CHAPTER 23:
The Art of Central Banking:
Targets, Instruments and Autonomy
FOCUS OF THE CHAPTER
This chapter begins with an introduction to the operating instruments, intermediate targets, and ultimate goals of monetary policy. This is followed by an analysis of the policies of monetary targeting and interest rate pegging. The issue of the autonomy or independence of the central bank is discussed towards the end of the chapter. The theory of political business cycles is briefly discussed in the section on central bank autonomy.
Learning Objectives:
Explain the distinction between economic variables that are instruments of monetary policy and those that are targets of monetary policy
Describe why monetary policy involves choosing either to control an interest rate or to control money supply, but not both
Explain how the Monetary Conditions Index works and what it measures
Analyze why political influences arising from elections or partisan political factors, or from the legal relations between a central bank and the government, are important
Determine why central banks might follow rules in setting interest rates
SECTION SUMMARIES
Targets and Instruments of Monetary Policy
Central banks possess a set of operating instruments or tools (such as the monetary base and overnight rate) which can be manipulated to affect intermediate targets (such as M1 or M2 money supply aggregates and interest rates) and thereby achieve ultimate (or final) goals (such as low inflation and a high economic growth rate). The manipulation of instruments by the central bank affects intermediate targets, and the changes in targets, in turn, affect variables representing ultimate goals.
The problem of choosing an appropriate monetary aggregate, assessing the stability of the money multiplier, and specifying the final target and predicting its movements, all make it difficult to achieve final targets. The effectiveness of monetary policies also depends on the level of credibility of the policies pursued. Whether the central bank should be committed to a single target or multiple targets is an important question about monetary policy. The potential for incompatibility of goals, and for conflict between the goals of policy-makers and the central bank, are areas of concern for monetary policy in pursuing multiple final goals.
Monetary versus Interest Rate Control: A Simple Characterization
The intermediate targets of monetary control (controlling the money supply) and interest rate control have different consequences on the stability of interest rates.
Changes in unpredictable factors shift the demand curve upward and downward over time. The supply curve also shifts upward (leftward) and downward (rightward) over time, due to changes in factors (such as the currency-deposit ratio) that are not under the direct control of monetary authorities (see Figure 23.2 in the text).
Money Supply Control: Recall that the rate of interest is determined by the demand for money (Md) and the supply of money (Ms). Suppose that the money supply is controlled within a range, between a maximum and a minimum. Given the Md, the rate of interest (R) changes as Mschanges. This means that the rate of interest fluctuates between a maximum and a minimum, depending on the position and slope of the existing demand curve for money. The fluctuation, or volatility, of R increases as the slope of the Md curve increases (i.e., as the Md curve becomes more and more inelastic with respect to the interest rate). See Figure 23.3 in the text.
The variability of interest rates may be caused either by changes in the slope of the Md curve or by changes in the position of the Md curve (uncertainty of the Md curve). If interest rate uncertainty is undesirable, then the central bank might implement a policy of interest rate control.
Interest Rate Pegging: The policy of fixing an interest rate is referred to as interest rate pegging. If the central bank pegs the interest rate, the money supply curve becomes perfectly elastic (horizontal) at the fixed rate. In this case the equilibrium quantity of money changes as the demand for money changes. The central bank can either fix the interest rate (peg) or allow the interest rate to fluctuate freely within a band. The fluctuation of equilibrium of the quantity of money in response to a change in demand for money (a shift in Md curve) is relatively greater if the interest rate is allowed to fluctuate freely within a band (adopting a band). See Figure 23.4 in the text.
Controlling the Money Supply or Interest Rates? Two problems faced by the monetary authorities in pursuing monetary policies are: 1) changes in money demand and supply functions due to disturbances; and 2) uncertainties about the slopes of the money demand and supply functions. Under a policy of money supply targeting, the rate of interest becomes volatile as the demand and supply functions or their slopes change. Under a policy of interest rate control, the equilibrium quantity of money becomes volatile as demand for money changes. Considerable evidence exists that central banks prefer interest rate stability to money supply stability. As a result, the interest rates they directly control change gradually and slowly.
Since the introduction of the overnight band, the target interest rate in Canada, in general, has behaved as follows: a sharp rise in late 1994 and early 1995; following that a decrease until 1997; an increase in 1997 and 1998; a decrease since 1998; a sharp fall in 2001, and a bias toward rising future short-term rates since early 2002. (see Figure 23.5 in the text).
The Monetary Conditions Index:Canada is a small open economy. Therefore, interest rate movements may not always signal the present stance of the monetary policy. Partly because of this, the Bank of Canada has developed the Monetary Conditions Index (MCI) to assess the ease or tightness of monetary policy:
MCI = (Rt-7.90) + (100/3) [Log C6 - Log(91.33)]
Where, R is the 90-day yield on corporate paper, C6 is the Canadian dollar index against its major trading partners, 7.90 is the corporate paper rate (in percent) in January 1987, and 91.33 is the exchange rate against the C6 in the same month. An increase in the MCI signals a tighter monetary policy, while a decrease in the MCI signals a looser monetary policy, relative to the chosen base period (January 1987).
Central Bank Autonomy and Inflation
Politicians may be tempted to interfere in the actions of the central banks for at least two reasons: 1) the outcomes of monetary policy can influence electoral outcomes; and 2) politicians directly control fiscal policy. The link between the autonomy (independence) of the central bank and the effectiveness of its performance (inflation control, in particular) is considered in this section.
The Political Business Cycle: Fluctuations in economic activity that generate the phases of peak, recession, trough, and recovery (or expansion) are referred to as the business cycle. The theory of political business cycles argues that business cycles can be generated by the actions of politicians, and therefore, may be linked to the dates of elections. This theory assumes that the government tends to use fiscal policy and to influence monetary authorities to pursue monetary policies to generate outcomes favourable to their re-election. Governments resort to expansionary monetary policies (and fiscal policies) just before elections and to contractionary monetary policies (and fiscal policies) once they are elected to office. There is some empirical evidence to support this theory. GDP growth has increased and unemployment rates decreased just before many elections.
Compatible Fiscal Policy: A fiscal policy consistent (compatible) with monetary policy is necessary for the success of monetary policies such as inflation targeting. Conflict between monetary and fiscal policies is one reason why economies show a distinct bias toward some inflation.
The Record on Inflation Control: In the recent past, a growing number of countries have adopted inflation targets. In addition to price stability, the stability of economic performance in terms of economic growth and employment has been an advantage of adopting inflation targets. There is an increasing recognition that countries with low inflation tend to outperform other countries in terms of economic growth. Because of this, perhaps, many countries are trying to stabilize prices. The rate of inflation among the G7 countries diverged in the early 1970s and began to converge in the 1980s.
Price stability has become the primary goal of many central banks. Many countries, including Canada, now mandate their central banks to maintain some form of price stability.
Evaluating Central Bank Independence: In evaluating the independence of the central bank, one should consider the degree to which the bank has goal independence and instrument independence. New Zealand is a country in which there is instrument independence and no goal independence. The Bank of Canada’s mandate is very broad, so it has both goal and instrument independence. However, since 1990, under the policy of inflation targeting, goal independence effectively no longer exists.
Broadly, economists have followed two approaches in evaluating the degree of independence of central banks: 1) ranking central banks according to their statutes; and 2) estimating and analyzing the reaction functions. Under the first approach, some interpret the statute in relation to the following factors and rank the central bank's: 1) monetary policy formulation, 2) conflict resolution, 3) central bank objectives, 4) term of office,
and 5) limitations to lending on governments (see Table 26.1 for examples of this approach).
Reaction Functions and Monetary Policy Rules: The second approach to analyze central bank behaviour is to estimate a reaction function such as:
ΔRt = a0 + a1 ΔUt-1 + a2 Δt-1 + a3POLt + a4 ΔRt-1
where R is the rate of interest, U is unemployment, is inflation rate, and POL is a political variable. Δ denotes change, and the subscript t refers to the time period. The a0, a1,a2,a3,and a4are coefficients to be estimated. An equation like this helps evaluate how the bank reacts (for example, by changing R), to changes in unemployment, inflation, and political events.
The results of studies using this approach have shown that the central banks in the industrial countries effectively operate with a high degree of autonomy. This finding has led to the suggestion that the central bank should follow a monetary policy rule. Some economists have suggested that the rate of interest should be set according to the Taylor’s Rule given by the following equation:
Rt = a + 0.5 ( a- *) + 0.5(yt- yp) + a
where a is the average inflation rate, * is the target inflation rate, yt is actual real GDP, yp is potential real GDP, and a is the average real interest rate. Canadian experience seems to suggest that such a rule may be a promising avenue for implementing monetary policy in the future.
MULTIPLE-CHOICE QUESTIONS
1. Open market operations, monetary base, and overnight rate are
a) instruments traded in financial markets.
b) operating instruments of the central bank.
c) intermediate targets of the central bank
d) ultimate goals of monetary policy.
2. Which of the following is an intermediate target of the central bank?
a) the current forecast of inflation
b) Special Purchase and Resale Agreements (SPRAs)
c) the foreign exchange rate
d) the overnight rate
3. Money multipliers are regarded as an uncontrollable element in the conduct of monetary policy because
a) they vary as currency drain ratios fluctuate.
b) they vary depending on lending activities of the banking sector.
c) they vary if banks hold excess reserves.
d) any and all of the above may occur.
4. The demand for money curve
a) shifts over time due to changes in income levels.
b) shifts over time due to changes in the rate of interest.
c) shifts over time due to changes in the money supply.
d) shifts upward due to a decrease in the real income level.
5. Under money supply targeting,
a) the greater the elasticity of money demand, the greater the volatility of the interest rate.
b) the lower the elasticity of money demand, the greater the volatility of the interest rate.
c) the volatility of the rate of interest does not depend on the elasticity of money demand.
d) there is no variability in the rate of interest.
6. Under a policy of interest rate pegging,
a) the supply curve of money becomes perfectly inelastic.
b) the supply curve of money becomes perfectly elastic.
c) the demand curve for money becomes perfectly inelastic.
d) the demand curve for money becomes perfectly elastic.
7. Empirical evidence shows that the central banks, in general,
a) prefer money supply stability to interest rate stability.
b) have no preference for interest rate stability or money supply stability.
c) prefer money supply stability to money demand stability.
d) prefer interest rate stability to money supply stability.
8. The idea of political business cycles refers to
a) the fluctuations in voter turnout in federal and provincial elections.
b) the growth cycles of a political party.
c) the cyclical fluctuations of economic activity generated by the actions of politicians.
d) the counter-cyclical fiscal and monetary policy prescriptions of the policy makers.
9. The Bank of Canada
a) has neither goal independence nor instrument independence.
b) has only instrument independence.
c) has only goal independence.
d) has both goal independence and instrument independence.
10. The Monetary Conditions Index
a) is an index of the stance of monetary policy in Canada.
b) is an index of prices of money market instruments traded in Canada.
c) is an index of stock prices traded on the Toronto Stock Exchange.
d) is the nominal money supply divided by the Consumer Price Index.
11. The Monetary Conditions Index
a) gives equal weight to increases in the interest rate and inflation rate.
b) gives three times as much weight to an increase in the interest rate as it does to the exchange rate.
c) gives three times as much weight to an increase in the exchange rate as it does to the interest rate.
c) gives equal weight to an increase in the exchange rate as it does to the interest rate.
12. Taylor’s rule suggests that the interest rate should rise in all of the following situations except
a) if income levels are rising.
b) if inflation rates exceed the target level of interest rates.
c) if the real interest rate rises.
d) if the income level exceeds the full employment level.
PROBLEMS
1. What are the operating instruments, intermediate targets, and ultimate goals of monetary policy? Explain how they are linked to each other.
2. What is monetary targeting? Explain under what conditions the volatility of interest rates would be relatively larger under monetary targeting.
3. What is a political business cycle? Is there any connection between the autonomy of the central bank and political business cycles? Explain.
4. a) What is Taylor’s Rule?
b) Using the Taylor’s Rule, calculate the interest rate if the desired rate of inflation is 4%, the average rate of inflation is 5%, the real interest rate is 3%, and the output gap as a percent of potential GDP is 2%.
ANSWER SECTION
Answers to multiple-choice questions:
- b(see page465,466)
- a(see page 466)
- d(see page 465,466)
- a(see page 468)
- b(see page 469)
- b (see page 470)
- d(see page 471)
- c(see pages 474-475)
- d(see page 477)
- a(see page 473)
- b (see page 473)
- a (see page 481)
Answers to problems:
1. The tools or instruments used by central banks to achieve intermediate targets of monetary policy are called operating instruments. They include variables such as the monetary base, government deposits, open market operations, and the overnight lending rate. Intermediate targets are a set of economic variables, such as various measures of monetary aggregates (M1, M2, and M2+) and key interest rates. The ultimate goals of monetary policy are the broader objectives to be achieved by monetary policy. These include goals such as low inflation or price stability, a lower unemployment rate, higher economic growth rate, and stability of interest rates. Economic variables representing these goals (such as price level, unemployment rate, and real GDP) are not directly under the control of monetary authorities, but are affected by changes in intermediate targets. Manipulation of operating instruments by the central bank affects intermediate targets, and the changes in intermediate targets affect the variables representing ultimate goals.
2. The policy of controlling the money supply within a target range of values (between a maximum and minimum value) is referred to as monetary targeting. Under a regime of monetary targeting, the volatility of interest rates depends on the changes in the demand and supply functions of money (caused by disturbances) and their slopes. The volatility of the interest rate is larger when the volatility in the demand for money function is greater and the elasticity of the existing money demand is smaller.
3. A business cycle generated by the actions of politicians is a political business cycle. According to the theory of political business cycles, governments tend to use expansionary fiscal and monetary policies to stimulate the economy just before elections in order to increase their chances of winning. Eventually, after their election to office, they tend to favour contractionary fiscal and monetary policies. As a result, economic activity is linked to the dates of an election.
If the degree of independence (autonomy) of the central bank is limited, the government (politicians) can easily influence the central bank to adopt monetary policies to their liking. Therefore, business cycles are more likely to occur in an economy in which the autonomy of the central bank is limited.
4. a) Taylor’s Rule is a monetary policy rule which proposes that the central bank set the interest rates according to the following equation:
Rt = a + 0.5 ( a- *) + 0.5(yt- yp) + a
where a is the average inflation rate, * is the target inflation rate, yt-y is the real output gap as a percent of the potential GDP, and a is the average real interest rate.
b) Rt = 5 + 0.5 (5- 4) + 0.5(2) + 3
= 5 + 0.5 + 1 + 3
= 9.5