The Future Monetary Policy

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categorie: Economie

nota: 9.41

nivel: Facultate

Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets, and perhaps more broadly as well. Does Chairman Greenspan believe that the U.S. business expansion has advanced to the point where a new round of wage inflation may be imminent? Did President Duisenberg imply that because Article 103 of the Maastricht Tre[...]
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Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets, and perhaps more broadly as well. Does Chairman Greenspan believe that the U.S. business expansion has advanced to the point where a new round of wage inflation may be imminent? Did President Duisenberg imply that because Article 103 of the Maastricht Treaty refers to Article 102a, and both Article 102a and Article 105 refer to Article 2, Europe’s chronic high unemployment may be a proper object of policy concern for the European Central Bank after all? Is Governor Hayami content to allow Japan to languish in a slump for yet another half-decade?

Central bankers’ public utterances and other, more subtle signals on such questions regularly move prices and yields in the financial markets, and these financial variables in turn affect nonfinancial economic activity in a variety of ways. Indeed, a widely shared opinion today is that central banks need not actually do anything. With a clear enough statement of intentions, “the markets will do the work for them.” In truth, the ability of central banks to affect the evolution of prices and output in the.2 nonfinancial economy has always been something of a mystery. It is not that there are no good accounts of how this influence might arise.

There are many. The problem is rather that each such story, while plausible enough at first or even second thought , turns out to depend on one or another of a series of by-now familiar fictions: Households and firms need currency to purchase goods and services. Banks can issue only reserve-bearing liabilities. No nonbank financial institutions create credit. And so on.

This central mystery notwithstanding, at the practical level there is today little doubt that a country’s monetary policy not only can but does largely determine the evolution of its general price level over the medium to longer run, and almost as little doubt that monetary policy exerts significant influence over aspects of real economic activity, like output and employment, over the short to medium run. The assumptions necessary to explain in simple terms how this happens are fictions, but they are useful fictions. Apart from purely empirical matters of magnitude and timing, the live question today is which set of fictions (that is, which model) provides the most useful description of the underlying causal process.

Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. A later scene in Levin’s film shows Morley still magnificently clothed but now lying in the mud, face blackened by gunpowder, in the wake of a Mongol attack on the Chin capital. There may well have been an earlier time when the might of the Chin empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders reconsider and withdraw. But by Wang Wei-shao’s day that time had evidently passed..

The object of this paper is to consider the possible future of central banks’ monetary policymaking — say, over the next quarter-century — in light of several significant aspects of how the circumstances that bear on this process have been changing over the past quarter-century. Simply extrapolating in this way the recent development of financial market institutions and practices is, of course, no substitute for actually knowing what lies ahead, but doing so at
least provides some observationally grounded basis for thinking about the future. The point is to work out the implications for central banks’ ability to carry out monetary policy.

The question of what to do in response to those implications, should they indeed materialize, lies beyond the scope
of this paper..

The Central Bank as Monopolist

The easiest way to see why the influence of central banks over nonfinancial economic activity is such a puzzle is to consider their small size, and the even smaller size of their monetary policy operations, in relation to the economies that they supposedly influence. In the United States, for example, a year’s production of final output is more than $8.5 trillion. Including the production and exchange of intermediate goods and services, the volume of nonfinancial
transactions that take place in the course of a year is several times $8.5 trillion. Yet the total volume of reserves that banks and other financial institutions maintain with the Federal Reserve System is less than $50 billion.

And the difference between 2% per annum growth of reserves (which most observers would consider a tight monetary policy, all else equal) and 10% per annum reserves growth (which most would think highly expansionary) is whether the Federal Reserve buys $1 billion or $5 billion of securities over an entire year. The more typical way of looking at the central bank’s influence over the nonfinancial economy side-steps these quantitative disparities by focusing on market interest rates.

Firms as well as households rely on borrowing to finance their spending for many purposes, from putting up factories and houses to buying new cars and refrigerators, to paying college tuitions or simply taking vacations. It is not surprising that the cost of financing these expenditures therefore affects the willingness to undertake them. Moreover, in many cases where spending does not rely on borrowing, interest rates and expected asset returns more generally represent the relevant opportunity cost. Hence the ability to affect interest rates and asset returns is in turn sufficient to enable the central bank to affect spending in nonfinancial markets..
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