Chapter 21
Conduct of Monetary Policy
Goals of Monetary Policy
Stability
• Price Stability: Low and predictable of
inflation
• Business Cycle Stability: Stable GDP and
unemployment level.
• Financial Market Stability: Interest rate
stability, exchange rate stability, stock
market stability, banking system stability.
Monetary Policy Framework
1. Policy Tools are the direct procedures
available to the central bank.
2. Operating Targets are the prices and
quantities directly determined by policy
tools.
3. Intermediate Targets are the objectives
for financial variables that the central
bank will help it to achieve its ultimate
goals. [Possibly outdated concept]
4. Goals are the ultimate macroeconomic
outcomes that the policy is meant to
achieve.
Monetary Policy
Tools
Open Market Operations
Discount Policy
Convertibility Undertaking
Reserve Requirements
Operating Target
Reserves
Interbank Rate
Exchange Rate
IntermediateTarget
Monetary Aggregates
Interest Rates
Goals
Stability
Price
Business Cycle
Monetary Policy in USA
• Federal Open Market Committee (FOMC)
consists of a group of Federal Reserve
officials.
• After regular meetings the FOMC selects a
Federal Funds target. Fed trading desk will
set open market operations to maintain that
policy regimes.
Policy Shift
• Defensive Transactions Reserve Demand
Shifts. Fed traders are instructed to purchase
securities to keep the Fed funds rate within a
narrow band of policy target.
– Many short-term defensive transactions are
undertaken using reverse transactions.
• If demand for reserves rise short-term, central bank
may engage in repo operation. Simultaneously
purchase securities and promise to resell them at a
later date.
• If demand for reserves fall short-term, central bank
may engage in reverse repos: simultaneously selling
securities and promise to rebuy them at later date.
Defensive Transactions
Response to Increase in Demand for
Reserves
iFF
D
D’
S
2
iFFP
1
NBR
NBR’
Defensive Transactions
Response to Decrease in Demand for
Reserves
iFF
D
D’
S
iFFP
1
2
NBR´
NBR
Adjusting Policies
• Dynamic Transactions: If the FOMC decides to
have a policy shift to reduce the Fed Funds
target, they will instruct their traders to engage in
an open market purchase of securities to drive
down the Fed Funds target. If they shift the
policy to raise Fed Funds Target, they will have
an open market sale.
Dynamic Transactions
FOMC decides to increase the interest rate
iFF
D’
D
S
iFFP
2
iFFP
1
NBR
NBR’
Dynamic Transactions
FOMC decides to increase the interest rate
iFF
D’
D
S
iFFP
1
iFFP
2
NBR
NBR’
Fed Funds
Discount Window
Oct-05
Sep-05
Aug-05
Jul-05
Jun-05
May-05
Apr-05
Mar-05
Feb-05
Jan-05
Dec-04
Nov-04
Oct-04
Sep-04
Aug-04
Jul-04
Jun-04
May-04
Apr-04
Mar-04
Feb-04
Jan-04
%
Change in U.S. Discount Policy
US Interbank Market
5.00
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Transmission Channel
• The central bank attempts to control the
macroeconomy through adjusting the monetary
base.
• The transmission mechanism occurs through the
money market.
• Our model of the money market will examine the
trade-off between holding short-term assets
which pay interest and liquid money which pays
no interest but is useful for transactions.
Money Market: Demand
• Demand: People hold liquid assets to
engage in transactions at the cost of
earning interest.
– Money Demand is a negative function of the
interest rate.
– Money Demand curve is shifted by changes in
nominal economic activity (i.e. the number of
transactions)
Money Market: Supply
We will treat the money supply as
determined by policy. Draw this as a
vertical line. This approach will incorporate
two possibilities:
– Money Supply is the Intermediate Target.
Money supply curve only shifts as a direct
policy.
– Money Supply curve shifts endogenously as a
response to keeping an interest rate target.
Money Market
MS
i
i*
MD
M
Equilibrium in the Money Market
• If interest rate is less than i*, savers will keep
their wealth in the form of liquid assets and
withdraw their funds from savings accounts and
bonds. In order to maintain their own liquidity,
banks higher interest rates on deposits.
• If interest rate is greater than i*, savers will
deposit more funds in savings accounts. Banks
will have too much liquidity and lower the
interest rate.
Asset Transactions
• If the central bank engages in an asset market
purchase, they will increase reserves and
increase the available money supply.
• Savers will have an excess amount of money
relative to their liquidity needs.
• Savers will attempt to acquire low liquidity
interest paying assets. Increase in demand for
bonds will push down interest rates until money
demand equals money supply.
Money Market: Asset Market Purchase
i
MS
MS
1
i*
2
i**
MD
M
Money Market: Asset Market Sale
i
MS
MS
2
i**
1
i*
MD
M
Maintaining Policy Target
• There is a connection between demand for
reserves and money demand. The more
transactions that people undertake, the
more reserves banks will need to keep in
their reserve accounts.
– Holding reserves constant, this would push up
interest rates.
Increase in Money Demand
(Money Money Supply Fixed)
MS
i
2
i**
i*
1
MD’
MD
M
Increase in Reserve Demand
D’
iFF
D
2
iIBOR
S
iIBOR
1
NBR
NBR’
Operating Target: Interest Rate
• Interest Rate: If the intermediate target is
the Interbank lending rate, then the Fed
must increase supply of reserves (through
a defensive OMO purchase). This (through
the money multiplier) will increase the
money supply stabilizing the money
market interest rate. .
Fed Funds
Euro Deposits
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
Jan-73
Jan-71
US Dollar Money Market
25
20
15
10
5
0
Increase in Money Demand/
Interest Rate Target
i
MS
MS’
2
i*
1
MD’
MD
M
Defensive Transactions
Response to Increase in Demand for
Reserves
iFF
D
S
2
iFFP
1
D’
NBR
NBR’
The Money Market and Fixed
Exchange Rate
• Under perfect credibility, the HK$ money market
interest rate should be equal to the US$ money
market interest rate.
• Equilibrium
– If equilibrium HK$ interest rate is greater than US$
interest rate, it will attract flow of funds into HK. Bank
reserves will increase, increasing the money supply
until interest rate is equal to US rate.
– If equilibrium HK$ interest rate is lower than the US$
rate, funds will flow out of HK, reducing reserves and
the money supply.
Increase in Money Demand/
Exchange Rate Target
MS
MS’
i
2
iUS
i*
1
MD’
MD
M
Cut in US Interest Rate on HK$
Money Market
MS
i
iUS
1
iUS
’
2
MD
M
Fixed Exchange Rates
• From the standpoint of monetary policy, a fixed
exchange rate monetary policy might be thought
of as an implicit interest rate target.
• The interest rate target will always be the
interest set by the anchor country.
• In times of imperfect credibility, the interest rate
target is the interest in the anchor country minus
expected interest rate appreciation.
Post-war Monetary Policy
• Prior to 1971, most countries adopted an
exchange rate target with the United States. In
return, US maintained a fixed exchange rate with
gold. In 1971, US abandoned gold standard.
• Many large economies including USA, Germany,
Japan, UK, and Canada operated monetary
targets for some time.
• Almost all of these economies (plus the
European Central Bank) have adopted interbank
interest rates as an intermediate targets.
Intermediate Targets
• Prior to the 1990’s, or so, central banks
would assess their level of operating target
with respect to the money market
performance.
• Central bank would announce some
interest rate or monetary quantity that they
would like to see prevail in the money
market.
Problem with Monetary Targets
• Money demand is volatile and unpredictable.
– Economies with monetary targets have often had
volatile interest rates leading to instability in
financial markets.
• Money supply is hard to control because the
money multiplier is subject to fluctuations.
• Effect of money supply on real economy or
inflation is difficult to predict.
Monetary targets have been largely
abandoned
Simple Model of Macroeconomics
• Supply: Firms have pricing strategies which
makes inflation essentially exogenous
overtime.
• Demand: Negative relationship between
high prices and demand for goods.
– Demand affected by fiscal policy, consumer and
business confidence, and interest rates.
• Potential Output: Profit maximizing level of
output. In long run, firms will adjust pricing
strategies until demand equals this level.
To achieve stabilization, central bank should set interest
rates to keep AD-AS intersection near potential output
level.
π
Potential Output
If AD is not
shifted back,
inflation will rise.
AS
AD(i)
GDP
Demand Curve/Supply Curve
Potential Output
π
AS
AD(i)
GDP
Challenges of Monetary Policy
• Most interest sensitive parts of economy
(autos, capital equipment, housing) are
affected by long-term interest rates.
• Central bank has very strong control of
short-term interest rates but can only
affect long-term rates indirectly.
• Even the effect of interest rates on the
economy occurs through long and variable
lags.
Fed Funds
10 Year Treasuries
Oct-05
Jul-05
Apr-05
Jan-05
Oct-04
Jul-04
Apr-04
Jan-04
Oct-03
Jul-03
Apr-03
Jan-03
Oct-02
Jul-02
Apr-02
Jan-02
Oct-01
Jul-01
Apr-01
Jan-01
Oct-00
Jul-00
Apr-00
Jan-00
US Monetary Policy
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
Using monetary policy to manage AD
Curve during a recession
• To reduce long-term rate, the central bank
must display commitment to low shortterm rates for a persistent period of time.
• Persistently expansionary monetary policy
will lead to money growth and inflation and
high interest rates through the Fischer
effect.
Commitment and Consistency
• Central bank must commit to having low
short-term rates for long-enough to
stimulate economy out of a recession, but
not so long it leads to increase in
inflationary expectations.
• Managing market expectations is an
important part of monetary policy. To
manage expectations, central bank policy
must be predictable and consistent.
Price Stability
• Many central banks make price stability,
(interepreted to mean a low and steady
inflation rate).
• When central bank perceives downward
pressure on inflation, cut interest rates
until disinflationary pressure eases.
• When central bank perceives upward
pressure on cut interest rates until
inflationary pressure eases.
Inflation Targeting Rules
• Under inflation targeting, the central bank
announces some target level of goods
price inflation that they are aiming to
achieve.
• In 1990, New Zealand moved to an
inflation targeting rule. Australia, Canada,
UK have an explicit, announced inflation
target.
• ECB has a commitment toward price
stability defined as inflation between 0-2%
per year.
Inflation Targeting in New Zealand
Inflation in New Zealand
18.00%
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%9 70
1
72 9 74 9 76 9 78 9 80 9 82 9 84 9 86 9 88 9 90 9 92 9 94 9 96 9 98 0 00 0 02
19
1
1
1
1
1
1
1
1
1
1
1
1
1
2
2
Inflation
#REF!
Inflation Target Rule
• In a recession, a central bank with a
strong commitment to an inflation target
will keep interest rates low as long as it
takes to get the economy (giving best
chance of reducing long-term rates) out of
a recession but no longer.
• A credible low inflation target will reduce
inflationary expectations and minimize
Fisher effects.
U.S. Approach to price stability.
• John Taylor of Stanford argues that interest rate
target in the USA is a systematic function of
inflation and real output.
it  i  1.5( t   )  .5(GDPt  GDP)
• Federal Reserve commitment to price stability is
embodied in the person of central bank
chairman, Alan Greenspan
• Some economists advocate more formal rules
for price stability that will stay in place after Dr.
Greenspan retires.