Tuesday, November 06, 2007

The Good, The Bad, and The Unpleasant Arithmetic

I can't find a good metaphor for what I'd like to blog here, so let us be a little bit more serious. But not too serious as you can still think about it, while sipping your espresso and listening to Dave Brubeck's Take Five, -the way we in this cafe make money out of you.

In macroeconomics, there are two great enemies an economy, a country, always wants to get rid of: low growth and (too) high inflation --and the other is high unemployment. Low growth is like having your pie getting bigger, yet at lower rate than your neighbourhood has. Inflation is that your money in your pocket now can not buy you a pie as big as before.

To handle a normal economy, we have two important offices: Ministry of Finance (MoF) and Central Bank. The former is more to stabilize the output (the pie) against its ups and downs, keeping it on track for an upward path. The Central Bank is responsible for money supply, maintaining the inflation rate sensible, hence, your money purchasing power.

And in standard macroeconomic model, both are well linked.

Now, enter favorite words that you may often hear as a cocktail conversation or read in newspaper: the central bank independency. The argument goes that in managing the economy, central bank's policy (on money supply and inflation rate) needs to be independent from MoF's (output stabilization). Why?

MoF policies oftentimes, due its proximity to political pressures, go for higher budget deficits (government spends more, say, on big projects or subsidies than what it gets from taxes), rely on pushing central bank to print more money --a politically induced inflation, that is. And in a corrupt country, it spurs a big business on monetary policy misuses. In this part one of this story, MoF is the bad guy. (See Alesina and Gatti, 1995)

In part two, meet the unpleasant monetary arithmetic (Sargent and Wallace, 1981). Now suppose Central Bank thinks that current inflation is higher than targeted rate, because, say, MoF carelessly raises the budget deficit. The Bank dispatches then a tight money policy (reduce the money supply). But while lowering current inflation rate, it is at the cost of future inflation rate. The catch is here: higher expected inflation rate in the future tends to raise current price level, a.k.a current inflation, as the current price level depends not only to current but also all anticipated money supply. Feel dizzy already? Don't worry, just recall: There is a good chance that the Bank's effort to curb current inflation is ineffective.

If you want, you can order another cup of Colombia supremo now, before we move on.

Now, let's get into another easier-to-imagine situation. If the Bank always want to tame inflation independently, it will react every ups and downs of price shocks. And as the latter is usually volatile, so is the money supply set by the Bank for keeping it steady. As money supply affecs the size of our pie (output) and employment, these two will be more volatile accordingly. This is bad and, here, Central Bank is the bad guy. (Rogoff, 1985)

But you may ask that earlier the bad guy is MoF. So which is which? When you are in this situation, play Sherlock Holmes with Google Scholar finding the empirical evidences. The most famous one (Alesina and Summers, 1993) says that for OECD (meaning the rich countries), central bank independency brings lower inflation and no effect in output and employment. So, the Bank is the good guy for the economy, let him be independent. Central Bank 1 - MoF 0.

OK, time out. But before you go, let me give you a question to think about: Is it really the Kebon Sirih gang better than the Lapangan Banteng's? Next time you drop by at our cafe, tell me


  1. I guesstimate every time DepKeu issues new Indon Govt Bonds, BI must ensure interest rate environment is low. Then, driving the yield up afterwards along with the entire interest rate environment for some premium. Next, pushing the yield down to repent from the "inflation sin", but then banks and investors are happy to generate profits.
    Team-up! DepKeu = premium + BI

    In Mar 04, Apr 05, Oct 05, Oct O5, Feb 07 there are 5 govt bonds issued with total nominal of USD6,000,000,000 (apprx Rp60trillion)and only one bond (Indo-17) issued on Feb 06. Pls check out the SBI graph from DiskusiEkonomi, the 5 Bonds are issued at low SBI rates.

    Anyway not being judgmental but it's a very big sin aligning state business, interest rate and market momentum. Don't you think? Even some people think interest is a sin.

  2. This post reminded me of how I only managed a 71 in my central banking midterm exam, despite feeling that I had a sufficient understanding of what Alesina and Summers, Rogoff, McCallum, Cukierman, and Kydland and Prescott, had to say.

    But, given all the superfluity of information and the contradiction viewpoints, I find myself leaning more towards an independent central bank with policies and decisions based on rules rather than discretion. It just seems more logically plausible as the way to keep inflation from rising higher than we want it to.

  3. Anymatters, interesting thought. Maybe you should write a systematic paper on that "tacit" coordination, if any, among them.

    Fik, a 71, you said? isn't it a good news, yes? :-). OK, on rule based over discretion policy, yes, everyone talk about it, too. I tend to agree with you, but somehow I still need to look at more on that issue.

    And, keep up those good writings at youthful insight.

  4. I myself am not quite sure yet what to think, because the information provided by my Central Banking lecturer also seems a bit biased in favor of independence and rules, so I also need to find other sources of indo.

    A 71 isn't bad, per se, but it was lower than my expectations and some of my friends' scores, so to put into needlessly complicated terms, it was the relative rather than the absolute result that's getting me down, hehe.

    As for Youthful Insight, thanks for reading, Pak. We're constantly expanding, and I expect the writings should be pouring in from the new recruits soon. Please keep reading, and do comment if you have time. Thanks!