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Political Economy of Monetary Policy PowerPoint Presentation
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Political Economy of Monetary Policy

Political Economy of Monetary Policy

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Political Economy of Monetary Policy

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  1. Political EconomyofMonetary Policy November 2003

  2. Presentation Index • Introduction. • Areas of Interest. • Endogenous Monetary Policy Formulation • Fiscal and Monetary Policy • Foreign Exchange Arrangement and Monetary Policy • Unemployment, Inflation and Monetary Policy. • Q&A

  3. Introduction • The objective of monetary policy is to influence the performance of the economy as reflected in such factors as inflation, economic output and employment. It works by affecting aggregate demand across the economy, specifically peoples’ and firms’ willingness to spend money on goods and services. • Monetary policy is conducted by a nation’s central bank and influences demand by targeting (raising or lowering) short term interest rates or controlling the money supply. • Monetary policy has two basic goals: to promote “maximum” output and employment, and to promote “stable” prices.

  4. The presentation will be based on certain aspect of political Economy and monetary policy Unemployment & Inflation Monetary Policy Exchange Rate Policy Fiscal Policy • Havrilesky • Kliponen • Parkin • Edwards • Frieden • Leblang • Bach • Kaley et al • Persson et al

  5. Keynesians: Central bank is seen as an independent manipulator of int, exchange, unemployment and growth rates. • An apolitical institution in charge of choosing the optmital instruments and target variables. • Game Theory: Central Banks play indefinite loss-minimizing games with atomistic market participants whose voting power generates the only incentives • Models do not deal with the reciprocity between interests groups, politicians and central bankers • Partisan Theory: MP is somehow driven by economic preferences of voters, since they know politicians preferences, but still face electioral uncertainties. • Determine the factors the influence the endogenous process of monetary policy formulation. • Two variations: central bank‘s burocreatic self interest and redistributive considerations. • Monetary policy therefore responds neither to targets for output or inflation, but reacts to political pressures resulting from sectoral dissonances. • Rent seeking by interests groups places strong pressures on monetary policy making (directly or indirectly), so that income is redistributed through inflation or interesta rates. • For eg, MP will respond to contain inflation only when the “cost“ of it (in terms of aggregate wealth) exceeds the cost of interests groups organizing to lobby for monetary restrains. • The government‘s reaction function changes every time there is a change in the political environment (incluidng but not limited to elections) The Political Economy of Monetary Policy (Havrilesky, 1994) Objective Public Choice Model Previous Theories

  6. “Optimal Fiscal and Monetary Policy and Economic Growth” – Foley et al (Journal of Political Economy) • Government goals: • Maximization of utility of per capita consumption (social welfare) • Management of aggregate demand to achieve stable consumer price level (maintenance of • price stability) • Government tools: • “Its deficit appears as transfer income and influences the demand for consumption goods.” • It intervenes at the asset market by open market policy – it affects price of capital and therefore • economy’s growth path. • (Therefore, it manipulates deficit and OMP to induce the private sector to produce investment goods • at the optimal rate at each instant). • Optimal per capita deficit is an increasing function of the capital labor ratio. • Initial debt has no influence on economy’s growth path; Economy’s growth possibilities are only • constrained by its technology and its initial endowments of capital and labor. • The economy seeking the higher long-run per capita consumption (less impatient government) • may follow a fiscal and monetary policy leading to a higher long-run per capita debt. • The higher the community’s propensity to save, the higher is the long run debt (taking the • government's objective function as given).

  7. “Monetary-Fiscal Policy Reconsidered” - G.I. Bach (Journal of Political Economy) • “Instead of guaranteeing full employment without inflation, in a free society monetary-fiscal policy may well guarantee inflation without full employment because of the upward income pressures of monopolies and organized political power groups”. • Government has two goals – price stability and full employment • Author proposes 6 assumptions for the workable monetary-fiscal policy; One of them is: “For effective policy monetary-fiscal authority must operate without irresistible pressures from special interest groups (business, labor and agriculture) seeking to place their welfare above that of the general public”. • While interest groups are exerting expansionary pressures on government, Government is acting as a protector of the income of a particular social group – the unorganized fixed-income receivers. • Upward income and price pressure cannot be effectively resisted by a government whose monetary-fiscal guide is “full employment”. • Necessary condition for successful monetary-fiscal policy is voluntary consensus among interest groups (public support).

  8. “Time Consistency of Fiscal and Monetary Policy “ – Persson et al (Econometrica) • The problem of time inconsistency arises from: • Incentive for each government to engage in an initial unanticipated inflation • Incentive for each government to deviate from the path of taxes announced by the preceding government • Government under discretion has an incentive to deviate from previously announced policy. • Suggestions: 1) Fixed rules – commitment policy • 2) Reputation issue (allows discretion policy) • 3) Carefully managed structure of debt – each new government had to honor the previous government debt (allows discretionary policy) • 1 - Each government should leave to its successor net nominal claims on the private sector equal to the money stock • 2 - Government has to engage in partial commitment – just to honor previous national debt. New government inherits the right maturity structure of its nominal and indexed debt, which enables it to conduct optimal policy without time inconsistency.

  9. Exchange Rate and the Political Economy of Macroeconomic Discipline (Edwards, 1996) • Determine the factors the influence the choice of a particular exchange rate arrangement. • Constructs a data set of 63 countries (developed and less developed) covering 1980-1992. • Constructs a theoretical model contrasting the effects of political instability and the authorities discount rate in the ex-ante decision of chosing the exchange rate regime • Runs a probit regeression, setting the dependant variable to be the probability of choosing a pegged regime. Research Objective Results Sign on Coefficient Political Instability Bilateral exchange-rate changes Variation of real export Methodology Degree of Openness Domestic Liquidity’s Growth Rate Inflation History International Reserves Real GDP growth Per Capita GDP

  10. The Political Economy of Currency Pegs (Frieden, 2003) The Political Economy of Exchange Rate Policy (Leblang, 2003) • All other things being equal, the empirical evidence indicates that speculative attacks are more likely: • (i) under left rather than under right governments • (ii) after electionsrather than before them. (due to short term governmetn spending) • Aside from economic fundamentals, markets take into account the timing of elections and the partisanship orientation of the government • The exchange rate policy reflects a government’s tradeoff between the competitiveness of tradable goods (influenced by interests groups) and antiinflationary credibility. • An impending election increases the conditional likelihood of staying on a fix peg system by about 8% • After the election, the probablility of going off a peg increaes by 4% • Controlling for economic factors, 1% point increase in the size of the manufacturing sector in the country, is associated with a reduction of six months in the longevity of the country‘s peg. • Government’s decision to defend the peg reflects institutional, electoral and partisan incentives. • Test these arguments with Hazard models to analyze the duration dependence of Latin American exchange rate arrangements from 1960-1999 • Test the hypotheses from this model on a sample of 90 developing countries between 1985 and 1998 using a probit model Research Objective (Frieden) Research Objective (Leblang) Methodology Methodology Findings Findings

  11. The Political Economy of Monetary Policy and Wage Bargaining (Kilponen, 2000) • When wage setters commit to an inflation targeting régime, inflation can reach the target level, but there may be a substantial loss in output. The loss in output is related by the desire of the central bank to accommodate related labor market distortions. • When labor markets are sufficiently decentralized, regardless of the weight the government attaches to output stabilization, the government would prefer explicit inflation targeting over discretion even if the wage setters had a possibility to precommit. Additionally, under discretion, the whole society would be better off, especially unions. • When the wage setters responded to the policy rule of the government, it was found that the government’s policy was not time inconsistent in the usual sense of creating inflationary bias, because the government would find it optimal to reduce inflation.

  12. Unemployment and Inflation (Parkin, 1998) • Optimally, monetary policy should set a short term interest rate and a contingency rule to target zero inflation, and to smooth out fluctuations in unemployment. • The general view is that the natural unemployment rate fluctuates and the trade-off between the change in inflation and unemployment is influenced by many factors: rates of entry and exit into job market, unemployment compensation arrangements. • The trade off between the change of unemployment and inflation is of limited policy relevance. • Dynamic General Equilibrium (DGE) Model-shows the design and conduct of monetary policy would make predictions about the influence of monetary actions on unemployment and inflation. • Combines production technology, job matching technology, shopping-time technology, and price setting technology into one model. • Shocks to this model would show how other sectors would recover when one sector is hampered.