Thesis Working Paper n°3
In his March 1968 Presidential address, Milton Friedman[1] summarized the broad aims of every mainstream economic policy: ‘high employment, stable prices, and rapid growth’. He was also quick to point out that these goals are not always easy to bring together, and while these aims seem to be the consensus among economists, instrument policies designed to implement these objectives do not elicit the same agreement.
Monetary Policy is one of these instruments that were the subject of much debate; The global economy moved from a decade-long era of low inflation and robust growth –both of which were considered to be partly the result of sound monetary policy- to that of an economy hurled into financial turmoil, and ultimately, into persistent depression. Central bankers, just like government, put together policies and instruments to deal these economies out of recession in ways that were unimaginable a couple of years ago (ironically, Friedman finds the tight FED policy in the 1920’s as a factor in the Great Contraction. It seems Central bankers today did not make the same mistake). Although there is much debate about the efficiency of monetary policies –especially on the long run-, the fact remains, the historically low levels of interest rates are contributing to sustain world growth and OECD growth in particular. In contrast with other policy instruments, monetary policy moved to be a subtle tool, one that is not as interventionist as, say a fiscal stimulus or tax cuts, but proves to be, at least in the short run, a very powerful and effective instrument.
Just as Friedman underlined, monetary policy is there to avoid mistakes. And it seems that this negative proposition somewhat overshadows the other assigned objective to the Central Bank, namely ‘to provide a stable back-ground for the economy’ (Friedman does acknowledge the monetary policy’s ability to balance off non-monetary shocks, though). Later on, empirical research by Taylor[2] (1993) provides policy makers with both a theoretical and practical tool to engage in a more active (but not necessarily activist) policy scope in setting interest rates.
We deal with the following: In a game theory setting, the central bank has to assign levels of interest rates and output as targets for the economy (i.e. other players) to factor-in their own computations. These targets are not computed ex-nihilo; they are the outcome of preferences over two main variables, i.e. the levels of inflation and unemployment, both of which are considered to be the main, if not the only parameters the monetary policy-makers care about. We shall prove that, if a certain set of conditions is met, the monetary policy can deliver systematically optimal welfare for the economy. We shall also verify that this optimal welfare is a Nash and strategy-proof equilibrium as per a social choice function designed by the Central Bank. As a policy-maker, the first step is to delineate the Central Bank’s preferences over levels of inflation and unemployment, levels that can be proxy for setting interest rates and output gap targets, these targets are in turn set so as to reach a certain common welfare (whose existence and salient properties are to be proven and verified in the process)
Barro & Gordon[3] (1981) provided a simple but accurate model of Unemployment and Inflation, which will be adapted to fit in some game theory axioms used in this paper. The Barro-Gordon model can then be used to describe the Central Bank’s preferences and thus provide insight of the way of it computes both interest rates and output gap. This preliminary study of the Central Bank’s own preferences is crucial to the other players in the economy, as it conditions, up to a point, their own expectations and ultimately, their response to the Central Bank’s decisions. We shall also verify whether pre-commitment and other institutional arrangements (such as independence from the Government or ‘special interest’ groups) can help to reach a Pareto-optimal social welfare. Once conditions of rationality and Pareto-optimality are verified, The game theory setting will provide us with elements defining the equilibriums –if there are any-, first in a simple bargaining process between the Central Bank, and a Private Firm. We shall then move to a multi-players game, and verify again that earlier predictions about the Central bank’s preferences can yield an optimal welfare to the economy. Finally, we shall consider the conditions whereby the ‘Lucas Critique’[4] effect is either minimized, or precluded altogether.
We shall consider the improved version of Kydland & Prescott (1977) model, by Gordon (1980):
Where Ut and Utn are respectively the unemployment rate and the ‘natural’ rate of unemployment, πt and πte respectively the inflation rate and the equilibrium, ‘anticipated’ inflation rate. As a policy-maker, the central bank values these parameters, but does also take into account a ‘social cost’ function defined by the deviation of both variables from respective anchor values:
We shall however use an altered version of the said model, namely by introducing different axioms/assumptions, mainly about the use of the information set and the inflationary expectations. The rational expectation equilibrium πt is computed on the assumption that “Because there are many private agents, they [the agents] neglect any effect of their methods for formulating πte on the policymaker’s choice of πt”[5]. We will not however retain such assumption;
Indeed, in the first very simplified instance, Central Bank faces only one private agent – and so inflationary expectations are going to be part of a strategic game, the information set will have a different use to both players. Then, in a more generalized setting, the Central Bank faces n non atomistic players, which means that their own inflationary expectations cannot be treated as given by the Central bank. Quite the opposite, the social function it devises has to be strategy proof with respect to each player’s anticipations.
This non-atomicity assumption is essential in computing the Central Bank’s desired level of inflation (and thus, the target levels of interest rates and output gap). It goes without saying that the proposed equilibrium in the Barro & Gordon model does not fit in this particular instance. The equilibrium can no longer be computed directly as a rule, but becomes a strategic game whereby each player has a certain type preference over unemployment and inflation (and react accordingly when recording signals of interest rates and output gap), and it is up to the Central Bank to devise a social function that completes the objectives assigned above.
[1] Milton Friedman, ‘The Role Of Monetary Policy’ Presidential Address to the 80th Meeting of the American Economic Association. The American Economic Review, Vol. LVIII, Number 1 March 1968
[2] Taylor, John B. ‘Discretion versus Policy Rules in Practice’ Carnegie-Rochester Conference Series on Public Policy (1993)
[3] Robert Barro & David Gordon, ‘A Positive Theory of Monetary Policy in a Natural-rate Model’ Working Paper n°807, NBER November 1981
[4] Tesfatsion, Leigh ‘Notes on the Lucas Critique’ Iowa State University (2010)
[5] Robert Barro & David Gordon, p.34
The inflationist food for thought
According to the latest (to date) IMF working paper concerning Morocco, everything is going fine in Morocco; Indeed,
” Moroccan banks are stable, profitable, adequately capitalized, and resilient to shocks, but the financial system as a whole will need to adapt to the inherent risks of changing macroeconomic policies and conditions. Major reforms have been achieved since the 2002 FSAP within a policy of actively promoting economic and financial sector opening”.
So in essence, the banking and financial system is stable. It is however, quite fragile, or rather, should develop some more resilient mechanisms. The IMF namely states that:
“BAM and other supervisory bodies require the necessary operational independence and resources, supported by accountability structures, to conduct an autonomous monetary policy and effective supervision. The authorities have taken welcome steps in this context, and promulgated the new articles of incorporation of BAM confirming its autonomy, a new banking law, a new anti-money laundering law, and a large number of secondary regulations.”
The Moroccan economy is doing well, admittedly because of the sound macroeconomic policy successive governments followed since the late 1990’s. These policies included low inflation-oriented policies, conservative fiscal policy, and shy attempts in implementing a policy rate by conceding more autonomy to the Central Bank. This set of policies is considered to be the standard and sound macroeconomic policy every responsible government should follow.
Let us first tackle the inflation policy. Bank Al Maghrib made an announcement of the ‘target inflation’ for 2010, and set it to 1.2%, a rate of historical low of course. It is, however, a figure quite difficult to match, because of the other economic parameters party in ‘shaping’ the inflation rate.
According to the Bank’s own monthly monetary report (Dec.2009), inflation rate set at 1.4% in September 2009, a figure in line with the global inflation (due mainly to the effects of a global recession).
Going back to the inflation policies, the national/total consumption is considered to be of sizable influence on inflation rate (I will come back on that later on). Basically, the report points out:
‘La consommation finale nationale devrait croître de 7,3% en 2009, rythme moins rapide que celui des trois dernières années mais qui demeure supérieur à la moyenne de la décennie. Concernant plus particulièrement la consommation finale des ménages, elle devrait augmenter de 7,1% après une progression moyenne de 10,9% durant la période 2006-2008.
Globalement, les principaux indicateurs disponibles à fin octobre laissent présager la poursuite de la bonne orientation de la consommation des ménages durant les prochains trimestres.’
(a trend confirmed in the June issue : ‘Au total, la consommation finale nationale devrait croître en 2010 à un rythme situé entre 6 et 7% en termes réels.’)
Now, Olivier Blancard, with other economist colleagues, produced an interesting piece (rather a working paper, really) a couple of months ago for the IMF. “Rethinking Macroeconomic Policy”; and there was a bit about inflation policy:
‘Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This was the result of a coincidence between the reputational need of central bankers to focus on inflation rather than activity (and their desire, at the start of the period, to decrease inflation from the high levels of the 1970s) and the intellectual support for inflation targeting provided by the New Keynesian model. In the benchmark version of that model, constant inflation is indeed the optimal policy, delivering a zero output gap (defined as the distance from the level of output that would prevail in the absence of nominal rigidities), which turns out to be the best possible outcome for activity given the imperfections present in the economy’
What about our own policies on that matter? First off, let us have a look to the Bank’s views on inflation; the latest issue of the Revue de la Conjoncture Monétaire et Financière (May, 2010); They produced a couple of interesting graphs that speak for themselves:
The good news is, core inflation is pretty stable. Economists tend to use the core inflation rather than CPI (Consumer Price Index) fluctuations because they need to capture the relevant data, and oust any volatile random error term (mainly in econometrical techniques)
However, the graph below somewhat confirms a thesis I held to be true: our inflation is heavily correlated to current consumption goods (say, food like edible oil, sugar, wheat, etc…) as shown on the following graph:
While it is true inflation is gradually beaten down (which, ceteris paribus, is a good thing for the consumer), the Central Bank, as well as the Finance ministry, seem to have failed to address its volatility. In essence, the finance ministry implemented stabilizing inflation policies, succeeded in doing so, but only with the core inflation, and not on the CPI, which is quite critical, for it has a definite impact on the Moroccan consumers’ purchase power.
Blanchard then goes on: “There was an increasing consensus that inflation should not only be stable, but very low (most central banks chose a target around 2 percent). […] In a world of small shocks, 2 percent inflation seemed to provide a sufficient cushion to make the zero lower bound unimportant. Thus, the focus was on the importance of commitment and the ability of central banks to affect inflation expectations’.
Leaving the neo-Keynesian theoretical background aside, the kind of inflation the Moroccan economy experiences is of the highest interest to me: I believe every sound government and every sensible Central Bank should make inflation control policy on of their top priorities (beside economic growth and addressing inequalities, for the ministry that is).
However, it is quite odd that, while it undeniably preserves purchase power and good public finances, a certain ‘acceptable’ level of inflation is needed to boost businesses and, to some extent, help retail investors as well. In layman’s terms, the ‘good level’ of inflation alleviates the real debt burden a bit on businesses (for they actually pay lower real interest) and allow for retail investors to build up their portfolio on financial markets and exchange. However, the kind of inflation we are discussing here does not benefit to businesses neither household in Morocco.
We have seen earlier on that while core inflation is remarkably stable, the CPI components are much more volatile. And it is recognized to be so : ‘Impactée principalement par des chocs ponctuels, l’inflation demeure modérée au cours des derniers mois. En effet, après s’être établie à 0,1% en février, l’inflation annuelle est passée à 0,9% en mars. L’analyse détaillée des différentes composantes de l’IPC laisse indiquer que cette évolution traduit exclusivement le renchérissement des prix des produits alimentaires volatils, l’inflation sous-jacente n’ayant que légèrement progressé, pour se situer à 0,2% au lieu de 0,1% un mois auparavant.’
We are through the looking glasses here: the CPI is definitely what makes the inflation rate goes up, and there are several ways to explain it so:
– CPI underlying commodity prices went up on the period from Q4 2009 to Q2 2010. It is quite possible, for a constant domestic demand, to take on inflation because of a rise in commodity prices. The first idea is to look at future commodities indices. According to the Bloomberg figures, futures prices were quite volatile from October 2009 to May 2010, but were they
Let us take an even more systematic approach. The following graphs depict Exchange Traded Commodities tracking benchmark indices, all of which give a fair idea of how likely the commodities’ prices behaved during the past 6 months. The selected commodities benchmark are Oil Brent for Oil (ETF Securities Brent Oil Index), then the UBS CMCI Wheat Index for Crop/Wheat and finally UBS CMCI Sugar Index for Sugar. (All of which are listed on the London Stock Exchange, and for anyone interested in discussing the technicalities of index rebalancing as well as the relevant choices, I would with vivid alacrity)
The result is quite puzzling: there seems to be no noticeable relation (lagging or dynamic) between inflation fluctuations, and the selected commodities, though these are most important in the Moroccan consumption basket. The commodities’ prices are, therefore, not the main explaining factor for the CPI inflation.
– Domestic demand went up on the same period:
‘La consommation finale nationale devrait croître de 7,3% en 2009, rythme moins rapide que celui des trois dernières années mais qui demeure supérieur à la moyenne de la décennie. Concernant plus particulièrement la consommation finale des ménages, elle devrait augmenter de 7,1% après une progression moyenne de 10,9% durant la période 2006-2008’.
Basically, in a moody conjecture, the main variable that pulled our economic growth was the domestic consumption.
My two cents are up. I shall write very soon on the topic of inflation and conumption relation. However, It must be pointed out that the Central Bank and the FInance Ministry, while achieving a relative success in dealing with inflation, the two bodies failed in addressing volatility inflation, and thus, the main objective every policymaker should make theirs: stable long term growth.
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