Circumstances where the pursuit of monetary and financial stability conflict

Daithio

Hi all,

I'm applying to the Bank of England grad scheme, and one of the questions wants me to talk about circumstances where the pursuit of monetary and financial stability may conflict. I've come up with the following situations, are there any other obvious ones which I've missed?

Quantitative easing: there was a real threat that credit would entirely freeze up, so the Bank had to move to print money to provide lenders with extra cash to lend. This will almost certainly lead to higher levels of future inflation, but the downside risk of a credit freeze superceded these concerns.

Deliberate weakening of the currency in the face of an aggregate demand shock which leads to the importing of inflation. (I have to word this one carefully as apparently a deliberately weak pound isn't a policy of their's!) But in theory this could be a circumstance where the pursuit of financial stability supercedes the pursuit of monetary stability, right? The growth in net exports could offset a negative aggregate demand shock, however this would in turn lead to inflation as retailers offset higher import costs.

What about debtflation? Could there be a situation where Government debt is so high that it is a threat to the economy as a whole, so the bank adopts a policy of targeting a higher rate of inflation for a few years to inflate away the debt? Is this getting into dodgy territory? I'm thinking they might be a bit sensitive about a graduate applicant calling into question their independence!

What about "leaning against" asset bubbles? Say if consumer prices are stable but an asset bubble is developing. I'm thinking intervention in these circumstances might be more probable in the future given recent events. I suppose the risk involved here is that through raising rates you undershoot your inflation target. Would a situation like this ever be realistic?

What if they think an asset class is undervalued? Would they ever intervene here, forfeiting their inflation target in the process?

Thanks in advance for your replies.

Flamed Diving

Do you mean fiscal stability?

Daithio

Flamed Diving wrote: »

Do you mean fiscal stability?

Nope, financial stability.

Économiste Monétaire

Don't use the phrase 'print money' in a job interview with a central bank. It's a phrase for commoners, instead say they've responded with an increase in reserve lending (central bank reserves). When the BoE lends to banks it doesn't actually print the money off and send it down the road in a truck; it's important to differentiate between physical money and central bank reserves.

Daithio

Économiste Monétaire wrote: »

Don't use the phrase 'print money' in a job interview with a central bank. It's a phrase for commoners, instead say they've responded with an increase in reserve lending (central bank reserves). When the BoE lends to banks it doesn't actually print the money off and send it down the road in a truck; it's important to differentiate between physical money and central bank reserves.

Yeah I was going to say "bought assets through the creation of new money" but your way sounds better

Économiste Monétaire

You could say they've "bought assets through the creation of new central bank reserves" . On the debtflation issue, be careful of implying deliberate inflation by the CB to transfer wealth from lenders to borrowers and move onto the topic of falling prices, real wage increases and nominal wage rigidity because workers are over-leveraged. From here you could say how central bank support could, umm, 'ease the burden' on borrowers (both personal and corporate) and thus help move the inflation rate close to the target rate while stabilising output .

Daithio

Économiste Monétaire wrote: »

You could say they've "bought assets through the creation of new central bank reserves" . On the debtflation issue, be careful of implying deliberate inflation by the CB to transfer wealth from lenders to borrowers and move onto the topic of falling prices, real wage increases and nominal wage rigidity because workers are over-leveraged. From here you could say how central bank support could, umm, 'ease the burden' on borrowers (both personal and corporate) and thus help move the inflation rate close to the target rate while stabilising output .

You make it sound so easy Yeah I am very wary about wording any debtflation issue very carefully

Économiste Monétaire

Just some more nitpicking.

Daithio wrote: »

This will almost certainly lead to higher levels of future inflation,

Not if the velocity of that money is zero. What are banks doing with the money? We often assume v to be constant and > 0 but when you have little demand for borrowing this relationship becomes muddled. Can they remove the extra reserves to avoid this inflation and balance the timing so not to cause another panic? A nice topic to cover, even the political aspects of this and how important the BoE's independence is for this.

Daithio wrote: »

What about "leaning against" asset bubbles? Say if consumer prices are stable but an asset bubble is developing.

Bingo. There's still no agreement on whether CBs can be effective in proactive measures against asset bubbles. You might want to discuss herding effects and how difficult it is for, say, Mervyn King to make statements on asset bubbles without being labelled a doom-monger.

Daithio

Économiste Monétaire wrote: »

Bingo. There's still no agreement on whether CBs can be effective in proactive measures against asset bubbles. You might want to discuss herding effects and how difficult it is for, say, Mervyn King to make statements on asset bubbles without being labelled a doom-monger.

Well there's also the issue that central banks have no more tools or knowledge at their disposal than the markets do, so how can they detect these imbalances? I read an interesting point on the ECB's website in response to this. Basically saying that yeah, CB's don't have any more tools than the markets, but the incentives are different; even if market participants know that assets are overvalued, it can still be in their interests to "ride the wave" in the face of uncertainty over when the bubble will burst.

Économiste Monétaire

Daithio wrote: »

Well there's also the issue that central banks have no more tools or knowledge at their disposal than the markets do, so how can they detect these imbalances? I read an interesting point on the ECB's website in response to this. Basically saying that yeah, CB's don't have any more tools than the markets, but the incentives are different; even if market participants know that assets are overvalued, it can still be in their interests to "ride the wave" in the face of uncertainty over when the bubble will burst.

Good point to make. Bubbles are very clear ex-post and there's a tendency for people to fall into hindsight bias. On the point of investors betting against bubbles, you might want to throw in a quip from Keynes; "The market can stay irrational longer than you can stay solvent" .

Hmm, haven't changed the questions from last year. I discussed:

1) http://www.voxeu.org/index.php?q=node/2549
2) Mandatory capital ratios(financial stability)+falling asset prices+increasing uncertainty/risk aversion > banks hoard capital > investment falls > AD falls > deflation > monetary instability
3) Monetary stability > low interest rates > firms misread permanent changes as temporary changes > take on debt instead of changing prices > inflationary signals masked > poor signals from real economy > suboptimal allocation of savings > financial instability

I highly advise reading their inflation reports and other publications as much for the style they use as the content.

Daithio

Cool, so I just submitted it there, with 10 minutes to go before the deadline. I mainly discussed quantitative easing and using monetary policy to lean against financial imbalances, and how the crisis has somewhat shifted the consensus on this. I think it was a pretty good answer. I decided to avoid anything that could be construed as controversial (eg a deliberately weak pound, debtflation) and given that they only give you 250 words I doubt they're expecting you to cover EVERY circumstance which may lead to a conflict.

Cheers for your advice illegalbutthead, I made sure to go through their publications about QE etc to ensure that I phrased it in the same way they did.

My only concern now is that even if I do get an interview, I'll be quite rusty compared to most of the other applicants, having graduated over a year ago now. Also, all my uni notes and books are in Australia, so I can't go back over them.

Economiste Monetaire, I thought you might be able to recommend a decent book for brushing up on monetary economics? I suppose the less technical the better, I think their approach is to test you on the basics, rigorously.

Économiste Monétaire

Monetary Economics: Policy and Its Theoretical Basis by Bain and Howells would be a good choice. It's written by two U.K. academics with the BoE in mind. There was a new edition released earlier this year so it's pretty up-to-date. It's relatively non-technical, it's nowhere near Recursive Macro or anything like that. Frederic Mishkin also has some goods textbooks on the area.

Daithio

Thanks man, I really appreciate it.

Daithio

OK, so I've been invited to a 90 minute analytical written test, designed to test my technical economics skills. I talked to a friend who got to this stage before, and I think the idea is that you have to write a report based on a lot of information which they give to you in a large pack; full of other reports, graphs etc.

I was wondering if anybody has ever had to do an assessment like this, and if so, how would you recommend preparing?

Thanks again for all the replies

Plan your answers. Be able to convey complicated economics in simple, concise language. Refer to the charts and numbers. Practice typing under pressure. I would highly highly recommend getting your mate to tell you what the questions were last year and preparing answers for them.

st3232

Hello,
Is there anyone here who have the experience of the analytical written test? Daithio, would you please explain the test in 2009?