Percentage game

Indian Express, 12 March 2007

How do central banks respond to business cycles in a market economy?

Central banks use monetary policy to stabilise business cylces. If inflation goes up, monetary policy is used to bring it down. If output growth goes down, montary policy is used to increase output in the short run. In other words, the aim of monetary policy is to be counter-cyclical.

What are the instruments used to conduct monetary policy?

Modern monetary economics has moved away from controlling money supply to impact interest rates to directly controlling interest rates. Today, in industrialised countries the rate at which the central bank lends to commercial banks has become the main instrument through which monetary policy is conducted. This rate is set by the central bank, the producer and supplier of money.

How do central banks set interest rates in response to growth and inflation?

Central banks respond to deviations of inflation rate from a target inflation rate and to deviations of actual from potential output by bringing about changes in the real interest rate. The real interest rate is the inflation adjusted interest rate. For instance, in the case of the US, the federal funds interest rate minus the expected infation rate gives us the real interest rate.

In a seminal paper in 1993, John Taylor, the current undersecretary of the US Treasury showed that historically the US Federal Reserve Bank had responded to primarily to inflation and potential output while making interest rate decisions since 1987. While other economists have argued that there have been many deviations from the Taylor Rule, as the observed monetary policy response of the US Fed estimated by John Taylor, came to be known, many agree that actual policy moves over the past 15 years are approximated by the Taylor rule.

What does the central bank do when inflation is above the target rate?

When in the short run the inflation rate is above the inflation target then the central bank raises interest rates. It has been seen that to control inflation central banks raise rates by more than the deviation of inflation from its target. This means that if inflation is one percent above target, then the nominal interest rate like the fed funds rate has to rise by more than one percent so that the real interest rate rises to bring about a contraction in demand. Thus if inflation has to be brought down from 6 percent to 5 percent it is not enought to rise interest rates by 100 basis points, interest rates have to rise by more than that. The US Fed has in the past raised nominal rates by 150 basis points in such situations. Other central banks around the world are also found to exhibit similar responses, regardless of whether they have explicit inflation targets or not.

What does the central bank do when output is below potentail?

In this case too central banks lean against the wind. When output is below potential central banks usually respond by reducing real interest rates so as to increase demand and help expand output. There are, however, difficulties in measuring potential output and thus in this case the response of central banks often involves an element of dicretion, rather than simply following a rule.

Why has the focus of central banks shifted from output to inflation control?

It has been seen that in long periods when inflation is kept low, the booms and busts of the business cycles are much more tame. The volatility of GDP growth is lower when inflation is low and predictable. Central banks have therefore increased the focus on inflation control. In some countries there is an explicit inflation target. In others, such as in the US, the target is implicit. Most people think of a 2 percent rate as the target rate. Some central banks follow a rule such as the Taylor rule. Others use much more discretion. But one thing is increasingly becoming common among central banks of advanced countries. They try to signal that their policy of low inflation is credible. For that, various signals may be given to the market. One of the objectives of this policy is to manage expectations of market participants. When participants believe that the central bank is committed to low inflation, then in the various business decisions that get taken all over the economy, low inflationary expectations are factored in. This helps to keep investment and output stable.

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