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.

Economy Central Bank

HK ?

USA ?

Eurozone ?

PRC ?

UK, Canada, Japan, Korea

?

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

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.

Interbank Market

SBR

DBR

iIBR

Reserves

i*

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.

Equilibrium

SBR

DBR

iIBR

Reserves

i

i

i*

MONETARY POLICY UNDER FLOATING EXCHANGE RATES

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 decreases the aggregate supply of reserves.

Open Market PurchaseSBR

DBR

iIBR

Reserves

i*

SBR'

i**

Open Market SaleSBR

DBR

iIBR

Reserves

i*

SBR'

i**

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.

Fed Funds & Money Market Rates

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Domestic Monetary Policy Causes D.C. Interest Rates Go Up

Relative Demand for US$ Goes DownE

Supply

Demand

E*

Supply'

Demand'

E**

Domestic Currency Appreciates1

2

Excess Supply

Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up

E

SupplyDemand

E*

Supply'

Demand '

E**

Domestic Currency Depreciates

2

1

Excess Demand

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.

Expectation of Et+1 Increases

E

SupplyDemand

E*

Supply'

Demand'

E**

Domestic Currency Depreciates1

2

Excess Demand

MONETARY POLICY UNDER FIXED EXCHANGE RATESHong Kong’s Exchange Rate Regime

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.

US Monetary Policy Causes US Interest Rates Go Down, Strengthening Pressure on HK$

E Supply

Demand

E=7.8

Supply'

Demand'

Appreciation Pressure on HK$

1

Excess Supply

Hong Kong Interbank Market:HIBOR higher than US interest rate.

SBR

DBR

iHIBOR

Reserve Accounts

iFedFunds

i*

SBR 'Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong1

2

Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically

E Supply ' '

Demand ' '

E=7.8

Supply'

Demand'

Hong Kong Interest Rate Falls

1

Excess Supply

Fixed Exchange Rate

1 0 .Ft tt t

t

E Ei i

E

• 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.

Loss of Credibility• 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.

1HIBOR FF t tt t

t

E Ei i

E

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Overnight US$ and HK$ Interest Rates

Interbank Offered Rate: Overnight (Hong Kong) Federal Funds Rate: Month Average (United States)

Iron Triangle of International Finance

Pick 2 items from this menu

Open International Capital Flows

Independent Interest Rate

Stable Exchange Rates

MONETARY POLICY AND BUSINESS CYCLE

Operating Instruments: Target Interest Rates

• In many economies, on a day to day basis, central banks express their policy in terms of the interest rate in interbank market as an operating instrument

Fed Federal Funds RateBoJ Uncollateralized

Call Money RateECB Main Refinancing

Rate/Euribor

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

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.

Cut Policy Rate

Cut Money Market Rate

Reduce Cost of

STFinance

WeakenForexRate

Raise Asset Prices

CutBond Yields

Cheaper to BorrowInvestment increases

People WealthierConsumption Increases

Improved CompetitivenessNet Exports Increases

Consumer Purchases and Inventory Investment

Increase

Extra Liquidity Creates Extra Loanable FundsSLFDLF

LF

r*

LF*

rS′LF

r**

LF**

P

YAD

Expansionary Monetary Policy

AD′ΔI ΔC, ΔNX

P

Y

AD

An Expansionary Cycle Driven by monetary policy

P**

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

3

SRAS′

P*

P***

3. Tight labor markets. SRAS returns to long run equilibrium

2. Monetary Policy Cuts Interest Rate. The AD curve shifts out.

P

Y

AD

A Contractionary Cycle Driven by monetary policy

P**

SRASYP

AD′

1

2

Output Gap<0

1. Economy at LT YP.

3

SRAS′P*

P***

3. Slack labor markets. SRAS returns to long run equilibrium

2. Monetary Policy Raises Interest Rate. The AD curve shifts in.

Bank of England Estimates of Effect of Interest Rate

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

P

Y

AD

Demand Driven Recession w/ Counter-cyclical monetary policy

P*

SRASYP

AD′1

2

Gap < 0

3

P**

2. Economy in a recession. Fed detects deflationary pressure

3. Monetary Policy Cuts Interest Rates. AD curve shifts back to original equilibrium

1. Economy at LT YP.

P

Y

AD

Demand Driven Expansion w/ Counter-cyclical monetary policy

P*

SRAS

YP

AD′

1

Gap > 0

3

P** 2

1. Economy at LT YP.

2. Economy in a expansion. Fed detects inflationary pressure

3. Monetary Policy Raises Interest Rates. AD curve shifts back to original equilibrium

Taylor Rule• Economist named John Taylor argues that US target

interest rate is well represented by a function of 1. current inflation

2. Inflation GAP: current inflation vs. target inflation

3. %Output Gap: % deviation of GDP from long run path

• Function: Inflation Target π* = .02

*1 12 2.02 ( )TGT t

t t t Pt

Output Gapi

Y

The Taylor Rule Download

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.

Monetary Policy Lags• Monetary policy beset by lags between the time policy

shifts and time for private sector to respond to lower interest rates. Monetary policy must be forward looking.

Monetary Policy Problems

Zero Lower Bound

• Money market rates cannot be reduced below zero, because interest rate on cash is always zero.

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.

45

Inflation Reports

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

P

Y

SRASt

Inflation Pressure

ADt

Yt*

YtP YP

t+1

Forecast ADt+1

SRASt+1

Y*t+1

Pt*

P*t+1

Target Inflation

Raise Interest Rate Target at time t

P

Y

ASt

Dynamic AS-AD Model: Recession, Inflation Deceleration

ADt

Yt*

YtP

YPt+1

Forecast ADt+1

ASt+1

Y*t+1

Pt*

P*t+1Target Inflation

Gap

Demand expands slower than expected

Negative Output Gap

Cut interest rates to hit inflationtarget

Forecast Inflation

Zero Lower BoundSBR

DBR

iIBR

Reserves

i*

SBR′

i**

SBR′ ′

i***

SBR′ ′ ′ SBR′ ′ ′ ′

1

2

3 4 5

When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

Japanese Monetary Policy

CALL MONEY RATE

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Zero Lower Bound• Interest rate cannot be set below zero.

Link

Raise Inflation Target

• Cost of borrowing (in terms of

purchasing power) is the interest rate

adjusted by the inflation rate

between the time a loan is made and the time is

repaid.

51

1t t t tr i E

With zero interest rates, real borrowing rates will fall when inflation rises.

The newly-introduced "price stability target" is the inflation rate that the Bank

judges to be consistent with price stability on a sustainable basis. … Based

on this recognition, the Bank sets the "price stability target" at 2 percent in

terms of the year-on-year rate of change in the consumer price index (CPI) -- a

main price index.

Quantitative Easing/Forward Guidance• Commit to future liquidity to raise expectations of future

inflation to bring down real interest rates.

Monetary Policy Statement April, 2012

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014

Learning Outcomes

Students should be able to:• Use the supply and demand model of interbank markets

to demonstrate the effect of monetary policy on interest rates.

• Use the AS-AD model to demonstrate the effect of monetary policy on the price level and the output gap.

• Use the supply and demand model of exchange rates to demonstrate the effects of either current or future monetary policy on exchange rates.