A little bit of filler on monetary policy: An addition to the Dom article

While working on the Dom Post article I was given a few questions I might get.  I quickly tried to rope together some incredibly average answers.  I am going to post them here so I don’t lose them 😛

“I’d like to know why controlling inflation is important and why monetary policy is good at that. Why is that the only appropriate goal for it?”

In the medium term, printing more money just leads to more inflation it doesn’t do anything else.  In the short-term it can increase activity – but it only does this by forcing the allocation of resources to be suboptimal and tricking people about the relative value of their sales (as a result the welfare impact of the higher GDP stat is ambiguous).

Furthermore, if we have a central bank that can commit to low inflation, then in the face of a “demand shock” the policy that smooths economic activity and the policy that keeps inflation low is the same!!  We need to Bank to be able to commit as there is a “time inconsistency problem”.

This problem is as follows.  People form inflation expectations on the basis on the basis of an information set with lagged variables in it, and expectations of current and future variables.  Given these expectations, monetary authorities can print money now and push up output, but this will lead to inflation in the future (when people realize that it was just money rolling into the economy, not an increase in actual productive capacity).  If the monetary authority has some sort of loss function that is positively related to deviations in output and inflation from their natural rate it will be tempted to do this.

As a result, people will realize this temptation and form expectations on the basis they expect the central bank to do this – which then causes inflation expectations (and thereby price setting, and thereby inflation) to be higher.  If the Bank can commit to a path of future interest rates (by committing to a loss function in only inflation for example) then they can anchor inflation expectations without any output cost.

I probably wasn’t very clear – for a better explanation you can just look at the Barro-Gordon model.

“I’m not convinced by the ‘one instrument-one target’ thing. Can I target the money supply and inflation at the same time? It may sound facile to ask, but you’re not preaching to a sophisticated audience, I imagine.”

The growth in the money supply is (in some sense) inflation.  They are the same target.  We can’t have policy goals with one instrument and two targets – as there is no guidance about what to do when there is a trade-off between the targets.  This is ultimately an issue of “credibility” and “accountability” again – it’s not saying that monetary policy only influences one thing in the short-term, it is about making the nature of monetary policy transparent.

“I’d also like to know what you think the appropriate policy response to low growth is”

Depends why we have low growth.

If it is because technology is static and/or population growth has stopped then there is no policy response.  I need a market/government failure before I can give a policy response – low growth in itself isn’t a defined failure.

Note:  I didn’t cover a lot of this in the article – because I can’t fit it in.  Monetary policy is really about anchoring inflation expectations and (in some sense) thereby just making sure that the technical increase in the money stock is sufficient to meet implicit demand in society.

  • Owen

    “The growth in the money supply is (in some sense) inflation.”

    Im interested in what sense its not?

  • steve

    “low growth in itself isn’t a defined failure.”

    I agree in the usual way we think of efficiency, but surely policies can be used for more purposes than just market failure. And in the case of technology, if NZ isn’t recieving the technology improvements that other countries have seen, isn’t this a failure? that our firms are too small (and don’t benefit from co-located large firms) to effectively do R&D and create innovations? that they face a market which doesn’t provide the same benefits as firms in foreign markets face? These are all failures.

    If technology has static, while the rest of the world is improving, this is a failure that the government can do something about. If the population isn’t increasing (and assuming there are clear benefits to population growth, such as reducing the drain of skilled NZers to Aus and increasing skilled imigrants) this is also a failure that the government can do something about. There is clearly a policy response in these types of failure even though they are not traditional “efficiency” market failures.

    If you want to stick to an efficiency argument, how about this as a sort of proxy for what i’m suggesting? Consider a market for “knowledge” or a market for “ideas”, or “innovation”. All of which I am using as a proxy for the main driver of economic growth. (one must also consider separately the labour and capital markets as the other drivers of growth). If this market is ineffecient, i.e. the quantity supply of ideas is less than an expected equilibruim, then technology in NZ is static, or less than it should be, and there is a reason for a policy response.

    personally I would suggest other policy responses but some might suggest a monetary policy response because higher interest rates (for example, or a volitile exchange rate) on businesses might prevent innovations being successful (or more successful) – Isn’t this the point of the whole monetary policy discussion? And the taskforce for that matter.

  • @Owen

    An issue I should undoubtedly post on in the new year.

  • @steve

    “I agree in the usual way we think of efficiency, but surely policies can be used for more purposes than just market failure”

    Redistribution.

    Market failure and redistribution is all I’ve got.

    “There is clearly a policy response in these types of failure even though they are not traditional “efficiency” market failures”

    But if we don’t have a “market failure” we are saying that individual actions are indicative of the full social costs and benefits of their actions. This implies that any “government intervention” to change their choices will be suboptimal.

    “If this market is ineffecient, i.e. the quantity supply of ideas is less than an expected equilibruim, then technology in NZ is static, or less than it should be, and there is a reason for a policy response.”

    If the market is inefficient there must be an identifiable market failure.

    “personally I would suggest other policy responses but some might suggest a monetary policy response because higher interest rates (for example, or a volitile exchange rate) on businesses might prevent innovations being successful (or more successful) – Isn’t this the point of the whole monetary policy discussion? And the taskforce for that matter.”

    Monetary policy currently functions to ensure that changes in the general price level in the economy are stable – so that individuals and firms can focus on responding to underlying relative price signals.

    If there is an identifiable market failure for these other industries then sure, government intervention is useful. But it is neither possible for nor the purpose of monetary policy to correct other policy errors or market failures.

  • steve

    What I am describing is not a market failure as such, I just use the “market for innovations” as an analogy to show a kind of failure where government intervention would help, that is neither traditional market failure nor redistribution.

    I think you have missed the point of what I describe.

    If the problem is that we don’t have as many innovations coming to market as we should (causing a lack of economic growth) then shouldn’t we consider all policy alternatives to help? including monetary policy? I agree we should address the specific causes (which in my opinion isn’t monetary policy) but as you rightly point out it is not necessarily a market failure that is the cause of low economic growth.

  • @steve

    Innovations are endogenous in the choices of agents in the market economy right. So we either have a market failure, or we have the optimal amount of innovations for given preferences of individuals in the economy.

    Eg, look at this normative statement you make:

    “If the problem is that we don’t have as many innovations coming to market as we should”

    How do you define should here … it has to be through a market failure.

    For “innovations” to be “too low” we need to say that current level of innovations is lower than the level of innovations in a counterfactual market where the social benefit is maximised – which is where the relative prices are indicative of the full social benefit and cost of “innovation”. As a result, for our should statement to hold we need to come up with a market failure.

    Now, if we can’t think of a market failure that would cause this the initial normative statement is false.

    A traditional market failure is simply somewhere where some costs and benefits are not incorporated in the individuals choice to supply or demand the good/service. If we think there is a situation for innovation where this happens AND there are significant transaction costs to the creation of a market that accounts for these external effect we have a market failure.

  • steve

    “If we think there is a situation for innovation where this happens AND there are significant transaction costs to the creation of a market that accounts for these external effect we have a market failure.”

    Ok, that is my point, but you have put it much more clearly. I would suggest there are significant transaction costs, preventing knowledge spillovers and therefore reducing innovations. given this type of market failure, what is your policy response (even beyond monetary policy)? I don’t believe the correct response is to play with monetary policy, but I can see why some would see it as a simple solution.

  • @steve

    Indeed, if there are spillovers from innovation then the social benefit exceeds the private benefit – market failure. I wouldn’t quite say it prevents the spillovers, it just leads to a suboptimal amount of innovation as marginal benefit to the innovators is lower than the marginal benefit to society.

    And you are right when you say using monetary policy to clean this up is a crazy way to view it. And that is how I feel with a lot of the “problems” in the economy.

    If we can just identify IF and WHAT ARE the market failures we can create policies to target them – hitting at monetary policy is both indirect and dangerous.

  • steve

    I was talking about knowledge spillovers as a driver of innovation, i.e. a high portion of knowledge (even more so for new knowledge) is tacit and requires face-to-face contact or firm/country migration in order to spillover and create innovation in other firms/industries/countries/economies, therefore there are high transaction costs to facilitating these spillovers and hence fewer innovations are successful and lower economic growth.

    But otherwise yes, you get my point, there are benefits to society, like higher wages (& tax revenue & govt spending), that are not given to innovators, which justify targeting this type of market failure.

    changes to monetary policy may assist innovators, but at the expense of the rest of the economy; and fail to address the actual cause, which is the economic spatial distance from the rest of the world.

  • @steve

    So a market for knowledge with positive externalities that cannot be internalised because you can’t write a contract for the skills and human capital that are created externally when the transaction happens. Rightio 🙂 .

    “there are benefits to society, like higher wages (& tax revenue & govt spending), that are not given to innovators”

    BTW, these aren’t externalities in the efficiency sense. Wages are a market price for labour (so the benefits are internalised), taxes and government spending are set according to spending and redistribution targets (so these are exogenous).

    http://en.wikipedia.org/wiki/Pecuniary_externality

    The main issue in terms of policy is whether the direct and immediate marginal social benefit is equal to the marginal social cost of the transaction. The fact that wage rates and tax take will change is not policy relevant – we should not subsidise on the basis of them.

    The point is to have the right relative price for “knowledge” in this case compared to other goods in the economy – aggregate variables like wage rates and government spending are irrelevant for defining these relative prices.