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Monetary Policy

The document discusses monetary policy and the challenges central banks face. It explains how central banks use tools like open market operations and interest rates to influence money supply and aggregate demand. It also discusses the difficulties of monetary policy, like operating with incomplete data and uncertain lags, and the risks of overstimulating an economy which can cause high and costly inflation.

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8 views19 pages

Monetary Policy

The document discusses monetary policy and the challenges central banks face. It explains how central banks use tools like open market operations and interest rates to influence money supply and aggregate demand. It also discusses the difficulties of monetary policy, like operating with incomplete data and uncertain lags, and the risks of overstimulating an economy which can cause high and costly inflation.

Uploaded by

p4320697
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Monetary Policy

Manish K. Singh
email-id: [email protected]

Department of Humanities and Social Sciences


Indian Insititute of Technology Roorkee

April 22, 2024


Recap 1: How central banks influences money supply?

Central bank uses three primary tools to change money supply,


namely
1. open market operations in which the Fed buys bonds, which
increases the money supply and reduces interest rates, or the
Fed sells bonds, which decreases the money supply and
increases interest rates;
2. lending to banks and other financial institutions; and
3. changes in the interest rate paid on reserves.
Recap 2: Aggregate Demand

→
− → →
− − →
M +−
v = P + YR

Money Supply Growth + Growth rate Velocity =

Inflation + Real GDP Growth


What we would like to answer today

When should the RBI try to influence AD?;


When will the RBI be able to influence AD?; and
When will the influence on AD result in higher GDP growth
rates?
Monetary policy: The best case
A negative shock to aggregate demand
Two issues
Even in the best case scenario:
1. The Central bank must operate in real time when much of the
data about the state of the economy is unknown.
• Was the dip in employment last month a precursor of a
recession or was it an exception?
• If the price of oil went up last month, does that indicate a
longer-term trend or was it the result of some temporary
shock?
• Is a decline in the stock market predicting a future recession or
not?
2. The RBI’s control of the money supply is incomplete and
subject to uncertain lags.
• an increase in the money supply typically affects the economy
with a lag that can vary in time from 6 to 18 months.
• If banks aren’t willing to lend, then although the RBI may
increase the monetary base, the larger monetary aggregates
and thus aggregate demand won’t increase very much in
response.
Getting monetary policy just right is not easy
What happens when RBI overstimulates?

Inflation will rise


• price signals will become difficult to interpret;
• will arbitrary redistribute wealth (from rich to poor, from old
to young);
• will make long-term planning and contracting more difficult;
• ...
Bringing down the rate of inflation is costly because prices
and wages are not full flexible in the downward direction.
That means economies sometimes get stuck between a rock
and a hard place-between continuing a costly rate of inflation
or reducing it at the risk of a recession.
Question

Many economists think that the Federal Reserve did overstimulate the
economy in the 1970s; and, as a result, by 1980, the inflation rate hit
13.5% a year. Ronald Reagan was elected to the presidency in part to
change economic policies. By 1983, tough monetary policy under Reagan
and cigar-chomping Federal Reserve Chairman Paul Volcker had reduced
the inflation rate to 3%, but the consequence was a very severe recession
with an unemployment rate of just over 10%.
In India, in 2016, we decided to have an inflation targetting framework
(inflation around 4%). Before this, Indian economy had a high inflation
(around 7%) and high growth rate. The growth rate has slowed down as
well. Do you think this is because we are trying to lower down
inflation?
Some definitions

A disinflation is a significant reduction in the rate of inflation.


A deflation is a decrease in prices, that is, a negative inflation
rate
A monetary policy is credible when it is expected that a
central bank will stick with its policy.
RBI as manager of market confidence

Market confidence: One of the RBI’s most powerful tools is


its influence over expectations, not its influence over the
money supply.
Why aggregate demand falls in the first place:
• Uncertainty or ”wait and see” mode: When investors are
uncertain, they often prefer to wait, to delay, and to try to
gather more information, before they commit themselves.
• Bandwagon effect: It pays to coordinate your economic
actions with those of others-that is, you want to be investing,
producing, and selling at the same time that others are
investing, producing, or selling. So we see a lot of time
bunching or clustering of investments.
The Negative Real Shock Dilemma
How the equilibrium will move?
The Negative Real Shock Dilemma
How should monetary policy respond?

1. Focus on the inflation rate, which has jumped from 2% to


8%. What is the recipe for reducing inflation? Cut money
→
−
supply (↓ M )
• But this will reduce growth further!
2. Forget the inflation, let’s just bring the real growth back.
→
−
What’s the recipe for this? Increase money supply (↑ M )
• The growth rate might increase a little!
• Inflation will rise further up (more steeply)
Trying to bring the bring growth back
Complicating this further

Real shocks are often accompanied by aggregate demand


shocks so the pictures above are considerably simplified.
The RBI is looking at real-time data, which as we have noted
are often uncertain and subject to revision.
The bottom line is that with a real shock, the central bank
faces a dilemma: it must choose between too low a rate of
growth (with a high rate of unemployment) and too high a
rate of inflation.
• The central bank, in fact, stands a good chance of getting a
mix of both problems.
The lesson is this: If you are a central banker, hope that
you don’t face too many negative real shocks in your
term!
Assignment question

Covid-19 is a real shock which is expected to become an


aggregate demand shock.
Based on your understanding so far, try to figure out the best
course of action for RBI?
• Use graphs (Aggregare Demand, Short-run Aggregate Supply)
• Assume 5.5% as the Solow growth rate for India (real growth
if we weren’t hit by the Covid-19)
Sometimes central bank does too much
References

Chapter 16, Cowen and Tabarrok: Modern Principles -


Macroeconomics
The bottom line is this: Monetary policy is difficult in the worst of
times and it’s not easy in the best of times.

Questions!

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