MONETARY POLICY

Master 1
Pr Jean-christophe Poutineau
University of Rennes 1- France
 Chapter 3
Conventional Monetary Policy
Introduction:
• a brief reminder of monetary policy operation in normal times
• Interest rate setting
• The ZLB situation
• How interest rate decisions affect money supply
• Short run policy rates and the ZLB
The danger of a ZLB
summary
• Presentation of macroeconomic relations in a stylized NK model
• Conventional monetary policy implementation
• The Taylor Rule
• Optimal Monetary Policy
• policy efficiency
• The ZLB and limitations of conventional monetary policy decisions
I – The NK model

A – General structure

• Theoretical concerns:
• accounting for intertemporal decisions
• Short run nominal, real (and recently) financial frictions

• Introduction to the general structure (M2 course explores the

microfoundations)
Real business cycle component
• Representative agent approach
• Microfoundations and optimisation to explain individual
behavior
• Key role of intertemporal decisions
• Key role of real supply shocks in explaining economic
fluctuations
• Rational expectations

80’s :
• Robert E Lucas, Thomas sargent, Kydland, Prescott, Rebelo,
keynesian component
• nominal rigidities (with microfoundations: price, wage)

• real rigidities (with microfoundations: consumption

habits, adjustment costs in production decisions)

• financial rigidities (with microfoundations: collateral to get

a loan, bankrupcy…)

• underemployment in input use

• Since late 90’s

• Main authors:
• Goodfriend and King [1997]
• Clarida, Gali and Gertler [1999].
• Gali and Blanchard
Synthesis model
• Microfoundations, intertemporal decisions, rational
expectations, rigidities…

• Monetary policy conducted by an independent central bank

according to a policy rule

• Theoretical analysis and quantitative evaluation of models

DSGE models

• « Dynamic Stochastic General Equilibrium Model »

• Jointly developed by universities and central banks

• Combine three dimensions

General equilibrium

Central
Bank

Firms Households
Intertemporal
accumulation

t-1 t t+1

anticipations
Stochastic
Frisch-Slutsky approach

Impulses

Propagation

Fluctuations
B – original version
• The three equation model
• A Philips curve (supply side, inflation rate)
• An IS relation (demand side, output gap)
• A MP relation (demand side, policy relation, short run interest rate)

• Provide a compact exposition of the model (from the point of view of

the CB)

• Allows a simple exposition of policy decisions

,

« new keneysian Philips curve », NKPC

Relation between :
- current inflation
- Expected future inflation
- Output gap
- Exogeneous inflationary shock
• The dynamic IS relation

Relation between :
- current output gap
- Expected future output gap
- Real interest rate
- Exogeneous demand shock
• The taylor rule
• Simple approach to conventional monetary policy:
• Relation between :
- Current nominal interest rate
- Wicksellian interest rate
- Current inflation
- Current output gap
- Monetary innovation
C – BMW model

• Static version of the NK model

• Bofinger, P., Mayer, E., and Wollmershäuser, T. (2006). The bmw model:
a new framework for teaching monetary economics. The Journal of
Economic Education, 37(1), 98–117.

• Buttet S. and Roy U. (2014) A Simple Treatment of the Liquidity Trap for
Intermediate Macroeconomics Courses The Journal of Economic
Education, 45(1), 36-55.
• To make the model static some main asumptions

• Supress all expected terms

• Monetary policy is perfectly credible (so private agents
expect the targeted inflation rate in the future)
• The economy operates near the full equilibirum (so the
future, expected valeu of the output gap is equal to zero)
• To do so:

• Assume perfect credibility of monetary policy, so : E(p)=p0

• Asume a situation close to full employment thus: E(y)=y0

• Combine the second and third relations to get an aggregate
demand (AD) condition

• Keep the PC relation unchanged

• Thus, the consequences of monetary policy rules following a demand
or inflationary shock are analysed in a two system model
II – Simple conventional policy
• Explore the characteristics of the BMW model under a Taylor rule
• First step : solve the static equilibrium

• Three equations
• Three variables
Reduced form
Graphical analysis
• A graphical analysis is usefull to understand the way conventional
policy operates

• We concentrate on two shocks:

• Demand shock
• Inflationary shock
• The first graph presents the conseuqneces of the shocks on the AD PC
system

• The second graph presents the consequences of the shocks on the IS

MP system
Demand shock
• A positive Demand shock
moves IS upwards
(proportionaly) and AD (less
than proportionnaly)
• The inital consequence
moves the economy to B and
B’
• In both points output gap is
positiv and generates
inflation
• B and B’ induce a monetary
policy tightening
Dans le détail
• Following an increase in
inflation MP moves leftwards
to MP’
• Equilibrium moves form B to
C and b’ to C’
• Finally reduce the increase in
the output gap and in
inflation
• However monetary policy is
able to dampen the
consequences of the
demand shock on both
variables
Dans le détail
• Finally, following a demand
shock:

• Activity increases (from y0 to

yC)

• Inflation rises (from p0 to pC)

• The interest rate increases

(taylor principle)
In dynamic terms
Inflation shock
• A positive inflation shock
moves PC upwards
• The equilibirum moves from
A to B
• This raises inflation, which
induce a reaction of
monetary policy in the
second panel
• Following policy reaction the
IS MP equilibirum moves
form A’ to B’
• Finally, following an inflation
shock:

• Activity decreases (from y0 to

yB)

• Inflation rises (from p0 to pB)

• The interest rate increases

(taylor principle)
In dynamic terms
• Explanation of te time path of macroeconomic aggregates in the
french case
• Use the three equation model

• E. Gallic, JC Poutineau et G Vermandel, L’impact de la crise financière

sur la performance de la politique monétaire conventionnelle de la zone euro,
Revue économique, septembre 2017, pp 63 à 86
III Optimal monetary policy

•what should happen if the central

bank was able to react optimally to
exogenous shocks ?

•The central bank could implement

policy measure to maximize welfare
• The Formal analysis can be borrowed from the previous chapter

• The central bank minimizes the loss function

• subject to the inflation/output arbitrage

Solution procedure

• Lagrangian

• First order conditions

• The targeting rule (marginal rate of substitution between activity and

inflation)
• Solution for inflation and activity (using PC)

• Solution for interest rate (using IS)

• results
• Two different situations
• Demand shock: divine coincidence
• Monetary policy is able to dampen the consequences of the demand shock
on activity and inflation
• Inflation shock: arbitrage between activty and inflation
• The central bank has to make a choice between the two objectives.
• A more conservative central bank will stabilize inflation and neglect activity
Graphical explanation
The divine coincidence
• A negative demand shock moves
IS curve to IS1

• For an unchanged interest rate

this creates a negative output
gap

• Authority decrease the interest

rate (r moves downwards) to
close the output gap

• The economy goes back to the

bliss point
Inflation shock and arbitrage
• An exogenous shock moves PC to PC1
upwards

• Authorities adjust the interest rate

upwards to minimize the deviation of
activity from full employment

• They choose the tangencey between

PC1 and the new Loss curve

• They adjust the interest rate

accordingly in the first panel

• In the new equilibirum y1 is lower,

while p1 is higher
• The condition of the arbitrage between the variability
of inflation and the variability of the output gap is
described by the Taylor curve
• The Taylor curve combines points characterised by a
joint minimal variability in inflation and output gap
• We move along the curve by
affecting the relative weight on
inflation vs output concenrns in
the loss function

• Points located below the curve

(such as B) can not be reached

• Points located above the curve

(such as A) are inefficient (for a
given volatity of inflation,
authorities can reach a lower
volatity of output, by adopting
an optimal policy reaction)
• Application :
• Taylor curve for the Eurozone
• Conventional policy inefficiency

Source: E. Gallic, JC Poutineau et G Vermandel, L’impact de la crise financière sur la performance de la

politique monétaire conventionnelle de la zone euro, Revue économique, septembre 2017
The Taylor curve for the Eurozone
Distance from the efficient frontier
IV- ZLB and deflation risk
• Limits of conventional monetary policy: the zero lower bound
• In this case the interest rate can no longer be used as a policy
instrument
• Problems to stabilize the macroeconomy
• End of the « normal » conduct of conventional policy
• Short run policy rates and the ZLB
The danger of a ZLB
In this section
• A NK model with the possibility of htting the ZLB
• The two possible equilibria (orthodox and deflationary equilibria)
• Equilbrium stability and deflationary spiral
• Policy solution to exit the ZLB
A - A NK model with the possibility of hitting the ZLB
B – Equibrium of the model
• Solution procedure:
• Get the AD curve depending on monetary policy situation
• Solve for the orthodox situation
• Solve for the zlb situation
• Deflation vs inflation
Orthodox equilbrium
Deflationnary equilibrium
C – Policy decisions to avoid deflation
Conclusion
• Discussion of conventional monetary policy
• interest rate rules
• Simple vs standard rules
• The ZLB situation
• Deflation vs inflation