MONETARY POLICY
Chap. 31
MONETARY POLICY &
INTEREST RATES
• Central Bank:
A special
governmental
organization or
quasigovernmental
institution within
the financial
system that
controls the
medium of
exchange.
Economy
HK/Singapore
Central Bank
Monetary Authority
USA
Federal Reserve
Eurozone
European Central Bank
PRC
Canada/Japan/
Korea
India/NZ/Australia
People’s Bank of China
Bank of ?
Reserve Bank of ?
Interbank Payment Systems
• Commercial banks keep accounts at the central bank for
interbank payments. referred to generally as reserves,
specifically as clearing balances in Hong Kong.
• These accounts, along with cash, constitute the monetary
base.
Hong Kong Interbank Clearing Limited
Interbank Market
• Individual banks will face a short-fall in reserves if
they have too many outflows and borrow funds from
other banks facing a surplus.
• Banks will keep an inventory of reserves to meet their
own liquidity needs but the interest rate is the
opportunity cost of holding reserves.
• Desire to hold reserves is a declining function of the
interest rate.
• Central bank controls the total supply of reserves
available to banks.
Interbank Market
iIBR
SBR
i*
DBR
Reserves
Equilibrium in the Interbank Market
• If interest rates are too low, banks will want to hold more
reserves than available. Banks facing a shortfall of
reserves will be willing to bid up interest rates until all
banks are content with reserves available.
• If interest rates are too high, banks will want to lend out
their excess reserves. To do so in a liquid market, they
must lower interest rates.
Equilibrium
iIBR
SBR
i
i*
i
DBR
Reserves
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 decreases the
aggregate supply of reserves.
Open Market
Sale
Open Market Purchase
SBR'
iIBR
i**
i*
i**
SBR
SBR'
Excess Liquidity in
Interbank Market
pushes down interest
rate.
Liquidity shortage in
Interbank Market
pushes up interest
rate.
DBR
Reserves
Money Supply and Interest Rates
• If the central bank engages in an open market
PURCHASE, they will increase the reserve
holdings of counter-party commercial banks.
• This will increase liquidity in the reserve funds
market.
• Banks with excess reserves can lend them out
pushing down interest rates in broader money
market.
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Korean Money Market
8
Source: CEIC
Database
7
6
5
Call Money Rate
4
KIBOR 1 week
6 Month KIBOR
3
1 Year Treasury
3 Month NCD
3 Month Commercial Paper
2
1
0
Exchange Fund: Liabilities: Certificates of Indebtedness
Monetary Base
400000
350000
Reserves
• Bank of China, HSBC,
and Standard
Chartered print
banknotes under
licenses called
Certificates of
Indebtedness
300000
250000
200000
150000
Au
g08
Fe
b09
Au
g09
Fe
b10
Au
g10
Fe
b11
Au
g11
Fe
b12
Au
g12
Fe
b13
Au
g13
Fe
b14
Au
g14
used to finalize
transactions: Currency+
Millions HK$
• Money that can be
Certificates of
Indebtedness
increase when
currency increases
Money Supply vs. Monetary Base
Monetary
Base
*
Money
Multiplier
=
Money
Supply
Categories
of Broad
Money
M1
M2
M3
M1 Currency
+ Checking Acct.
M2 M1 +Savings Acct.
+ “More Liquid”
Time Deposit
M3 M2 + “Less Liquid”
Time Deposit
Money Multiplier
• The money multiplier can be derived by the ratio of money to
the monetary base.
Money Cash  Deposits


Base
Cash  Reserves Cash
Cash
1
Deposits
 Reserves
Deposits
Deposits
• 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.
Fractional Reserve Banking
• Banks keep only a fraction of any deposits they
receive on hand in the form of vault. The rest is
used to acquire other assets, especially loans.
• Regulatory Requirements – Some regulatory
regimes have minimum reserve levels.
• Most developed economies have either rr= 0 (e.g.
HK) or modern banking techniques make them
non-binding.
Reserve Ratio = Required Reserves Ratio + Excess
Reserves Ratio
(Reserves/Deposits) = rr + ER/Deposits
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Monetary Policy
China
• PBoC uses frequent changes in rr
to manage liquidity in the banking
system.
The People's Bank of China Required Reserve Ratio
25
20
15
10
5
0
China's Evolving Reserve Requirement, BIS
MONETARY POLICY AND
BUSINESS CYCLE
Operating Instruments:
Target Interest Rates
• In many economies, on a day
to day basis, central banks
express their policy in terms of
the interest rate in interbank
market as an operating
instrument
Fed
BoJ
Federal Funds Rate
Uncollateralized
Call Money Rate
ECB Main Refinancing
Rate/Euribor
RBI Report of the Working Group on Monetary Policy...
Dynamics of Monetary Transmission
• Open market purchase 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.
Lower interest rates tend to increase asset prices which makes
consumers feel wealthier.
Aggregate demand shifts out. Given fixed wages this increase
in demand increases equilibrium output.
Ultimately, wage demands will increase and prices will rise.
Cut
Bond
Yields
Cut
Policy
Rate
Cut
Money
Market
Rate
Cheaper to Borrow
Investment increases
Raise
Asset
Prices
People Wealthier
Consumption Increases
Weaken
Forex
Rate
Improved Competitiveness
Net Exports Increases
Reduce
Cost of
ST
Finance
Consumer Purchases and
Inventory Investment
Increase
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
1. Economy at
LT YP.
An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate.
The AD curve
shifts out.
YP
SRAS′
P
P***
3
SRAS
2
P**
P*
1
3. Tight labor
markets. SRAS
returns to long
run equilibrium
AD′
AD
Y
Output Gap
1. Economy at
LT YP.
A Contractionary Cycle Driven by
monetary policy
SRAS
YP
2. Monetary
Policy Raises
Interest Rate.
The AD curve
shifts in.
P
P*
1
SRAS′
2
P**
P***
3
3. Slack labor
markets. SRAS
returns to long
run equilibrium
AD
AD′
Y
Output Gap<0
Bank of England Estimates of Effect of
Interest Rate
Interest Rate Management
• In most economies around the world, the central bank does not
simply act to maintain a fixed money supply.
• Rather, they adjust interest rates in response to business cycle
conditions.
U.S. Central
bank cuts
interest rates
during
recessions
Demand Driven Recession
w/ Counter-cyclical monetary policy
1. Economy at
LT YP.
YP
P
SRAS
AD′
1
2. Economy in a
recession. Fed
detects
deflationary
pressure
3
P*
P**
2
AD
Y
Gap < 0
3. Monetary
Policy Cuts
Interest
Rates. AD
curve shifts
back to
original
equilibrium
Demand Driven Expansion
w/ Counter-cyclical monetary policy
1. Economy at
LT YP.
2. Economy in a
expansion. Fed
detects
inflationary
pressure
YP
P
SRAS
P**
2
3. Monetary
Policy Raises
Interest
Rates. AD
curve shifts
back to
original
equilibrium
3
P*
1
AD′
AD
Y
Gap > 0
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
i
Output Gapt
 .02   t  2  ( t   )  2 
Yt P
1
*
1
The Taylor Rule Download
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.
Monetary Policy Problems
Monetary Policy Lags
• Monetary policy beset by lags between the time policy
shifts and time for private sector to respond to lower
interest rates. Monetary policy must be forward looking.
Zero Lower Bound
• Money market rates cannot be reduced below zero,
because interest rate on cash is always zero.
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 Reports
• Central bank publishes
its inflation forecast with
probability distributions
to indicated degree of
uncertainty.
35
Inflation Pressure
YPt+1
YtP
SRASt+1
SRASt
P
P*t+1
Target Inflation
Pt*
Forecast ADt+1
ADt
Raise Interest Rate
Target at time t
Yt*
Y*t+1
Y
Dynamic AS-AD Model: Recession, Inflation Deceleration
YtP
P
P*t+1
Pt*
ASt+1
YPt+1
ASt
Demand expands
slower than
expected
Target Inflation
Forecast Inflation
Cut
interest
rates to
hit
inflation
target
Forecast
ADt+1
ADt
Gap
Yt*
Y*t+1
Negative
Output Gap
Y
Zero Lower Bound
• In theory, interest rate
cannot be set below zero.
Link
Zero Lower Bound
SBR′
SBR
SBR′ ′
SBR′ ′ ′
SBR′ ′ ′ ′
iIBR
DBR
i*
i**
i***
1
When
nominal
interest rate
reaches
zero,
demand for
money turns
infinite since
money pays
just as good
an interest
rate as
bonds.
2
3
4
5
Reserves
40
Raise Inflation Target
• Cost of borrowing
(in terms of
purchasing power)
is the interest rate
adjusted by the
inflation rate
between the time a
loan is made and
the time is repaid.
The newly-introduced "price stability
target" is the inflation rate that the Bank
judges to be consistent with price
stability on a sustainable basis. … Based
on this recognition, the Bank sets the
"price stability target" at 2 percent in
terms of the year-on-year rate of change
in the consumer price index (CPI) -- a
main price index.
rt  it  Et t 1
With zero interest rates, real borrowing rates will fall
when inflation rises.
Quantitative Easing/Forward Guidance
• Commit to future liquidity to raise expectations of future
inflation to bring down real interest rates.
Monetary Policy Statement April, 2012
To support a stronger economic recovery and to
help ensure that inflation, over time, is at the rate
most consistent with its dual mandate, the
Committee expects to maintain a highly
accommodative stance for monetary policy. In
particular, the Committee decided today to keep
the target range for the federal funds rate at 0 to
1/4 percent and currently anticipates that
economic conditions--including low rates of
resource utilization and a subdued outlook for
inflation over the medium run--are likely to
warrant exceptionally low levels for the federal
funds rate at least through late 2014
-1
Link
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42
Switzerland Sets Deep Negative Rate
Swiss Money Market
4
3
2
1
0
-2
-3
Policy Rate: Month End: Overnight Average Rate: SARON
Challenges to Monetary Policy Effectiveness
Call Money Rate: Swiss National Bank
PUZZLE: Why can interest rates be
persistently negative?
Commercial banks may be willing to hold reserves that
pay negative interest since:
(1) Reserves may be more convenient than paper
currency in making payments.
(2) Currency may have large holding costs
US$1Million
US$1Trillion
Central BANK SETS NEGATIVE Deposit facility
iIBR
iLF
S
0
i*
D
iDF
MRO
Reserve Accounts
FISCAL POLICY
Chapter 30
Government Accounts
Outlays
Spending
• Expenditure on Goods &
Services
• Employee Compensation
Receipts
Revenues
• Direct Taxes
• Profits
• Personal Income
• Transfer Payments
• Retirement Benefits
• Unemployment Benefits
• Indirect Taxes
• VAT
• Sales Taxes
• Interest Expense
• Fees
• Interest Income
Average OECD % of Revenue
Income and profits as a percentage of total
taxation
Social security as a percentage of total
taxation
Payroll as a percentage of total taxation
Property as percentage of total taxation
Goods and services as percentage of total
taxation
Other tax revenues as a percentage of total
taxation
Budget Deficit
Revenue
Cyclical
Deficit
• Governments in most
economies issue debt
to make up for
shortfalls in revenues
in relation to spernding.
Budget Deficit =
Outlays – Receipts
• Tax collection is
cyclical so the budget
deficit tends to be
counter-cyclical.
Structural
Deficit
Deficit
Cyclical
Deficit
Outlay
Yt
YP
Output Gap
Y
Policy Lags
• Recognition: Lag in
• Fiscal Policy has long
observing economic
conditions
• Implementation/LawMaking: Lag in
adjusting policy
• Impact: Lag in
response of economy
to policy
implementation lags.
• Monetary Policy has
long impact lag.
Multiplier Effect
• Government spending has a more than 1-for-1 effect on
Aggregate Demand.
• Circular flow of income
Multiplier Effect: Feedback Loop
Government spending
increases production
to fill gov’t contracts.
Production
Consumption
Firms hire workers
and pay more
wages
Income
Workers income
rises and they
increase
spending
Savings
1. Economy at
LT YP.
Expansionary Fiscal Policy
2. Government
increases
spending by
ΔG. The AD
curve shifts out.
YP
P
ΔC
ΔG
SRAS
2
**
ΔG
ΔC
3. Income
expansion
leads to
consumption
expansion.
AD′
1
AD
Y
Output Gap
Automatic Stabilizers
• Taxes are usually collected as a fraction
of incomes of households. Even if the
government keeps the tax rate
unchanged.
• When the economy goes into a boom, taxes
are automatically raised mitigating the
effects of the boom.
• When the economy goes into a recession,
taxes are automatically cut, ameliorating the
recession.
OECD Countries
120
100
% of GDP
80
60
40
20
0
Gross Debt
Net Debt
2007
74.57
38.07
2008
80.52
43.19
2009
92.13
51.35
2010
97.91
55.77
2011
102.1
61.02
2012
108.12
65.02
2013
109.26
65.26
Learning Outcomes
Students should be able to:
• Use the supply and demand model of interbank markets
to demonstrate the effect of monetary policy on interest
rates.
• Use the AS-AD model to demonstrate the effect of
monetary policy on the price level and the output gap.
• Use the Taylor rule to benchmark monetary policy.
• Use the AS-AD model to identify the effects of fiscal
policy.
• Identify the elements of government budget.