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2019 | Book

Long-Run Growth: The Basic Framework Read chapter Read first chapter

Money: Theory and Practice

Authors: Jin Cao, Gerhard Illing

Publisher: Springer International Publishing

Book Series : Springer Texts in Business and Economics

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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About this book

This textbook provides an introduction to modern monetary economics for advanced undergraduates, highlighting the lessons learned from the recent financial crisis. The book presents both the core New Keynesian model and recent advances, taking into account financial frictions, and discusses recent research on an intuitive level based on simple static and two-period models, but also prepares readers for an extension to a truly dynamic analysis. Further, it offers a systematic perspective on monetary policy, covering a wide range of models to help readers gain a better understanding of controversial issues. Part I examines the long-run perspective, addressing classical monetary policy issues such as determination of the price level and interaction between monetary and fiscal policy. Part II introduces the core New Keynesian model, characterizing optimal monetary policy to stabilize short-term shocks. It discusses rules vs. discretion and the challenges arising from control errors, imperfect information and robustness issues. It also analyzes optimal control in the presence of an effective lower bound. Part III focuses on modelling financial frictions. It identifies the transmission mechanisms of monetary policy via banking and introduces models with incomplete markets, principal-agent problems, maturity mismatch and leverage cycles, to show why investors’ and intermediaries’ own stakes play a key role in lending with pro-cyclical features. In addition, it presents a tractable model for handling liquidity management and demonstrates that the need to sell assets in crisis amplifies the volatility of the real economy. Lastly, the book discusses the relation between monetary policy and financial stability, addressing systemic risk and the role of macro-prudential regulation.

Table of Contents

Frontmatter
1. Long-Run Growth: The Basic Framework
Abstract
This chapter focuses at the real economy, introducing important concepts for inter-temporal analysis which play a key role in modern monetary policy analysis. We start with a simple two-period endowment economy with one representative agent. We illustrate the concepts of wealth constraint, inter-temporal optimization with time preferences, marginal rate of substitution (MRS), and the real rate interest. We derive optimality conditions for the inter-temporal path of consumption (the Euler equation) and the natural rate of interest as key equilibrium condition. We show that our endowment can be interpreted as a base line model for a growing economy. As next step, we introduce government spending and taxation and extend our base line model by introducing the labor market, making production endogenous. We derive optimal price setting under monopolistic competition in an economy with heterogeneous firms for the case that all firms can adjust their prices optimally without cost. The general equilibrium conditions for this economy provide an important reference point for later analysis, characterizing the natural level of employment, potential output, and the corresponding natural real rate of interest in the absence of nominal rigidities.
Jin Cao, Gerhard Illing

Money and Equilibrium in the Long Run

Frontmatter
2. Money and Long-Run Growth
Abstract
This chapter looks at monetary policy design from a classical, long-term perspective. We consider a dynamic growth model with flexible prices, assuming that money will not affect real variables in the long run. We introduce various frictions to provide a microfoundation for money holding and show that, formally, the role for money generated by these frictions can be captured in a quite general way by the “money in the utility function” approach. By construction, the role of monetary policy is fairly limited in that context and straightforward to characterize: Central banks should aim to implement the Friedman rule to achieve price stability (low inflation), thus minimizing distortions arising from holding money balances. We show, however, that price level and inflation are determined not just by current monetary policy, but by the expected future path of monetary policy across time and analyze conditions to rule out indeterminacy with bubbles and self-fulfilling inflationary expectations.
Jin Cao, Gerhard Illing
3. Interaction Between Monetary and Fiscal Policy: Active and Passive Monetary Regimes
Abstract
This chapter analyses the interaction between monetary and fiscal policy in detail. We want to understand why there is no clear relation between debt and inflation. The current price level and inflation is not determined just by current monetary policy. Expectations about how monetary policy evolves in the near and distant future play a crucial role. Since monetary policy actions frequently have some fiscal impact, the effectiveness of monetary policy also depends on the response of fiscal policy. With government debt usually being denominated in nominal terms, movements in the price level may have substantial impact on the real value of debt. The real value erodes in periods of hyperinflation; it increases in periods of deflationary spirals. We distinguish between different regimes, depending on who is the active player. In one regime, fiscal policy automatically adjusts such that monetary policy is allowed to control inflation. Here monetary policy is active, free to pursue its objectives, with fiscal policy assumed to be passive, being constrained by central bank actions. However, there can also be an alternative regime, with active fiscal and passive monetary policy.
Jin Cao, Gerhard Illing

Monetary Policy in the Short Run

Frontmatter
4. New Keynesian Macroeconomics
Abstract
This chapter presents stylized New Keynesian model, allowing a share of prices to be sticky. We derive two core equations of the New Keynesian model from individual optimization. The Euler equation provides a microfoundation for the New Keynesian IS curve or aggregate demand curve. Price setting behavior of individual firms generates a traditional upward sloping aggregate supply curve when some share of firms is not able to adjust prices. Once prices have been set, shocks disturb the economy, shifting it away from long-run equilibrium. The model allows to analyze the impact of various shocks on all variables determining general equilibrium. We consider shocks to aggregate demand—shifting only the AD curve (pure demand shocks, like a change in the time preference parameter), aggregate supply (like shocks on technology and leisure) and so called mark-up or cost-push shocks. Whereas supply shocks affect both potential and efficient level of production in the same way, mark-up shocks shift the AS curve, but do not affect the efficient level of production. We show that these shocks will shift the economy away from natural output and the target price level if the central bank does not respond to shocks, keeping the nominal interest rate unchanged. Active interest rate policy, trying to stabilize the real interest rate at its natural rate, is needed in order to stabilize the economy. We show that the appropriate response crucially depends on the specific nature of underlying shock.
Jin Cao, Gerhard Illing
5. Optimal Monetary Policy
Abstract
In this chapter, we derive optimal monetary policy when the central bank minimizes welfare losses arising from price dispersion among different goods. We show that welfare losses can be captured by a quadratic loss function as second order Taylor approximation. The optimal policy response crucially depends on the specific nature of the underlying shock. Both for demand and supply shocks it is optimal to stabilize the price level, thus minimizing price distortions. Keeping price stable, output will stay at potential. In the presence of mark-up shocks, however, there is a trade-off between implementing price stability and bringing output close to the efficient level.Since market equilibrium is inefficiently low due to distortions, there is an incentive for a welfare maximizing central bank to trigger a surprise inflation. We characterize the problem of dynamic consistency using game theoretic concepts: The attempt to raise welfare results just in an inefficiently high price level, since the central bank cannot systematically raise output above market equilibrium.We discuss various mechanisms to impose binding rules as commitment mechanism. Since the adequate response depends on the nature of specific shocks, mechanical simple instrument rules are shown to be sub-optimal. Instead, targeting rules allow the use of all relevant information. They specify conditions for the (forecasts of) target variables, leaving the instruments at the discretion of the central bank.
Jin Cao, Gerhard Illing
6. Monetary Policy Under Uncertainty
Abstract
In this chapter, we take into account that real decision-making has to cope with control errors, imperfect information, and robustness issues. Intuition suggests that central banks should act less aggressively as a response to uncertainty, with policy response depending on the precision of noisy signals. The more precise the signal, the more active should be the response with Bayesian updating in case of a quadratic loss function. Similarly, actions should be dampened if there is multiplicative uncertainty about the transmission mechanism. Robust control theory, however, using minimax rules, suggests that under some conditions central banks might act more aggressively, aiming to avoid really bad extreme case outcomes. Optimal monetary policy strongly depends on variables which are hard to observe in reality. We show the challenges involved in estimating potential output, the natural rate of interest, and measuring expected inflation. We illustrate that simple rules, like the Taylor principle, may lead to quite ambiguous predictions if we take that issue seriously into account. Finally, we look at the impact of transparency and independence for central banks. Transparent communication is an essential ingredient of modern forward-looking policy. However, we show that there may be conditions when too much transparency might be harmful: Since public information plays also a coordinating role, private agents might overemphasize public signals.
Jin Cao, Gerhard Illing
7. The Liquidity Trap: Limits for Monetary Policy at the Effective Lower Bound
Abstract
In this chapter, we explicitly take into account the constraint imposed by the effective lower bound. We show that under this constraint the central bank should aim to keep interest rates low for a long period, in order to stimulate current demand by committing to low long-term rates. We illustrate this feature in a highly stylized three-period framework, characterizing explicitly the optimality conditions involved, and show that there is a problem of dynamic inconsistency, creating a deflation bias. This lesson had a strong impact on actual policy design. The notion of forward guidance, which plays a key role in unconventional policies, follows naturally from commitment to optimal interest rate policy at the zero lower bound. The attempt to communicate and commit in a transparent way to keep the path of short-term interest rates low for an extended period far into the future is a key element of optimal policy.
Jin Cao, Gerhard Illing

Part III

Frontmatter
8. Monetary Policy in Practice
Abstract
Well-functioning monetary policy uses a combination of various tools and relies on a well-functioning banking sector, transmitting monetary policy targets into supply of credits that further affects real activities in the macroeconomy. This chapter gives a survey of the channels of monetary transmission mechanisms and shows how they work via various tools affecting intermediation in the banking sector, with a focus on the link between central bank’s balance sheet management and the transmission into the banking sector. Financial crises impede the resilience of the banking sector, interrupting standard transmission mechanisms and triggering huge spikes in credit spreads. This chapter illustrates this failure during the Great Recession and analyzes various unconventional policy responses, in particular the policy of qualitative and quantitative easing. These measures can drive the shadow rate (as a measure of the effective stance of monetary policy taking unconventional policies explicitly into account) into negative territory.
Jin Cao, Gerhard Illing
9. Financial Frictions and Monetary Policy
Abstract
This chapter reviews models focusing on the role of financial sector, in particular on banks for the monetary transmission mechanism. Financial frictions prevent banks from allocating credit to those agents needing it most, and induce banks to overreact to macroeconomic shocks, increasing volatilities in output. This chapter characterizes conditions under which monetary policy can help to dampen the distortions arising from financial frictions, improving social welfare. This chapter focuses on financial frictions that impede the transmission of monetary policy to the real economy; in particular, four types of financial frictions are discussed: incomplete market, principal–agent problems, maturity mismatch, and leverage cycle.
Jin Cao, Gerhard Illing
10. Monetary Policy and Financial Stability
Abstract
This chapter analyzes the feedback between monetary policy and financial stability using two main approaches. The first one is a macro approach, integrating the banking sector in a standard DSGE model; the second one is a banking approach, integrating central bank in a partial equilibrium banking model. The feedback mechanisms motivate the need for macroprudential regulation, as a necessary companion for monetary policy, to address the systemic risks that cannot be fixed by monetary policy alone.
Jin Cao, Gerhard Illing
Metadata
Title
Money: Theory and Practice
Authors
Jin Cao
Gerhard Illing
Copyright Year
2019
Publisher
Springer International Publishing
Electronic ISBN
978-3-030-19697-4
Print ISBN
978-3-030-19696-7
DOI
https://doi.org/10.1007/978-3-030-19697-4