Updates
Demand Functions
• An algebraic equation representing
demand as a function of the price plus
consumer income levels and other factors

Q  Q P, Other Factors
D

• Example:
Linear:
QD = a – b × P
Exponential: QD = A × P-b

A demand curve is classified as INELASTIC if
the elasticity is between 0 and 1
Unit elasticity (elasticity equal to 1) is
the cutoff point
A demand curve is classified as ELASTIC if
the elasticity is greater than 1
Monetary Policy & Exchange Rates
• The central impact of the foreign currency
intervention is on domestic interest rates.
• Monetary policy that shifts domestic interest
rates will also shift exchange rates regardless of
whether it occurs through currency
intervention, OMO, or some other change in
quantity of bank reserves.
• Monetary policy that does not shift interest
rates will not shift exchange rates.
Notes on Price Indices: Quality
• Some categories of goods (computers, cars) observe
marked changes in quality over time.
• Price growth rates for these components often reflect
the price growth for certain characteristics (e.g.
MHz,GB HD, etc.). These are referred to as hedonic
price indices.
Problem
• You are a Chinese multinational that wants to
construct salaries to be paid to employees in
Canada that will provide same living standard
as salary of RMB20,000.
• Canada PPP in 2005 is 1.21.
• Some (Anglophone)
developed countries
have high job
separation rates but
high job finding rates.
• Developed Asian
markets typically have
lower job separation
rates and lower natural
unemployment.
Unemployment Dynamics in the OECD, 2008
Michael Elsby, Bart Hobijn, Aysegul Sahin
http://www.nber.org/papers/w14617
Japan
finding
seperation
19.30%
0.60%
Germany
Italy
France
6.00%
4.10%
7.80%
0.50%
0.40%
0.80%
Australia
USA
22.30%
57.50%
1.70%
3.60%
Continental countries have low job separation rates
but very low job finding rates.
St. Louis Fred Dataset
Business Cycles
Chapter 27, 29 p.711-712
Dynamic AS-AD Model: Trend Path
YtP
P
ASt
YPt+1
ASt+1
Demand
expansion
matches
supply
expansion
P*t+1
Average Inflation
P t*
ADt+1
ADt
Ch. 29, 711-712
Yt*
Y*t+1
Y
Money, Central Banking, and
Inflation
Chapter 25, 31
Evolution of Money
In more advanced societies with sophisticated
banking systems, broad money may be used
for transactions.
• Currency: Paper assets issued by central bank
• Checking Accounts: Paper promises to pay
definitive money on demand.
• Savings Accounts: Electronic Transfers, Credit
Cards, Debit Cards and ATM Cards can be used
to transfer funds to.
Ch. 31, 759-768
Interbank Market
iIBR
Supply
i*
Demand
Reserves
Money Supply Multiplier
• The money multiplier can be derived by the ratio of
aggregate money to the monetary base.
1
MS C  D
D
mm 


MB C  R C  R
D
D
C
• 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.
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 reduces the
aggregate supply of reserves.
Capital Markets
Chapter 24
Government Surplus
• Government surplus is gap between govt
revenue and spending and can be positive or
negative.
• If net positive, it adds to the supply of
loanable funds.
• If net negative, it adds to the demand for
loanable funds.
Consumers become less thrifty
(r does not fall, gap made up by capital inflows)
r
DLF
SLF
1
rW
2
SLF'
KA
LF
Central Bank Policy Makers reduce interest
target- Open Market Purchase
S
iIBR
S'
D
iTGT
1
2
iTGT'
D'
Reserve Accounts
Monetary Policy
Chapter 31
Open Market Practice
• On a daily basis, a central bank will provide
instructions to engage in defensive transactions
that will adjust supply to keep the interbank
interest rate near the target rate.
• Example: If there is an excess demand for
reserves, the traders might engage in an open
market purchase of bills, increasing the supply of
reserves pushing down the rate until it is near
the target.
An Expansionary Cycle Driven by
monetary policy
1. Economy at
LT YP.
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
SRAS
2
P*
AD′
1
AD
Output Gap
Y
3. Expenditure
rises. The
AD curve
shifts out.
4. Tight labor
markets.
SRAS
returns to
long run
equilibrium
Interest Rate Management
• In most economies around the world, the
central bank does not simply act to maintain a
fixed interest rate.
• Rather, they manage interest rate changes in
response to business cycle conditions.
List of
Inflation
Targeting
Countries
Rose
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
KEY GOAL OF CENTRAL BANKS:
PRICE STABILITY
HKMA Link
Policy Feedback: Taylor Principle
• Real interest rate impacts demand for goods in
economy.
• Real interest rate is rt = it - E[πt+1]
• When E[πt+1] rises, central bank should increase it
more than 1-for-1 to raise real interest rate, limit
demand and limit inflation.
• When E[πt+1] falls, central bank should reduce it
more than 1-for-1 to drop real interest rate, raise
demand and avoid deflation.
Learning Outcomes
• Use the model of bank reserves and the forex market
to describe the effect of Hong Kong’s monetary policy.
• Use the model of the bank reserves market to
qualitatively derive and describe the impact of
defensive and dynamic transactions on interbank rate
and quantity of reserves.
• Use the model of the money market and AS-AD to
qualitatively derive and describe the impact of
monetary policy transactions on the economy.
• Use the Taylor rule to quantitatively describe the
impact of economic conditions