous
What should monetary policy target?
? ? ? ?
?
Given the basic goal of keeping inflation low how would central banks achieve this goal? Historically there has been a big debate about money supply targetting and interest rate targetting. Today most central banks target short-term interest rates through their monetary policy. This is because monetary policy is easier to communicate through interest rates Also money supply targetting proved to be ineffective because of fluctuations between the relation between money supply and inflation
Rules versus Discretion
How much autonomy should central banks have? ? One extreme view (Milton Friedman) is that monetary policy should be conducted by predetermined rules leaving very little scope for discretion ? However the prevailing trend is for substantial discretion for central banks combined with greater autonomy from the government ? This autonomy has often been combined with concrete inflation targets which central banks are expected to attain.
RBI monetary instruments
? ?
?
Two broad types of monetary instruments Direct instruments: like CRR,SLR and administered rates are direct interventions by the central bank affecting variables like bank reserves. Indirect Instruments like outright open market operations and repo operations inject and withdraw liquidity into the system and indirectly affect interest rates
Direct Instruments
?
?
?
Cash Reserve Ratio (CRR): The proportion of time and demand deposits that banks need to hold in the form of cash reserves at the RBI. This remains an important monetary policy tool and is currently at 7.5%. Statutory Liquidity Ratio( SLR): Proportion of deposits that banks need to hold in terms of liquid securities like government bonds. This has been a relatively unimportant until recently. In the current crisis there have been calls to reduce SLR. Bank rate: Rate at which RBI lends to banks under various financing facilities. Currently at 6%. In practice there is only limited lending at the bank rate so this rate has become less important.
Diminishing Role of Direct Instruments
?
Over the last ten years the role of direct policy instruments has diminished in line with international practice.
Source:www.equitymaster.com
Indirect Policy Instruments
? ? ? ?
Open Market Operations: Outright operations: Sale and purchase of government securities. Sale of securities withdraws liquidity from the system Purchase injects liquidity
Liquidity Adjustment Facility
? ? ?
?
Liquidity Adjustment Facility (LAF): daily repo and reverse repo auctions Repo/ Reverse Repo: temporary injection and withdrawal of liquidity into the system Repo: RBI buys government securities from counterparty which will buy them back in a short period. In effect the RBI is making a short-term loan Reverse Repo: RBI withdraws liquidity temporarily from the system. Counterparty buys securities from RBI and sells them back in a short period.
Problems with LAF
? ? ?
?
?
Ideally short-term interest rates should fluctuate between the reverse repo rate and the repo rate. However in practice this has often been violated Repo transactions require bonds as collateral and if banks need liquidity above their treasury bill holdings, call money rates may spike On the other side the RBI has limits for liquidity absorbition through reverse repo. If there is greater liquidity call money rates may fall below corridor. Furthermore the gap between the reverse repo and repo, should be narrow enough to pin down a short term rate. Currently at 3% the gap is too large.
MSS
? ? ? ?
? ? ?
Market Stabilization Scheme was started in 2004 as a way for the RBI to control strong liquidity flows into the Indian economy. MSS uses the sale of government securities as a method of absorbing liquidity MSS limit current at Rs. 2 lakh crore MSS is an example of sterilization where a central bank combines an intervention in the forex market with an offsetting transaction in the bond market. E.g. Suppose the RBI wants to intervene in the forex market to prevent the rupee appreciating because of capital inflows. RBI will buy dollars and sell rupees. This will tend to increase the money supply in India. The MSS allows the RBI to offset this by absorbing liquidity by selling bonds
Monetary Policy in a Global Context
? ?
? ?
Global Integration introduces new variables in the conduct of monetary policy Global economic conditions have to be closely monitored for their effect on Aggregate Demand. International capital flows and FFI’s play an increasing role in the financial system There is a greater risk of contagion from the international financial system
Monetary Policy and Exchange Rates
There have been many currency arrangements over the last few centuries ? Broadly speaking they can be divided into three: Fixed exchange rates Flexible exchange rates Managed Floats (hybrid) Each system has its strengths and weaknesses The type of currency regime matters a great deal for monetary policy and each choice has its advantages and disadvantages.
?
Fixed Exchange Rates
?
? ? ?
The government fixes the exchange rate either with an important reference currency or a basket of currencies or an important commodity like gold. The exchange rate doesn’t fluctuate according to demand and supply. Instead the central bank intervenes in the foreign exchange market to maintain the fixed rate In addition foreign exchange controls may be used to allocate foreign exchange
Advantages
?
?
?
A fixed exchange rate reduces exchange risk and the disruptions caused by sudden exchange rate movements By anchoring itself to a more reputable currency, the government can commit to following a sound monetary policy This in turn will ideally lead to lower interest rates
Problems
A fixed exchange rate will make monetary policy less effective especially if you have free capital flows ? A fixed exchange rate will make the currency vulnerable to a speculative attack. ? E.g. ERM crisis in 1992 and the attack on the British pound ? A fixed exchange rate may encourage too much borrowing in foreigncurrency debt E.g. East Asian crisis ? Any rationing of foreign exchange can lead to inefficiency and corruption
?
Britain and ERM
? ?
?
?
ERM was a preparation for the single currency. Currencies fixed within a band In 1990 Britain joined ERM. By 1992 with rising German interest rates, the pound came under serious speculative pressure (eg. George Soros) Bank of England tried to defend the pound but on Sept 16 1993 (Black Wednesday) was forced to withdraw In the process of trying to defend the pound the Bank of England lost 3.3 billion pounds.
Flexible Exchange Rates
?
?
?
a) b)
In a flexible exchange rate, the exchange rate is set by demand and supply in the foreign exchange markets There is no intervention by the central bank or government Some of the factors that affect the exchange rate include: Its attractiveness as an investment destination Its inflation rate relative to trading partners
Benefits
? ?
?
?
?
The main benefit of a flexible exchange rate is that it preserves the freedom of the central bank to conduct monetary policy In fact under flexible exchange rates monetary policy will be extra effective because of the effect of capital movements on the exchange rate E.g. Suppose a government wants stimulate the economy, it will lower interest rates which will lead to a currency depreciation which will add further to total demand (how?) Flexible rates also eliminate the inefficiencies associated with exchange controls Flexible rates should lead to a faster adjustment to economic shocks
Problems
? ?
?
?
Flexible exchange rates add to volatility and increase transaction costs for international business Foreign exchange markets may tend to overreact and move beyond fundamentals The flexibility may tempt policy makers to create more inflationary policies Developing countries may have to pay an excessive exchange premium for international capital
Managed Float
An exchange rate which is flexible but where the central bank intervenes occasionally is called a “managed float” ? Reasons for central bank intervention: a) smoothing excessive fluctuations in exchange rates b) Exchange rates affect trade and aggregate demand ? Two main methods of influencing exchange rates: a) Direct intervention in the forex markets b) Indirect intervention through regular monetary policy which will indirectly influence exchange rates Many central banks including the RBI pursue a managed float. One major problem with this policy is that it makes monetary policy less transparent since there are two goals: keeping low inflation and managing the exchange rate.
?
Real effective exchange rate (REER)
?
?
? ?
?
The REER is a measure for whether a currency is undervalued or overvalued. The RBI has used it as guide to exchange rate management. Effective means that instead of looking at a single exchange rate, a composite is created of the exchange rates of various important trading partners NEER or nominal effective exchange rate is a composite of different exchange rates of a country’s various trading partners. Real means that the exchange rate is adjusted for inflation rates in both the home country and the trading partner. After adjusting the NEER for inflation you get the REER. For example if India has a higher inflation rate than its trading partners but its NEER remains constant then its REER will rise.
RBI and REER
? a)
b)
?
?
The RBI calculates two REER indices: A six-country index with currencies from the USA, Euro zone, Japan, UK, China and Hong Kong A 36 country index which covers around 75% of India’s trade. Both indices use 1993-94 as the base year and use three-year moving average trade statistics to assign weights to the different currencies. In general the RBI has intervened in the market to keep the REER between 95 and 105.
NEER and REER India from 93-94
NEER and REER for India
110 105 100 95 90 85 80 REER NEER
Source:RBI
19 93 -9 4 19 95 -9 6 19 97 -9 8 19 99 -0 0 20 01 -0 2 20 03 -0 4 20 05 -0 20 6 07 -0 8 (P )
Impossible Trinity
The following three are impossible to sustain simultaneously: 1)A fixed exchange rate 2)Free capital flows 3)Independent monetary policy This creates a dilemma for policymakers since all these three are desirable for different reasons Policymakers have to choose which of the two are most important for the economy in question Either they give up completely on one of the three or they partially adjust between the three.
?
Example
? ? ? ? ? ? ? ?
Think of the three legs of the impossible trinity and give them scores of 1-10: Independent monetary policy: 10 being a fully autonomous monetary policy Managed currency:10 being a fully fixed exchange rate Capital flows:10 being a fully open capital account. Then the impossible trinity says that a country can have at most a total score of around 20. One way of achieving this is to give one of the three legs completely and achieve close to full scores on the other two. Alternatively you can achieve a mix of the three: perhaps around 6 to 7 on each. Policymakers may change the mix according to conditions:e.g. going from 7 to 6 on capital convertibility in order to move from 7 to 8 on managed currency. Recent restrictions on PN’s and ECB’s may be viewed as an example of this.
RBI hits impossible trinity
? ? ?
?
?
In recent years the RBI has faced the constraints of the trinity. India has tried to partially keep all three parts It tries to maintain an independent monetary policy with some exchange rate management and some capital controls Compromise means that goals like inflation reduction may suffer Fundamental problem is that one instrument: monetary policy is used to achieve two targets: inflation and exchange rate
Current Consensus
? ? ? ? ?
?
Monetary policy rather than fiscal policy is the main tool for macroeconomic stabilization. The main focus of monetary policy should be low inflation The main tool of monetary policy is targeting short-term interest rates through open market operations Central banks have a fair amount of discretion in the way they conduct policy Central banks should have a high degree operational independence while remaining accountable for achieving low inflation A combination of moderately flexible exchange rates and moderately open capital flows
doc_825259332.ppt