Monetary Theory and Polıcy (ENG) — Ünite 5 Soru-Cevap

First, the quality of some goods in consumer price indices continuously improves due to technological developments, and their prices rise, reflecting such improvements. If appropriately adjusted for the embedded technology level, their prices may not be higher than similar goods covered in the price index basket with the old technology. It is claimed that the revisions of the relative weights of various items in consumer price indices could not keep up with this change. Therefore, the measured inflation may be slightly higher than the actual inflation. In this case, it is stated that it would be fine for the measured inflation target to be slightly higher than zero percent.

Second, a heated discussion has been on whether 2 percent inflation is low after the global financial crisis. The primary reason is that if an economy is in a recession that lasts long, as in the global financial crisis period, the natural response of the monetary policy is to reduce interest rates. Nonetheless, there is a natural lower bound for lowering the nominal interest rate; zero or a slightly negative value. If, in regular times, the argument continues, central banks keep their policy rates compatible with 2 percent inflation, the risk of hitting the zero-bound increases should their economies face a long-lived recession. Therefore, some economists recommend a higher inflation rate –say 3 percent, as compatible with price stability.

Third, taking  a  zero  inflation rate  as  compatible  with price  stability  and  aiming  at  reducing  inflation to this level could trigger a deflation. Deflation is the opposite of inflation, a continuous decline in the price level rate of change. Deflation is a considerable   economic   blow   since   economic agents refrain from purchasing a good whose price will decline quickly. Such postponements imply declining aggregate demand and push an economy to long-term stagnation.

Zero Lower Bound is a heated discussion has been on whether 2 percent inflation is low after the global financial crisis. The primary reason is that if an economy is in a recession that lasts long, as in the global financial crisis period, the natural response of the monetary policy is to reduce interest rates. Nonetheless, there is a natural lower bound for lowering the nominal interest rate; zero or a slightly negative value. If, in regular times, the argument continues, central banks keep their policy rates compatible with 2 percent inflation, the risk of hitting the zero-bound increases should their economies face a long-lived  recession. Therefore, some economists recommend a higher inflation rate –say 3 percent, as compatible with price stability.

There are  two  altered  views about this issue:  The first states that the economy will eventually return to its potential production level. Therefore, there is no need for a monetary or fiscal policy change. The second view highlights that the economy can only return to equilibrium with its dynamics over time. It recommends actively using monetary and fiscal policies to shorten this time. For example, suppose the production is below the potential level. In that case, it is recommended to reduce the interest rate or/and implement an expansionary fiscal policy (increasing public expenditures and lowering tax rates) to boost domestic demand.

Most countries do their best to increase aggregate demand, especially if production levels are well below their potential and unemployment rates have risen markedly. We observed the most concrete example of this during the global financial crisis. 

Why should a central bank try to lower the output level to its potential if the current output level is well above the potential? The reason is simple. It is impracticable to have output above its potential for a long time. The keyword here is ‘potential.’ Trying to keep above its potential will create considerable issues, such as high inflation, indebtedness, and high current account deficits in many countries. It is simply not sustainable. If a country is not content with its potential, it should try to escalate it, and monetary policy cannot accomplish this mission. It requires improving human capital, physical capital, and technology, creating a business-friendly environment, etc. Monetary policy can play a role in this framework to reduce uncertainties and broaden the planning horizon by establishing macroeconomic and financial stability.

Monetary policy can play two critical roles in financial stability. First is the central bank’s ‘lender of last resort facility’ function. What will a bank with a liquidity shortage do if it cannot borrow from banks with excess liquidity? If these conditions prevail, central banks need to step in and provide liquidity to banks that are not bankrupt but are short of cash, which fulfills central banks’ duty of ‘being the lender of last resort.’

The second role of a central bank is to minimize the   risk   of   such   liquidity   shortages   arising. Before the global crisis, the emphasis was on microprudential policies. Institutions responsible for microprudential policies depend on the financial structure of a country. It may be the responsibility of a central bank or another institution. For example, in  Turkey,  it  was  the  primary  responsibility  of the Banking Regulation and Supervision Agency (BRSA). Micro-prudential policies aim to catch the risks in a bank’s balance sheet and take the necessary steps to minimize these risks. For instance, such regulations include minimum capital adequacy ratios, minimum leverage ratios, and the maximum difference between foreign currency-denominated liabilities and assets (currency mismatch).

Nonetheless, the global financial crisis revealed how significant systemic risk is. To prevent such risks, implementing macro-prudential policies came to the fore. Complex relationships between financial institutions pose the risk that issues in one institution will eventually affect other institutions. Some of the macro-prudential policies aim to prevent these risks.

In Turkey, price stability is the main objective of the Central Bank of the Republic of Türkiye (CBRT). It has a role to play in achieving financial stability as well. The Banking Regulation and Supervision Agency (BRSA) is the institution   responsible   for   establishing   micro and macro-financial stability. There is a financial stability committee to coordinate these functions. The other committee members are the Ministry of Treasury and Finance, the Capital Markets Board of Turkey, and the Savings Deposit Insurance Fund.

Eventually, this is a process in which central banks face various complications for several reasons: first, future  uncertainties   will   rise. Second, some resources allocated to productive investments will replace existing physical capital with environmentally friendly physical capital. Third, with the global warming, the productivity of the workforce may fall. Fourth, limitless migrations from regions where the heat becomes unbearable by  getting  warmer  to  other  regions  (countries) will be observed. Fifth, there may be a decrease in agricultural productivity. Sixth, there will be significant  matters  in  energy  production.  Most of these factors will negatively affect the supply. Therefore, the seventh dilemma is the possibility of substantial price increases in some sectors, raising economic costs and creating a general wave of price increases. Eighth, income inequality may increase both within and between countries. Ninth, there will be increased pressure on central banks to possess devalued assets.

Although there is much uncertainty about how climate change will affect us, one thing is sure: there will be both significant physical risks and transitional risks. Physical risk refers to risks such as floods and large fires. On the other hand, transition risks are the risks posed by the irregularly taken measures to mitigate the effects of climate change. So, despite the uncertain timing, there is no doubt about the need for action. The main transition risk is the transformation of some assets into worthless assets in the transition period. For example, if a coal-based power generation facility is shown as collateral and a loan is taken, this development will adversely affect the lending institution. Consumption and investment preferences may alter, or new technologies developed to transition to low carbon emissions may profoundly affect the facilities that produce with the existing technology. In addition, asset price fluctuations may occur in the process. These risks are expected to multiply if the transition process is poorly planned and unevenly developed.

Institutions that regulate and supervise the financial system can play a significant role. They need to develop new models that will take these is  whether  to  reward  environmentally  friendly (green)  assets  or  to  impose  penalties  on  assets that pollute the  environment  while  calculating the  lowest  capital  adequacy  ratio  that  financial institutions should have.

The seigniorage revenue (s) as the real change in the base money:

Multiply and divide the right-hand side by M and rearrange:

The first term on the right-hand side is the base money growth rate (gm), and the second is the real base money (m).

Where real non-interest public expenditures by G, real tax revenues by T, domestic interest rate by i, foreign currency interest rate by iFC, domestic currency nominal debt stock by B, foreign currency nominal debt stock by BFC, nominal exchange rate by E, and general level of prices by P, central bank credit to the public sector by Cr.

The budget balance equation is    

If the left-hand side takes a positive (negative) value, there is a budget deficit (surplus). If there is a
budget deficit, the right-hand side of the equation denotes how it is financed. The right-hand side displays
the government’s debt stock decrease if a budget surplus exists. 

The first expression on the left side of the equation represents the primary budget deficit (surplus). If Pt(Gt – Tt) > 0, there is a primary budget deficit. On the contrary, there is a primary surplus if it takes a negative value. The second expression on the left side of the equation represents interest expenditures on domestic currency debt, and the third represents interest expenditures on foreign currency debt. These are interest payment liabilities arising from borrowing in period t-1. The first expression on the right-hand side of the equation illustrates the change in domestic currency debt stock (ΔBt ). The second expression indicates the change in foreign currency debt stock multiplied by the nominal exchange rate and converted into domestic currency EtΔBt
(FC) and the third expression exposes the change in the amount of central bank credit to the public sector ΔCrt (CB).

Two opposing forces control the seigniorage revenues. At low inflation and expected inflation levels, the positive impact of the base money growth rate (gm) term dominates the negative effect of the real base money (m) term. However, as the money supply’s growth rate increases, the expected inflation rate rises, and the negative impact of the m term increases. Consequently, as the rate of money supply grows, the increase of the seigniorage revenue declines. However, if the budget deficit is high and thus the need for monetary financing is high, in the absence of measures taken to decrease the budget deficit, gm keeps rising, the negative effect can dominate the positive effect. This process is shown as the main underlying reason for hyperinflations.

First, the higher the primary deficit to GDP ratio, the higher the total debt ratio. Second, the higher the total debt ratio inherited from the previous period, the higher the total debt ratio of the current period. Third, the higher the inflation and economic growth rates, the lower the total debt ratio. Fourth, the higher the expected inflation rate, the higher the total debt ratio. Fifth, as the monetary financing increases, the total debt ratio decreases. However, as discussed above, this amounts to an increase in inflation. Sixth, a rise in the exchange rate upsurges the total debt ratio, provided foreign currency debt exists.

Seventh, notice that an escalation in the real interest rate (borrowing rate of the government) leads to a rise in the total debt ratio. As we have seen in Chapter 3, as the risk of a financial asset increases, so does the interest rate of that risky asset. Here, the risk stems from a high budget deficit and high public debt leading to increased default concerns. Consequently, financial investors demand a risk premium; thus, the interest rate on the risky asset rises. At low debt levels, contained increases in the debt ratio do not significantly increase the government’s borrowing rate. However, as the debt ratio increases, the interest rate rises disproportionally (nonlinearly). A rise in the interest rate further upsurges the debt ratio, which is a vicious circle.

The unpleasant monetarist arithmetic argument indicates that even if the central bank initially abstains from monetizing the deficit, it has to give up this policy to prevent a debt default, eventually leading to higher inflation. Moreover, rational agents observing this outcome will form their inflation expectations accordingly, leading to higher inflation today. Fiscal dominance is an immense obstacle to properly working monetary policy. If there is fiscal dominance, budget deficits persist, and monetary policy has to obey fiscal policy. Even if it does not comply for the time being, it eventually has to, as in the example of the unpleasant monetarist arithmetic.

A central bank that implements monetary targeting has to answer the following two questions: Which money supply should be targeted? At what level that money supply should be kept?

The answer to the first question is clear: the monetary aggregate with the strongest correlation with inflation should be searched. Second, estimating the money demand corresponding to the inflation level a central bank aims to achieve is necessary. The money supply should be kept at the level corresponding to that demand.

Official dollarization has three disadvantages: First, the country that opted for using another country’s currency gives up seigniorage incomes because it halts printing its currency.

Second, this country puts its financial system at risk. When things go wrong in the financial markets, financial institutions refrain from lending to each other, causing borrowing rates to jump and leading to even more demand for and shortage of liquidity. Central banks must calm this tension. As discussed above, this is a central bank’s lender of last resort facility function. However, if official dollarization exists, how can that country’s central bank print dollars (or euros) and lend to banks desperately needing liquidity?

The final downside to official dollarization is the abandonment of monetary policy. The country whose money is used makes the monetary policy decisions appropriate for its economic conditions. However, those decisions may not be suitable for the domestic country.

There are three essential conditions that a currency board must meet. First, the exchange rate is pegged to a foreign currency. Second, economic units should not be restricted from exchanging domestic currency with the currency chosen as the anchor. Third, there must be enough foreign exchange reserves to meet the currency board’s liabilities at the pegged exchange rate. Unlike official dollarization, another country’s currency does not become that country’s official currency on a currency board.

Both the official dollarization and the currency board implementation come with numerous drawbacks. Despite all such drawbacks, despair is the main reason for adopting these systems. It is aimed at getting out of the high inflation, high-risk perception, high-interest rates, and lack of confidence environment caused by poor macroeconomic policies of the past and thus
assuring the markets that monetary policy will not be used again in a way that leads to those results.

Fixed exchange rate regimes are primarily introduced as a part of a disinflation program, especially in countries where the rate of change of the exchange rate is a crucial determinant of the inflation rate. Another reason is to remove uncertainty about a critical macroeconomic variable that affects economic agents’ decisions. A third reason is a desire for domestic interest rates to converge to low foreign interest rates.

A central bank implementing a pure floating exchange rate regime does not sell or buy foreign exchange to alter the exchange rate level. Supply and demand conditions determine the exchange rate in the foreign exchange market. The most significant advantage of the floating exchange rate regime is that no exchange rate level will be maintained, which takes the pressure off the monetary policy. The biggest drawback of the floating exchange rate regime is the uncertainty it creates regarding the exchange rate.

In the classical application of inflation targeting, there are two variables in the objective function of a central bank. The first one is the difference between inflation (π) and the inflation target (πT), called the inflation gap. If inflation is above (below) the target, the inflation gap becomes positive (negative). The second variable is the difference between the output level (Y) and the potential output (YP), called the output gap. If the output gap is positive (negative), the production level is above (below) its potential. Such regimes are called ‘flexible inflation targeting’ regimes. In flexible inflation targeting, the central bank aims to minimize the weighted sum of the two gaps.

The Taylor rule is an equation that displays the interest rate response of the central bank to developments in inflation and output gaps. John Taylor, a well-known economist from the USA, in a study published in 1993, developed a kind of interest rule. According to this rule, the central bank should increase the policy rate if the output gap is positive, that is, if production is above the potential level, as inflationary pressures will escalate. Similarly, as inflation rises, the central bank must respond by raising the short-term interest rate again.