Thursday, February 07, 2008

A couple of questions...

Well, as discussed before with our tutor , making an argument for a 50bps rate cut by the BoE; news came out today of only a 25bps cut (see attached Wall Street Journal article). The ECB, however, decided to leave rates unchanged, citing above-target inflation rate.

My question would be:
1. How did the ECB determine that a 2% inflation target is the appropriate level? What factors are considered in such determination?
2. The article mentions that the ECB’s mandate is to control inflation, is that its sole mandate? What about growth stimulus? It seems so one-sided.

Question #1. Politics. Or more broadly societal pressures as to what levels are acceptable. In the book In Defense of "Globalization" Jagdish Bhagwati states how different societies expect and demand inflation and growth within certain boundaries. He noted even the lower segments of the economy in India strongly oppose anything beyond a very low inflation rates. While structuralist point out that in Latin America double digit inflation rates are common without much complaining. Even now Venezuela has hit 20% annual rate at times.

From the 16th chapter page473 of the book International Finance by Keith Pilbeam states:
"Finally, the French and German governments have held differing views on the extent to which the ECB will be able to operate an independent monetary policy; the Germans preferring complete independence with the sole objective of maintaining price stability, while the French prefer a politically accountable ECB with wider objectives such as higher employment and economic growth."

The whole chapter 16 answers your question. Basically the Germans got the upper hand as the German Central Bank had the most influence on decisions.

Question #2. As far as I have read, yes sole mandate. Yes one-sided but it would be hard to meet two policy objectives with one tool. As (page 78):
"The idea that a country generally requires as many instruments as it has targets was elaborated by the Nobel Prize-winning Dutch economist Jan Tinbergen (1952), and it is popularly known as Tinbergen's instruments-targets rule."

Anyway, I am sure you will enjoy the class (if you have not taken it yet).

One thing we should notice is that capital is not perfectly mobile even with all the talk about Globalization. Otherwise the BP (IS-LM-BP) curve is horizontal and we would not see such fluctuations in rates across countries. But lastly we would want to see what the real rates or better yet the expected rates of return are across countries.

Sincerely,
Ron
(I feel claustrophobic...)

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