Monetary Policy
Chapter 31
Orientation/Objectives
Orientation
Objectives
Domestic
Price, Output Stability
External
Forex Rate Stability
IMF Exchange Rate Classification
60
50
40
Source Link
30
20
10
0
No Currency
Currency
Board
Fixed
Exchange
Rate
Band
Crawling
Peg
Managed
Float
Free Float
Hong Kong’s Exchange Rate Regime
Convertibility Undertaking
• May 2005 Under the strong-side
Convertibility Undertaking, the HKMA
undertakes to buy US dollars from
licensed banks at 7.75. Under the weakside Convertibility Undertaking, the HKMA
undertakes to sell US dollars at 7.85.
US Monetary Policy Causes
US Interest Rates Go Down, Strengthening
Pressure on HK$
S
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Hong Kong Interbank Market:
HIBOR higher than US interest rate.
iHIBOR
i*
iFedFunds
Supply'
Supply
Banks
convert US$
to Clearing
Balances to
take
advantage
of higher
interest
rates in
Hong Kong
1
2
D
Reserve Accounts
Passive Forex Intervention
i
M 
 P
Agents want
more Hong
Kong dollars
and excess
supply of US
dollars at
exchange rate.
D
i*
1
Rather than sell
US dollars at
falling prices,
sell to HKMA at
Strong Side
price
2
i**
M
MS
M S
P
P
P
HKMA
purchase of
forex increases
M and reduces
i.
Convertibility Undertaking Stabilizes Forex
Demand and Supply Curves Automatically
S
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Fixed Exchange Rate

If the central bank undertakes to keep the exchange rate
fixed and that is a credible undertaking, then
.
StE1  St
 0  it  itF
St

If the relative values of currency are fixed, then funds will
flow out of the domestic currency if domestic interest
rates are too low and flow into domestic currency if
interest rates are too high.
Fed Funds
HIBOR
Jun-04
Jun-03
Jun-02
Jun-01
Jun-00
Jun-99
Jun-98
Jun-97
Jun-96
Jun-95
Jun-94
Jun-93
Jun-92
Jun-91
Jun-90
Jun-89
Jun-88
Jun-87
Jun-86
%
HIBOR vs. Fed Funds Rate
Interbank Rates
20
18
16
14
12
10
8
6
4
2
0
Loss of Credibility

A fixed exchange rate will lose credibility if people
come to believe that the central bank will:



devalue the currency, (ie. raise S in the future)
revalue the currency (ie. reduce S in the future)
If market expects an exchange rate change,
commercial banks will adjust comparison rate for the
expectations of devaluation.
HIBOR
t
i
i
FF
t
 St 1  St  
E

S
t


Iron Triangle of International
Finance
Open to
International
Capital Flows
Monetary
Policy that
Controls The
Interest Rate
Pick 2 items from this menu
Fixed
Exchange
Rates
Domestically Oriented
Monetary Policy
Operating Instruments:
Target Interest Rates


On a day to day basis,
central banks express
their policy in terms of a
single easily observed,
easily controlled financial
market price or quantity.
In many economies,
central banks use the
interest rate in interbank
market as an operating
instrument
Fed
Federal Funds Rate
BoJ
Uncollateralized Call
Money Rate
ECB Main Refinancing
Rate
BoK Overnight Call Rate
UK
Official Bank Rate
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.

Interbank Market:
OMO to meet demand for reserves
S
iIBR
S'
D
2
i*
3
iTGT
1
D'
Reserve Accounts
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.

Dynamic Transactions and Policy
Changes
Central bankers shift monetary policy by
changing the interest rate target.
 In order to enact the change, the bank’s
traders are instructed to engage in dynamic
transactions.



A dynamic purchase of bills will be implemented to
reduce interest rates.
A dynamic sale of bills will be implemented to
increase interest rates.
Central Bank Policy Makers reduce
interest target- Open Market Purchase
S
iIBR
S'
D
iTGT
1
2
iTGT'
D'
Reserve Accounts
Monetary Policy: Money Supply Expands
i
i*
MS
M S
P
P
1
M 
 P
i**
D
2
M
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
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.
 Lower interest rates increase demand for US$ in
forex market depreciating the exchange rate.
 Aggregate demand shifts out. Given fixed input
prices this increase in demand stimulates output.

An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
1. Economy at
LT YP.
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
Bank of England Estimates of Effect of
Interest Rate
Monetary Policy –
Short-term vs. Long Term
In the short-run, expansionary monetary policy
can boost economic growth.
 But in the long-run, expansionary monetary
policy only leads to rising prices (i.e. inflation).

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.

Policy Framework
Price Stability



Fed Objective Humphrey Hawkins Act (1978): Fed instructed by
Congress to be “conducting the nation's monetary policy .. in
pursuit of maximum employment, stable prices, and moderate
long-term interest rates “
ECB Objective “The primary objective of the ECB’s monetary
policy is to maintain price stability. The ECB aims at inflation
rates of below, but close to, 2% over the medium term.”
Japan Objective: Bank of Japan Act Article 2 Currency and
monetary control by the Bank of Japan shall be aimed at
achieving price stability, thereby contributing to the sound
development of the national economy
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.
Inflation Targeting
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
Demand Driven Recession
w/ Counter-cyclical monetary policy
YP
P
SRAS
AD′
1
2. Monetary
Policy Cuts
Interest Rate
3
P*
2
AD
Gap < 0
1. Economy in
a recession.
Ctl Bank
detects
deflationary
pressure
Y
3. Investment
increases
spending to
shift the AD
curve back
to long run
equilibrium
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
SRAS
2
P*
1
AD′
3
AD
Gap > 0
Y
1. Economy in
expansion.
Ctl Bank
detects
inflationary
pressure
2. Monetary
Policy
Raises
Interest Rate
3. Decreased
spending to
shift the AD
curve back
to long run
equilibrium
U.S. Central bank cuts interest
rates during recessions
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.
 In the face of supply shocks, central banks must
make a trade-off between output gap and
inflation.

Stagflation
w/ Counter-cyclical monetary policy
YP
P
SRAS
3
P**
P*
2
1
AD′
AD
Y
1. Economy
experiences
stagflation
2. Monetary
Policy Cuts
Interest Rate
3. Investment
increases
spending to
shift the AD
curve to
long run
equilibrium
with higher
prices.
Stagflation
w/ Price Stabiliztion
YP
P
1. Economy
experiences
stagflation
SRAS
2
3
P*
1
AD′
AD
Y
2. Monetary
Policy
Raises
Interest Rate
3. Investment
decreases
spending to
shift the AD
curve to
equilibrium
with lower
output.
Taylor Rule
Economist named John Taylor argues that US target
interest rate is well represented by a function of

1.
2.
3.
current inflation
Inflation GAP: current inflation vs. target inflation
Output Gap: % deviation of GDP from long run path

Function: Inflation Target π* = .02
TGT
t
 .02   t 
i
1
 ( t   )  1 2  Output Gapt
*
2
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.

Zero Lower Bound

Link
Interest rate cannot be set below zero.
The Taylor Rule Download
Question: Problem with
Central Bank Stabilization


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.
Great Inflation of the 70’s & 80’s
CPI Inflation, % Annual Rate
35
30
25
20
15
10
5
OECD
East Asia
Subsaharan Africa
20
09
20
05
20
01
19
97
19
93
19
89
19
85
19
81
19
77
19
73
19
69
19
61
-5
19
65
0
Latin America
A Bias toward Expansionary
monetary policy
1. Central Bank
repeatedly
expands the
money supply
YP
P
2. Inflation
recurs
5
4
3
P*
2
SRAS′
AD′
1
SRAS
AD
YPhantom
Y
Demand Driven Recession
Counter-cyclical fiscal policy
YP
P
3
P*
1
2
Y*
Recessionary Gap
SRAS
w/
1. Economy in LT
equilibrium
2. Demand shifts
in
3. Government
increases
AD spending to shift
the AD curve
back
AD′
Y
Demand Driven Expansion
Counter-cyclical fiscal policy
YP
P
SRAS
1. Economy in LT
equilibrium
2. Demand shifts
out
2
P*
3. Government
cuts spending to
shift the AD
AD′ curve back
1
3
Y*
w/
AD
Inflationary Gap
Y
Monetary Policy Lags


Counter-cyclical fiscal policy beset by lags between the
time a recession is recognized and the time the
government can form consensus to act.
Monetary policy beset by lags between the time policy
shifts and time for private sector to respond to lower
interest rates.
Lags and Fiscal Policy



Administrative lags for fiscal policy may likely be large.
Except in absolute dictatorships, government will have
mechanisms for building a consensus for expenditures.
Adjusting this consensus will be time consuming.
If lags are too long, stabilizing government spending or
transfer payments may have a destabilizing effect, shifting
out demand after the economy has already recovered.
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