A non-technical explanation of technical aspect of monetary policy

Mishkin in his recent speechhas explained the technicalities in monetary policy really well. The speech basically covers that financial disruptions put a strain on the entire economy. So we need better risk management systems to make better monetary policy.

In particular, the standard textbook approach to analyzing optimal monetary policy utilizes a linear-quadratic (LQ) framework, in which the equations describing the dynamic behavior of the economy are linear and the objective function specifying the goals of policy is quadratic. For example, in light of the dual mandate, monetary policy is often characterized as seeking to minimize a loss function comprising the squared value of the inflation gap (that is, actual inflation minus desired inflation) and the squared value of the output gap (that is, actual output minus potential output).

While an LQ framework may provide a reasonable approximation to how monetary policy should operate under fairly normal circumstances, this approach is less likely to be adequate for thinking about monetary policy when the risk of poor economic performance is unusually high.

Reason: black swans

Most of the quantitative studies of optimal monetary policy have also assumed that the shocks hitting the economy have a time-invariant Gaussian distribution, that is, a classical bell curve with symmetric and well-behaved tails. In reality, however, the distribution of shocks hitting the economy is more complex. In some instances, the uncertainty facing the economy is clearly skewed in one direction or another; again, this is likely when there are significant financial disruptions.

So, how should monetary policy respond to these black swan kind of events?

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible

Read the speech for further details.

Meanwhile, I was also reading this fiscal stimulus primer(the latest buzzword is to give stimulus to the economy using fiscal policy) by Douglas W. Elmendorf and Jason Furman of Brookings Institution. They say principles are the fiscal stimulus should be timely, targeted and temporary. So first two principles are similar to the one highlighted by Mishkin. The difference is perhaps in the third point where fiscal stimulus should be temporary and monetary policy flexible and change its stance as per market conditions.

Taare Zameen Par lessons

TZP is an exceptional movie by one of the best actors in Indian cinema- Aamir Khan (AK) . He has matured considerably over the years and his “one movie at a time” strategy has worked wonders for the viewers. This time he directs the movie and does a wonderful job.

This blog is not meant to review movies but I thought this movie offers important lessons in economics. In one of the scene in the movie, AK shows his frustration at the fact that every parent in India wants his kids to become doctor/engineer etc. I don’t remember whether he mentions MBA also but we can add it to the list as well.

India has a huge population and we should see varied occupations. However, in India kids often follow a beaten path.

• At school most work extremely hard to get through limited seats available in engineering (read IIT) and medicine. The non-science students who can’t try their hand at Chartered Accountancy
• The left overs go to college (it is a substantial number) and after college most try their luck at MBA (read IIM). (Earlier the fad was to try luck at civil services, now it is MBA).
• The problem becomes extremely difficult to manage as most engineers want to do an MBA. No one seems to be interested in engineering and as a result we have cries of talent shortage in key industries (I however think talent shortage can be managed)

I don’t know whether we are able to see this or not but this trend of everyone wanting to become engineer/MBA/Doctor is going to become a bigger problem. As it is this year about 2,50,000 students gave the CAT exam this year and this number has been increasing everywhere.

The reason is simple- huge (assured?) salaries after the program. Well, I understand the reward theory but this hue and cry over high salaries is insane. We need to maintain a balance and it has clearly broken over the years.

There are elite colleges all over the world and I am yet to come across any other country where so much mention is made of salaries after getting some education. The focus should always be on quality of education and not placements.

I think students already been rewarded by getting education from the best institutes in the country which are gaining credibility over the years. As Bernanke said in his speech – Education is the best investment.

The institutes should have stopped this practice of releasing “how high the salaries were this year” to the media long back. This reduces the pressure on people opting for a career.

The biggest gainer from these developments is the huge increase in cashflows of coaching institutes that help you prepare for these exams. So much so, that private equity has started taking keen interest in this business ! The once laidback coaching places are seeing flurry of activity. There is huge competition in these institutes and you see a lot of ads showcasing their success ratios etc. The media has also ensured the hype only increases. There are many a interviews of the selected candidates in various magazines and news channels.

There is an urgent need to develop and appreciate alternative careers. It just helps development of the society better. There have to be better incentives for someone wanting to become a painter, archaeologist, etc. Most of the students interested in such careers have to opt out because of lack of proper incentives. There have been some efforts lately as we now have fashion designers, sportspersons (read cricketers) etc.

More effort is needed.

Assorted Links

1. Econbrowser has an excellent post on the fsiscal stimulus debate going on in Us economy.  WSJ Blog looks at a CBO report on the same. Mankiw also comments on the CBO plan.

Meanwhile MR points to who has the best fiscal stimuls plan?  

2. Mankiw points to Greenspan-Krugman consensus. I loved his take on forecasting.

3. Rodrik points to an article on how financial firms are using sovereign wealth fund money.

4. WSJ Blog saysBye Bye Bagehot. It also points to Italy’s Mr. Prices.

5. TTR points to an economist article that says China’s economy is not export dependent. The article is here. I have my doubts though.

6. Ajay Shah says fix the price distortions at once. He also  asks whether India is a social secular democratic republic?