Monetary policy

Case: “The Euro in Crisis: Decision Time at the European Central Bank” Harvard Business School case no. 9-711-049

Case preparation: The ECB During the Crisis, July 2021

Lecture handout: Monetary policy*

Textbook Reading: Chapter 7 (Section 7.1 and 7.5; pp. 200-211 and pp. 227-236) and Chapter 8 (Intro, Section 8.1 and 8.2; pp. 237-278)

This lecture covers a lot of ground but tries to give you a relatively simple, usable framework to relate monetary economics to monetary policy decisions. One problem when studying macroeconomics is the belief that it equips us with an ability to forecast. See my video on Economic Prediction for why I think we need to be careful (and here is a short follow up quiz). Ultimately, we shouldn’t expect central banks to be able to forecast a recession because if they could predict them they can prevent them. To predict a (demand side) recession, therefore, we are really trying to predict central bank incompetence.

You may think that I am being harsh on economic forecasters. But I agree with Andy Haldane when he said, “It has been argued that these models were not designed to explain such extreme events. For me, this is not really a defence. Economics is important because of the social costs of extreme events. Economic policy matters precisely because of these events. If our models are silent about these events, this jeopardises the very thing that makes economics interesting and economic policy important.”

The key finding of monetary economics is that the root cause of inflation is excessive money creation. We looked at some specific examples of hyperinflation, and to learn more you can watch “Zimbabwe and Hyperinflation: Who Wants to Be a Trillionaire?” (Marginal Revolution University). The ONS let you calculate your own personal inflation rate here.

Conventional monetary policy is a simple link between a target (usually inflation) and a tool (interest rates). During the lecture I implied that central bankers change interest rates relative to the current rate. In some cases, however, they may be trying to move the policy rate closer to some sort of benchmark. A common benchmark can be calculate using a Taylor Rule. For examples, see Kaleidic Economics.

To get a feel for how central bankers should respond to changing conditions, try these simulators:

A corridor system is when the central bank targets three policy rates. We looked at how those rates changed from 2003-2015 in the Eurozone. The ECB website has more recent data.

Recent changes to central bank targets include:

  • In August 2020 the Fed announced that it would replace a flexible 2% inflation target with a flexible average 2% inflation target (see here).
  • In July 2021 the ECB announced that it would replace a target of “below but close to 2%” with a symmetric 2% target over the medium term (see here).

This is a good explanation of current Fed policy:

@kylascan Reply to @joelsephs what does the federal reserve do? #federalreserve #monetarypolicy #inflation #economics #fyp #foryou #LIKEABOMBSHELL ♬ Spooky, quiet, scary atmosphere piano songs – Skittlegirl Sound

In “Is China better at monetary policy than America“, The Economist, April 22nd 2023, we are reminded that central bankers tend to be conservative – the technical term is “attenuation”, “if policymakers are uncertain about the effects of their own policies, they should do less than they otherwise would. In other words, if you are not sure of the potency of your medicine, administer less than you would if you were”. However, The Economist reports the problem with this, which is that markets, “will come to expect this stodginess and adjust their actions accordingly. If inflation gets out of whack, they will expect an inhibited response and, as a consequence, a more persistent misalignment of inflation”.

For a recent survey of the improvement in emerging market monetary policy due to central bank independence and inflation targeting, see “Laboratory accidents“, The Economist, March 11th 2023. It also reveals how increased reliance on non traditional tools may undermine this.

For a good primer on inflation see:

Here is an article I wrote on the implications of higher inflation for managers.

Group activity: Thermostat Worksheet, February 2020 // or complete this form
Group activity: Monetary Implications Worksheet, June 2020 

Additional activity: NGDP Masterclass

The key goal for monetary authorities is credibility: [Credibility flashcard]

Group activity: MPC Simulation, December 2012

You can read more details about the Bank of England’s MPC here. I used to regularly participate in the Shadow MPC. A useful resource may be the Kaleidic Dashboard.

Group activity: ECB Simulation, March 2011

The lecture also introduces the concept of the signal extraction problem. This isn’t the most intuitive concept to grasp, but it explains how nominal shocks can have real effects. In other words how changes in the money supply can affect inflation and real growth. A good article on this is Steve Horwitz’s ‘The Parable of the Broken Traffic Lights“.

Recommended audio

  • The EconTalk podcast, and the episodes with Milton Friedman on Money (August 28th 2006), Allan Meltzer on Inflation (Feb 23rd 2009), and Charles Calomiris on the Financial Crisis (Oct 26, 2009), are particularly relevant for this session.
  • I also recommend the episode of Macro Musings called Scott Sumner on The Money Illusion (October 2021)
  • This episode from Conversations with Tyler, Mark Carney on Central Banking (May 2021) does a nice job of setting the objectives of a central banker, in a modern economy, related to issues such as climate change and digital currencies. It provides an engaging awareness of some of the differences between major central banks.
  • The Macro Musings episode with Jens van ‘t Klooster on Recent ECB Policy (May 2022) discusses the recent change in the ECB’s remit, how ECB actions differ from the Federal Reserve, and does a really nice job of whether the 1990s model of central banks is outdated and needs to evolve due to changing circumstances and priorities (such as climate change and elevated sovereign debt).

Recommended video

For my account of the 2007-2008 financial crisis:

What is a yield curve:

Learning Objectives: Understand the root causes of inflation, and contribute to policy discussions. Understand how monetary policy affects business decision-making and thus generates macroeconomic fluctuations. See the operation of a conventional monetary policy regime in practice. Contrast the ways in which the Fed and the ECB acted during the global financial crisis.

Cutting edge theory: Nominal income targeting and surveying current monetary indicators. 

Focus on diversity: One of the most influential books on monetary economics was co-authored by Anna Schwartz. You can learn more about her here. In 2019 Christine Lagarde became the first female president of the ECB. Prior to that she was the managing director of the IMF. You can read her article on how women can grow the global economy here

Spotlight on sustainability: We look at how interest rates enable intertemporal coordination