About the blog
The BCC blog is a space of exchange among BCC stakeholders about topics of interest in the realm of central banking. It offers a space where latest trends can be discussed, practical experiences be shared, and a BCC community be developed.
The BCC programme, funded by SECO and implemented by The Graduate Institute, Geneva aims to support partner central banks in emerging countries in building the analytical and technical expertise to conduct effective monetary policy, promote stable and efficient financial sector, and be more operationally sustainable.
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Eric M. Leeper, University of Virginia
Macroeconomists have long understood that monetary and fiscal policies at times can work at cross purposes. Sargent and Wallace (1981) offer a dramatic example of a game of chicken between the two policy authorities, with potentially bad outcomes. Fiscal policy maintains a constant primary deficit financed by new bond sales, while monetary policy independently chooses to hold the money stock fixed. Both authorities understand there will come a time in the future when the private sector refuses to absorb further bonds. Something has to give: either the government reforms fiscal policy to convert deficits to surpluses or the central bank generates seigniorage revenues to finance the deficit and interest payments on the bonds.
Many readers take only a very narrow message from Sargent and Wallace: irresponsible fiscal policy can force inflationary monetary policy. The equally narrow policy lesson is to give central banks specific inflation targets and forbid the government from interfering with monetary decisions. But there is a more subtle and more general message: the impacts of monetary policy always depend on fiscal behavior. In fact, in their example, when fiscal policy runs constant deficits tighter monetary policy today leads to higher future, and possibly even current, inflation.
In recent years, European countries, both in and out of the euro area, have been running unprecedentedly expansionary monetary policies to lift a stubborn inflation rate toward target. Policy interest rates have been negative: in the euro area since June 2014; in Switzerland since December 2014; in Sweden since February 2015. Inflation in all three regions remains below target. Why does monetary stimulus seem so ineffective?
Many explanations have been offered, from increased globalization to low world real interest rates to “bad shocks.” I offer an alternative explanation that applies the more general message about monetary-fiscal policy interactions. Fiscal policies in these European regions may be undermining monetary efforts to inflate.
When the global financial crisis hit in 2008, many countries in the euro zone adopted fiscal stimulus measures. Government debt grew during the recession—as debt always does in recessions—and with that growth came hysterical calls for drastic fiscal consolidation. By 2010, though, the crisis was declared over, and those same countries reversed their fiscal stances. The euro area fiscal stance moved from a 3.4 percent primary deficit in 2010 to a 1.3 percent surplus in 2018. Germany government debt fell from 82 to 61 percent of GDP in the same period. Switzerland has run positive primary surpluses since 2006—even during the global financial crisis. Sweden has also been raising surpluses to retire outstanding debt.
How does fiscal contraction conflict with monetary expansion? The answer lies in understanding how monetary and fiscal policies must interact for the central bank to successfully target inflation. Monetary policy actions always have fiscal consequences. When the central bank combats inflation by raising interest rates, it also raises interest payments on outstanding government bonds. Those interest payments raise the wealth of bond holders, which raises the demand for goods. Higher demand tends to push up goods prices, counteracting the central bank’s goal. Fiscal policy can eliminate this wealth effect by raising taxes to cover higher interest payments.
This fiscal backing for monetary policy operates symmetrically. When the central bank seeks to raise inflation by lowering interest rates, fiscal policy eliminates the negative wealth effect of reduced interest payments by cutting taxes.
Negative interest rate monetary policies in Europe are reducing interest payments on outstanding government debt. Instead of cutting taxes to offset the negative wealth effects of the monetary policies, governments are raising primary surpluses: both monetary and fiscal policies are acting to reduce private-sector wealth. Lower wealth tends to reduce demand for goods and, therefore, consumer prices.
European governments are simply following the fiscal rules their countries have adopted. Those rules, unfortunately, give precedence to reducing government indebtedness without incorporating the key economic insight that successful inflation targeting requires appropriate fiscal backing for monetary policy. Fiscal rules can be designed to both stabilize debt and back monetary policy.
 Wallace (1981) formally establishes this point and Tobin (1980) applies similar reasoning.
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BCC Technical Workshop on Financial Stability Framework and the Role of Central Banks - by Robert Sheehy
Robert Sheehy, BCC external expert and moderator of the workshop
The central banks’ financial stability mandate has become more important over the last decade, with the development of a battery of macro-prudential tools aimed at preventing imbalances. To share experiences on the use of these tools among the BCC countries, a technical workshop on “The general financial stability framework, with special emphasis on macro-prudential policies and instruments for which the Central Bank is responsible” was held in Bogotá, Colombia, in October 2019. The event was under the sponsorship of the Banco de la República and the BCC programme. Participants from the central banks of Albania, Colombia, Peru, Tunisia and Ukraine discussed a wide range of issues relating to financial stability and agreed on several basic principles. These are discussed below.
The institutional framework should ensure that relevant data is shared and that financial stability risks are identified and analysed. In addition, it should promote the building of consensus among policymakers on those risks, as well as on the actions needed and the appropriate mix of macroeconomic, micro-prudential and macro-prudential policies to address risks. It is important that the institutional arrangements counter the bias to inaction or delay and ensure that policymakers can act. Policymakers should be enabled to implement corrective measures by clear decision making and the necessary policy tools.
Central banks must have a key role in financial stability due to their responsibility for monetary policy, their status as lender of last resort, and their management of systemic liquidity. Some central banks are also the micro-prudential regulator and supervisor, while others provide back-up funding for the payments systems that underpin the financial sector. Most central banks have well-established expertise in the identification and analysis of systemic risk, capabilities often not available elsewhere.
Some financial stability risks cannot be adequately addressed by traditional macroeconomic or micro-prudential policies owing to externalities particular to the financial system. These include the tendency of financial firms to amplify shocks due to leverage and limited capital, the pro-cyclical feedback between asset prices and credit, and the increasing structural linkages among financial institutions. Many of these externalities are directly relevant for the effectiveness of central bank policy actions. The purpose of macro-prudential measures is to address these and other externalities not covered by traditional policy instruments.
Macro-prudential policies should promote economic efficiency and limit distortions by focusing on specific externalities not addressed by other measures. Tools that allow adjustment through prices are usually more efficient than quantitative restrictions. The general level of knowledge about the impact of macro-prudential measures is still expanding rapidly and their effects are likely to vary considerably among countries. This implies that adjustment costs should be mitigated by phasing in new measures over time, and that careful monitoring of the impact of macro-prudential policies is necessary to assess their effectiveness and calibration.
The identification, analysis and measurement of systemic risk requires the monitoring of data for a wide range of variables. The early warning characteristics of each variable should be evaluated and the most reliable indicators followed on an ongoing basis, with particular attention to signs of emerging liquidity risk. It is useful to summarize the results, but important to do so in a manner that preserves intuitive value so as to facilitate communication with senior policymakers and the general public. The overall vulnerability index employed by the Banco de la República is one way to do so. More sophisticated tools to evaluate systemic risk - such as credit-gap or growth-at-risk analysis - are a useful supplement to the monitoring exercise. Regular reporting to policymakers and the public on developments in systemic risk (e.g., through a periodic financial stability report) should be undertaken.
The design of macro-prudential policies should take into account the specific circumstances of the financial sector concerned. There is no one-size-fits-all solution, as the financial structure and associated externalities vary widely among countries. Given the developing state of understanding of the individual and cumulative effects of macro-prudential measures, it is not generally necessary to use sophisticated models to design and calibrate such tools. A more intuitive and flexible approach, supplemented by careful ongoing monitoring and analysis, is likely to be more efficient and effective.
 Historically, central banks were initially established mainly to promote financial stability.
 Banco de la República (2019), Reporte de Estabilidad Financiera – I semestre de 2019, Bogotá.
 A good description of credit-gap analysis can be found in Drehmann, Mathias, and Kostas Tsatsaronis, “The Credit-to-GDP Gap and Countercyclical Capital Buffers: Questions and Answers”, Bank of International Settlements, BIS Quarterly Review, March 2014, pp. 55-73. See Prasad, Ananthakrishnan, et al., Growth at Risk: Concept and Application in IMF Country Surveillance, International Monetary Fund, Working Paper WP/19/36, February 2019, for a general explanation of the growth-at-risk methodology and its application.
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The size of fiscal multipliers and the stance of monetary policy in developing economies - by Jair Ojeda-Joya and Oscar Guzman
Jair N. Ojeda-Joya, Banco de la Republica, Colombia