Friday, September 28, 2007

Tinbergen Rule :Instruments and targets (II)

From the Tinbergen rule point of view, economic goals should be connected with the expected welfare level society might try to get , such that target and instrument connect to each other , in such a way that society can fulfil its welfare expectations. Mundell has suggested that ,in order to get that expectations done, those more effective instrument to get the target, should have a greater weight on the policy function ,such that it maximizes its impact.-
On the other hand, some times there is not sufficient instrument for every target (reduce inflation, increase employment),so there is no other alternative than to make a trade off ,which means to minimizes welfare losses. It is also feasible to have more instrument for each target. For example to reduce domestic expenditure, and current account deficits.
Uncertainty also have an important role on policy design. It is not possible for the economy, to work with real time data , to know in advance the precise value of the parameter in the reaction policy function , or the effective transmission mechanism for monetary policy . In the stabilization effort done after the Asian economies crisis rolled over, Chilean economic authorities at that time, could not anticipate the magnitude of the impact ,that increasing the interest rate would have on investment and GDP.-
Rules have the advantage of allowing markets ,to know in advance what the future economic policy course would look like given some set of assumptions .It allow to minimize the efficiency losses arising from the unexpected ,and it creates an institutional framework which support long term investment decisions plans.-
Discretionary macroeconomic policy decisions, try to get the best of every chance economic authority might intervene into the economy, without any prior optimization target to minimize welfare losses.
Rules are better than discretionary economic policy, because it reduces inefficiencies, macro variables variability and volatility .On the other hand ,rules must adapt itself to new conditions arising from the dynamic of the economy forces. Some fixed rule like that one stated by Friedman, that money supply must growth at the same pace than product growth, does not take into account the endogenous variables which influences the money demand, such that money supply might growth without getting inflationary pressure to get its way through.-
Latin America economies, are still far away from having a set of rules for macroeconomic policy stabilization purposes. Inflation is back in some countries, as long as fiscal expenditure moves forward. Thus Central Banks have a difficult task, when it comes to get back on track the macro fundamental.-

Friday, September 21, 2007

The Tinbergen Rule : Instrument and targets (I)

For policy maker, It is usual to confront macroeconomics problems with the dilemma of choosing properly the instrument such as it match rightly a defined target(for example increase in investment or reducing inflation) . The success of stabilization macroeconomics policy depend upon the decision about the right instrument which to work with. This issue is very important in cases study related to reducing inflation programs, which has been a problem in many Latin American economies. Although empirical evidence suggest that keeping inflation under control is the job of monetary policy, some textbook experiences ,like Chilean stabilization program applied in the mid seventies and nineties, used a different approach based on exchange rate policy .The assumption was that as long as exchange rate was fixed or within certain range of value, it would allow to reduce inflationary pressures allowing authorities to get the inflation target. In both cases, the result was a failure although for different reasons. While in the seventies the assumption was that the real economy was more flexible than it really was, in the nineties the assumption was that inflation was mainly a cost push phenomena, ignoring the role of a demand pressures and how important is to keep control of them.-
Both cases are “good” examples of not following the Tinbergen rule. In the first case fixing the exchange rate meant to make monetary policy ineffective, so the task of reducing inflation was an endogenous process depending on moderate fiscal policy , but fiscal policy is better aimed for short term product goal. In the second case monetary policy capability, was artificially limited with a semi fixed exchange rate system , supposedly complemented by moderate fiscal policy. The target were confused with the instrument, fiscal policy was not moderate as expected (minimum wages law were approved, and fiscal expenditure increase over the whole period )) . The wrong belief was that inflation reduction program , did not required strong monetary policy, as the key instrument. Instead ,It was thought that exchange rate policy was better instrument for doing so, confusing cost pressures as more important than demand pressures as a cause of inflation .. Recent development in normative macroeconomics, have made quite clear that it is monetary policy the instrument to consider when it comes to get inflation under control, so much so that these days it is applied following a rule ,the well known “Taylor Rule “ which set a framework for a more effective monetary policy to get inflation target. On the other hand, the pass through coming from cost pressures is limited to ability of Central Bank to control inflationary expectations.-
The current concern about global financial market volatility, is a good opportunity to take into consideration the Tinbergen Rule. This market volatility is due not only to the subprime housing market crisis itself ,but much more so to the way authorities will react to its consequences . Both factors are complementary variables in the same equation, which means that the timing for reaction is as much important as the choosing of the proper instrument . This means that as long as this crisis is expected to roll over as a solvency crisis, the proper instrument is the discount rate .(the rate at which the Central Bank allow banks to ask for loan).The interest rate (The rate at which banks lend to each other) is the instrument for inflationary purposes, mainly to keeping demand pressures in check with potential output .

Friday, September 14, 2007

Central Banks ,inflation and economic growth (II)

Because of its role and its influence, most of Central Banks are both independent and autonomous from political interests .The degree of independency , varies among different countries depending on their experience with past inflation. The degree of autonomy depends on the ability for pushing aside government pressures. Available evidence(Measures of central bank autonomy: Empirical evidence for OECD, developed and emerging markets economies. October 2006. WP06/228 :Arnone, Segalotto y Laurens), indicates that autonomy and independence have increased in a ten years period ranging from 1991 up to 2003. They use the GMT index ,and a revisited version of it based on Cukierman approach, for a smaller sample. Autonomy in particular, has increased in emerging economies and developing countries ,as much as economy autonomy. This improvement follows a three stage approach :
S1. To laid down the political fundamentals of Central Bank ´s job
S2. Operational autonomy development
S3. Central Banks get further autonomy in terms of policy formulation and appointment of senior management, due to changes in. Central Banks laws such as to increases its autonomy in the use of instruments.-.
OECD countries also have had an increase in political autonomy (setting of objectives such as price stability) as a consequence of European Central Bank converging to the Bundesbank model . Economic autonomy also has increased ,specially since the 1990,allowing to have a lower dispersion among different Central banks economic autonomy index.
Thus, no matter whether it is OECD or Emerging economy, there are a deeper sense of connexion and causal relationship ,between both economic and political autonomy and higher macroeconomic performance. The trend is for higher economic and political autonomy. Countries with high autonomy level can be found in PerĂº, Mexico, Brazil, Chile within the group of emerging economies.
Concerning political independence ,OECD CB ´s countries (45,4%of all cases )are more political independent than those CB from emerging (28,6%) or developing ones(26,0%). As far as economic independence is concern, OECD(36,2%), developing (32,7%)and emerging countries (31,0%),are evenly distributed..
Very much of all of this discussion is important in the current scenario of global markets volatility which means strong pressures upon Central Banks reaction function, to make quick and precise moves. According to the available data, Central Banks are in a very well endowed position to handle properly the current situation, away from political pressures, and keeping the risk balances properly between achievements in inflation and stable and not recessionary growth. However, the current volatility it is not just about CB interventions , but it is also about a credible approach to avoid a recession ,in the middle of a monetary program to reduce inflation, settle down the risk perception of massive default.. Which is the best option? .It is important to make the difference between fighting inflation (macroeconomic real setting),and avoiding a systemic crisis due to insolvency in housing markets (microeconomic financial setting ). Reducing the interest rate, might not have the expected effect upon a crisis defined by microeconomic parameter, rather than macroeconomic ones. Worse of all ,it might imply to risk the gains made on inflation control so far, such that sooner or later it will have to be raised again .Besides, with lower interest rate, Banks will not make a difference for debtors unable to pay their mortgage, because it has not changed their risk profile. Reprogramming debt program under special financing conditions might allow a better effect,even continuing adding cash to the financial system it is not a weak approach.-

Friday, September 07, 2007

Central Banks,inflation and global economic growth(I)

These days ,Central banks are on the market attention because of the way their reaction to the current issues of food prices increases, and the sub prime housing markets crisis, will impact the global economy.-
First of all it is important to say that Central Banks are in charge of monetary policy to keep control of inflation, aimed at the goal of getting price stability, which means they set interest rate(fund available for customers), discount rates (funds available for banks).To decide interest rate level, Central banks follows the “Taylor Rule”. This rule means that as long as effective inflation deviates either upwards or downwards, from a target value, interest rate might go up or down respectively . It goes up when inflation is above target ,and it goes down when it below target. The uses of this rule has decreased the volatility of inflation ,so it has decreased the volatility of GDP which reduces efficiency and welfares losses.
On the financial side of the economy ,Central Banks can carry out open markets operations, which means to sell and buy financial instrument. .Besides, Central Banks are the lender of last resort ,which means that they are the one which banks expect help from when there is a credit crunch and they might transitory run out of cash. Then ,a key second role for Central Banks ,is to keep stability on the financial sector , which means to keep the payment chain in motion and Banking sector liquidity .On this task ,there is no rule except that one arising from avoiding the risks of economic depression ,and a proper judgment of the macroeconomics conditions that financial institution are facing at some moment in time. For instance ,the current global volatility due to the housing sub prime market crisis in the USA, required Central Banks to support financial institutions ,which otherwise were close to run out of cash , which would have a subsequent impact on markets expectations about macroeconomic performance.. While it has been on the financial side, Central Banks have been able to cope with the requirements of a markets with higher risk aversion than before. What if it goes beyond the financial side of the economy? .-
Central banks also needs some complementary policies to get a better results and impact coming out from its decisions. On the aggregate macroeconomics side, fiscal policy should be closely coordinated with monetary policy.
Price stability and financial stability ,are the key contribution Central Banks can make to foster economic growth .Therefore, economic growth is not out of Central Banks ´s concern. In fact it is its third, although less visible, main concern. There is no sustainable economic growth with high inflation and financial instability . Some Central banks have this goal very explicit on their responsibility list, whereas others includes this concern in a less explicit format. Either way, there is no Central Bank chairman who is not aware of the implications for economic growth ,arising because inflation might be above target. On the other hand, the uses of rules have made Central Banks more reliable and credible because that means less volatility ,and future conditions are better predictable .
Because of its Importance and influence most of Central banks are independent .The degree of independency varies among different countries .-