It would be a rational expectation that as real interest rate increases, consumption and investment expenditures, that is, demand and production, will decrease, and vice versa.

I would like to continue with the new monetary policy series straight. Today I will discuss how to revise the monetary policy focused solely on price stability in a way that it regards both price and financial stability. I will call the former monetary policy based on price stability “the classical monetary policy.” This might refer to the classical inflation targeting regime as well as the policy the Federal Reserve (FED) implements. Under the classical policy, the objective of the central bank involves inflation gap and output gap. Inflation gap refers to the difference between the actual inflation and targeted inflation rate, and the output gap refers to the difference between the actual level of output and the potential level of output. A central bank implementing this regime aims to keep inflation close to the target and output close to the potential.

The economic theory offers conditions unique to countries or country groups with respect to the change in inflation and output. The theory suggests that there is a relation between real interest rate and the level of output. This relation stems from demand. It would be a rational expectation that as real interest rate increases, consumption and investment expenditures, that is, demand and production, will decrease, and vice versa. Moreover, if the difference between domestic interest rate and foreign interest rate increases, domestic currency appreciates in real terms, when risks are kept constant. This in turn lowers exports and increases imports, reducing the demand for domestically produced goods. On the other hand, in which direction inflation rate will change depends on the difference between the expected inflation and output gap, revealing the relationship between the level of demand and output, and inflation rate. 

Therefore, any change a central bank introduces on the real policy rate affects the level of output as well as inflation. One might ask how a change in nominal interest rate could affect the real interest rate. It is true that the central bank chances the nominal rate. But this will have an effect on the real interest rate as well if inflation rate and inflationary expectations are not influenced immediately.

Then, the question shall be revised as follows: How should the central bank revise the policy interest rate so that it serves the purpose? The models in the literature of economics suggests under which circumstances policy rate shall be changed: when inflation rate exceeds the target (the hike of the inflation gap), when output level exceeds the potential (the hike of the output gap), and a rise in the real interest rates across developed countries.

I will call the policy that will target price stability and financial stability simultaneously “the new policy.” There is no consensus on the characteristics of this new policy; we are still in search. A considerable portion of these proposals suggest a three-variable objective function for central banks. In addition to the objectives to minimize the output gap and inflation gap under the classical policy, central banks aim to minimize a third gap, hereinafter “the financial gap” under this new policy. This gap can be defined as the difference between the pace of credit growth and the “normal” pace of credit growth or you can add to the picture the deviation of real exchange rate from the equilibrium.

The bank therefore assumes that the level in demand will depend on rapid credit expansion or other similar macroeconomic variables as well as the above mentioned variables. Financial variables as the level of credit supply can be influenced by macro-prudential policy tools such as the reserves banks are required to keep to extend credits. Solving this new framework, we identify how central banks have to decide at which point to set the policy tools (at least two): real policy interest rate and macro-prudential policy tool. I will continue on Thursday.

This commentary was published in Radikal daily on 24.01.2012