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Stabilization Series Module 8

This note is part of the original knowledge series published under Online Learning.

The middle Road Stabilization module is a mega module series focussing on the stabilization policies implemented by the Central Banks globally. The educational series posted under Macroeconomics will be a significant educational series by the platform. To get the best out of an online learning experience, you should refer to an international quality textbook that covers these concepts. The modules from The middle Road are not a substitute for any academic classes but set forth to complement and build your understanding of concepts in Macroeconomics. The two textbooks for reference are listed at the beginning of the Macroeconomics section (Macroeconomics by Gregory Mankiw and Macroeconomics Policy & Practice by Frederic Mishkin). These are excellent books for reference for undergraduate and postgraduate courses and highly recommended by The middle Road. It not compulsory to refer to the recommended reads (research papers) mentioned at the end of this note but they are great reads to help you understand many concepts better. The series focuses more on the role of the Central Banks in driving monetary and macroeconomic policies but would also touch on topics related to the fiscal policies of the government. Module 8 begins with a look at Central Banks as enablers, its monetary focus on price stability introduces the concept of the trade-off between inflation and unemployment rate, discusses types of inflation variables used by selected Central Banks, few key tools used for monetary policy. Open Market Operations are covered in Module 8A and it’s embedded within this reading.

Macroeconomics concepts like the Theory of Liquidity Preference, Phillips Curve, Liquidity Trap are covered herein. Module 8 mentions Taylors rule and Mankiw’s rule, a framework in setting up policy rates using inflation and GDP/ Unemployment rate as input variables but these concepts will be covered separately in upcoming sections on this macroeconomic series.  Module 8 follows Module 7 that introduces economic fluctuations and its impact on economy. and a prerequisite for this series. 

Fig 1 Sweden price level and change in percent inflation from 1830 to 2020 | The middle Road | Data source: scb.se

The first part of the series will look at different policy rates of selected central banks, mandates ranging from hierarchical to single with a focus on price stability and unemployment rate, function as a lender of last resort. Under price stability, the key focus is given to inflation i.e. change of price levels over time (annually/ quarterly, monthly)  as calculated through consumer price index or other measures of a consumer price index. The module series introduces the concept of the Phillips curve i.e. the negative relation between inflation and unemployment growth with an introduction to simple regression analysis. The series includes detailed examples of topics and add-on tutorials on Open Market Operations, Phillips Curve, and expected augmentation Phillips Curve.

Since the 90s, Central Banks like Riksbank, Central bank of Sweden,  made inflation targeting their major monetary mandate. Founded in 1668, Riksbank is the oldest and one of the most prestigious central banks in the world. Fig 1 compares the price level and annual percent change in consumer prices. Post-1970, the slope of the rise in the price level is steep while the change in inflation rate stabilizes from the 1990s. Inflation 

Understanding Inflation measured as a change in the consumer price index can be computed in various ways. 

Why is Inflation Important? 

Why did Central Banks make inflation one of their core focus for monetary policy ? Why is moderate inflation example 2% good ? 

Fig 2 Calculation of Standard Deviation of the rate of inflation calculated using the standard deviation of CPI for preceding 40 quarters of each data point. The data source is OECD | Federal Reserve Economic Data; the quarterly, annual percent change from the previous year, not seasonally adjusted. The graph depicts the reduction in volatility over time. Since the 90s central banks have increasingly focussed on price stability (rate of inflation) which could be a significant factor in its stabilization. On the other hand, some economists argue that this could be due to the better availability of data. Central Banks use inflation as a measure of price stability as it is much easier to monitor changes in price levels over time than absolute price levels. Inflation usually have a two years lag of a policy implementation and serve as an excellent barometer of the state of an economy keeping other factors constant. Stable prices within an economy is one of the most important bedrocks of wellbeing among households and businesses.

Sustained moderate inflation is a barometer of positive business sentiment within an economy, leading to price stability, low unemployment rate, and high levels of well-being within society. A moderate inflation is a cushion against deflation i.e. when prices fall. Second, it gives economists and policy makers room to manoeuvre during the time of liquidity trap. Liquidity trap occurs when the interest rates are near zero and as the nominal interest rates cannot go less than zero, expected inflation is used to drive real interest rates negative to boost lending and investment. This situation occurs during deflationary scenario and the theory of liquidity preference does not hold.

  • Nominal Interest Rates  = (1+ Real Interest Rates) * (1+ expected inflation rate) ——————— Fisher Equation 
  • approximated as nominal interest rates =   real interest rates + rate of inflation (approximation) ——- Fisher Equation
  • Real Interest Rates = Nominal Interest Rates – Rate of Inflation (i= nominal interest rate, r = real interest rates and expected inflation rate) 

High inflation or runaway inflation leads to eroding of consumer wealth by lowering the real purchasing power of the individuals with far outreaching business sentiments. Nominal interest rates can best be described as interest on bonds or the opportunity cost of holding cash. As cash is not paying interest, the interest rate paid by bonds (as they are much safer than equity or alternative assets), becomes the benchmark of the opportunity cost of holding cash. The higher the interest rate offered by bonds, it’s more appealing to investors/ householders/individuals to invest in assets rather than holding cash. At the same time, householders or individuals are looking at the purchasing power of their wealth, therefore looking at real returns on their investments. Therefore, real interest rates i.e. nominal interest rates minus the rate of inflation are what investors look at. To be more accurate, investors look at real risk-adjusted return i.e. how much real return for a unit measure of risk as highlighted by risk-adjusted return measures. Read through Investment Analysis and Portfolio Management module, an epic offering from The middle Road. Periods of high inflation like that in the US during the 70s had a dampening effect on businesses. Periods of high inflation are accompanied by high-interest rates reducing the liquidity within the system. Does the past decade allude to that Inflation is purely a monetary phenomena ? 

Refer to the Theory of Liquidity Preference (will be further discussed in the IS-LM  model) and module 8B on Open Market Operations. 

Theory of Liquidity Preference 

John Keynes, one of the greatest economist of all time in his book The General Theory of Employment, Interest and Money laid out a model for determining interest rates over short term. Theory of Liquidity Preference builds up to the LM curve, part of the LM curve.  In the below model, r is denoted as interest rates although in the short run it is nominal interest rates. However, this is out of Mankiw book  and for the sake of simplicity expected inflation over short run is taken as constant  and as seen before expected inflation is the difference between nominal and real interest rates. Since the expected inflation is assumed to be constant, the differentiation of inflation with respect to time is zero in the short run. Therefore, nominal and real interest rates are same. In the upcoming module on theory of liquidity preference, nominal interest rates would be considered. In the below case, the money is supplied by Central Banks and people (used also interchangeably by household’s/individual’s in this read)  hold currency (cash) for precautionary and speculative purposes.  Link to the full read here.

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