De Grauwe, P. (2000). The Challenge of Monetary Policy in Euroland. In H. Ooghe, F. Heylen, & R. Vander Vennet (Eds.), *EMU: dé uitdaging* (pp. 135-156).
Ghent: Vereniging voor Economie.
-------------------------------------------------------------------------------------
Reading notes 10-11 April 2000. Book is in personal library (VUB office).
[Compare to the CEPR paper by De Grauwe, Feb. 2000 (exact reference
still to look up)]
[Abstract: still to complete]
135 1. Introduction
2. Central Banking and asymmetries of shocks
136 "The ECB, which is responsible for maintaining price stability and for stabilising
the economy in Euroland as a whole [emphasis in original] aggregates the numbers. "
(pp. 135-6) "
- Compares ECB’s reaction to (pure) asymmetric shock and to symmetric
shock in Phillips-curve diagrams. Base of comparison: each central bank sets
optimal policy (Barro-Gordon model, see appendix) (cf. section 3). "
137 - Conclusion: "To the extent that
there is some asymmetric component in the shocks, the ECB will always stabilise
too little from the point of view of the individual member state. " This
problem of insufficient stabilisation cannot be resolved (theory of optimum
currency areas). Hence, "There will (...) be a lot of conflict between
member-states and the ECB. " (138).
138 - How important will these asymmetric
shocks be in the future? "There is some empirical evidence (...) that as
Euroland integrates more an increasing amount of shocks are likely to be
regional [sub-national] or border-overlapping. [See however Braunerhjelm et al.
(2000) for a less optimistic view.] As a result, the problem the ECB will face
may not be very different from the problem any central bank of a country (that
is not too small) faces when regional shocks occur. [cf. paper Vanhoudt and
Buyst on Belgium in same volume] Such a central bank is equally incapable of
using its monetary policy to deal with a regional problem.
- But: "
(1) nation-states may react stronger than regions;
(2) nation-states may cause shock of political or social
origin, and look at ECB as scapegoat [refers to fiscal shocks or wage shocks??] "
(3) "(...) the existence of different nations with their
own legal and cultural systems leads to different transmission mechanisms of
the policies of the ECB (...) " [section 4] "
139 **3. EMU versus EMS** "
- Compares how ECB reacts to (pure) asymmetric shock and to symmetric shock
in Phillips-curve diagrams. Base of comparison: Bundesbank sets monetary policy
for all EMS countries (cf. section 2). With a pure asymmetric shock, one
country does better in EMU than in EMS, one worse. "
141 **4. Asymmetries in the transmission**
and optimal monetary policies** "
- due to different structures and institutions [refers to recent research
for Euroland by Ceccchetti (1999) and MacLennan et al. (1999), NOT INCLUDED IN
REFERENCES _ CHECK] "
- illustrates differences in transmission of monetary policy following a
symmetric shock in a country with flexible labour markets (flat SP curve in
(p,u)-space) and one with rigid labour markets (steep SP curve). Euro-wide SP
curve has slope that is average of individual SP curves. "
142 - results: "
- in flexible country: stabilisation by ECB is effective
in limiting the increase in unemployment. "
- in rigid country: stabilisation ineffective "
- can the ECB do better? yes, if it uses national
information (section 5) "
142 **5. Should the ECB use national information?** "
- ECB uses euro-wide aggregates: "The ECB has decided to formulate its
monetary policies by taking into consideration euro-wide aggregates of
macroeconomic variables such as inflation, unemployment and inflation [sic],
and thus by disregarding national information concerning theses macroeconomic
variables. This decision can be defended on the ground that the ECB must
represent the interests of Euroland as a whole, [p. 143 starts here] and not of
particular countries. The decision seems totally legitimate. Yet under certain
conditions it can lead to problems in that the welfare of all countries is
reduced relative to a situation where the ECB would take national information
into account when formulating its optimal policies."
143 Set-up same as in section 4 (Fig. 8 p. 144).
[include fig. 8 p. 144 in paper and use for presentation - make
transparency with colour overlays]
- The resulting policies are sub-optimal: "Both
countries [Rigid and Flexible] would prefer less expansionary monetary policies
than the one the ECB is applying [on basis of an "average " SP curve
and corresponding optimal stabilisation line] as a response to the shock [a
rightward shift of SP increasing u]. Put differently, both countries consider
the ECB response to the shock as excessively inflationary. " "
"The optimal policy derived by the ECB is not an average of the
inflation rates that the two countries (with the same preferences as the ECB)
find optimal. The ECB could do better by taking the average of the optimal
inflation rates derived directly from the national Phillips curves. This would
be a Pareto-improvement for both countries. "
144 "If there are important differences in the transmission process of the same shocks,
it is not desirable that the ECB uses an aggregate euro-model of the economy to derive
its optimal monetary policy. With large asymmetries in the transmission process the
euro-model approach creates important aggregation biases and leads to sub-optimal
policies. " "
- Policy implication: the ECB should use national variables. Proposes
procedure: ECB board uses euro-model to set optimal policy. Each national
governor does same using national variables. Confront national policies with
ECB board policy. If consensus, use ECB board policy. If not, take average of
national policies.
145 **6. The Monetary Policy Strategy of the ECB: a description**
147 **7. The Monetary Policy Strategy of the ECB: an evaluation**
7.1. The selection of the target
148 7.2. Is the inflation target of atmost 2% too low?
150 7.3. Excessive reliance on the money stock?
151 7.4. Inflation targeting: a model for the ECB?
152 **Conclusion** " [summarizes the paper]
153 **Appendix: The optimal stabilisation path in the Barro-Gordon model**
- Central Bank minimises quadratic loss function: inflation target = 0
unemployment target is below natural rate;
- subject to short-term Phillips curve; "
154 - yields expression for optimal
inflation (function of expected inflation, natural rate of unemployment, random
shock);
- assume rational expectations: agents use expression for optimal inflation
and use it to set their expectations; solving for expected inflation yields
p^e = ab(1- l)u^N
"... in equilibrium the average [that is, expected] inflation is
positive reflecting an inflation bias. " [result of setting unemployment
target below natural rate, 0 < l < 1] "
- "(...) central bank sets the inflation rate so as
to reduce the variance of unemployment. ": "
- yields expression for inflation rate: [unclear how
this result is obtained _check later in Scarth or Romer] "
p = "p^e +(constant)(random shock) (7) "
- substituted into Phillips curve yields expression for
u: u = u^N + (constant)(random shock) (8)
155 - optimal stabilisation path: central
bank sets inflation rate optimally in response to unanticipated shocks in
unemployment (p. 135):
find expressions for dp/de [reaction function] and
du/de ;
divide dp/de by du/de to obtain slope of optimal stabilisation line: dp/du = ab.