Prof. Dr. Stefan Jungblut
20.03.2013
Monetary Policies and Financial Stability: Recent Development and Lessons From
The Current Financial Crisis
Faculty of Business Administration and Economics
Department of Economics
Prof. Dr. Stefan Jungblut
Sherif Elkoumy
Master´s thesis defense in Business Administration
Prof. Dr. Stefan Jungblut
2 20.03.2013
• Introduction • Monetary
policy theory
• Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Introduction
Monetary policy theory – Overview
Types of monetary policies
Monetary-aggregate Targeting
Exchange-rate Targeting
Inflation Targeting
Flexible Inflation Targeting
Montary policies and Finacnial stability
Conclusion
Prof. Dr. Stefan Jungblut
3 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
The monetary policies are the central tool of macroeconomic
stabilization.
Central banks in developed and developing countries have
made great steps in the conduct of monetary policies.
Inflation rates have been decreased to levels that are consistent
with price stability.
Once price stability has been attained, growth rates of the
aggregate economy have been high.
The thesis looks at the recent development of monetary policies
by studying different monetary policies that allow monetary
policy to focus on domestic consideration.
Prof. Dr. Stefan Jungblut
4 20.03.2013
• Introduction • Monetary
policy theory
• Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Definition
The role of a nominal anchor
Basic principles of monetary policy
Price stability
Avoiding time inconsistency
Alignment of fiscal policy with monetary policy
Forward looking policy
Accountability
Central bank independency
Central bank accountability
Prof. Dr. Stefan Jungblut
5 20.03.2013
• Introduction • Monetary
policy theory
• Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Definition
- A process by which the monetary authority controls and
monitors the money supply.
- It can be either expansionary or contractionary .
The role of a nominal anchor
- A restriction on the value of domestic money. A single
variable central bank use to peg down expectations of
private agents about the nominal price level.
- Two types of nominal anchor
> quantity-based nominal anchor
> price-based nominal anchor
Prof. Dr. Stefan Jungblut
6 20.03.2013
• Introduction • Monetary
policy theory
• Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Basic principles of monetary policy
Price stability
- Low and stable inflation rate provides considerable benefits to
the economy.
Avoiding time inconsistency
- Follow short-term objectives results in poor long-term outcomes.
Alignment of fiscal policy with monetary policy
- Irresponsible fiscal policy affects on price stability.
Forward looking policy
- To metigate long lags from monetary policy.
Accountability
- Actions of the government should be publicly monitored.
Prof. Dr. Stefan Jungblut
7 20.03.2013
• Introduction • Monetary
policy theory
• Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Central Bank Independence
- The degree of independency affects on the rate of money
expansion and credit. High levels of independence with a
clear mandate for the bank are important to assure price
stability and a better macroeconomic performance.
Central Bank Accountability
- Central bank should be subject to government and public
supervision. Central banks are required to communicate
obviously their monetary policy strategy to illustrate their
targets and goals and how they plan to achieve them.
Prof. Dr. Stefan Jungblut
8 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Monetary-aggregate Targeting
Theoretical framework
Advantages and disadvantages
Exchange-rate Targeting
Theoretical framework
Advantages and disadvantages
Prof. Dr. Stefan Jungblut
9 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Monetary-aggregate Targeting
Theoretical framework
The strategy includes three main elements:
1. Depending on information delivered by a monetary-
aggregate to manage monetary policy.
2. Announcement of targets for monetary-aggregates.
3. Accountability mechanism to exclude large and systematic
deviations from monetary targets.
The strategy focus mainly on the growth of a chosen
monetary-aggregate.
Prof. Dr. Stefan Jungblut
10 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Monetary-aggregate Targeting
Advantages and disadvantages
1. Authorities reacts quickly to shocks in the domestic
economy.
2. Monetary targeting generates instantaneous signals about
the status of the monetary policy.
3. A solid relationship between the goal and the target
variable must be existed. If this relationship is not
available between income level, price level and the velocity
of money, monetary targets will not be able to convoy
clear signals about the stance of the monetary policy.
Prof. Dr. Stefan Jungblut
11 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Exchange-rate Targeting
Theoretical framework
- The central bank attempts to ensure nominal exchange rate
stability against the currency of a so-called anchor country via
interest rate changes and direct exchange interventions
thereby importing price stability.
- An adequate level of international reserves is required.
- An appropriate economic policy that ensures a low level of
inflation differential against the anchor country.
Prof. Dr. Stefan Jungblut
12 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Exchange-rate Targeting
Advantages and disadvantages
1. The framework fixes inflation rate for internationally
traded goods, and thus directly takes part to keep inflation
under control.
2. It anchors inflation expectation by providing an automatic
rule for the conduct of monetary policy.
3. It avoids the time-inconsistency problem
4. Exchange rate targeting hinders central banks from
establishing an independent monetary policy.
5. Exchange rate targeting is probably to stimulate financial
fragility in emerging markets countries.
Prof. Dr. Stefan Jungblut
13 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Theoretical approach
Inflation targeting framework
Assignment of the target
Interaction with other policy
Definition of target
Economic effects of inflation targeting
Drawbacks
Flexible inflation targeting
Prof. Dr. Stefan Jungblut
14 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
- A practical response to the downfall of the other monetary
policy strategies. Inflation targeting is a credible nominal
anchor for inflation expectations.
Theoretical approach
“..a framework for monetary policy characterized by the public
announcement of official target ranges over one or more time
horizons; low and stable inflation are monetary policy´s primary
long-run goal; vigorous efforts to communicate with the public
about the plans and objectives of the monetary authorities;
mechanisms that strengthen the central bank´s accountability for
attaining those objectives.”
Prof. Dr. Stefan Jungblut
15 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Inflation targeting framework
Assignment of the target
Interaction with other policy
Definition of target
• Horizon of the target
• Choice of price index
• Width of the target band
• Accountability
• Inflation forecasts
Prof. Dr. Stefan Jungblut
16 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Inflation targeting framework
Assignment of the target
• Who assigns the inflation target – Central bank or Government.
Interaction with other policies
• Full employment (in short-run, a tradeoff between the two
objectives may be occurred, in the long-run, achieving the target
is the best action to full employment objective).
• Financial stability should be compatible with the inflation
targeting framework.
• Fiscal policy objectives. Monetary policy requires considering the
impact of fiscal policy on the outlook for inflation. Similarly, fiscal
policy requires supporting the inflation target.
Prof. Dr. Stefan Jungblut
17 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Inflation targeting framework
Definition of target
• Horizon of the target (it depends on the inflation rate at
the time of setting inflation target).
• Level of the target (theoretically, zero inflation is equal to
price stability, practically, having inflation target above zero
is preferred).
• Choice of price index (vary due to the different methods
in calculating the CPI and the relative sensitivity of the CPI
inflation rate to supply shocks).
Prof. Dr. Stefan Jungblut
18 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Inflation targeting framework
Definition of target
• Width of the target band (should it be a numerical
number or a band?).
• Accountability (increased accountability of inflation
targeting allows monetary authority to monitor and improve
the understanding of expectations).
• Inflation forecasts (due to its forward-looking nature,
inflation targeting dynamically uses forecast; therefore, the
central bank´s forecasts of inflation are critical).
Prof. Dr. Stefan Jungblut
19 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Economic effects of inflation targeting
• Inflation targeting has remained within the targeted range or close
to the target rate.
• Inflation targeting has been successful in controlling inflation.
• Inflation targeting can promote growth and does not lead to
increased output fluctuations.
• Inflation targeting increases accountability which helps
ameliorates the time-inconsistency problem.
• Increased transparency and accountability under inflation
targeting helps promote central bank independence.
• Inflation targeting can help build credibility and anchor inflation
expectations more rapidly and durably.
Prof. Dr. Stefan Jungblut
20 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Economic effects of inflation targeting
• Inflation targeting grants more flexibility.
• Inflation targeting includes a lower economic cost in the face of
monetary policy failure.
• Effects on inflation (average inflation has decreased on average,
fluctuations in inflation have declined).
• Effects on growth and business cycle variability (a slight increase in
the average growth, growth variability has declined generally).
• Effects in interest rates and exchange rates (a decline in inflation
expectations and the inflation risk premium on nominal interest
rates, real exchange rate variations have declined on average).
Prof. Dr. Stefan Jungblut
21 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Economic effects of inflation targeting
• The performance of inflation targeting strategy over the past 20 yrs.
Inflation and growth performance (Roger, 2010)
Output and inflation smooth (Roger, 2010)
Prof. Dr. Stefan Jungblut
22 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
Drawbacks
• September 2008, central banks that had been depending on
inflation targeting have not given enough consideration to assets-
price bubbles.
• improper responses to supply shocks and terms-of-trade shocks.
• Inflation targeting cannot work in countries that do not meet a
stringent set of preconditions.
Flexible inflation targeting
• Set weight on real GDP growth in the short-run, so long as there is a
clear longer-term target for CPI inflation.
• Inflation targeting should not be a strict inflation targeting but a
flexible inflation targeting.
Prof. Dr. Stefan Jungblut
23 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
The relationship between monetary policy and financial
stability
• Inflation can be viewed as one of the major factors creating
financial stability in the first place.
• Monetary policy and financial stability policy are inherently
connected to one another .
Assets price bubbles
• Asset price movements and asset price bubbles can directly
endanger financial stability.
Lessons from the crisis
• Price stability is not enough to attain financial stability and good
flexible inflation targeting by itself does not attain financial
stability.
Prof. Dr. Stefan Jungblut
24 20.03.2013
• Introduction • Monetary
policy theory • Types of
monetary policies
• Inflation
Targeting • Monetary
Policies and Financial stability
• Conclusion
• Inflation targeting clearly outperforms both monetary-
targeting and exchange-rate regime. While the latter suffers
from many drawbacks, the former shows an improved
performance in terms of inflation reduction and economic
conditions.
• To overcome these severe drawbacks, inflation target should
be flexible and gives some weight on real GDP growth in the
short-run, so long as there is a clear longer-term target for CPI
inflation.
• flexible inflation targeting does use all information that is
relevant for the forecast of inflation and resource utilization.
Prof. Dr. Stefan Jungblut
25 20.03.2013