MONETARY POLICY Chap. 31

MONETARY POLICY & INTEREST RATES

• Central Bank: A special

governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

Economy Central Bank

HK/Singapore

USA

Eurozone

PRC

Canada/Japan/KoreaIndia/NZ/Australia

Monetary Authority

European Central Bank

Federal Reserve

People’s Bank of China

Bank of ?

Reserve Bank of ?

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*

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 Purchase

SBR

DBR

iIBR

Reserves

i*

SBR'

i**

SBR'

i**

Open Market Sale

Excess Liquidity in Interbank Market pushes down interest rate.

Liquidity shortage in Interbank Market pushes up interest rate.

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.

Korean Money Market

2004

0701

2004

1201

2005

0501

2005

1001

2006

0301

2006

0801

2007

0101

2007

0601

2007

1101

2008

0401

2008

0901

2009

0201

2009

0701

2009

1201

2010

0501

2010

1001

2011

0301

2011

0801

2012

0101

2012

0601

2012

1101

2013

0401

2013

0901

2014

0201

2014

0701

0

1

2

3

4

5

6

7

8

Call Money Rate

KIBOR 1 week

6 Month KIBOR

1 Year Treasury

3 Month NCD

3 Month Commercial Paper

Source: CEIC Database

Monetary Base

• Money that can be used to finalize transactions: Currency+ Reserves

• Bank of China, HSBC, and Standard Chartered print banknotes under licenses called Certificates of Indebtedness

Exchange Fund: Liabilities: Certif icates of Indebtedness

150000

200000

250000

300000

350000

400000

Aug-0

8

Feb-0

9

Aug-0

9

Feb-1

0

Aug-1

0

Feb-1

1

Aug-1

1

Feb-1

2

Aug-1

2

Feb-1

3

Aug-1

3

Feb-1

4

Aug-1

4

Mill

ion

s H

K$

Certificates of Indebtedness increase when currency increases

Money Supply vs. Monetary Base

Monetary

Base

Money

Multiplier

Money

Supply* =

Categories of Broad Money

M1 Currency + Checking Acct.

M2 M1 +Savings Acct.+ “More Liquid” Time Deposit

M3 M2 + “Less Liquid” Time Deposit

M1

M2

M3

Money Multiplier• The money multiplier can be derived by the ratio of money to

the monetary base.

• As long as the reserve ratio is less than 1, the money multiplier is greater than 1.

• Multiplier is decreasing in reserve-deposit ratio and decreasing in cash-deposit ratio.

1CashMoney Cash Deposits Deposits

Cash ReservesBase Cash ReservesDeposits Deposits

Fractional Reserve Banking

• Banks keep only a fraction of any deposits they receive on hand in the form of vault. The rest is used to acquire other assets, especially loans.

• Regulatory Requirements – Some regulatory regimes have minimum reserve levels.

• Most developed economies have either rr= 0 (e.g. HK) or modern banking techniques make them non-binding.

Reserve Ratio = Required Reserves Ratio + Excess Reserves Ratio

(Reserves/Deposits) = rr + ER/Deposits

Monetary Policy China

• PBoC uses frequent changes in rr to manage liquidity in the banking system.

China's Evolving Reserve Requirement, BIS

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15

20

25

The People's Bank of China Required Reserve Ratio

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

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.

35

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 Bound• In theory, interest rate cannot be

set below zero.

Link

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.

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.

40

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

Switzerland Sets Deep Negative Rate

Challenges to Monetary Policy Effectiveness

42

Link

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Swiss Money Market

Policy Rate: Month End: Overnight Average Rate: SARON Call Money Rate: Swiss National Bank

PUZZLE: Why can interest rates be persistently negative?

Commercial banks may be willing to hold reserves that pay negative interest since:(1) Reserves may be more convenient than paper

currency in making payments.(2) Currency may have large holding costs

US$1Million US$1Trillion

Central BANK SETS NEGATIVE Deposit facility

S

D

iIBR

Reserve Accounts

0

iLF

iDF

MRO

i*

FISCAL POLICY

Chapter 30

Government Accounts

Outlays

Spending• Expenditure on Goods &

Services• Employee Compensation

• Transfer Payments• Retirement Benefits• Unemployment Benefits

• Interest Expense

Receipts

Revenues• Direct Taxes

• Profits• Personal Income

• Indirect Taxes• VAT• Sales Taxes

• Fees• Interest Income

Average OECD % of Revenue

Income and profits as a percentage of total taxation

Social security as a percentage of total taxation

Payroll as a percentage of total taxation

Property as percentage of total taxation

Goods and services as percentage of total taxation

Other tax revenues as a percentage of total taxation

Budget Deficit• Governments in most economies issue debt to make up for shortfalls in revenues in relation to spernding.

Budget Deficit = Outlays – Receipts

• Tax collection is cyclical so the budget deficit tends to be counter-cyclical. Y

Revenue

Outlay

YP

Structural Deficit

Yt

Output Gap

Deficit

Cyclical Deficit

Cyclical Deficit

Policy Lags

• Recognition: Lag in observing economic conditions

• Implementation/Law-Making: Lag in adjusting policy

• Impact: Lag in response of economy to policy

• Fiscal Policy has long implementation lags.

• Monetary Policy has long impact lag.

Multiplier Effect• Government spending has a more than 1-for-1 effect on

Aggregate Demand. • Circular flow of income

Multiplier Effect: Feedback Loop

Income

Production

Savings

Consumption

Government spending increases production to fill gov’t contracts.

Firms hire workers and pay more wages

Workers income rises and they increase spending

P

Y

AD

Expansionary Fiscal Policy

**

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

3. Income expansion leads to consumption expansion.

2. Government increases spending by ΔG. The AD curve shifts out.ΔG

ΔG ΔC

ΔC

Automatic Stabilizers•Taxes are usually collected as a fraction of incomes of households. Even if the government keeps the tax rate unchanged.• When the economy goes into a boom, taxes are automatically raised mitigating the effects of the boom.

• When the economy goes into a recession, taxes are automatically cut, ameliorating the recession.

2007 2008 2009 2010 2011 2012 2013

Gross Debt 74.57 80.52 92.13 97.91 102.1 108.12 109.26

Net Debt 38.07 43.19 51.35 55.77 61.02 65.02 65.26

10

30

50

70

90

110

OECD Countries

% o

f G

DP

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 Taylor rule to benchmark monetary policy. • Use the AS-AD model to identify the effects of fiscal

policy.• Identify the elements of government budget.