BOFINGER MONETARY POLICY PDF
As the regime shift to a common monetary policy was likely to change the way expectations are formed, there was a risk that empirical relationships between. Get Instant Access to Monetary Policy: Goals, Institutions, Strategies And Instruments By Peter. Bofinger #e3b7 EBOOK EPUB KINDLE PDF. This book provides an in-depth description and analysis of monetary policy in Europe and the United States. Unusually for a volume in the field, it focuses on.
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bofinger - Download as Word Doc .doc), PDF File .pdf), Text File .txt) or read It then analyses the performance of the common monetary policy in terms of. Suggested Citation: Bofinger, Peter; Mayer, Eric (): Monetary and Fiscal Policy Keywords: Monetary policy, inflation targeting, fiscal policy, policy. 1. Monetary Policy - Goals, Institutions, Strategies, and Instruments. Prof. Dr. Peter Bofinger. E R R A T A. (12 December ). Chapter 3: The process of money.
We explain the mechanics of foreign exchange market interventions and sterilization and we explain why a central bank has an interest of controlling simultaneously the two operating targets.
We derive the monetary policy rules for the two operating targets from a simple open economy macro model in which the uncovered interest parity condition and the monetary conditions index play a central role. Preview Unable to display preview. Download preview PDF.
References Ball, L. Google Scholar Bofinger, P. Google Scholar Calvo, G. Google Scholar Canales-Kriljenko, J. Google Scholar Clarida, R. Google Scholar Edison, H. Google Scholar Eichengreen, B. Google Scholar Evans, M. Google Scholar Fischer, S. Google Scholar Frankel, J.
Google Scholar Froot, K. The nominal gap is defined as the deviation of the actual stock of M3 from the level consistent with monetary growth at the reference value, taking December as the base period. The real gap is defined as the nominal money gap minus the deviation of consumer prices from the definition of price stability, taking December as the base period.
According to the first measure there is still a positive gap of about 4 percent, according to the second measure the gap is only 1 percent.
Modern monetary theory: the dose makes the poison
While such an exercise is much more adequate than an analysis of year-on-year rates, it is nevertheless a rather ad-hoc solution: First, the calculation of money gap on the basis of December is only adequate, if this base period is characterised by an equilibrium of money holdings.
The ECB has so far not addressed this issue. Second, the calculation of a real money gap using the actual deviation of consumer prices from price stability neglects the relatively long lags about 6 quarters between monetary impulses and the price level. In other words, the inflation that took place between December and November has been the result of the monetary growth in the period between, say, June and Mai In many public speeches in the year the representatives of the ECB tried to justify the increase of the ECBs interest rates with the strong growth rate of M3.
This implies that an increase in short-term interest rates would have a negative effect on the demand for M3. However, empirical estimates for the demand for money in the Euro area by ECB economists Coenen and Vega have come to the conclusion that such a negative interest rate elasticity exists only for the spread between along and short term interest rate. In other words: An increase in the short term rate that leaves the long term rate unchanged has a positive effect on the 8.
This has now been implicitly recognised by the ECB, when it has tried to explain the strong growth rate of M3 with the flat yield curve. On contrary, the continuing overshooting of the reference value on the basis of unrevised data, the strong adhoc adjustment of the underlying data and the unclear impact of short-term interest rates on M3 growth have created a permanent source of confusion about the rationale of the ECBs policy.
The second pillar: Too broad to serve as a guidepost for monetary policy The second pillar of the ECBs strategy looks, at first sight, very similar to an inflation forecast. However, the ECB tries to avoid that term forecast although it is not clear why an assessment of the future inflation outlook is conceptually different from an inflation forecast.
The ECB intends to base this assessment on a wide range of economic indicators which will include many variables that have leading indicator properties for future price developments.
They include inter alia: wages, the exchange rate, bond prices and the yield curve, various measures of real activity, fiscal policy indicators, price and cost indices and business and consumer surveys.
ECB a, p. If one regards as a minimum requirement for a strategy that it provides at least some reduction of the complexity of the decision process, the simple enumeration of many variables is by itself not yet something that would deserve the label of a monetary policy strategy. Thus, it is difficult to see the role of the second pillar for the internal decision making of the ECB as well as for its dialogue with the broader public.
Of course, the ECB can always explain an interest rate decision with one or several of the variables that are included in the second pillar. But this would be also the case, if the ECB had no announced strategy at all. In sum, while the first pillar is too narrowly focused on the money stock M3, especially if the year-on-year rates are used, the second pillar is much too broad to provide any guidance for the ECBs internal decisions or its dialogue with public. This has the negative consequence that, when looked from the outside, the status quo is not very different from a situation without any announced strategy.
The lack of a clear framework for an assessment of the ECBs monetary policy became especially apparent in the second half of when more and more observers criticised the ECB for reducing its interest rates too little and too late. While it is certainly true that a deceleration of growth took place in , it is not obvious that the ECB could have avoided such an outcome without threatening its target of price stability.
Duisenberg , Press Conference 30 August The ECBs interest rate policy in the light of the Taylor rule An alternative conceptual framework for an analysis of these important issues is provided the Taylor rule. While it is difficult to derive such a rate theoretically, in practice it is normally calculated as a long-term average. For the Euro area often the average of German short-term real rates is chosen, since the ECB has been constructed after the model of the Bundesbank.
In the period from the average short-term real rate in Germany was 2. As a central banks must act in nominal terms, even if thinks in real terms, it has to add the expected inflation rate to its estimate of the neutral real rate. The Taylor rule relates the central banks instrument to a variety of independent variables, typically deviations of actual or forecasted variables from their desired levels, namely an inflation gap, i.
In the original version of the Taylor rule both gaps are weighted with a factor of 0. Many studies have shown that such a rule mimics actual central bank behaviour with considerable accuracy over a wide range of countries. By adjusting the neutral rate for these gaps the rule provides for an interest rate response to demand shocks which affect both gaps in the same direction.
Several theoretical studies have shown that this heuristic leads to fairly good results in different model environments. In our present context it would be of interest to understand whether a suitable specified Taylor rule adequately mimics the ECBs setting of its short-term rate. An estimation of a Taylor rule poses some difficult questions: What is the best estimate of the neutral real rate?
Should the gaps refer to actual or to forecasted values of inflation rate and the output gap? Should the headline or the core inflation be used for the inflation term? Which weights are adequate for the two gaps? It is quite instructive to find out with which parameters the interest rate policy of the ECB can be simulated. Chart 9 shows a three different versions of a Taylor rule which come more or less close to the actual values of the overnight rate in the Euro area EONIA.
For all three versions the rule has been calculated as follows: For the neutral short-term rate we assume a value of 2. The rule is named after the U. He detected this rule when he tried to explain the actual interest rate policy of the Fed in the years ; Taylor 9 By the way, for the United States during the same period, the average is also 2. In order to use monthly values we calculate monthly data for the output gap as an average of the annual values for the respective years.
Taylor rule 1 is the most basic version with the actual HICP rate and with an equal 0. Chart 9 shows that during most of the time the actual short-term rate has been much lower. Until May this rule comes relatively close to the actual interest rate policy of the ECB. It indicates that in the second half of the ECBs rates could have been about 50 basis points lower. In the second half of the fit gets lost but this seems to mainly due to the fact that the OECD has made internal revisions of its forecasts.
With data of the December outlook the Taylor rate comes closer to actual rate, but it is still higher. This provides some indication that the ECB is willing to give some additional stimulus to the Euro area. It is interesting to note that the actual interest rate policy of the ECB can be mimicked best by Taylor rule 3. It gives the output gap a weight of 1 and weights the inflation gap with 0. The most important result of this simulations is that the ECBs interest rate policy can be explained too a large part with a fairly standard version of the Taylor rule.
As the Taylor rule provides for a anticyclical response of monetary policy in the situation of demand shocks, this indicates that the ECBs policy has shown a responsiveness to the developments in the real economy. While it is difficult to find out whether this response was sufficiently strong, one can see that at the end of the ECBs interest rate was definitively lower than the simulated values for all three versions of the Taylor rule.
Thus, in contrast to the ECBs rather confusing strategy an interest rate-based heuristic like the Taylor rule is able to provide some insights in the way of how the ECB has taken its interest rate decisions. Above all, one can see that the ECB is pursuing a policy that is willing to take expected demand shocks into account.
As the overall economic performance of the Euro area in the first three years of the ECBs policy has been satisfactory especially in comparison with other central banks, this approach has so far been quite successful. The gap between the ECBs marketing and its true approach This assessment leads to the interesting conclusion that the ECB is proclaiming a policy strategy that differs substantially from its actual policy.
Thus, instead of making monetary policy more transparent the ECBs strategy is obscuring the actual determinants of its interest rate decisions.
While in theory this should impair a central banks credibility, we have seen that according to standard indicators of credibility the ECBs credibility is very high. This astonishing result seems to indicate that in spite of its prominence in academic circles, financial market participants do not pay to much attention to the announced strategy of a central bank.
In fact, the Feds monetary policy has so far enjoyed a very high reputation although it was never based on a comprehensive strategic framework. Obviously, in the area of central banking deeds seem to be much more important than words.
Since that date the Euro has somewhat recovered but in the whole year it could not significantly appreciate above the 90 cent level.
Among a host of explanations three arguments have received a special attention in this debate: The Euro is weak because of an underlying weakness in the Euro areas economic fundamentals, especially in relation to the US economy. The Euro is weak because of the specific institutional and political framework of the Euro area with a single central bank but 11 and later 12 national fiscal policies.
As far as the structural problems are concerned, a main flaw of this explanation is that they were already existing long before the introduction of the Euro so that with forward looking financial markets this information should have been incorporated in the exchange rate before In fact, if one compares the overall situation of the Euro in when the Dollar was extremely weak vis--vis European currencies with the year which we have already described in detail it is hard to deny that a significant improvement has taken place on labour markets and in terms of sound public sector finances.
The ad-hoc nature of this argument was also reflected by the weakness of the Euro vis--vis the Japanese Yen. Until October the depreciation was as strong as the depreciation vis--vis the Dollar although the Japanese economy had to cope with much more serious structural problems than the Euro area and a much weaker growth rate of real GDP. Chart 10 shows that over a long term horizon the changes in the DM-Dollar exchange rate and since the -Dollar exchange rate cannot be systematically explained with the values of the growth and the interest rate differential.
The Chart demonstrates the general phenomenon that the volatility of financial market prices is much higher than the volatility of underlying fundamentals. In a similar vein some observers argued that the European currency would suffer from the risks that are associated with the forthcoming enlargement of the European Union by countries from Central and Eastern Europe.
For a discussion of this 11 12 See Shiller See also , p. It is in a crises in the sense that current macroeconomic approaches to exchange rate are empirical failures: the proportion of monthly exchange rate changes that current models can explain is essentially zero. Chart 11 shows the depreciations of international key currencies of a longer period of time.
Compared with the historical depreciations of the D-Mark and the Dollar, the weakness of the Euro in its first three years looks not especially impressive. As it constitutes no singular event, it makes also little sense to explain it with specific political or institutional problems of the Euro area.
If economic fundamentals have to be excluded, what remains is the rather vague concept of psychological factors. In financial markets research such influences have been analysed under the relatively new research programme of behavioural economics or behavioural finance. As a result, instead of using complex models and processing all available information decisions in financial markets are often based on relatively simple and frugal heuristics Gigerenzer and Todd A main characteristic of heuristics that can be observed on financial markets is an element of familiarity.
An unconscious form of familiarity is the key feature of the so-called anchor effect: decisions are shaped by a information that has nothing to do with the decision itself but it shapes the decision because it was received shortly before the decision was made.
It would be foolish, in forming our expectations, to attach a great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. There was absolutely no precedence for such an endeavour and the new currency was not available in the form of bank notes and coins.
In some sense, it was a foreign currency to everybody. In addition, the public perception of the Euro was suffering from negative anchor effect: In relation to the initial exchange on 4 January after each new depreciation a new historical low could be announced although calculated in terms of the D-Mark the true historical low is still 25 February with an exchange rate of 0.
The strong impact of psychological effects in the Euro depreciation becomes also obvious by the fact that the decline could be stopped effectively with two waves of intensive foreign exchange market interventions conducted by the ECB in October together with the United States and in November One size fits all monetary policy and its problems With its membership in a monetary union a country has to give up its monetary policy autonomy, i.
While most economists regard this loss of autonomy as a main disadvantage of a monetary union, one should not overlook that especially for smaller countries it is generally very difficult to pursue a completely independent monetary policy in an open economy. As already mentioned, under flexible rates there is a high risk that a country is confronted with a depreciation or an appreciation of its exchange rate that is completely unrelated to its economic fundamentals.
Therefore most member countries of the European Union had very early sought for an institutional framework which limits the shortterm volatility as well as medium term misalignments of exchange rates.
Monetary Policy (eBook, PDF)
The European Monetary System which was established in was very useful in this regard Bofinger However, it implied that the common monetary policy was set by the Bundesbank according to the requirements in the Germany economy, and that in periods of crisis e. Thus, the main economic advantage of EMU consists in completely ruling out speculative attacks within the common currency area and at the same time providing a common monetary policy which is guided by the economic situation in the Euro currency area as a whole Nevertheless, the problems of a one-fits-all monetary cannot be overlooked.
Under a monetary union the central bank can target the average inflation rate only, so that at the national level higher or lower rates are possible.
Thus, even if the average inflation rate is within the target range of the ECB in some countries a higher increase in prices has to be accepted.
As Chart 12 shows there have been indeed strong divergences in national inflation rates. For such divergences two different explanations are possible: an unbalanced macroeconomic policy mix at the national level, i.
While the first cause of national inflation is a cause of concern, the second is relatively unproblematic since it reflects unavoidable structural adjustments within a currency area.
In the following we try to shed some light into these important issues. The mix of EMU monetary policy and national fiscal policies If a national economy is confronted with an idiosyncratic demand or supply shock, the only available policy instrument is the national fiscal policy. This requires a solid fiscal policy in years without shocks so that national fiscal budgets are more or less in equilibrium.
Only then a country possesses the necessary breathing space for situations with negative demand shock, i. In order to assess whether the national fiscal policies in EMU have been able to fulfil this compensating task we calculate first the deviation of a national Taylor rule interest rate from actual Euro interest rate.
For this purpose we use the most simple variant of a Taylor rate, i. The difference between these two rates is shown in Chart It shows that for the three large economies the average euro interest rate has been more or less in line with national Taylor rate. Continuing large discrepancies can be identified for Ireland, the Netherlands, Portugal and Spain. For Finland only in an overly expansionary interest rate can be identified. This would require that a restrictive fiscal policy has been followed in the four EMU countries where interest rates have been definitively too low.
For an assessment of the stance of fiscal policy, the structural fiscal deficit is a good indicator since it allows to identify the discretionary actions of policymakers. Chart 14 shows a very high structural surplus for Finland and Ireland, which has been somewhat reduced in This parallels to some degree the reduced discrepancy of interest rates. In contrast to these two countries, in Portugal no offsetting fiscal policy can be detected.
The country has a very high structural deficit and has made little efforts to consolidate it. In Spain, the deficit is lower, but there are also no indications that fiscal has tried to compensate the monetary policy stance. In the Netherlands, pronounced changes in structural budget balance have taken place which have counteracted the effects of relatively low interest rates.
In addition, because of an increase in indirect taxes in the Netherlands, the Taylor rate for shows an upward bias. The only case for a too restrictive policy mix is Finland which has achieved a very high surplus in its structural fiscal balance in and As a result and also because of the weakening of the global demand for ITC products this country has experienced a much stronger deceleration of GDP growth in than all other EMU members: its growth rate declined form 5.
The only, but very important exception is Germany. This country will not only experience an above average output gap in , but with a projected deficit of 2. Here, the very arbitrarily set limits of the Stability and Growth Pact prevent a stronger fiscal impulse which seems clearly warranted given the below average GDP growth performance of Germany in The Balassa-Samuelson effect As already mentioned, in a monetary union the common monetary policy can only target an average inflation rate.
In addition to an inadequate policy mix divergences of the national inflation rate from the EMU average can be due to catching-up processes of member countries with below average income levels.
In this case an above average inflation performance is due to the fact that high productivity increases in the manufacturing sector make it possible to provide generous wage increases for the workers in this sector.
This has a strong tendency to affect wages in other sectors of the economy, above all services, where productivity increases are lower or even absent. As a result the national price index which consists of traded goods with a low increase in unit labour costs and non-traded goods with a relatively high increase in unit labour costs shows a stronger increase than in the more wealthy countries of a monetary union.
Thus, because of this so-called Samuelson-Balassa effect it is unavoidable for catching-up countries to accept an inflation rate somewhat above the target range of the ECB. As most studies on the costs of inflation show Barro , such the costs of such a divergence are relatively low. While the former is relatively unproblematic the latter tends to threaten a countrys international competitiveness over time.
In Chart 16 we present several indicators for an overheating in the period to unit labour costs in manufacturing: We calculate the difference between the increase in unit labour costs in the two countries with lowest average annual increase Germany and Austria and the average increase in other member countries. If the SamuelsonBalssa effect is in operation, differences in unit labour costs should be very low. For the three largest EMU member countries Chart 16 shows a rather balanced situation.
Only Italy has a somewhat deteriorating export performance. For the smaller countries the results are more diverse. Again for Portugal all indicators show a very bleak picture: a strong increase in unit labour costs combined with a negative export performance and a very high current account deficit.
Thus, the macroeconomic imbalance that we have identified in Charts 13 and 14 has obviously led to a high wage pressure and to negative effects on the international competitiveness of Portugal. In all other smaller countries the diagnosis is more difficult. In Ireland the above average inflation seems mainly related to the BalassaSamuelson effect.
Its increase in unit labour costs compared to the EMU countries with the lowest wage pressure is relatively small.
Its export performance has been better than in all other EMU countries and the current account shows a very small deficit. In Spain the wage pressure is relatively high and the current account deficit is the second largest of all EMU countries, but its export performance has been positive in each year.
In the Netherlands, the wage pressure is almost as high as in Portugal which fits with the indication that the Euro interest rate was much too for this country. But so far, neither the export performance, nor the current account have been negatively affected. Thus, from the four countries with an above average inflation, Portugal is an obvious case for a major macroeconomic imbalance. Indications for a somewhat overheated economy can be found in Spain and the Netherlands.
From the perspective of present member countries the economic significance of the prospective EMU entrants is relatively limited. Thus, the overall economic performance of the Euro area is affected only too a very limited degree by developments in individual countries of this.
Even if under a national law monetary policy is granted independence, the law can always be changed and there is still some informal and formal influence of the national government, e.Especially in Ireland. We calculate the difference between the increase in unit labour costs in the two countries with lowest average annual increase Germany and Austria and the average increase in other member countries.
Obviously, in the area of central banking deeds seem to be much more important than words. This is reflected by a monetary condition index for the Euro area. This has now been implicitly recognised by the ECB, when it has tried to explain the strong growth rate of M3 with the flat yield curve.
In the course of the lack of demand affected non-residential investment and the deterioration of the global economy lead to a drastic decline in export growth.
In the period from the average short-term real rate in Germany was 2. Bundesbank comes to a rate of 1. The Euro depreciation in a longer perspective A second argument for the explanation of the weak Euro is related to specific institutional and political environment under which the new European Central Bank is operating, above all to a lack of a strong political union.