MONETARY POLICY

Master 1
Pr Jean-christophe Poutineau
University of Rennes 1- France
GENERAL INTRODUCTION
• 24 hours devoted to the topic of monetary policy

• Handouts, slides and references on my webpage:

https://sites.google.com/view/poutineau/teaching
Textbook
• Carl Walsh
• Monetary Theory and Policy
• MIT Press, 2010
• This course provides the tools to analyze how alternative monetary
and credit policies affect economies.

• Concentrate on both normal conditions (pre 2007 consensus) and the

consequences of the 2007 financial crisis (unconventional monetary
practices, macroprudential concerns…)

• Part of the course should also be connected with open economy

aspects and exchange rate regime choice.
3 topics in this general introduction

• Two main concepts: Monetary policy and central banks

• Stylised facts on macroeconomic outcomes

• Organization of the lectures

I - Two main concepts
• Monetary policy is the process by which the monetary authority of a
country, controls the supply of money, to ensure price stability and
general trust in the currency.

• Further goals of a monetary policy are usually

• to contribute to economic growth and stability,
• to lower unemployment,
• to maintain predictable exchange rates with other currencies.
• A central bank is a public institution that manages the currency of a
country or group of countries and controls the money supply –
literally, the amount of money in circulation.

• The main objective of many central banks is price stability.

• In some countries, central banks are also required by law to act in

support of full employment.
• Monetary Policy objectives and practices may differ internationally

• A tale of three Main central Banks

• The ECB
• The FED
• The BOE
Monetary Policy in the Eurozone (ECB)
• Primary objective
• The primary objective of the ECB’s monetary policy is to maintain price stability. This is the best
contribution monetary policy can make to economic growth and job creation.

• What does monetary policy do?

• Monetary policy operates by steering short-term interest rates, thereby influencing economic
developments, in order to maintain price stability for the euro area over the medium term.

• The ECB's monetary policy strategy

• The ECB has defined price stability as a year-on-year increase in the Harmonised Index of
Consumer Prices (HICP) for the euro area of below 2%.
• The strategy also includes an analytical framework for the assessment of all relevant information
and analysis needed to take monetary policy decisions. This framework is based on two pillars:
economic analysis and monetary analysis.
Monetary Policy in the US (FED)
• Primary objectiveS
• Monetary policy is the Federal Reserve's actions, as a central bank, to achieve three goals
specified by Congress:
• maximum employment,
• stable prices,
• moderate long-term interest rates.

• What does monetary policy do?

• The Federal Reserve conducts the nation's monetary policy by managing the level of short-
term interest rates and influencing the availability and cost of credit in the economy.
• Monetary policy directly affects interest rates; it indirectly affects stock prices, wealth, and
currency exchange rates. Through these channels, monetary policy influences spending,
investment, production, employment, and inflation in the United States.
Monetary Policy in the UK
• Primary Objective
• The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to
that, to support the Government’s economic objectives including those for growth and
employment.
• Price stability is defined by the Government’s inflation target of 2%. The Government's inflation
target is announced each year by the Chancellor of the Exchequer in the annual Budget
statement.

• What does monetary policy do?

• The Bank seeks to meet the inflation target by setting an interest rate. The level of interest rates
is decided by a special committee – the Monetary Policy Committee (MPC).
• The MPC consists of nine members – five from the Bank of England and four external members
appointed by the Chancellor. It is chaired by the Governor of the Bank of England. Decisions are
made by a vote of the Committee on a one-person one-vote basis.
• Independence and transparency
• If the target is missed by more than 1 percentage point on either side the Governor
of the Bank must write an open letter to the Chancellor explaining the reasons why
inflation has increased or fallen to such an extent and what the Bank proposes to do
to ensure inflation comes back to the target.

• The Bank is accountable to the parliament and the wider public. The legislation
provides that if, in extreme circumstances, the national interest demands it, the
Government has the power to give instructions to the Bank on interest rates for a
limited period.

• The MPC is committed to the greatest possible degree of transparency around its
decision-making. The minutes of the MPC meetings are published simultaneously
with the interest rate decision. They also record the votes of the individual members
of the Committee. The minutes give a full account of the policy discussion, including
differences of view.
• This course shall focus mainly on the analytical aspects of central
bank intervention

• We will illustrate the theoretical results with examples taken from

actual central bank practices (ECB, FED, BOE etc.)
II - macroeconomic outcomes
• What can monetary policy do ?
• Some stylised facts regarding fluctuations in
• prices,
• activity
• interest rates
• Different sub periods
• Great Inflation
• Great Moderation
• Great Financial Crisis
Great Inflation
• Sharp fluctuations in activity and inflation
• Bretton woods system (fixed exchange rate regime) up to the begining
of the 70’s
• Peak values of inflation in the 70’s
• Loose monetary policies up to the end of the 70’s/begining of the 80’s
• Much macroeconomic volatility
Great Moderation
• Quieter period

• Small fluctuations in activity and inflation

• Monetary policy played a key role in this achievement

• Up to the financial crisis of 2007 monetary policy was considered to

be a relatively straightforward and uncomplicated business.
• All that the central bank needed to do was to set the policy rate so
that inflation ended up close to the target at the same time as
production and employment developed in a satisfactory manner.

• the role of price stability was considered as crucial in achieving

economic stability more generally, and in providing the right
conditions for sustainable growth in output and employment.
Since 2007: the great financial crisis
Policy reaction
Inflation
Limits of the Taylor rule
Quantitative easing policies
The financial crisis has introduced new challenging questions for monetary policy
Channels Through Which Monetary Policy can Affect Financial Stability

• Changes in the monetary stance can affect the risk-taking behavior of

financial intermediaries.
• With asymmetric information, low monetary policy rates can create incentives
for banks to over leverage or reduce efforts in screening borrowers.
• Moreover, if monetary policy is expected to be eased during recessions to
support not only the real economy but also the financial system, the effect may
be stronger because this may give rise to additional incentives to correlate risks.
• Monetary policy can give rise to exchange-rate externalities.
• In open economies, interest rate increases can attract excessive capital flows,
appreciating the exchange rate, and leading to excessive borrowing in foreign
currency and exchange-rate externalities
• Changes in the monetary stance can affect the tightness of
borrowing constraints and the likelihood of default.
• Monetary easing relaxes collateral constraints, as asset prices rise and
borrowers’ net worth increases, and lowers the costs of external financing,
thereby easing overall credit conditions.
• Conversely, a tightening of rates can adversely affect borrowers’ capacity to
repay, possibly leading to higher default rates and financial instability.
III - Roadmap
• Chapter 1: Monetary policy episodes
• Chapter 2: central bank independence
• Chapter 3: conventional monetary policy
• Chapter 4: The post 2007 new normal
• unconventional monetary policy,
• macroprudential policy
• Chapter 5: Monetary policy in the open economy