Unanticipated and Anticipated Monetary Policy - Research Paper Example

Econometric Research paper: Does Unanticipated and Anticipated Monetary Policy influence Real GDP? Submitted by……………………………………………………… Introduction This paper evaluates whether anticipated or unanticipated monetary policy changes influence real GDP or the unemployment rate. We used historical data on U.S real gross domestic product and various money measures so as to meet the objective of this paper. According to Barro (2008), an example of the crucial aspects of the new conventional approach to macroeconomics that began in the 1970s is the difference between the actual impacts of anticipated and unanticipated alterations in nominal variables, for instance money supply. Gwartney (2009) argue that what will affect money and employment is the unanticipated monetary policy shocks or surprises. Conversely, economists, especially those in the Keynesian culture emphasize that the unexpected monetary policies are what have great impacts on the economic situation of any country. In relevance to the analysis on macroeconomics, one of the serious issue is the real influence of both unanticipated and anticipated monetary policy. A comprehensive study on the topics affirms to the relative significance that it receives. For quite some time, progress in both the theoretical and empirical fronts acted as a basis for an appropriate analysis on the effect of anticipated and unanticipated policy shocks in the real economic sector of a country. Similarly, the crucial transformation in the behavior of the policy of financial issues have significant consequences in the study of anticipated and unanticipated monetary policy since two decades ago. Targeting inflation requires that the central banks make public the inflation targets that they should be able to attain in a given duration. As a result, in regards to this context, the economic agents have the capability to undertake actions concerning anticipated monetary issues. Subsequently, this resulted to better accomplished expectations that gave rise to a substantial drop in both the level and unpredictability of inflation rate. This essay reexamines the debate on the actual consequences of anticipated and unanticipated policy shocks. The aim is to offer a well-founded understanding of this concern about the central banks. As a result, this will expectantly result to a better perception of the way that central banks are using towards a more approachable and effective behavior of monetary policy. In addition, this article is structured as follows: the next section offers a short review of the literature on business cycle frameworks and the debate on anticipated and unanticipated monetary policy shocks. The third section describes a partial look at the inflation targeting in the Philippines. The next section offers an empirical justification of the real effects of anticipated and unanticipated money shocks in the Philippines case. This is followed by the fifth section that acts as a conclusion. Hypotheses According to the objectives of the study, this article has come up with and intended to test out the following hypothesis: Ho : Real GDP of a country will only be affected by the anticipated monetary policy shocks. H1 : Real GDP of a country will not only be affected by the anticipated monetary policy shocks but also unanticipated monetary shocks. Literature Review Classical economists have confidence in the distinction between nominal and real variables. Variations in nominal variables, that is supply of money has no effect on real variables, for example output and employment in a long term basis. Consequently, money is regarded to be neutral due to the fact that it only has an effect on the level of pricing but not on the prevailing economic variables. Conversely, Keynesians do not support the idea of classical distinction between nominal and real variables. Assumption on inelasticity in the economy is what acts as the basis of their argument. The Keynesians argue that prices and remunerations slowly adjust in the short-run because fluctuations in the supply of money causes aggregate demand and also affects the other real macroeconomic variables. The supposed distinction between nominal and real variables raises the question as to whether there are real effects on monetary policy. Arnold (2014) on his work, the author illustrates sensible prospects and how money is neutral and acts as a basis for the progress of micro-founded monetary business cycle aspects that examine the connection between money growth and economic development. Sensible expectations suggest that those employed by the firms ought to maximize on the usage of the available information in an attempt to develop projections of the price levels and remuneration rates that can succeed in the economy. According to Parkin (2002), it is difficult to experience systematic errors in the prediction of the future and that any variations from ultimate predictions are unplanned. Lucas argues that, with rational foresights, there cannot be any change in the actual GDP in a systematic or predictable manner so long as there is existence of anticipated monetary policy. Arnold (2014) also agrees with the authors like Barro (2010) in the implication that movements of output far from the normal level advocates for a shock. Effect on the output can only occur if the monetary authorities create a shock and not through an anticipated alteration in monetary policy. In the model given by Arnold (2014), it is obvious that the market agents have no capability to immediately give a distinction as to whether the changes in the prices from unanticipated growth in the money levels are either general or relative. If firms observe the variation in the prices as a being a relative change, as a result, the firms would increase the rate in production with the anticipation that there has is an increase in demand for their commodity. In addition, it would imply that the firm has to hire more employees. Nonetheless, higher demand for workers put pressure on remunerations to increase which increases the cost of production. With an increase in demand for resources to be used in production the result would be an upsurge in the commodity prices. With continuing rise in the salaries and wages, and prices, it implies that the market agents start to understand that the change in prices is a general variation and thus the production level should be adjusted to its previous state. Thus, in a short term basis, the unanticipated change in money resulted in greater increase in the output, which cannot, nonetheless, be sustained in the long term basis. METHODS AND DATA From FRB and BEA web sites, we collected quarterly real GDP and certain money measure such as M1, M2, and MZM. These money measure were deflated. We developed an analysis model so as to give an illustration how these money measures affect real GDP growth rate. The summary of this research was basically set on the above factors. The dependent variable was log series of real GDP growth rate and the independent variables were log series of M1, M2 and MZM. Data was organized as quarterly series and a regression analysis was done using STATA. The theoretical concept to look into the determinants of real GDP growth rate were done using the changes that took place in log series of money measure. As such, the model of the research was as shown below: lngdpt = α + β1lnM1t  + β2lnM2t + β3lnMZMt + ut…………………………………………..….(model 1) Where; lnM1t represented log series of total physical currency of bank reserves plus the money in demand accounts, that is, “current” or “checking" accounts at time t; lnM2t represented log series of M1 plus most money market accounts, savings accounts, small denomination deposits, and retail money market funds at time t; lnMZMt represented money of zero maturity at time t. It was a measure of supply side with regard to financial assets redeemable on demand; α represented the autonomous change in real GDP; and ut represented the error term at time t. Results and Discussion A plot of U.S quarterly historical real GDP data since 1982 gave as an impression that real GDP has been growing steadily (see graph 1). Such a steady growth can be explained in line with arguments put forward by economists, especially those in the Keynesian culture. The school of thought associated with Keynesian emphasize that the unexpected monetary policies are what have great impacts on real GDP growth or economic situation of any country. For a long time, the progress in both the theoretical and empirical fronts acted as a basis for an appropriate analysis on the effect of anticipated and unanticipated policy shocks (money supply) in the real GDP growth of U.S. Moreover, the results of our regression analysis revealed that the different money measures significantly influence real GDP. Table 1. Gives a summary statistics for the regression analysis. Table 1. Summary statistics for the regression analysis. Dependent Variable (lngdp) Coefficients Std.Err t value Critical value lnM1 0.4884 0.05979 8.17 0.000 lnM2 0.2083 0.06562 3.17 0.002 lnMZM 0.3709 0.1286 2.88 0.005 Constant 0.2350 0.1592 1.48 0.142 Observations 132 R2 0.9685 From the regression results, we could say that when M1 increases by one unit, real gross domestic product increases by 48.8%. Similarly, when M2 and MZM increases by one unit each, real gross domestic product increases by 20.8% and 37.09% respectively. As such, the relationship between money supply and real gross domestic product is a significant positive relationship. Moreover, we rejected the null hypothesis, Ho since the t-statistic, for all money measures, were greater than the corresponding critical values. This implied that both unanticipated and anticipated monetary shocks positively influences real gross domestic product. However, unanticipated monetary shocks does not heavily influence real GDP as is the case with anticipated monetary shocks. Looking at our R2 of 0.9685, we could confidently say that our data fitted the model at 96.85%. This meant that the money measures used in the model explained our dependent variable (real GDP) almost perfectly (96.85%). From Table 2, it is evident that there is a very strong positive correlation between money measures M1, M2 and MZM. This implied that all the variables move in the same direction, that is, if, for instance, M1 increases then M2 also increases. Table 2. Correlation matrix Variables lnM1 lnM2 lnMZM lnM1 1.0000 lnM2 0.8979 1.0000 lnMZM 0.9577 0.9686 1.0000 The difference between effects of change in anticipated and unanticipated in nominal variables is one of the ongoing matters in the research of macroeconomics. Our research just confirmed the findings of some previous studies such as Walsh (2003). Some economists hold the idea that only unexpected monetary policy can have an effect on the output and employment while some economists, especially those of the Keynesian, argue that anticipated monetary policy shocks, just as the unanticipated also affect the economy. This matter is key to central banks because it has crucial penalties in the behavior of the monetary policy. The central banks that embraced the inflation targeting started during the 1990s. This resulted into crucial effects for the debate regarding the anticipated and unanticipated monetary policy shocks. For example, the monetary shocks are well anticipated, and the usage of strict monetary policy in Information Technology. The central banks are protected from the con of discretionary policy formulation by the use of the inflation targeting. In addition, the same safety measures protect the private sectors and assists the private sector to be more precise in anticipating forthcoming policy which improves the efficiency of the policy. Such loyalty to a strict monetary policy restricts usage of unanticipated money surprises to handle economic recessions. Supposedly the unanticipated shocks are substantial enough, then they can anchor the expectations of inflation that could result into lifelong alterations in the long term trend of inflation (Tucker, 2014, pg. 39). The crucial trait of using central banks is shown in the latest research conducted on anticipated and unanticipated policy shocks; which is the critical obligation of the communication strategy of the central bank. The efficiency of a central bank in publicizing its policy that is transparent communication, mainly affects its capacity to handle prospects and to produce greater economic benefits. Unanticipated money shocks resulted into higher production gap and lesser levels of inflation and policy amount as related to the anticipated situation in the short term. Similarly, the nominal exchange rate changes gradually under the unanticipated circumstance. These research findings are reliable as compared to the observation made in the literature that unanticipated money shocks cause real benefits in the short duration. However, the real aftermath of unanticipated money shocks are not sustainable in a long term basis. The final produce begins to drop to its previous state though inflation rate is on a higher level. These results are in line with the summary given in the literature that actual benefits from the use of unanticipated shocks are seen only in the short duration but the subsequent effects of inflation continue in the long term basis The outcomes of the simulation also revealed that anticipated policy shocks can result into actual impacts in the consequent period. Output niche is greater during the quarters of decreasing policy rate, especially in the initial four quarters. This discovery can act as a reflection on the capability of central bank to appropriately inform the public of its policy resolutions and the optimistic performance of market agents. Upcoming research can contemplate into considering more observation and substantiate the actual effects of anticipated policy surprises in inflation targeting. Economists argue that short-term, anticipated shocks occurs when people properly expect inflation, in the short term, an extensive but restrictive monetary policy will result into and rise or drop on prices. Actual output and employment will be constant. There will be an increase in the nominal interest but with a constant rate on the real interest. Long-term anticipated is when an extensive but restrictive monetary policy results into an increase or decrease the in the inflation rates with a consequential rise or drop decrease in the rates of nominal interest. Monetary policy is not affected by actual rates on interest, level of employment, and the output. Unanticipated restrictive monetary policy result into a rise on the real interest rates, lowering rate on inflation, and at the same time reducing the employment and a subsequent decrease on the output. In case the economy is operating at an optimal than full employment, then it is appropriate to embrace this kind of a policy. Extensive monetary policy results into rise in both the rates of inflation and nominal interest, with no positive change on the real interest rates, real output and real employment. An important point to remember is that, in the long run, inflation is the primary effect of expansionary monetary policy. Opportunity costs results in cases of holding money that could be invested in other areas and earn interest. Though the money is kept in a bank account that is earning interest, like in this case a checking account; an increased interest rate can possibly be earned by buying financial tools such as bonds. The interest rates and opportunity cost of money are proportionally related. As a result, as the interest rates rises falls, the possibility of the people to hold cash will be less or more. The central bank in Canada or the Federal Reserve in the United States are the sole bodies charged with the responsibility of supplying of money to the economy. It is important to note that the expected money supply is inversely related to the rate of interest. A graph for the supply and demand for money, with interest rate being the constraint, would be more or less the same as shown in the figure 1. Figure 1.Money supply and Demand Interest Supply Rates Demand Quantity of Money The assumption in drawing this graph is that the other constraints are kept constant. An increase in the quantity of production of goods and/or an increase with the price level, this results into an increase in the demand for money. The effect of this is that there is a substantial shift to the right of the demand curve. In a situation when there is a decline in the economic activity, the result will be a fall in the demand for money. Changes in the availability of financial tools are also affecting the demand for money. The extensive accessibility of credit cards has reduced the level of money that households require to have as disposable cash. Conclusion This paper has inspected whether anticipated or unanticipated monetary policy changes influence real GDP or the unemployment rate. We have used historical data on U.S real gross domestic product and different money measures in order to meet our objective. We found out that when M1 increases by one unit, real gross domestic product increases by 48.8%. Similarly, when M2 and MZM increases by one unit each, real gross domestic product increases by 20.8% and 37.09% respectively. As such, the relationship between money supply and real gross domestic product is a significant positive relationship. In general, this affirmed that both anticipated and unanticipated monetary policy changes influence real GDP. Bibliography Arnold, R. A. 2014. Economics. Melbourne, Vic.: South-Western Cenage Learning. Barro, R. J. 2008. Macroeconomics: A modern approach. Mason: Thomson. Barro, R. J. 2010. Intermediate MACRO. Mason, OH: South-Western Cengage Learning. Gwartney, J. D. 2009. Macroeconomics: Private and public choice. Mason, OH: South Western Cengage Learning. Henderson, D. R. 2008. The concise encyclopedia of economics. Indianapolis, Ind: Liberty Fund. Miller, R. L. R. 2004. Economics today: The macro view. Boston: Pearson/Addison Wesley. Parkin, M. 2002. Macroeconomics. Reading, Mass. [u.a.: Addison-Wesley. Rush, M., & Parkin, M. 2005. Study guide [to accompany] Macroeconomics, seventh edition [by] Michael Parkin. Reading, Mass. ; London: Pearson Addison-Wesley. Tucker, I. B. 2014. Economics for today. Walsh, C. E. 2003. Monetary theory and policy. Cambridge, Mass. [u.a.: MIT Press. Read More