Money and Stabilization Policy
Monetary Policy
• In the US (and Euroland and Japan and
most OECD economies), the central bank
sets monetary policy by picking a short-run
interest rate they would like to prevail.
• In HK, the central bank sets monetary
policy by picking a fixed exchange rate.
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
TGT
t
i
 .025   t 
1
 ( t   )  1 2  Output Gapt
*
2
The Taylor Rule
What should be the current Fed Funds
rate? Will they be increasing it soon?
• Step 1. Find Inflation Rate
• Step 2. Find Output Gap
• Step 3. Calculate Taylor Rule implied rate
and compare with current rate.
Channel of Monetary Policy
• When the central bank increases the monetary base, the
money supply will increase.
• Banks have excess liquidity which they use to make
more loans.
• The supply of liquidity will exceed demand and banks
must compete to attract borrowers who will hold this
liquidity only at a lower interest rate.
• Lower interest rates increase demand for US$ in forex
market depreciating the exchange rate.
Question
• Use S & D model of the exchange rate to
show the impact of expansionary monetary
policy on the exchange rate.
Dynamics of Monetary Transmission
• Money supply expansion reduces interest
rates
• Lower interest rates implies an increase in
borrowing and affects demand for interest
sensitive goods.
– Corporate Investment
– Residential Housing
• Aggregate demand shifts out. Given fixed
input prices this increase in demand stimulates
output.
Demand Driven Recession
w/ Counter-cyclical monetary policy
YP
P
2
P*
SRAS
2. Monetary
Policy Cuts
Interest Rate
1
AD′
Y*
Recessionary Gap
1. Economy in
a recession.
Fed detects
deflationary
pressure
AD
Y
3. Investment
increases
spending to
shift the AD
curve back
to long run
equilibrium
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
2. Monetary
Policy
Raises
Interest Rate
SRAS
1
P*
2
AD
AD′
Inflationary Gap
1. Economy in
expansion.
Fed detects
inflationary
pressure
Y
3. Investment
decreases
spending to
shift the AD
curve back
to long run
equilibrium
U.S. Central bank cuts interest rates
during recessions
Lags, Mistakes and Monetary
Shocks
• It is often said that there are long and variable
lags in the monetary transmission mechanism in
that it might take several quarters for the strongest
effects of monetary policy on demand to appear
plus it is difficult to predict how long exactly it
will take for monetary policy to have its intended
effects.
• Also difficult to know what exactly is potential
output level.
• What happens if a monetary expansion
destabilizes the economy?
An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
1. Economy at
LT YP.
SRAS
3. Investment
rises. The
AD curve
shfits out.
2
P*
1
AD′
AD
Output Gap
Y
4. Tight labor
markets.
SRAS
returns to
long run
equilibrium
An Expansionary Cycle Driven by
monetary policy
Money
Demand
Money Supply Money Supply'
1. Increase in
money supply
pushes down
interest rates
r
3
i*
1
i**
2
M
2. Rising price
level increases
demand for
money
balances
increasing
rates.
Zero Lower Bound on Interest Rates
• Nominal interest rates cannot go below zero
– no one will lend money at an interest rate
below that of money itself.
• In Japan, central bank increased money
supply to get the economy out of a
recession. Pushed the interest rate to zero.
• Once the zero lower bound was reached
monetary policy has no effect.
Question
• Situation: Economy is in long-run
equilibrium, but central bank overestimates
potential output.
• Draw outcome if central bank believes that
the potential output is higher than it is.