Market Power and the Macro-Economy – A Simulation Approach  Having assessed some evidence on the evolution, and macro-economic implications, of increased mark-ups and market power, the next question is what implications these may have for the setting of monetary policy. This does not appear to have been an extensively examined area of research, whether among academics or 17  policymakers. What follows is an initial exploration of some of the potential channels. One simple way of beginning to gauge how a rise in mark-ups might affect the economy and monetary policy is to simulate their impact using a macro-economic model. For this purpose, we model the economy using the Bank of England’s in-house DSGE model, COMPASS. Taylor rule, with interest rate smoothing. 19  18  Monetary policy is assumed to follow a simple  The simulations are shown for a variety of different values of the  relative weight policymakers place on output and inflation deviations from target in the Taylor rule. Chart 13 considers the impact on inflation, the output gap and monetary policy of a temporary mark-up shock that delivers a one percentage point increase in annual inflation. The dynamics of the economy are largely as we would expect following an adverse supply shock. The inflation rate rises, and real GDP usually contracts, in both cases temporarily. Although temporary, these disturbances are often material and always persistent, despite monetary policy acting to damp these fluctuations. The reason monetary policy struggles to damp these fluctuations is because a mark-up shock is trade-off inducing.

A major step forward was taken last year in the concurrent stress-testing of banks across Europe. This followed the successful practice first adopted in the US in 2009. Concurrent stress-testing of the whole banking sector allows both top-down and bottom-up perspectives to be brought to bear when assessing individual firms’ risks. This opens up the possibility of taking seriously complex behavioural interactions, both within the financial sector and between it and the wider economy. For example, a capital-deficient firm might withdraw funding and cause wider liquidity pressures for other banks. Or a sequence of capital-deficient banks might contract lending in a credit crunch, thereby damaging the wider economy and feeding back negatively to other banks’ portfolios (Haldane (2009)). Yet it remains early days in the development of stress-testing technologies. A system of systems perspective could be useful in enabling stress-testing technologies to better capture system-wide risks. For example, interaction and feedback channels could usefully be built into future stress-testing frameworks used by central banks, including the Bank of England, the Federal Reserve and the ECB. At the next level of policy resolution, a key area of progress in the post-crisis period has been in developing the macro-prudential framework and the instruments necessary to execute it (IMF (2013)). Many countries internationally now have a macro-prudential framework in place. And international case law on the efficacy of different macro-prudential tools is being built rapidly (IMF (2013)). Nonetheless, there is much further to go in understanding and calibrating the impact of macro-prudential tools.