Credibility and reputation

The issues of credibility and reputation of monetary authorities were introduced by the "New classical economists", in order to develop additional arguments in favour of monetary policy rules and against the use of discretionary policies. Their main goal was to show that an "inflation bias" emerges in cases where monetary policy is discretionary. Monetary authorities are said to be credible if private agents believe in their commit- ment to price stability. Kydland and Prescott (1977) showed that it is in the best interests of central banks to announce a low-inflation policy and then, if private agents believe in the policy announced, to switch to a higher-inflation policy in order to temporarily reduce the rate of unemployment. As a matter of consequence, central banks will have a credibility issue, because rational agents will not believe them.

This credibility issue raised by Kydland and Prescott (1977) can only arise under very restrictive theoretical circumstances: central banks have to make their decision first before private agents can react, the game needs to be a one-shot one, and agents as well as the central bank must have full information and must not cooperate.

Credit bubble

A credit bubble is a sustained and accelerating growth of bank loans relative to the growth of Gross Domestic Product (GDP), which finances a boom in both economic activity and in asset prices. The proposition that this growth of credit adds to demand - especially for financial assets - above and beyond that generated from existing incomes contradicts the "loanable funds" vision of lending in which loans are "pure redistribu- tions" which "should have no significant macroeconomic effects" (Bernanke, 2000, p. 24), as lending simply redistributes spending power from lender to borrower without enhancing aggregate demand. However, in the endogenous-money view, lending enables demand to increase in the aggregate, thus financing a growth in economic activity and rising prices on asset markets. Prior to the global economic and financial crisis that erupted in 2008, the dominant view in economics was that the proposition that "credit bubbles" had any macroeconomic significance was a figment of the imaginations of non- economists. The Modigliani-Miller theorem (Modigliani and Miller, 1958) - the relevant subset of the efficient markets hypothesis - argued for the irrelevance of credit to both the valuation of firms (except for the effect of the tax-deductibility of interest payments) and economic performance. The proposition that there could be a "financial accelera- tor" (Bernanke et al., 1996) gave conventional theory an argument as to how credit could impact on economic activity, but this mechanism relied on agency costs owing to asym- metric information and acted through the price of credit rather than its volume.

Deleveraging

Deleveraging is the process by which either economic units (taken individually) or the economy as a whole get rid of their debts. The most obvious way of carrying this out is by repaying existing debt, which should result in the aggregate stock of debt decreasing. However, while debt may fall in nominal terms, the attempt to deleverage - that is, to repay debts accumulated in the past - can increase the burden of debt in real terms.

According to Fisher (1933), repaying the debt implies a decrease in the means of payment in circulation and therefore a fall in the price level. This logic is based on the quantity theory of money. As a result, this fall would increase the debt in real terms; during a crisis, therefore, the attempt to repay debt would result in a larger debt. This means that if all units simultaneously try to deleverage, a debt deflation could occur, resulting in a self-defeating exercise.

Flow of funds

The flow of funds (or financial account) is a system of accounting that records all finan- cial transactions of an economy. Bookkeeping both the financial stocks and flows, it tracks the sources and uses of funds for each institutional sector and for the economy as a whole. The flow of funds is one of the key instruments in national accounting together with the national income and product account, the national balance sheet, and the input- output matrix. It is one of the primary components of the System of National Accounts (SNA) of the United Nations. First published in 1953, the flow of funds was incorpo- rated within the SNA in 1968.

Core inflation

There are several measures of inflation. The official measure - that is, the rate of change in the Consumer Price Index (CPI) in most countries - is also referred to as "headline inflation" owing to its ability to make news headlines. Headline inflation, however, is often subject to large and temporary fluctuations arising from supply shocks, for example production declines due to unfavourable weather conditions or external factors affecting the prices of one or more consumer goods imported into a country. Another measure of inflation aims at removing these volatile components from headline inflation. The concept of core inflation is based on the idea of identifying the underlying persistent trend of inflation.

There are multiple approaches to derive core inflation from headline inflation. Among them, the most widely used approach is excluding selected groups of items from the basket used to compute headline inflation and recalculating the weighted change of prices of the remaining items in the basket. Food and energy items and interest charges are the most popular exclusions. The exclusion method is used by central banks more frequently than other methods, as that method is computationally simple, easy to understand and derivable without any time lag.

Draghi, Mario

Mario Draghi (1947-) is an Italian economist who has held and holds important politi- cal offices. At the time of writing, he is the President of the European Central Bank (ECB).

Draghi's vision of economic policy is partially, but significantly, influenced by Keynes's theory, although he explicitly affirmed that monetary policy "can become an effective, stabilising factor and contribute to collective prosperity in an independent and active way" only if monetary policy decisions are built "into a systematic and predictable strategy, based on price stability, which drives expectations and guides the economy but doesn't shock it" (Draghi, 2012a).

After receiving a Jesuit secondary education, Draghi graduated in 1970 from the University "La Sapienza" in Rome, under the supervision of the Keynesian economist Federico Caffé - the revolutionary reformist who suddenly disappeared in 1987 - and with a dissertation entitledEconomic Integration and Variation of the Exchange Rates, in which he criticized the project of the single European currency (see Draghi, 2012a, minutes 25:00-25:22). He received a PhD from the Massachusetts Institute of Technology in 1976 under the supervision of Franco Modigliani and Stanley Fisher. During the 1980s, Draghi taught economics at the University of Florence and worked for the Inter-American Development Bank and the World Bank in Washington, DC. In 1990, he was hired as economic advisor at the Bank of Italy.

Currency crisis

A currency crisis is a form of financial crisis marked by the abrupt devaluation of a nation's currency ending a period of fixed or pegged exchange rates. A sudden shift in international asset portfolios, with its rapid reversal of capital flows, is the proximate cause of a severe collapse in the external value of a nation's monetary unit. And most would agree that all such events are characterized by "investors fleeing a currency en masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated" (Krugman, 2007, p. 1). While investor action driven by a fear of a crisis drives the actual crisis, the dramatic change in the external value of a nation's currency defining the actual crisis implicates a nation's macroeconomic accounts, particularly its fiscal deficit, sovereign debt, and balance of payments.