principles of banking (iii): macroeconomics of banking (1)...

IntroductionMonetary Economics in a Nutshell (*)

Principles of Banking (III): Macroeconomics ofBanking (1) Introduction

Jin Cao(Norges Bank Research, Oslo & CESifo, Munchen)

J. C. Macroeconomics of Banking: Introduction

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Outline

1 Introduction

2 Monetary Economics in a Nutshell (*)Market frictions and real impact of moneyTraditional monetary policy analysisModern monetary policy analysis




Disclaimer

(If they care about what I say,) the views expressed inthis manuscript are those of the author’s and shouldnot be attributed to Norges Bank.




The macro side of banking

As we have already known, banking system is the artery ofmodern economy, channeling funds into real economy. Thisleads to two implications on studying the macro side ofbanking:

1 The state may intervene the real economy through bankingsector, via conducting monetary policy through centralbanking ;

2 The frictions in banking system may amplify volatilities inreal economy, even make the entire economy implode:macro-finance linkages.




(Conventional) monetary policy in central banking

In a modern economy, central bank — the bank of all banks— is established to stabilize the macroeconomy, throughimplementing monetary policy via monetary instruments;

It usually has clear mandates, and is independent for betterachieving the mandates;It usually has clear targets for monetary policy, asindicators for stable macroeconomy;It usually use interest rates instruments to shift banks’ costof funding, hence money supply, or, banks’ aggregate creditsupply, to affect real economy;

We focus on transmission machanisms, i.e., how monetarypolicy affects aggregate demand and real economy throughbanking sector.




Unconventional monetary policy (of Fed) during turmoil

However, in crises conventional monetary instruments oftencease to work

Conduits in banking get clogged, need to be cleaned up andget restarted ;Conventional monetary instruments often soon reach limitsand cannot be pushed further;

We take Fed as an example of a central bank in crisis modeto show

How monetary policy effectively reduces banks’ funding costand restarts the banking system;How central bank takes over failing market and pulls theeconomy out of the crisis.




Unconventional monetary policy in Europe

European Central Bank (ECB) has been facing similarproblems as Fed, while in addition subject to severesovereign debt issues. (Framing the unconventional monetary policiesconducted by ECB since 2007 is left as your exercises)




Market frictions and real impact of moneyTraditional monetary policy analysisModern monetary policy analysis

Why monetary policy has real impact?

The most fundamental question in central banking is: whyis monetary policy able to move real economy?

What central bank controls is fiat money; it doesn’tdirectly mobilize real resources in the economy;

Thought experiment: suppose central bank doubles itsmoney base. If price level doubles, too, the purchasingpower of money will be unchanged → no real impact;

Therefore, if monetary policy does have real impact, theremust be (nominal / real / financial / behavioral) frictionsor imperfections preventing the prices from goinghand-in-hand with monetary disturbances.





Frictions: “Evil is the root of all money”

Price Stickiness: firms may not adjust pricesimmediately after monetary shocks;

Wage rigidity: price of labor doesn’t change frequently;

Matching inefficiency: imperfection in matchingbetween labor and vacancies;

Capital adjustment cost: firms can only change capitalstock at a cost;

Credit constraints: frictions in financial sector hindersefficient allocation of credit;

Habit: consumers are reluctant to deviate from favoriteconsumption bundles;

......





Price stickiness: an example of nominal rigidity

A well known example of such frictions is price stickiness:

Observation: markets are far from perfect competition;they are at most monopolistic competitive (because ofproduct differentiation, transaction cost, etc);

Result: market power allows firms to charge higher pricethan marginal cost; natural rate of output is lower thaneconomy’s full capacity;

Price stickiness: firms may not adjust prices after everymonetary shock. Therefore, monetary shocks may shiftaggregate demand.





Equilibrium under monopolistic competition

To see how price stickiness arises, suppose the economy ispopulated with monopolistic firms who face a downwardsloping demand curve D.

Pric

e

Quantity

𝐷

𝑀𝑅

𝑀𝐶

𝑝

𝑞

𝐴

𝐸





Equilibrium under monopolistic competition

Under monopolistic competition

A firm chooses the output q to maximize its profit, whenthe marginal revenue equals marginal cost (MR = MC );As a result, equilibrium price p is higher than MC — “markup”= AE ;And the natural rate of output q is below the level underperfect competition.

“Imperction” that distorts efficient allocation.





Flexible price adjustment under demand shock

Pric

e

Quantity

𝐷

𝑀𝑅

𝑀𝐶

𝑝

𝑞

𝐴

𝐷′

𝑀𝑅′

𝐵

𝑞′

𝑝′





Price adjustment under demand shock

Suppose a negative demand shock shifts D to D ′ and MRto MR ′

If price is flexible, profit maximizing firms will adjust p top′ to make MR ′ = MC ;And cut down output to q′;

However, if they stay with (p, q′′) instead of shifting to(p′, q′)

The loss in profit (red triangle) is rather small;A small cost in price adjustment (“menu cost”) is enough toprevent price change → sticky price.





Menu cost and sticky price

Pric

e

Quantity

𝐷

𝑀𝑅

𝑀𝐶

𝑝

𝑞

𝐴

𝐷′

𝑀𝑅′

𝐵

𝑞′

𝑝′

𝑞′′

𝐶





Real impact of monetary policy under sticky prices

With price stickiness, firms only adjust prices under bigmonetary shocks, or adjust infrequetly under small shocks;

Therefore, if price level doesn’t change proportionally withmoney supply, there will be change in real demand;

As a result, central bank can use monetary policy to shiftshort-term real demand and stabilize the output;

How does central bank respond to supply / demand shocksand conduct properly designed optimal monetary policyrules? Traditional IS-LM view and modern rocket science.





Recap: monetary economics in IS − LM world

LM curve: combinations of nominal interest rate andoutput that lead to money market equilibrium for givenprice level;

Based on “liquidity preference” theory, M–money base,P–price level, i–nominal interest rate, Y –output

M

P= L

((−)

i ,(+)

Y

).

0 =∂L

∂i

∂i

∂Y+∂L

∂Y⇒ ∂i

∂Y= −

∂L∂Y∂L∂i

> 0.





Recap: monetary economics in IS − LM world

IS curve: goods market equilibrium such that planned andactual expenditure on output are equal;

Based on “Keynesian cross”, Y –real income, i − πe–realinterest rate, G–government expenditure, T–taxes

Y = E

((+)

Y ,(−)

i − πe ,(+)

G ,(−)

T

), 0 <

∂E

∂Y< 1.

∂Y

∂i=∂E

∂Y

∂Y

∂i+

∂E

∂ (i − πe)⇒ ∂Y

∂i=

∂E∂(i−πe)

1− ∂E∂Y

< 0.





Monetary expansion in IS − LM world

𝑌

𝑖

𝐼𝑆

𝐿𝑀

𝐿𝑀′





Target for monetary policy: money supply

Targeting money supply leads to maximum volatility inreal output:

𝑌

𝑖

𝐼𝑆

𝐿𝑀

𝐼𝑆′ 𝐼𝑆′′

𝑖∗

𝑌 𝑌′′ 𝑌′





Target for monetary policy: real output

Targeting real output leads to maximum volatility innominal interest rate (inflation):

𝑌

𝑖 𝐿𝑀

𝐼𝑆 𝐼𝑆′ 𝐼𝑆′′

𝑌∗

𝑖

𝑖′

𝑖′′





Choosing targets for monetary policy: loss function

People dislike both inflation and output fluctuations →central bank’s aim: min L = (Y − Y ∗)2 + α (π − π∗)2;

Short-term trade-off: “flexible inflation targeting”.

6

Short-term trade-off in monetary policy

Va

ria

tio

n in

in

fla

tio

n

Variation in output

Strict output

target

Flexible

inflation target

Strict inflation

target

6





The rocket science of modern monetary policy

However, in the past two decades central bank went farbeyond IS − LM world:

Micro-founded framework to better understand relevantfrictions and impacts on conducting monetary policy;A framework of fluctuations to capture the stylized facts ofthe uncertain world;Estimated models for better quantitative analysis andforecasting;General equilibrium to see co-movements;Dynamic model for intertemporal trade-offs;

Work horse in modern central banks: Dynamic StochasticGeneral Equilibrium (DSGE) model.





Ingredients in a standard DSGE model

Infinite time horizon. In each period:

Households: making decisions on labor supply,consumption / saving, investments in financial assets;

Firms: monopolistic competition, employing labor andcapital;

Central bank: conducting monetary policy rule tostabilize price and output;

Price stickiness: only some firms can adjust prices ineach period.

Shocks: “technological shock” to firms’ productivity.





The canonical new Keynesian system

New Keynesian IS curve: θ–coefficient of relative riskaversion, y–output gap (deviation from natural rate)

yt = Et [yt+1]−1

θ{it − Et [πt+1]} ;

New Keynesian Phillips curve: uat –productivity shock

πt = κyt + βEt [πt+1] + uat ;

Monetary policy rule (Taylor Principle): rn–naturalreal interest rate

it = rn + φπEt [πt+1] + φyEt [yt+1] , φπ > 1.





What’s new in new Keynesian?

Woodford revolution: short-term interest rate (it),instead of money base, is the sufficient tool to stabilizeprice and output;

Forward-looking:

Today ’s aggregate demand and inflation respond to people’sexpectation on future output and inflation;Therefore, central bank should follow a forward-lookingmonetary policy rule, plus actively and credibly managingpeople’s inflation expecation.





New Keynesian monetary policy targets

Objective: loss function minimization

min Lt = Et

{+∞∑τ=0

βτ[y2t+τ + απ2

t+τ

]};

With new Keynesian IS curve:

yt = Et [yt+1]−1

θ{it − Et [πt+1]} ;

And new Keynesian Phillips curve:

πt = κyt + βEt [πt+1] + uat .





Optimal monetary policy rules

Central bank needs optimal monetary rules to achieve theoptimal outcome, which is not trivial;

The biggest barrier is time-inconsistency problem

Political pressure to push output beyond natural rate →expansionary monetary policy by surprise → inflation bysurprise;If central bank does so, people would raise inflationexpecation in the first place;This makes monetary policy ineffective.

Need to build up credibility : being independent, delegationby conservative central bankers, etc.





Monetary policy and financial stability

On the micro level of transmission mechanisms

Monetary policy in practice works directly on banks’balance sheets;Therefore, it has a great potential to affect banks’risk-taking behavior → “risk-taking channel”;

However, central bank’s monetary policy decision is basedon macro DSGE framework

Where financial frictions are poorly modeled, if notnon-existing at all;Banking sector there is rather passive “financialaccelerator”, not trouble maker;

Is such biased policy to be blamed for current crisis?


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