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Monetary Policy Part 2.pdf

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ECON 304
Jean- Paul Lam

Economics 304 - Winter 2013 Monetary Theory Jean-Paul Lam Monetary Policy in Canada and the US: Part 2 n oi tcudort1nI In the previous lecture, we present a detailed analysis onayoiiilmtdi Canada. While the objective of monetary policy in Canada and in many other countries is simple, that is to target a given level of the CPI, achieving this objective is complex. In this lecture, we give an overview of some of the data that the sta▯ and governingcouncilusetocometoadecision regarding the level at which they should set the overnight ra te. yci lo praten mnatniatre cU In formulating monetary policy, central banks have to deal with substantial uncertainty. Uncer- tainty is often pervasive and can come from numerous sourcesand can take many forms. Uncertainty can be grouped under three categories: data, model and shheaudycoso- tain errors and are often subject to revisions. For example,GDP in Canada published by Statistics Canada every quarter is often revised as new information is revealed, new methodologies are im- plemented and/or mistakes are discovered. As central banks have to take decisions in real time but use data that are often revised, this source of uncertain ty complicates the conduct of monetary policy Central banks have to make forecasts about the economy and they use various models to forecast important macro variables such as inflation, GDP and the exchange rate. The forecasts will thus heavily depend on the types and accuracy of the models they us e. As models are not perfect, there is always an inherent uncertainty when using them. There is also uncertainty regarding the relationship between variables in a given model and the valu es that these variables take. Parameter uncertainty arises when central banks are unsrow changes in one variable a▯ect the other (size and direction). For example, how much does inflation and GDP change following a 1% increase in the interest rate? Di▯erent models and di▯erent methodologies will give di▯er- ent answers. In addition, often the confidence interval surrounding point estimates is large and the relationship between variables can change over time due to structural changes. This type of uncertainty also complicates the conduct of monetary polic y. Typically central banks respond more cautiously the bigtre uncertainty regarding the pa- rameters of the model. This is the essence of “Brainard princ iple”. The Brainard Principle basically states that policy-makers should exhibit conservatism and be more cautious in the face of parameter uncertainty. Central banks also face uncertainty regarding the nature ainfnmik. They observe changes in macro variables but often do not know the cause of the changes. As the policy response of a central bank can depend on the nature and duration of the shock, it is therefore important for them to know the nature of the shock. For example, suppose the central bank observes a significant increase in real wages. If real wa ges are increasing because of a shock 1 to nominal wages but production remains the same, then this increase in wages will likely trigger inflation in the future as firms will pass on the rising costs to consumers. In this case, the central bank should be forward looking and take the appropriate acti ons to contain any future increases in prices. On the other hand, if real wages are increasing because of a rise in productivity, in this case, the central bank should not react as this increase in wages is not likely to trigger inflation in the future. Central banks deal with these various sources of uncertaii aumrofa. Mey policy nowadays is conducted in a era of rich data. Central banks take advantage of this by analyzing data on various sectors and parts of the economy. The sta▯ at the Bank of Canada monitors a large number of data. While the focus is on macro data, they also pay a lot of attention to micro data on households and firms. Central banks also use di▯erent models to forecast the economy. Since there is a great deal of uncertainty regarding the forecast of any given model, central banks typically employ di▯erent types of models (size, transmission mechanism). The sta▯ tah te Bank of Canada uses various models to provide information to governing council. Most of the models used at the Bank of Canada are structural models. The main projection and policy-analysis model used at the Bank of Canada is called TOTEM (Terms-of-Trade Economic Model). It is an open-economy, dynamic stochastic general equilibrium model (DSGE) that is estimated to provide forecasts and policy recommendation to governing council. They pay particular attention to the various measures of pressures on capacity such as the output-gap, capacity utilization, vacancy rates and unit labour cost. The output-gap is a very important variable central banks pay attention to as the latter is assumed to be a key driver of inflation. yci lo praten ofoataehT In this section, we present some of the information and data used by the Bank of Canada in the formulation of monetary policy. The approach followed beBakofCndagdighe setting of the target overnight interest rate is based on models and data pertaining to the Canadian and overseas economies. One of the central components of thiosiamarbigbyhe Bank sta▯ to Governing council. This briefing is focused around the analysis prepared by the sta▯ based on forecasts and projections coming from the di▯erent models used by the Bank, in particular TOTEM, information from surveys conducted by the regional o▯ces (Senior Loans O▯cer Survey and the Business Outlook Survey), information from financiala,i ilrmsd households credit data and information from financial marke ts, in particular market expectations regarding inflation and interest rates. We present an overview of the di▯erent types of information that the Bank of Canada use in coming to a decision regarding interest rates. We begin with measures of capacity pressures and focus on the output-gap which is one of the key variable they use. 3.1 The output-gap This section of the notes borrows partly from “Information and Analysis for Monetary Policy: Coming to a Decision” by Ti▯ Macklem, Bank of Canada Review Summer 2002. 2 The output-gap is the di▯erence between the economy’s actual output (GDP) and the level of production it can potentially produced. This potential out put represents the amount of output an economy can achieve with existing labour, capital, and technology without putting sustained upward pressure on inflation. The gap is positive when actual output exceeds the economy’s potential and negative when actual output is below potential output. A positive output gap is also referred to as excess demand and a negative output gap is referred to as excess supply. Since positive (negative) output-gaps are associated with excess demand (supply), they are often used as indicators of capacity pressure in the economy. Excess demand and hence a positive output-gaps ifnadasnel indication of increases in future inflation. When spending in the economy is high in relation to capacity,this tends to put upward pressure on prices. Conversely, a low rate of spending tends to put downward pressure on prices. This relationship can also be expressed in the reverse manner—if the rate of inflation begins to increase, it is typically a sign that spending levels are approaching the economy’s level of potential output and that output growth is not sustainable. Conversely, if therateofinflationtlywelosten expectations, this is a sign of continuing slack (excess capacity) in the economy. The Bank of Canada is concerned about both too much and too little demand in the economy when either puts sustained upward or downward pressure on prices (remember the Bank of Canada tries to keep inflation within the 1-3% and, aiming for the middle of the band). Thus, when the output gap is thought to be small and demand is seen to be increasing faster than potential output, the Bank of Canada will typically act to tighten monetary conditions to curb demand and the inflationary pressures. If the economy can be kept from overheating, then it will be less likely that even tighter monetary conditions will be required later to control inflation. 3.2 The output-gap and inflation We saw that a positive output-gap is an indication of eex mcensd in the economy and as we mentioned earlier, a positive output-gap is often a signal that there will be pressure on prices to increase in the future. The link between the output-gap and inflation can be summarized by the Phillips curve. We will develop the Phillips curve in the coming lectures. For now, assume that the output-gap at time t is given by x ,niainy ▯ .Teirttenk t t of Canada use in their models take the following form: ▯t= ▯E ▯t t+1 + ▯x t ▯ t (1) ▯ and ▯ are parameters and ▯ it an exogenous shock to inflation. The above equation is a forward- looking Phillips curve. In this equation, inflation at time t depends on expected future inflation, the output-gap and an inflation shock. If x is positive, the output-gap is positive, implying there t is an excess demand in the economy. If this is the case, there will be pressure on inflation to increase. Inflation also depends on expected inflation, a key driver. The Phillips curve is a very good representation of how excess demand or supply and inflation expectations a▯ect inflation. This forward-looking Phillips curve implies that the central bank can e▯ectively reduce inflation through two channels. By reducing inflation expectations and/or by increasing the policy rate so that the output-gap becomes negative. A reduction in inflation expectations can come from the policy actions of the central bank but it can also come from an nouncements from the central bank. 3 The latter is possible if and only if the central bank is very credible. Credibility as we will see later on is a key driver of inflation expectations. 3.2.1 Measuring the output gap The output-gap is not easy to measure and there is a great deal of uncertainty around estimates of the output-gap. This is because potential output is an unobserved variable that depends on numer- ous factors (productivity, technology, population growth,etc...)Bothelofptialoutput and the output gap are estimates, and therefore there is majoruncertyintheircalorlationF this reason, the Bank of Canada also uses other indicators of capacity when formulating policy. Figure 1 shows estimates of the output-gap for Canada from 2007-2012Q4 as well as two mea- sures of capacity from the Business Survey Outlook that the Bank of Canada conducts every quarter. The red line is an estimate of the output-gap by the Bank of Canada, the blue bars indicate the percentage of participants in the Business Outlook survey that have di▯culty meeting demand/sales and finally the green bars is percentage of firms in the survey indicating experiencing labour shortages. The output-gap became very negative (about 3%) at the height of the financial crisis in 2009, indicating that there were pressures on inflation to fall below the target during this period. The output-gap is still negative according to the estimates of the Bank, indicating that there is still some slack or excess supply in the economy. As a result, this indicator implies that there is some mild pressure on prices to fall below the target of 2%on by the Bank of Canada. 3.2.2 Other measures of capacity On top of the output-gap as a measure of capacity and degree of excess demand and supply, the Bank of Canada uses many other indicators of capacity. Most oft hma epbedbySii Canada. These include unit labour costs, aggregate stock-tosa est,maufungspmes, labour shortage from the regional survey and various measures of cost and inflation. The blue and green bars in Figure 1 shows two such measures. They are the response from participants in a survey that the Bank conducts every quarte ra mngbuisi Cnd. hse two measures respectively provide some indication whethfi erms are having problems meeting demand and whether they are experiencing labour shortages. If firms are unable to meet demand, this would indicate that there will be pressure on prices to increase as this is an indication of excess demand. In the same spirit, if firms are having di▯culties hir ing workers, this shortage will put pressure on wages to rise and hence on inflation if higher wage sfediopi. Figure 2 present di▯erent measures of labour cost that the Banko fCndamnsey quarter. These di▯erent measures of unit labour cost gives an indication of wage pressures and hence wage inflation in Canada. If wages are growing faster th an productivity, this may be a sign of wage inflation in the economy. In addition total or headline CPI, the Bank of Canada monitorsv sormasof inflation to have an indication if there are pressures on prices to increase, Figure 3 shows various measures of inflation. As we mentioned in the previous lecture, core inflation is the measure of inflation that the Bank of Canada follows closely and uses for forecasting and policy-analysis. However, the Bank also follows several other measures of inflation such as CPIXFET and CPIW. 4 CPIXFET is CPI excluding food and energy and indirect taxes, whereas CPIW adjusts each CPI b
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