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Monetary Policy

Monetary Policy . Chap. 31. Implementing Monetary Policy. Central Bank : A special governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange. . Interbank Payment Systems.

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Monetary Policy

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  1. Monetary Policy Chap. 31

  2. Implementing Monetary Policy

  3. Central Bank: A special governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

  4. Interbank Payment Systems • Commercial banks keep accounts at the central bank for interbank payments. referred to generally as reserves, specifically as clearing balances in Hong Kong. • These accounts, along with cash, constitute the monetary base. Hong Kong Interbank Clearing Limited

  5. Interbank Market • Individual banks will face a short-fall in reserves if they have too many outflows and borrow funds from other banks facing a surplus. • Banks will keep an inventory of reserves to meet their own liquidity needs but the interest rate is the opportunity cost of holding reserves. • Desire to hold reserves is a declining function of the interest rate. • Central bank controls the total supply of reserves available to banks.

  6. Interbank Market iIBR SBR i* DBR Reserves

  7. Equilibrium in the Interbank Market • If interest rates are too low, banks will want to hold more reserves than available. Banks facing a shortfall of reserves will be willing to bid up interest rates until all banks are content with reserves available. • If interest rates are too high, banks will want to lend out their excess reserves. To do so in a liquid market, they must lower interest rates.

  8. Equilibrium SBR iIBR i* i DBR Reserves

  9. Monetary Policy Under Floating Exchange Rates

  10. Open Market Operations • In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves. • In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This increases the aggregate supply of reserves.

  11. Open Market Purchase SBR SBR' iIBR i* i** DBR Reserves

  12. Money Supply and Interest Rates • If the central bank engages in an open market PURCHASE, they will increase the reserve holdings of counter-party commercial banks. • This will increase liquidity in the reserve funds market. • Banks with excess reserves can lend them out pushing down interest rates in broader money market.

  13. Fed Funds & Money Market Rates

  14. Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down S Supply Supply' Domestic Currency Appreciates 1 S* Excess Supply S** 2 Demand Demand'

  15. Foreign Monetary Policy CausesForeign Interest Rates Go Up/Relative Demand for US$ Goes Up S 2 S** Domestic Currency Depreciates 1 S* Excess Demand Supply' Demand ' Supply Demand

  16. Monetary PolicyExpectations and Exchange Rates • Future exchange rates affect the expected profitability of holding bank accounts in a country’s currency. • Current level of the exchange rate guided by the future path of interest rates.

  17. Expectation of St+1 Increases S 2 S** Domestic Currency Depreciates 1 S* Excess Demand Supply' Demand' Supply Demand

  18. Monetary Policy Under Fixed Exchange Rates Hong Kong’s Exchange Rate Regime

  19. Clearing Accounts Reserves • May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.

  20. US Monetary Policy Causes US Interest Rates Go Down, Strengthening Pressure on HK$ S Supply Supply' 1 S=7.8 Excess Supply Excess Supply of US Dollars S** Demand Demand'

  21. Hong Kong Interbank Market:HIBOR higher than US interest rate. iHIBOR SBR ' SBR Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 i* iFedFunds 2 DBR Reserve Accounts

  22. Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically S Supply Supply' 1 Excess Supply of US Dollars S=7.8 Demand Demand'

  23. If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. Fixed Exchange Rate

  24. A fixed exchange rate will lose credibility if people come to believe that the central bank will: devalue the currency, (ie. raise S in the future) revalue the currency (ie. reduce S in the future) If market expects an exchange rate change, commercial banks will adjust comparison rate for the expectations of devaluation. Loss of Credibility

  25. Iron Triangle of International Finance Independent Interest Rate Stable Exchange Rates Open International Capital Flows Pick 2 items from this menu

  26. Monetary Policy and Business Cycle

  27. Operating Instruments: Target Interest Rates • On a day to day basis, central banks express their policy in terms of a single easily observed, easily controlled financial market price or quantity. • In many economies, central banks use the interest rate in interbank market as an operating instrument

  28. RBI Report of the Working Group on Monetary Policy...

  29. Dynamics of Monetary Transmission • Open market purchase reduces interest rates • Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods. • Lower interest rates increase demand for US$ in forex market depreciating the exchange rate. • Lower interest rates tend to increase asset prices which makes consumers feel wealthier. • Aggregate demand shifts out. Given fixed wages this increase in demand increases equilibrium output. • Ultimately, wage demands will increase and prices will rise.

  30. Cut Bond Yields Cheaper to Borrow Investment increases Raise Asset Prices People Wealthier Consumption Increases Cut Money Market Rate Cut Policy Rate Weaken Forex Rate Improved Competitiveness Net Exports Increases Reduce Cost of ST Finance Consumer Purchases and Inventory Investment Increase

  31. Extra Liquidity Creates Extra Loanable Funds SLF S′LF DLF r r* r** LF LF* LF**

  32. Expansionary Monetary Policy P ΔI ΔC, ΔNX AD′ AD Y

  33. An Expansionary Cycle Driven by monetary policy • Economy at LT YP. • Monetary Policy Cuts Interest Rate. The AD curve shifts out. • Tight labor markets. SRAS returns to long run equilibrium YP P SRAS′ P*** 3 SRAS 2 P** P* 1 AD′ AD Y Output Gap

  34. Bank of England Estimates of Effect of Interest Rate

  35. Interest Rate Management • In most economies around the world, the central bank does not simply act to maintain a fixed money supply. • Rather, they adjust interest rates in response to business cycle conditions.

  36. Demand Driven Recession w/ Counter-cyclical monetary policy • Economy in a recession. Fed detects deflationary pressure • Monetary Policy Cuts Interest Rate • AD curve shifts back to original equilibrium YP P SRAS AD′ 1 3 P* P** 2 AD Y Gap < 0

  37. Demand Driven Expansion w/ Counter-cyclical monetary policy • Economy in expansion. Fed detects inflationary pressure • Monetary Policy Raises Interest Rate • AD curve shifts back to original equilibrium YP P SRAS P** 2 P* 3 1 AD′ AD Y Gap > 0

  38. U.S. Central bank cuts interest rates during recessions

  39. Taylor Rule • Economist named John Taylor argues that US target interest rate is well represented by a function of • current inflation • Inflation GAP: current inflation vs. target inflation • %Output Gap: % deviation of GDP from long run path • Function: Inflation Target π* = .02

  40. The Taylor Rule Download

  41. Price Stability • Counter-cyclical monetary policy stabilizes output near potential output, YP, but also stabilizes the price level near P*. • Central banks may pursue price stability as a goal and also stabilize output as well if business cycles are caused by demand shocks.

  42. Inflation Targeting • A growing number of central banks, beginning in New Zealand in the 1980’s conduct monetary policy under the framework of “inflation targeting” • Bank states an explicit target for inflation and publishes inflation forecasts under current conditions. Policy is set in order to bring actual inflation within a range around the target. • Central bankers are judged by their ability to hit target and repeated failures may result in policymakers losing their jobs.

  43. Inflation Targeting

  44. Dyn.AS-AD Model: IT YPt+1 YtP SRASt+1 P SRASt Demand expansion matches supply expansion P*t+1 Average Inflation Pt* ADt+1 ADt Y Yt* Y*t+1

  45. Counter-cyclical fiscal policy beset by lags between the time a recession is recognized and the time the government can form consensus to act. Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates. Monetary Policy Lags

  46. Inflation Reports • Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty.

  47. Inflation Pressure YPt+1 YtP SRASt+1 P SRASt P*t+1 Target Inflation Pt* Forecast ADt+1 ADt Y Yt* Y*t+1 Raise Interest Rate Target at time t

  48. Dynamic AS-AD Model: Recession, Inflation Deceleration ASt+1 YPt+1 YtP ASt P Demand expands slower than expected P*t+1 Target Inflation Forecast Inflation Pt* Cut interest rates to hit inflation target Forecast ADt+1 ADt Negative Output Gap Gap Y Yt* Y*t+1

  49. List of Inflation Targeting CountriesRose, 2006A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

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