The Money Market &Monetary Policy

Demand for Money• Transactions demand for money to pay for

current transactions. Related mostly to the level of income.

• Asset demand for money to finance unanticipated transactions (precautionary) and to finance speculative purchases (speculative)

Demand for Money

Fig 16.4

Money

Inte

rest

rat

e

MDMD

An inverse relationship betweenAn inverse relationship betweenthe interest rate and the the interest rate and the quantity of money thatquantity of money thatpeople are willing to people are willing to

hold at any givenhold at any giveninterest rate.interest rate.

Change in r = a

movement along the

demand curve

Why does the Demand for Money curve Slope

Downwards

• As interest rates increase, the opportunity cost of holding money in non or low interest bearing forms increases. The incentive of not holding money increases or the incentive of holding money decreases.

Supply of Money

• At a point in time, the supply of money is fixed. It is not related to the interest rate.

Money

Inte

rest

rat

e

Ms

Money Market

Money

Inte

rest

rat

e

Md

Ms

r

Market equilibrium interest rate (r) occurs where quantity demand for money equals quantity supplied.

At interest rate above r, Ms > Md. Market forces drive

interest rates lower.

At interest rate below r, Ms < Md. Market forces drive

interest rates higher.

Demand conditions change

Money

Inte

rest

rat

e

Md

Ms

r

Md’

Incomes increase. Price level increases Transactions demand for money increases.

Interest rates increase.

r’

Supply conditions change

• Money supply is controlled by the RBNZ.

• Money supply is controlled through changes in the OCR and through OMO and through “Moral Suasion”.

NZ Monetary PolicyReserve Bank Act 1989

• The administration of monetary policy was passed from the Minister of Finance to the Reserve Bank.

• The objectives of monetary policy were reduced to the single goal of obtaining and maintaining stability in the general level of prices.

NZ Monetary Policy

• Policy Target Agreement (PTA) defines price stability. The % is negotiated between the Government and the RBNZ.

• PTA defines price stability as annual increases in the CPI of between 1% and 3% on average over the medium term.

Official Cash Rate

• The Official Cash Rate (OCR) is an interest rate set by the Reserve Bank to implement monetary policy, so as to maintain price stability.

• By setting the OCR, the RBNZ is able to influence short term interest rates such as the 90 day bill rate

Official Cash Rate

• When an OCR is announced - it is a percentage number - the Reserve Bank undertakes to pay financial institutions an interest rate 0.25 per cent below the OCR for money deposited in Reserve Bank settlement accounts. The Reserve Bank also undertakes to provide overnight cash to banks, charging interest at 0.25 per cent above the OCR.

Official Cash Rate

• The effect of this is that no commercial bank is likely to offer short-term loans at a rate significantly higher than the Official Cash Rate. That's because other banks would undercut that, using credit from the Reserve Bank.

Open Market Operations

• The purpose of the Bank's liquidity management operations, which comprises the daily Open Market Operation (OMO), FX swaps and Bond repurchase window, is to offset the big day-to-day fluctuations in government spending and revenue. The Bank currently targets a daily settlement cash level of $20 million through its OMO.

Open Market Operations

• The Bank prepares and maintains forecasts on the influences to settlement cash and uses these to determine how much cash to inject or withdraw on any given day. These forecasts are prepared some months ahead and are then updated on an ongoing basis, as more information comes to hand.

Moral Suasion

• The RBNZ instructs the financial markets what it would like the markets to do. Financial markets usually respond to such ‘suasion’.

• These instructions can be expressed in periodic press releases or in released MPS (monetary policy statements).

Inte

rest

rate

Money

MDMD

MSMS11

Inte

rest

rate

Money

MDMD

MSMS11

LoweringLoweringOCROCR

RaisingRaisingOCROCR

MSMS22

RBNZ OCR Changes

Fig 16.6 & 16.7

MSMS22

Loose Monetary PolicyDecrease in OCR

Decrease in OCR Bank reserves decrease

Supply of money increasesInterest rates decrease

I

C

ERX M

Higher Aggregate Demand

Increase in real GDP

Tight Monetary PolicyIncrease in OCR

Increase in OCR Bank reserves increase

Supply of money decreasesInterest rates increase

I

C

ERX M

Lower Aggregate demandReduced inflationary pressure

Decrease in real GDP

The buying and selling ofbonds by the central bank.

Open Market Operations

To increase theTo increase themoney supply, themoney supply, thecentral bank buys central bank buys

bonds.bonds.

To decrease theTo decrease themoney supply, themoney supply, thecentral bank sells central bank sells

bonds.bonds.

Open Market OperationsOpen Market Operations

Inte

rest

rate

Money

MDMD

MSMS11

Inte

rest

rate

Money

MDMD

MSMS11

Buying back bondsBuying back bonds Selling BondsSelling Bonds

MSMS22

RBNZ OMO Changes

Fig 16.6 & 16.7

MSMS22

The Business Cycle & Monetary Policy

%GDP change

Time

Economic boom

In times of economic growth, inflationary pressures are usually high. Capacity is tight, resources are fully employed, the output gap is small and there is pressure for the price level to rise.

The RBNZ employs a tight monetary policy increasing the OCR regularly. This tends to reduce inflationary pressures.

The Business Cycle & Monetary Policy

%GDP change

Time

Economic

Recession

In times of economic recession, inflationary pressures are usually low. There is excess capacity, resources are unemployed, the output gap is high and real GDP is decreasing.

The RBNZ employs a loose monetary policy decreasing the OCR regularly. This tends to boost spending and real GDP.