Monetary Policy - Questions & Answers.docx

QUESTIONS & ANSWERS OF MONETARY POLICY (questions in bold are examples of the third question)

1. Come viene descritta la domanda di moneta dell’approccio di portafoglio 2. Quale relazione esiste tra flessibilità dei salari e unione monetaria secondo la teoria delle aree valutarie ottimali? Esistono, in una unione monetaria, dei meccanismi di aggiustamento alternativi alla flessibilità dei salari? 3. Si spieghi la seguente affermazione: “…per ciò che attiene all’Europa è stato stabilito che un livello prossimo, ma inferiore al 2%, indica la stabilità dei prezzi…Diversa l’opinione di Olivier Blanchard, capo economista del FMI, secondo cui sarebbe bene alzare la soglia obiettivo dell’inflazione al 4%, in modo tale da dare alle banche centrali più spazio per agire…” 4. Si descriva come la “scoperta” delle aspettative razionali abbia influenzato il dibattito sull’efficacia della politica monetaria. 5. Usando il modello IS-LM si descriva l’impatto di un’espansione monetaria sul tasso di cambio (flessibile) e gli effetti di brevissimo e quindi breve-medio termine sulla bilancia commerciale. 6. Il livello dei prezzi è 2, il reddito nominale ammonta a 100 euro, la domanda di moneta a 50 euro. Qual è il valore della velocità di circolazione della moneta? Immaginando, come nei primi classici, una velocità di circolazione costante, che cosa accade al livello dei prezzi se la domanda di moneta aumenta da 50 a 100 euro? 7. Sotto quali condizioni (di mercato) una modifica nella riserva obbligatoria imposta agli istituti di credito della Banca Centrale non è tale da modificare sensibilmente l’offerta di moneta? 8. Fino a che punto l’attuale crisi europea è dovuta al fatto che l’area dell’euro si discosta dal modello di area valutaria ottimale teorizzato da Mundell? 9. Si descrivano i principali canali di trasmissione della politica monetaria. 10. Per quale ragione l’adesione all’unione monetaria fu inizialmente vincolata al rispetto di un criterio sul livello dei tassi di interesse (oltre agli altri criteri di Maastricht) 11. Si discuta dell’importanza e del funzionamento del “canale esterno” nella trasmissione della politica monetaria della BCE nella crisi attuale. 12. Che relazione esiste tra la curva di offerta aggregata e la curva di Phillips? 13. Il governo di un paese che è in regime di cambi fissi opera un’espansione fiscale. Si descrivano gli effetti sulle principali variabili macroeconomiche, utilizzando il modello IS-LM. Come cambia la dinamica descritta se il paese in questione è non in regime di cambi fissi ma membro dell’unione monetaria europea in cui le politiche fiscali sono rimaste nazionali ma la politica monetaria è unica. 14. Si descriva il ruolo della Banca Centrale Europea nell’attuale crisi europea del debito. 15. Si descriva il modello Barro-Gordon. 16. Monetary Policy at the Zero Lower Bound and possible exit strategies (Federal Reserve’s Proposed Exit Strategy) 17. Explain the following statement. Fed Chairwoman Janet Yellen justified the Fed’s quarter-point interest-rate hike on June 14th by arguing that the strong (and getting stronger) labor market has created the conditions needed for an eventual acceleration in inflation, using he own words “…in a few years, the Fed will have achieved its twin goals of maximum employment and stable prices…Inflation is right around the corner”. The Federal Reserve lifted its benchmark interest rate to between 1% and 1.25%, stuck to plans for one more rate hike in 2017 and said that it will gradually shrink its massive $4.5 trillion balance sheet. The decisions taken by the Fed were telegraphed completely, and took almost no one by surprise. The Fed falls back on the theory that an economy that is employing all of its resources is susceptible to rising prices, arguing that the fundamental relationship between full employment and rising inflation of the Phillips Curve remains in place.

1. Come viene descritta la domanda di moneta dell’approccio di portafoglio? 1. The first to introduce a classification on money according to its functions: a unit of account, a store of value, a medium of exchange, with Keynes three motives for holding money: the transactions, the precautionary, and the speculative motives was J. Hicks in his seminal work “The two triads. Lecture 1”. The transaction motive, for Keynes but also in the classical approach, individuals are assumed to hold money because it is a medium of exchange that ca be used to carry out everyday transactions, like the classical economists, Keynes considered the transactions component of the demand form money to be proportional to income. The precautionary motive, introduced newly by Keynes, recognize that people hold money as a cushion against an unexpected need. For Keynes, these balances are determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income. Money demand with a transaction and precautionary motive is MD=f(Y). The precautionary demand for money is negatively related to interest rates. The speculative motive, another reason for which people hold money is as a store of wealth, as a form of financial investment alternative to assets (speculation based on difference between current and future return on assets). Money demand with a speculative motive is MD=f(i), the speculation revolves around the difference between the current and the expected interest rate. The different motives received differentiated attention across schools of economic thought. In the classical theory (Fisher 1911) the money demand is caused only for transaction purposes, and in the Equation of Exchange (identity): M*V = P*Y(or T) according to Fisher V, the velocity of money, is constant in the medium-term and a function of institutional factors and therefore constant in the short-run, as such the quantity of money supplied affects directly the price level: M = P. In the Neoclassical theory of demand for money, put forward by Marshall and Pigou from the Cambridge School, the money if used for transaction and for precautionary motive (both proportional to income), as such the public wants to hold a certain constant proportion of their income as money: MD= k*P*YN, in which the velocity of money is a function of institutional factors and therefore constant in the short-run, and in which income is determined by real factors (Y = YN). K is called the Cambridge k, and it shows what proportion of money income the public likes to hold in the form of money. The quantity theory implies direct correlation between a rise in money supply and a rise in price level, the real quantity of money (M/P) is constant, and more importantly the assumption of Money neutrality (variations of M do not affect Y). According to Keynes’s theory of the demand of money, which he called the liquidity preference theory, he postulated that there are three motives behind the demand for money: the transactions motive [current consumption], the precautionary motive [future consumption] and the speculative motive [store of value]. Features of MD with a speculative motive:  Money has maximum liquidity  Bonds is the only alternative  Bonds have inverse relation between interest rate and price  Current interest rate (i) matters not the expected rate (ie)  In the Keynes’ analysis an individual holds his wealth in either all money or all bonds depending upon his estimate of the future rate of interest.

The portfolio approach to demand of money put forward by Tobin, Baumol and Friedman is a response to the limits to Keynes’ theory:

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The gap between current level of the interest rate and expected rate (normal level) tends to disappear in the long-run Speculative motive is secondary to the transaction motive, implying low interest rate elasticity of money demand, while the modern theories of money demand show that money held for transaction purposes is interest elastic The public, unrealistically holds either money or bonds, for Keynes, while it is possible a combination of both

Tobin’s Portfolio Approach to Demand for Money James Tobin explained that rational behavior on the part of the individuals is that they should keep a portfolio of assets which consists of both bonds and money, so the problem is what proportion of portfolio to keep in the form of money and what in interest-bearing bonds. According to Tobin, individual’s behavior shows risk aversion, they prefer less risk to more risk at a given rate of return and are uncertain about future rate of interest. Baumol’s Investory Approach to Transactions Demand for Money Baumol concentrated on transactions demand for money from the viewpoint of the inventory control or inventory management similar to the inventory management of goods, asserting that individuals hold inventory of money because this facilitate transactions (i.e. purchases) of goods and services. For both Tobin and Baumol the transaction demand for money depends is sensitive to rate of interest; interest represents the opportunity cost of holding money instead of bonds, saving and fixed deposits. The higher the rate of interest, the greater the opportunity cost of holding money. There is also a benefit to holding money, the avoidance of transaction costs. Friedman’s Theory of Demand of Money In 1956, Milton Friedman developed a theory of the demand for money in the article “The quantity theory of money: a restatement”, in which he expressed his formulation of the demand for money: According to Friedman, individuals hold money for the services it provides to them. His approach to demand for money, unlike Keynes’, does not consider any motives for holding money, nor does it distinguishes between speculative and transactions demand for money. The demand for money is considered merely as an application of a general theory of demand for capital assets. Friedman, unlike Keynes, including many assets as alternatives to money, recognized that more than one interest rate is important to the operation of the aggregate economy. Also, he viewed money and goods as substitutes, the public chooses between them when deciding how much money to hold. Unlike Keynes’s theory, which indicates that interest rates are an important determinant of the demand for money, Friedman’s theory suggests that changes in interest rates should have little effect on the demand for money; because changes in interest rates should have little effect on incentives for holding other assets relative to money, these incentive terms remain relatively constant, because any rise in the expected returns on other assets as a result of the rise in interest rates would be matched by a rise in the expected return on money. So Friedman’s money demand function, in which permanent income is the primary determinant of money demand can be approximated by: Another issue stressed by Friedman was the stability of the demand for money function. Demand for money can be predicted accurately by the money demand function, combined with his view that the demand for money is insensitive to changes in interest rate, this means that

velocity is highly predictable, yielding a quantity theory conclusion that money is the primary determinant of aggregate spending. The conclusion that money is the primary determinant of aggregate spending was the basis of monetarism, the view that the money supply is the primary source of movements in the price level and aggregate output. Liquidity trap An extreme case of ultra-sensitivity of the demand for money to interest rates in which monetary policy has no direct effect on aggregate spending, because a change in the money supply has no effect on interest rates. An increase in money supply fails to generate a fall in the interest rate because there’s an inferior limit to it; when nobody is willing to hold bonds and all the public want just money.

2. Quale relazione esiste tra flessibilità dei salari e unione monetaria secondo la teoria delle aree valutarie ottimali? Esistono, in una unione monetaria, dei meccanismi di aggiustamento alternativi alla flessibilità dei salari? 2. The wage flexibility is one of the two mechanisms that will automatically bring back equilibrium in two countries in case of a demand shift (an asymmetric shock), explained by Mundel (1961) in his seminal article on optimum currency area (OCA). Between two countries that have abandoned their national currencies in favor of a common currency which is managed by a common central bank, the shift in preference by consumers from country F products to country G products is an asymmetric shock in aggregate demand (in a fixed exchange rate regime, like Bretton Woods)

Both countries will have an adjustment problem. Country F has reduced output Y and higher unemployment u, while country G experiences a boom, which leads to higher inflation. There are two mechanisms that will automatically bring back equilibrium in the two countries. One is based on wage flexibility, the other on the mobility of labour.  Wage flexibility (if wages are flexible): in F the wage claims will be reduced, while the contrary will happen in G. The reduction of the wage rate in F shifts the aggregate supply curve downwards, whereas the wage increases in G shift the aggregate supply curve upwards. These shifts lead to a new equilibrium. In F the price of output declines, making F products more competitive, and stimulating demand. The opposite occurs in G.  Mobility of labour: the second mechanism that will lead to a new equilibrium involves mobility of labour. The F unemployed workers move to G where there is excess demand for labour. This movement of labour eliminates the need to let wages decline in F and increase in G. In a floating exchange rate regime, F could have lowered its interest rate, thereby stimulating aggregate demand, while G could have raised its interest rate, reducing aggregate demand. These monetary policies conducted by F and G would likely have led to a depreciation of the F currency and an appreciation of the G currency, thereby making the F products sold in G cheaper. On the contrary, in a pegged (fixed) exchange rate regime, F would have been able to devalue the F currency against the G currency, thereby achieving similar effects on aggregate demand. The devaluation (contrary revaluation) of the F currency would have increased the competitiveness of the F products, thereby stimulating the demand coming from G. Labor mobility is very limited in Europe, especially for low skilled workers, the main reason behind is the social security systems in place

3. Si spieghi la seguente affermazione: “…per ciò che attiene all’Europa è stato stabilito che un livello prossimo, ma inferiore al 2%, indica la stabilità dei prezzi…Diversa l’opinione di Olivier Blanchard, capo economista del FMI, secondo cui sarebbe bene alzare la soglia obiettivo dell’inflazione al 4%, in modo tale da dare alle banche centrali più spazio per agire…” 3. Answer:

4. Si descriva come la “scoperta” delle aspettative razionali abbia influenzato il dibattito sull’efficacia della politica monetaria. 4. The simple principle (derived from rational expectations theory) that expectation formation changes when the behavior of forecasted variables changes led to the famous Lucas critique of econometric policy evaluation. (pag. 596)

5. Usando il modello IS-LM si descriva l’impatto di un’espansione monetaria sul tasso di cambio (flessibile) e gli effetti di brevissimo e quindi breve-medio termine sulla bilancia commerciale. 5. Answer:

6. Il livello dei prezzi è 2, il reddito nominale ammonta a 100 euro, la domanda di moneta a 50 euro. Qual è il valore della velocità di circolazione della moneta? Immaginando, come nei primi classici, una velocità di circolazione costante, che cosa accade al livello dei prezzi se la domanda di moneta aumenta da 50 a 100 euro? 6. P = 2; Y = 100; MD =50; V = ?  V = (P*Y)/MD = 4 P = ?; Y = 100; MD = 100; V = 4  P = (V*MD)/Y = 4

7. Sotto quali condizioni (di mercato) una modifica nella riserva obbligatoria imposta agli istituti di credito della Banca Centrale non è tale da modificare sensibilmente l’offerta di moneta? 7. Answer:

8. Fino a che punto l’attuale crisi europea è dovuta al fatto che l’area dell’euro si discosta dal modello di area valutaria ottimale teorizzato da Mundell? 8. Answer:

9. Si descrivano i principali canali di trasmissione della politica monetaria. 9. The complex of monetary policy instruments, intermediate objectives and final objectives forms the transmission mechanism of monetary policy of the ECB. The transmission mechanisms of monetary policy include: a. The interest rate channel b. The exchange rate channel c. The price of financial assets: Tobin’s q theory d. The bank credit channel e. The financial credit financial traditional interest-rate channels that operate though the cost of capital and affect investment; other asset price channels such as exchange rate effects, Tobin’s q theory and wealth effects; and the credit view channels – the bank lending channel, the balance sheet channel , the cash flow channel, the unanticipated price level channel and household liquidity effects. The traditional interest-rate channels, can be summarized by the following schematic, which shows the effect of an expansionary monetary policy:

An important feature of the interest-rate transmission mechanism is its emphasis on the real (rather than nominal) interest rate as the rate that affects consumer and business dicisions. In addition, it is often the real long-term interest rate (not the real short-term interest rate) that is viewed as having the major impact on spending. Other asset price channels: exchange rate effects on net exports, Tobin’s q theory, wealth effects Credit view: bank lending channel, balance sheet channel, cash flow channel, unanticipated price level channel, household liquidity effects

10. Per quale ragione l’adesione all’unione monetaria fu inizialmente vincolata al rispetto di un criterio sul livello dei tassi di interesse (oltre agli altri criteri di Maastricht) 10. Answer:

11. Si discuta dell’importanza e del funzionamento del “canale esterno” nella trasmissione della politica monetaria della BCE nella crisi attuale. 11. Answer:

12. Che relazione esiste tra la curva di offerta aggregata e la curva di Phillips? 12. In 1958, economist A.W. Phillips published an empirical paper that examined the relationship between unemployment and wage growth in U.K. Later other economists extended his work to other countries, substituting wage growth with inflation a variable more central to macroeconomic issues than wage growth; the negative relationship resulting between unemployment and inflation became known as the Phillips curve. In 1967 and 1968, M. Friedman and E. Phelps pointed out a severe theoretical flaw in the Phillips curve analysis… From the Phillips curve is possible to derive an aggregate supply curve, which represents the relationship between the total quantity of output that firms are willing to produce and the inflation rate.

13. Il governo di un paese che è in regime di cambi fissi opera un’espansione fiscale. Si descrivano gli effetti sulle principali variabili macroeconomiche, utilizzando il modello IS-LM. Come cambia la dinamica descritta se il paese in questione è non in regime di cambi fissi ma membro dell’unione monetaria europea in cui le politiche fiscali sono rimaste nazionali ma la politica monetaria è unica. 13. Answer:

14. Si descriva il ruolo della Banca Centrale Europea nell’attuale crisi europea del debito. 14. Answer:

15. Si descriva il modello Barro-Gordon (The time-inconsistency problem). 15. The economic governance of EMU is built on the Barro-Gordon model (1983). The economic policy authorities have a desired rate of inflation, expressed in the case of the ECB, by a growth of the IAPC, representative of the stability of prices in the Eurozone, in a period of twelve months inferior but close to 2%. They also believe that the natural rate of unemployment is suboptimal and aim at an unemployment below the natural rate. So the problem the economic policy authorities are presented is an optimization problem where they try to obtain unemployment below the natural rate by creating surprise inflation (away from their desired inflation rate) thus creating positive loss function because unemployment is not below the natural rate and inflation is above the desired rate. That’s the reason the inflation target of the ECB is quite low. Private sector modifies its behavior according to the expectation of the public sector, so it’s crucial that the last one,

16. Monetary Policy at the Zero Lower Bound and possible exit strategies (Federal Reserve’s Proposed Exit Strategy) 16. The first thing to establish is the differentiation between “weak” and “strong” zero lower bound traps. A strong trap corresponds to the liquidity trap, a situation in which prevailing interest rates are low and savings rates are high making de facto monetary policy ineffective. In a liquidity trap, the public choose to avoid bonds and keep their funds in savings, because of the prevailing belief that interest rates will soon rise, thus discarding an asset with a price inversely correlated with the interest rates. Should the regulatory committee try to stimulate the economy by increasing the money supply, there would be no effect on interest rate, as the public doesn’t need to be encouraged to hold additional cash. The monetary authority loses the ability to implement the Taylor Rule at the zero lower bound. However, the promise to implement a Taylor Rule upon exit remains and effective policy instrument. Taylor Rule: is a monetary policy rule developed by John Taylor. It states that the central bank must modulate the short-term interest rate in response to discrepancy between the actual inflation rates and the target inflation rate, and between the actual and potential output. In practice It means that, when inflation is above its target or when the production is above its potential level, the central bank should rise the interest rate. On the contrary, when inflation is below its target or when the output is below potential output level, an expansionary maneuver is recommended.

17. Explain the following statement. Fed Chairwoman Janet Yellen justified the Fed’s quarter-point interest-rate hike on June 14th by arguing that the strong (and getting stronger) labor market has created the conditions needed for an eventual acceleration in inflation, using he own words “…in a few years, the Fed will have achieved its twin goals of maximum employment and stable prices…Inflation is right around the corner”. The Federal Reserve lifted its benchmark interest rate to between 1% and 1.25%, stuck to plans for one more rate hike in 2017 and said that it will gradually shrink its massive $4.5 trillion balance sheet. The decisions taken by the Fed were telegraphed completely, and took almost no one by surprise. The Fed falls back on the theory that an economy that is employing all of its resources is susceptible to rising prices, arguing that the fundamental relationship between full employment and rising inflation of the Phillips Curve remains in place. 17. Answer.