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Monetary Policy
Dr Teng Ge
Hull University Business School

WELCOME
Learning and Teaching Motheds.
References,
Topics,
Lecture and tutorials,

Contacting Methods:
t.Ge@hull.ac.uk

Lecture 1. Money and Monetary Policy

Foundations of a Monetary Economy.
Why money is used, and what functions it
perform?
How money comes into existence and what
causes it to change over time?

Monetary Policy and Policy Objectives.

Quantity theory of money and classical dichotomy.
Keyness contribution and after.
Structures and objectives of central banks.
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References
Mishkin, Matthes , and Giuliodori, Chapter 13,
19.
Case, Fair, and Oster, Chapter 10.
Fender, Chapter 1 and 2.
Abel, Bernanke and Croushore, Chapter 7, 14.

What is money?
Money is defined by its functions:
Medium of exchange
Barter is inefficientdouble coincidence of wants
Properties: portability, divisibility, homogeneity, and
durability.

Unit of account
Simplifies comparisons of prices, wages, and incomes
Closely linked with the medium-of-exchange function

Store of value
used to save purchasing power over time.
the most liquid of all assets but loses value during inflation.
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Evolution of the Payments

Commodity Money: precious metals, cigarettes.
Fiat Money (token money): paper money decreed
by governments as legal tender.
Cheques: an instruction to your bank to transfer
money from your account
Electronic Payment (e.g. online bill pay).
E-Money (electronic money):
Debit card
Stored-value card (smart card)
E-cash (Bitcoin)
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How can the emergence of money be

explained?
Money must emerge as an optimal exchange
system from a world of barter.
What are the specific properties of money
that make its use general?
Money is a social phenomenon - exists only in
societies where exchange takes place.
A simple story by Kiyotaki & Wright (1989).

An Absence-of-Double-Coincidence
Economy

1-8

Good 1 as a Commodity Money in the

Absence-of-Double-Coincidence
Economy

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Fiat Money in the Absence-of-DoubleCoincidence Economy

1-10

Classical View
Money exists on efficiency grounds.
The problem of double coincidence of wants
The search for a trading partner involves costs.
The longer the search time the lower the
transaction cost.
But the longer the search time, the higher the
waiting cost

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Money and Inflation

Quantity Theory of Money (Mainly by David Hume) is described by
Equation of Exchange
MV=PT
Velocity of Money: the number of times the average pound bill
changes hands in a given time period.
In practice it represents the rate at which money circulates.
Example: suppose that in 2007 we have 500 billion in transactions
and money supply is 100 billion. The average pound is used in five
transactions in 2007. So, velocity = 5

Assuming that:
(1)T= Y(GDP); (2)T (and hence Y) is constant /independent of others;
(3) V is constant / independent; (4)P is proportion to GDP;
=

the quantity theory implies that the price level in the long-run is
determined by the quantity of money supply
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Relationship Between Money and

Inflation
The quantity theory implies that in the long-run
the money supply only affects nominal variables
through its effect on prices and NOT REAL
VARIABLES.
Use approximation to the quantity equation:

+
=
+

= +

In particular the theory doesnt predict that the

inflation rate will equal the money growth rate. It
does predict that a change in the money growth
rate will cause an equal change in the inflation
rate.
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Neutrality of Money
It is in connection with the exchanging phenomena in
a money economy that the monetary facts and
happenings come into being, together with the real
facts and happenings.
Take the real facts and happenings away, and the
monetary facts and happenings necessarily vanish
with them; but take money away and real facts and
happenings will remain as they are. In this sense,
money clearly is a veil.

---Pigou, <The Veil of Money> (1941)

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Inflation vs. Money Growth: 1960-2007

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Inflation vs. Money Growth

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Inflation and Interest Rate: the Fisher

Effect
Define:

, actual inflation rate (not known till occur)

, expected inflation rate
Real interest rate, r, adjusted for inflation

ex post real interest rate

ex ante real interest rate
Fisher equation = +

Fisher effect does not imply that the nominal interest

rate EQUALS the inflation rate. It implies that CHANGES
in the nominal interest rate equal CHANGES in the
inflation rate, given a constant value of the real
interest rate.
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Inflation and nominal interest rates in

the U.S., 1955-2007

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Keyness Contribution
Born in the midst of the Great Depression,
characterised by mass unemployed, essentials
of Keyness ideas are:
Nominal (money) wage may be fairly inflexible
downwards;
Real wage failed to fall in economic downturns;
For given money wages, output is determined by
the intersections of an AS and AD for output;
Policies work inasmuch as they affect either the
AS or AD curve.
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Money Growth and the Business Cycle in the

United States 19502011

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Macroeconomics policy objectives

Internal objectives include low unemployment, low
inflation and economic growth
External objectives include balance of payment
equilibrium and preventing excessive exchange rate
fluctuation.
Internal balance is referred to Keynesian fullemployment
External balance refers to balance of payment
equilibrium.

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Structures of central banks

In the Anglo-French model:
Price stability is only one of the objectives and does not
receive any privileged treatment.
Political dependence.

In the German model:

Price stability is considered to be the primary objective of
the central bank.
Political independence.

The German model prevailed in the design of the

European Central Bank.
intellectual development, i.e. the monetarist counterrevolution
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The Case for Independence

Political pressure would impart an inflationary
bias to monetary policy

Political business cycle

Could be used to facilitate Treasury financing
of large budget deficits: accommodation
Too important to leave to politiciansthe
principal-agent problem is worse for
politicians

The Case Against Independence

Undemocratic
Unaccountable
Difficult to coordinate fiscal and monetary
policy
Has not used its independence successfully

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Explaining Central Bank Behavior

One view of government bureaucratic behavior is that
bureaucracies serve the public interest (this is the public
interest view). Yet some economists have developed a theory
of bureaucratic behavior that suggests other factors that
influence how bureaucracies operate
The theory of bureaucratic behavior may be a useful guide to
predicting what motivates the Fed and other central banks

Explaining Central Bank Behavior

(contd)
Theory of bureaucratic behavior:
objective is to maximize its own welfare which
is related to power and prestige
Fight vigorously to preserve autonomy
Avoid conflict with more powerful groups

Does not rule out altruism

Structure and Independence of the

European Central Bank
Patterned after the Federal Reserve
Central banks from each country play similar
role as Fed banks
Executive Board
President, vice-president and four other members
Eight year, nonrenewable terms

Governing Council

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Differences Between the European System

of Central Banks and the Federal Reserve
System
National Central Banks control their own
budgets and the budget of the ECB
Monetary operations are not centralized
Does not supervise and regulate financial
institutions

Governing Council
Monthly meetings at ECB in Frankfurt, Germany
Twelve National Central Bank heads and
six Executive Board members
Operates by consensus
ECB announces the target rate and takes
questions from the media
To stay at a manageable size as new countries
join, the Governing Council will
be on a system of rotation

How Independent Is the ECB?

Most independent in the world
Members of the Executive Board have long
terms
Determines own budget
Less goal independent
Price stability

Charter cannot by changed by legislation; only

by revision of the Maastricht Treaty

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Independence and accountability

Whenever the government delegates power to
the central bank there is a corresponding need to
have accountability.
The reason is that the government maintains its
full accountability towards the voter.
Thus it cannot afford to delegate power without
maintaining control over the use of this power.
Independence and accountability are part of the
same process of delegation.

Optimal relation between independence

and accountability
Independence

ECB
Bundesbank

Fed

Accountability

Structure and Independence of Other

Foreign Central Banks
The Federal Reserve System
Highly independent in both its goal and instruments.

Bank of England
Has some instrument independence.

Peoples Bank of China

Relatively less independent.

The trend toward greater independence

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The ECB: a conservative central bank

Creation of ECB was dominated by fear of
inflation bias.
This led to idea that ECB should be
conservative, i.e. given overriding importance
to price stability neglecting output and
unemployment stabilization if necessary.
Is there evidence that ECB behaves in a more
conservative way than the Fed?

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Is there evidence that the ECB acted as a conservative

central bank?
Policy interest rates in the Eurozone and the US (%)

US Fed seems to have reacted more to economic slowdown of 2001 than ECB
(keeping interest rate too low for too long)
Then it reacted sharper to the boom of 2004-06 and the recession of 2007- 08)
than the ECB
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Short-term interest rate and output gap (19992010)

Eurozone
Eurozone

ECB does react to

movements in output gap

Thus it gives some weight

to output stablization

US

US Fed reacts more

strongly to decline in output
gap than ECB
It appears that Fed
attaches greater weight to
output stabilization than ECB
In this sense ECB is more
conservative than Fed
Note that US Fed may have
kept the interest rate too low
during 2002-05
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Take-away messages
Money emerges due to market frictions.
Keynes revolution challenged the classic
dichotomy of money.
Price stability, among with the other goals of
policy makers, is the major concern of central
banks.
Question: Why do central bankers have power
over the economy?
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