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This chapter provides an overview of Abenomics’ effects on financial markets and the real economy, with a focus on the effect of monetary policy. While many financial and real economic indicators showed success, consumption growth was sluggish. Household-level data from the Family Income and Expenditure Survey suggest that this is in part because monetary policy did not have the predicted expansionary effect on household consumption, even for those households expected to benefit most.
This chapter presents an overview of the development of inflation and monetary policy in Israel since the early 2000s. Unlike the discussion in the previous book, which centered on the disinflation process and the transformation of the economic and institutional environment as a result of the Stabilization Program in the mid-1980s (Ben-Bassat, 2001, Section II), the setting of the current chapter is of a large external shock: the 2008 global financial crisis against the background of a relatively stable domestic environment of economic policy — monetary and fiscal — and of inflation. The chapter describes inflation and its characteristics, monetary policy, and the mechanisms of transmission from policy to inflation. It focuses on recent years, those following the financial crisis, which have been typified, in Israel and abroad, by a low-inflation environment in view of very accommodative monetary policies. The last section concludes the chapter and offers some thoughts going forward.
Multiple equilibria arise in standard New Keynesian models when the nominal interest rate is set according to the Taylor rule and constrained by a zero lower bound (ZLB). One of these equilibria is deflationary and referred to as an expectations-driven liquidity trap (ELT) as it arises because of the de-anchoring of inflation expectations. This study demonstrates that a simple tax rule responding to inflation can prevent a liquidity trap from arising without increasing government spending or debt. We analytically investigate the necessary and sufficient conditions to prevent an ELT and show that both the frequency and persistence of ELT episodes affect the extent to which the tax rule must respond to inflation. In brief, the higher the frequency or the longer the persistence of the ELT, the greater the response of the tax rate must be.
This paper has two main goals. The first is to fill a gap in the literature on inductive risk by exploring the relevance of the notion of inductive risk to macroeconomics. The second is to draw some general lessons about inductive risk from the case discussed here. The most important of these lessons is that the notion of inductive risk is no less relevant to the relationship between the proximate and distal goals of policy than it is to the relationship between specific policies and their proximate goals.
Sets out what central banks can and must contribute to the sustainability agenda, especially on climate change, given their existing mandates and objectives. That includes monetary policy, financial stability, prudential regulation, balance sheet-management and even bank notes. Central banks do not need and should not wait for changes to their legal duties, because climate change is a material influence on all their existing responsibilities. Meanwhile, macroeconomic stability is a pre-requisite for the wider sustainability agenda and so there needs to be a continuing priority focus on monetary and financial stability.
I assess a novel rule that was introduced in the UK in 2015. It gave the British government fiscal flexibility whenever GDP growth warranted it. This rule lasted just a year, but it had features worth exploring. I apply solution methods for models with occasionally-binding constraints to assess the demand stabilisation properties of state-contingent fiscal rules. First it is shown that fiscal flexibility can make recessions shallower. Second, it is suggested that GDP growth, rather than measures of the output gap, is a better indicator for triggering fiscal flexibility.
This paper investigates how a combination of monetary and macroprudential policies might affect the dynamics of a small open economy (SOE) with financial frictions under alternative discretionary shocks. Discretionary shocks in productivity and domestic and foreign monetary policies identify the roles of alternative interest rate and reserve requirement rules to stabilize the economy. The model is calibrated for the Brazilian economy. The exchange rate channel of transmission is relevant for foreign but not for domestic shocks. The interest rate rule should target domestic inflation and should not react to the exchange rate. The countercyclical reserve requirements rule, in its turn, should aggressively react to the credit-gap and not include a fixed component. Under both domestic and foreign shocks, the countercyclical effectiveness of the macroprudential policy improves when the degree of openness increases. There is a complementarity between monetary and macroprudential policy rules to stabilize the SOE.
Money and credit are ubiquitous in actual economies, but there is an active theoretical debate on whether they are both necessary if they can both be used in all transactions. Recently, Gu et al. (2016) have shown that money and credit cannot be simultaneously essential and debt limits do not matter for the determination of real allocations in a class of monetary economies. In this paper, we revisit their irrelevance result in a monetary economy based on Lagos and Wright (2005), which exhibits a misallocation of liquidity that is common in search models of money. We show that monetary loans, which naturally require the use of both money and credit, implement Pareto superior allocations in which the size of debt limits matters.
After September 1992, there remained considerable uncertainty about the longer-term possibility of the UK eventually joining the Eurozone, a prospect that few liked, but equally almost no policy-maker wanted to rule out definitively. There thus remained a substantial ambiguity in the question of the UK’s relation to the giant monetary experiment of the European Union. The Bank started to think about exporting its new policy framework, based on an inflation target, as a superior model, also for European monetary management.
This introductory chapter outlines the transformation or modernization of the Bank of England in the twenty years after 1979: how governance and accountability were transformed, and communication was accorded a greater role, as the Bank moved to policy autonomy or operational independence from the UK government. The process amounted to what might be described as an informational revolution. The transformation of macro-economic management may also be considered as part of a broader process of globalization. Central banks everywhere became much more aware of international activities and developments, and policy-makers reflected more on how the UK was affected by what went on beyond its frontiers. There was also a greater legalization: a need for legislation to define what was involved in banking, and how to regulate banking. Finally, the nature and definition of money and of monetary stability became the subject of a political debate.
After September 1992, the Bank was at the forefront of the search for a new policy framework. It pushed the idea of central bank independence, that was heavily supported by academic theory, as well as by the framework established in 1991 at the Treaty of Maastricht. The reform was driven by the new Governor, Eddie George, but also by Chief Economist Mervyn King. The Bank also defined its mission in terms of three core purposes, monetary stability, financial stability, but also the promotion of the efficiency and effectiveness of the UK financial services sector; and reformed its administrative organization – a move that was highly unpopular with its staff. The key to the new policy was an inflation target, established by the government, and implemented through regular meetings of the Chancellor of the Exchequer (at that time Kenneth Clarke) and the Governor of the Bank. These attracted considerable publicity, and were known as the Ken and Eddie show: it was often thought to be an exercise in which a hawkish Governor pressed for interest rate rises, which a doveish and politically sensitive Chancellor resisted.
The 1997 system, which appeared to have been functioning so smoothly and satisfactorily, was severely tested after 2007–2008, in what became known as the Global Financial Crisis. Both elements of the new approach to economic governance – the operational independence of the Bank on monetary policy, and the separation of financial supervision – stood as subjects of controversial debate, and a new wave of institutional upheaval set in. There was - and there is - no obvious and easy solution to the question of designing monetary management as part of a broader economic policy-making framework. What is involved in being the very model of a modern central bank is today no longer quite as obvious as it had been at the end of the twentieth century.
The incoming Labour government immediately in 1997 set a new framework for the Bank’s operational independence, while removing debt management and transferring financial supervision to the new Financial Services Authority (FSA). The FSA would operate in a trilateral framework, in regular contact with the Bank, which established its own Financial Stability Committee in parallel to the newly created Monetary Policy Committee. But the Bank’s role was increasingly seen as primarily in setting monetary policy, with an overall inflation goal of 2.5 per cent, and the obligation to write an explanatory letter to the Chancellor of the Exchequer if the target were to be seriously missed. Chancellor Gordon Brown saw the Committee structure, with half the Committee appointed by the government, as a path to cutting down the powerful figure of the Bank Governor as an alternative economic policy-maker. The early years of the MPC were overshadowed by disputes over the resources allocated to the external (government-appointed) members of the Committee, and by increasing press attention to divisions within the MPC between ‘hawks’ and ‘doves’. By the time George stepped down as Governor in 2003, the MPC process looked highly credible.
Chapter 9 deals first with the reforms needed for the cornerstones of the EMU macroeconomic policies, i.e. the common monetary policy and the macro-prudential regulation that has recently added to it. As to the former, one of the main proposals is to raise its optimal target, for reasons that add to those recently suggested by some eminent economists; in addition, the prohibition to the ECB to act as a lender of last resort to governments should be reconsidered. As to the latter, the need arises of strengthening the existing legislation. On the other hand, fiscal policy is the Cinderella of the EMU macroeconomic policies and its deflationary and asymmetric orientation, to which the fiscal compact has recently added, is to be radically reconsidered, moving towards a fiscal union. Finally, wage policy can be implemented in a way to help dealing with the different country structural problems in a way that cannot be done by the common monetary policy.
Chapter 2 describes the institutional background for the analysis of the imbalances that emerged over time, in Europe, which are central to our enquiry. The main aspect of the EMU institutions is their “incompleteness,” from the point of view of a more “mature” one, of the kind of a federalist structure. Incompleteness derives from a strong measure of persistent national, and thus, independent decision-making that interacts and overlaps with the few common institutions and often dominates over them. The EMU’s design is founded on a few common institutions, a single currency (to which a common macroeconomic policy has added recently) and the free operation of markets, as well as harmonization of some rules. All the other policy instruments are to be managed by the member states, with constraints on some policies, especially fiscal policy. Wage policy is completely disregarded. Thus, most national borders are maintained. In the mind of the founding fathers of the Union, these common institutions were necessary, and sufficient conditions for getting rid of frictions and the uneven distribution of resources and opportunities across the countries, thus resulting in a uniform process of growth of the whole Union.
This chapter provides an introduction to flexible exchange rates. It presents both a simple supply and demand model of exchange rate determination and the assets-based approach of the interest rate parity condition. It considers the role of interest rates and expectations in exchange rate determination. An appendix analyzes monetary policies and the nominal exchange rate.
This chapter provides an introduction to fixed exchange rates. It first considers a range of possible exchange rate regimes. It presents a simple supply and demand model of exchange rate determination and the assets-based approach of the interest rate parity condition, both applied to a fixed exchange rate regime. It considers the role of interest rates and expectations under fixed exchange rates. It briefly considers the impossible trinity and currency boards. An appendix analyzes monetary policies under fixed exchange rate regimes.
This study investigates if the reaction function of the Federal Reserve switches between two distinct policy rules. Using a time-varying transition probability framework, we also determine if forward-looking macroeconomic or financial covariates signal an impending monetary regime switch. We find that US monetary policy is best described by a Markov-switching model with two regime processes, one of which controls for heteroskedasticity in the shocks to the policy rule. We find that the Fed switches between an aggressive regime with a relatively high weight on inflation and a dovish regime that is less responsive to inflationary pressures. We find that an increase in private forecasters’ expectations of an impending recession signals a switch from the more aggressive policy regime to the less aggressive regime. A recovery in equity returns signals a return back to the more aggressive regime.
Based on a thorough analysis of the BIS Annual Reports from the early 1970s to the late 2010s, this chapter traces the evolution of the BIS’s thinking on the international monetary and financial system. It demonstrates how – as a result of the growth of the Eurocurrency markets in the 1970s and of the sovereign debt crisis of the 1980s – the BIS’s traditional focus on exchange rates and their potential impact on monetary stability gradually shifted to global capital flows and to the risks posed by an increasingly complex and interconnected banking system. The 1995 Mexico crisis and 1997–8 Asian crisis reinforced this shift and led to an overriding concern with the procyclicality of the financial system as a potential threat to financial stability. While recognising that the focus of the BIS on a macro-financial stability framework has contributed a lot to advancing the work of the Basel-based committees and standard-setting bodies, the chapter also concludes that not much progress has been made in coordinating monetary policies or in addressing the fundamental problem of excessive elasticity of the financial system.
It is a commonplace to state that we live in a time of continuous change. But that doesn’t make it any less true. The force and impact of change become all the more obvious when considering a horizon that spans two generations. Fifty years ago, a mere handful of advanced industrial economies dominated the global economy. Since then, a wide array of countries have emerged as new economic powerhouses. Economic development and prosperity are now more equally spread across the globe than at any other time over at least the past two centuries.