Understanding Macroeconomic Stability

Originally posted as part of the Stabilization Macroeconomics series, the academic focussed publication sets the tone for the upcoming Macroeconomic Online Course on Stabilization. The series focuses more on the role of the Central Banks in driving monetary, fiscal, and macroeconomic policies of the government. 

The course 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 the unemployment rate. Includes discussion on the types of inflation variables used by selected Central Banks, along with a few key tools used for monetary policy. Open Market Operations is separately covered as a topic. 

Macroeconomics concepts like the Theory of Liquidity Preference, Phillips Curve, and Liquidity Trap are covered herein. The stabilization course mentions Taylor’s rule and Mankiw’s rule, a framework for 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.

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, and 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 price indexes. 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 CurveSince the 90s, Central Banks like Riksbank, the 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 is measured as a change in the consumer price index that can be computed in various ways. 

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.

 

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 course 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.

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

Understanding Inflation 

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.
Video: Taylor’s Rule in Calculating Policy Rates | The middle Road  

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. Moderate inflation is a cushion against deflation i.e. when prices fall. Second, it gives economists and policymakers room to maneuver during the time liquidity trap. A 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 negatively to boost lending and investment. This situation occurs during a 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 while investing. To be more accurate, investors look at real risk-adjusted return i.e. how much real return is for a unit measure of risk as highlighted by risk-adjusted return measures. Periods of high inflation like that in the US during the 70s had a dampening effect on businesses.  

# Theory of Liquidity Preference 

John Keynes, one of the greatest economists of all time. His book The General Theory of Employment, Interest, and Money laid out a model for determining interest rates over the short term. Theory of Liquidity Preference builds up to the LM curve, part of the LM curve. In the model below, r is denoted as interest rates, in the short run these are nominal interest rates.  For the sake of simplicity expected inflation over the 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, In the short run, the differentiation of inflation to time is zero. Therefore, nominal and real interest rates are the same. In the upcoming module on the 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 in this read) hold currency (cash) for precautionary and speculative purposes. As the amount of loanable currency is fixed, an increase in nominal interest rates would lead households to move non interest bearing money i.e. currency into bonds. Nominal interest rates are interest rates paid by bonds. Investors look for real return, we must look at real money balances. 

Assumptions of the model below.

  • Money is supplied by the central bank | PY=MV ————– Quantity Theory of Money  (In Keynes model velocity is not fixed but depends on interest rates fluctuations)
  • M = Money Supply; P = Price Level |  M/P = Fixed supply of Real money balances
  • Cash is equated with currency; it is not interest bearing (In selected economies savings account does pay interest on the minimum balance during the month but for this model this is ignored.)
  • Interest rate is one of the determinants of how people/householders use cash/currency.
  • Keeping supply of money and price level fixed, the supply of real money balances is also fixed.
  • The supply of real money balances does not depend on nominal interest rates  and therefore is a vertical line. For any level of interest rates within the economy, the supply of real money balances is fixed. The demand for real money balances is downward sloping inversely related to nominal interest rates. The intersection point of the demand and supply curve gives the interest rate i.e. point A in the fig 2.

For a high rate of inflation, households would demand a higher return as compensation for loaning out funds to maintain the status quo of living i.e. maintain real purchasing power. At high-interest rates, the supply of loanable funds reduces within an economy, this reduction in the supply of real money balances leads to an increase in the nominal interest rates. In fig 3, the supply of real money balances is fixed by the central bank i.e. M/P. The nominal output of an economy is a factor of money supply and velocity of money.

In the liquidity preference model, the loanable money supply is fixed with interest as one of the determinants of the propensity of people to invest. As interest rates rise, households would demand a higher return as compensation for loaning out funds. If households hold cash, then they are not investing in the economy and vice versa. As equilibrium interest rates (the point where the money demanded is equal to money supplied herein point A) rise, the household will have excess cash with them, part of which they will invest in interest-bearing financial instruments. The loanable cash within the system reduces, the supply of real money balances shifts to the left, and the equilibrium to point B. Note: The Central Banks are the suppliers of money, so if there is no new supply of money, the loanable supply within the economy is fixed.

Fig 3: Liquidity Preference LM Curve | The middle Road | Ref Macroeconomics, Mankiw

Note: In the short run, a reduction in money supply will increase nominal interest rates according to this model as prices are sticky. In the long run, a reduction in money supply leads to a reduction in nominal output, lowering inflation and nominal interest rates. 

In the long-run prices are flexible. In the short run, not all prices are sticky.

Hyperinflation are defined as periods wherein inflation grows more than 50% per month. Recent examples include the runaway inflation of Zimbabwe or the early 20’s period in Germany. In the fig 1, look at the high levels of inflation in Sweden. Hyperinflation is one the greatest weapon of mass destruction, a monetary phenomena that destroys the very fabric of living. You could get up in the morning and get a shock that  the price of bread is three times the yesterdays price. A rapidly increasing inflation implies the rapid reduction of purchasing power of  goods and services. A 10 unit of currency that could be enough to buy a decent two square meals might be worthless tomorrow to buy even a half loaf of bread. A deflationary scenario on the other hand leads to fall in prices with a negative business outlook. Consumers prefer to save rather than invest, leading to a fall in investment and loans within an economy.   

Inflation is impacted by two kinds of variability: Demand Push and Cost-Push. Demand push arises when demand for goods and services exceeds the supply of goods and services leading to the heating up of the economy. This happens when the economy is in a boom or expansion phase. Cost-push happens when the factors affecting the cost of goods and services rise example fluctuation in exchange rates, import prices, or capital flows that affect the price of cost of goods or services. A weakening exchange rate would inflate the prices of goods or services imported leading to an increase in  domestic inflation rate. Central Banks have a varied structure in tracking inflation it could range from a point estimate example 2% to target inflation between a range over different tenures. Example, Reserve Bank of New Zealand targets CPI between 1 to 3 percent on average over medium term: future average inflation is 2% midpoint.

Policy Rates

The preamble or mandate of central banks varies. ECB, Bank of England, and Riksbank follow a hierarchical method with a preference for price stability by monitoring inflation. On the other hand, the FED (unemployment and inflation), and the People’s Bank of China (growth and stability of currency rates) follow a dual mandate. The relationship between the unemployment rate and inflation will be covered the online series on stabilization through the concept of the Phillips curve. Inflation and Unemployment have an inverse relationship although in recent times the curve is flattening i.e. there is no causal relationship between the two variables keeping other factors constant.

The Consumer Price Index or Cost of Living index is an excellent tool to understand the prices of selected goods or services and the consumption level of the population. CPI can be divided into core and headline inflation; core inflation is less volatile as compared to headline inflation. Core inflation is headline inflation minus the change in prices of energy, food, alcohol, and tobacco. (Some banks calculate core inflation as headline inflation minus food and energy). Many Central Banks track core inflation like the Federal Reserve, the Central Bank of the United States of America, or headline inflation tracked by the European Central Bank.

Core Inflation removes the transient effect of supply disruptions that increases the volatility of the consumer price index that might not be a true reflection of the state of the economy. Another good way would be to use the moving average method to smoothen out variations in the price levels. 

Fig 4 Comparison of Core and Headline CPI fixed interest rate Sweden | The middle Road | Source Statistics Sweden and Riksbank

 

Another good way would be to use the moving average method to smoothen out variations in the price levels. Federal Reserve or the Fed follows a dual mandate of price stability (inflation) and unemployment rate. 

For any doubts or queries write to nishant@themiddleroad.org

 

References and Recommended Reads 

  • Macroeconomics by N Gregory Mankiw
  • Macroeconomics Policy & Practice by Frederic Mishkin
  • Central Bank Tools & Liquidity Shortages by Stephen Cecchetti and Piti Disyatat
  • Brookings Article:  What is the repo market, and why does it matter?  Jeffrey Cheng & David Wessel
  • The Riksbank’s operational frameworks for monetary policy, 1885–2018  by Peter Sellin*
  • A Skeptic’s Guide to Modern Monetary Theory By N. Gregory Mankiw*
  • The Riksbank’s inflation target – target variable and interval
  • Inflation Targeting: A New Framework for Monetary Policy? Ben S. Bernanke and Frederic S. Mishkin
! Nominal Interest Rates can be negative, Central Banks do support policies of negative interest rates. This point is added to post publication to remove any miscommunication due to wordings of the piece. Refer to online courses under applied learning on The middle Road. 

 

 
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