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The role of Expectations in Monetary Policy GVHD: TS Trần Ngọc Thơ Nhóm : Đinh Xuân Minh Hoàng Thị Thu Hà Content Lucas Critique of Policy Evaluation Policy conduct: Rules or Discretion The role of credibility and a Nominal Anchor Applications Approaches to Establishing Central Bank Credibility Summary Expandation Lucas Critique of Policy Evaluation ∗ Economists have long used macroeconometric models to forecast economic activity and to evaluate the potential effects of policy options ∗ In essence, the models are collections of equations that describe statistical relationshops among many economic variables ∗ Economists can feed data into such models, which then churn out a forecast or prediction Lucas Critique of Policy Evaluation Econometric Policy Evaluation: ∗ ∗ To understand Lucas’s argument, we must first understand how econometric policy evaluation is done For example: Federal Reserve wants to evaluate the potential effects of changes in the federal funds rate from the existing level of 5%.Using conventional methods, the Fed economists would feed different fed funds rate options—say, 4% and 6%—into a computer version of the model The model wouldthen predict how unemployment and inflation would change under the different scenarios Then, the policymakers would select the policy with the most desirable outcomes Lucas Critique of Policy Evaluation Econometric Policy Evaluation: ∗ ∗ Relying on rational expectations theory, Lucas identified faulty reasoning in this approach if the model does not incorporate rational expectations, as was true for macroeconometric models used by policymakers at the time: When policies change, public expectations will shift as well For example, if the Fed raises the federal funds rate to 6%, this action might change the way the public forms expectations about where interest rates will be in the future Those changing expectations, as we’ve seen, can have a real effect on economic behavior and outcomes Lucas Critique of Policy Evaluation Application: The Term Structure of Interest Rates ∗ ∗ ∗ Let’s now apply Lucas’s argument to a concrete example involving only one equation typically found in econometric models: the term structure equation The term structure equation relates the long-term interest rate to current and past values of the short-term interest rate It is one of the most important equations in macroeconometric models because the longterm interest rate, not the short-term rate, is the one believed to have the larger impact on aggregate demand Lucas Critique of Policy Evaluation Application: The Term Structure of Interest Rates ∗ ∗ In Chapter 6, we learned that the long-term interest rate is related to an average of expected future short-term interest rates Suppose that in the past, when the shortterm rate rose, it quickly fell back down again; that is, any increase was temporary Because rational expectations theory suggests that any rise in the short-term interest rate is expected to be only temporary, a rise should have only a minimal effect on the average of expected future short-term rates Lucas Critique of Policy Evaluation Application: The Term Structure of Interest Rates ∗ ∗ Suppose the Fed wants to evaluate what will happen to the economy if it pursues a policy that is likely to raise the short-term interest rate from a current level of 3% to a permanently higher level of 5% The term structure equation that has been estimated using past data will indicate that just a small change in the long-term interest rate will occur However, if the public recognizes that the short-term rate is rising to a permanently higher level, rational expectations theory indicates that people will no longer expect a rise in the short-term rate to be temporary Lucas Critique of Policy Evaluation Application: The Term Structure of Interest Rates ∗ ∗ Instead, when they see the interest rate rise to 5%, they will expect the average of future short-term interest rates to rise substantially, and so the long-term interest rate will rise greatly, not minimally as the estimated term structure equation suggests The term structure application demonstrates another aspect of the Lucas critique The effects of a particular policy depend critically on the public’s expectations about the policy If the public expects the rise in the short-term interest rate to be merely temporary, the response of long-term interest rates, as we have seen, will be negligible Lucas Critique of Policy Evaluation Application: The Term Structure of Interest Rates ∗ ∗ The Lucas critique points out not only that conventional econometric models cannot be used for policy evaluation, but also that the public’s expectations about a policy will influence the response to that policy The Lucas critique should also apply, however, to sectors of the economy for which rational expectations theory is more controversial, because the basic principle of the Lucas critique is not that expectations are always rational but rather that the formation of expectations changes when the behavior of a forecasted variable changes Appoint “Conservative” Central Bankers ∗ The problem with this approach to solving credibility problems is that it is not clear that it will continue to work over time If a central banker has more “conservative” preferences than the public, why won’t the public demand that central bankers who are more in tune with their preferences be appointed? After all, in a democratic society, government officials are supposed to represent the will of the people Appoint “Conservative” Central Bankers Summary ∗ ∗ The simple principle (derived from rational expectations theory) that how expectations are formed changes when the behavior of forecasted variables changes led to the famous Lucas critique of econometric policy evaluation Lucas argued that when policy changes, how expectations are formed changes; hence the relationships in an econometric model will change An econometric model that has been estimated on the basis of past data will no longer be the correct model for evaluating the effects of this policy change and may prove to be highly misleading The Lucas critique also points out that the effects of a particular policy depend critically on the public’s expectations about the policy Summary ∗ ∗ Advocates of rules to conduct monetary policy believe that rules solve the timeinconsistency problem because policymakers have to follow a set plan that enables them to stick to the plan and achieve desirable longrun outcomes Advocates of discretion believe that rules are way too rigid because they cannot foresee every contingency and not allow the use of judgment Constrained discretion imposes a conceptual structure and its inherent discipline on policymakers, but it does so without eliminating all flexibility, so that it combines some of the advantages ascribed to rules with those ascribed to discretion Summary ∗ ∗ An important way to constrain discretion is by committing to a credible, nominal anchor, a nominal variable, such as the inflation rate, the money supply, or an exchange rate, that ties down the price level or inflation to achieve price stability A credible nominal anchor helps solve the time-inconsistency problem and anchor inflation expectations Credibility has the benefit of stabilizing both output and inflation fluctuations and also enables anti-inflation policies to lower inflation at a lower cost in terms of lost output Summary ∗ Approaches to establishing credibility include implementing actual policies to keep inflation low, inflation targeting, exchange-rate targeting, and the promotion of central bank independence Another approach to establishing central bank credibility is the appointment of a “conservative” central banker (like Paul Volcker) who is hawkish on controlling inflation Expand A New Keynesian model for analysing monetary policy in Mainland China ∗ This paper adopts a four-equation New Keynesian model to evaluate the ∗ appropriateness of China’smonetary policy framework Our simulation results show that a hybrid rule that uses both interest rate and quantity of money as instruments outperforms the rules using one instrument alone at the current stage of economic and financialmarket development Our analysis also shows that a sharp appreciation of the renminbi exchange rate, though effective in containing inflation pressures, would be quite disruptive to growth Expand A New Keynesian model for analysing monetary policy in Mainland China ∗ ∗ Why is the interest rate rule alone inadequate? Structural impediments such as the underdeveloped banking system and market segmentations have made the interest rate rule alone inadequate First, the credit channel of monetary policy transmission via China’s banking system does not appear to be effective Despite the increasing importance of direct financing, the structure of financing in China continues to be dominated by banks The banking sector accounts for the largest share of China’s financial assets and intermediates (about 75% of financial capital), suggesting that credit markets remain the key channel of monetary transmission (McKinsey Global Institute, 2006) While the efficacy of the credit channel of monetary policy transmission has improved in recent years, as indicated by a sharp drop in the nonperforming loan ratio from about 40% to 50% in the late 1990s to less than 2% in late 2009,3 operational reforms in commercial banks, especially those large state-owned commercial banks, have just begun and most banks are still insensitive to market risks This suggests the role of interest rates in allocating capital remains inadequate despite years of financial reforms and the increased pace of interest rate liberalisation Expand A New Keynesian model for analysing monetary policy in Mainland China Expand A New Keynesian model for analysing monetary policy in Mainland China ∗ Market segmentations have also led to inefficient transmissions of monetary policy via interest rates China’s money markets consist of three submarkets The first one is the interbank market in which banks borrow funds among themselves from overnight to up to four months The second one is the interbank bond market in which PBoC bills, fiscal bonds, and policy and commercial bank bonds are issued This is by far the most liquid market (Peng et al., 2006) The third one is the bond repo-market in which short-term borrowing dominates This market, though less liquid than the interbank bond market, is more liquid and less volatile than the interbank market Regulatory restrictions have to some extent hindered the development of arbitrage activities among these markets As shown in Fig 3, the central bank bill rate has been below CHIBOR and interbank bond repo rate, while the gap between the latter two has also been sizeable Market segmentations should also be blamed for the lack of a benchmark term structure of interest rates fundamental to pricing bonds and other debt instruments (Chen & Yeung, 2006) Expand A New Keynesian model for analysing monetary policy in Mainland China Why is the quantity of money rule alone also inadequate? ∗ Geiger (2006) shows that the intermediate target of M2 has often been missed, particularly after the 1994–1995 high inflation episode (Table 1) Some have attributed the failures to achieve intermediate targets to the unstable money multiplier, while others consider the pegged exchange rate regime as the culprit Green and Chang (2006) find that there has not been a strong relation between the growth in reserve money (M0) and that in M2, despite the ability of the PBoC to control the former Laurens and Maino (2007) find that there has been a downward trend in the money multiplier since 1994, reflecting technological progress related to the payment systems, financial liberalisation, and the opportunity costs of holding money Furthermore, their VAR analysis indicates that money does not have any short-run impact on output, compared with a limited impact of interest rate on output Expand A New Keynesian model for analysing monetary policy in Mainland China The model Expand A New Keynesian model for analysing monetary policy in Mainland China Concluding: This paper is perhaps one of the first to adopt a New Keynesian model to analyse the appropriateness of China’s monetary policy framework Our simulation results seem to demonstrate that the current approach adopted by the PBoC that uses both interest rate and quantity of money as policy instruments is well vindicated The interest rate instrument may not be effective for the PBoC to rely upon alone to conduct monetary policy because of structural impediments such as the segmentation of financial markets and the still emerging modern banking system However, relying on the quantity rule of money alone is also inadequate, as it takes away the interest rate instrument for the PBoC to fine-tune the economy in the interim Our model simulations show that the monetary policy rule that combines both interest rate and quantity of money for monetary policy operations brings about the largest welfare gains measured by stability in inflation and output ∗ Expand A New Keynesian model for analysing monetary policy in Mainland China Concluding: ∗ Our simulation analysis also has some important policy implications First, the exchange rate policy, although effective in helping curb inflation, has a limited role in managing economic growth Second, a sharp appreciation of the renminbi exchange rate would be rather disruptive to growth Gradual appreciation, on the other hand, is much less disruptive and seems to be a preferred policy option It should be noted that the gradual approach to the exchange rate appreciation does not exclude the policy option that the authorities could also adjust the pace of the exchange rate appreciation in light of inflationary pressures of the domestic economy ... helping adults to resist pursuing the discretionary policy of giving in, a nominal anchor can help overcome the timeinconsistency problem by providing an expected constraint on discretionary policy. .. depend critically on the public’s expectations about the policy If the public expects the rise in the short-term interest rate to be merely temporary, the response of long-term interest rates, as... pursuing discretionary expansionary policy, they will recognize that this is likely to lead to higher inflation in the future They will therefore raise their expectations about inflation, driving