Macroeconomic Analysis 2003
Monetary Policy: Transmission
Mechanism
http://www.bankofengland.co.uk
http://www.bis.org
Lecture 16
1
Learning Objectives
• Objectives, instruments and targets of monetary
policy
• Transmission Mechanism of Monetary Policy
• Keynesian Model
– Impact on output
– Impact on interest rate
• Money Market
– Supply and Demand
Lecture 16
2
Basic Points About Money
Origin of money with Goldsmiths; Bank of England -1994
What is money?
Currency, Demand and time deposits, Financial assets
and other liquid assets
Why do people want money?
Medium of Exchange
Classical
view
Unit of account
Standard for differed payment
Keynesian
and
Monetarist
View
Store of Value
Value of Money
1
P
Lecture 16
3
Objective Targets and Instruments of Monetary Policy
Ultimate objective: stability (P, r, E), high growth rate of
output, low unemployment rate
Targets: inflation only; or money supply only; or exchange
rate only; all of them; or two of them; or none of them.
Instruments: Open market operation on treasury bills rediscounting
Fixing the interest rate, credit control
Money supply rule, reserve requirement
Deposit insurance
Effectiveness of monetary policy depends upon
Central bank independence and credibility ie, who appoints
the governor?
Moral hazards - bank panics, systematic risk, regulation bank supervision
Lecture 16
4
Bank of England’s View on Transmission Mechanisms of Monetary Policy:
How Does Money Supply Affect the Price Level?
i,r,er,Pe
Market
rate
Official
rate
MS
Domestic
demand
Y
Domestic
inflationary pressure
Total demand
Asset
prices
Expectations
and confidence
P
C+I+G
Inflation
Net external
demand
X,M
π
Import
prices
Exchange
rate
Two Conditions to have real effect of Monetary policy
Central bank controls monetary base M1 = R + Cu
Prices do not adjust instantaneously
M
M  i, r  C , I , X , G  Y  P   
 i, r 
P
Lecture 16
5
Effects of Changes in the Rate of Interest
First round effects
Households: saving, housing, wealth,
foreign asset, portfolio allocations
Firms: cost of capital, debt-equity,
portfolio allocations P  1  i P  P  P2
2
1
1
1  i 
Second round effects: consumption
spending, additional demand for goods
Time lags: anticipated and unanticipated
policy changes.
Lecture 16
6
Bank of England’s Fan Chart for Forecast of an
Economic Variable
Percentage
increase in
prices on a
year earlier
Lecture 16
Source: Inflation Report, Bank of England, November 2000
B&W Figure
9.7
7
An Increase in Money Supply Can Lower Real
and Nominal Interest Rates in the Short but not in the Long Run
M
M  i, r  C , I , X , G  Y  P   
 i, r 
P
iT  rn  
Fisher Equation
i
i0  rn
r
0
T
t0
time
Monetary policy can have some real effect in the short run but not in the long run.
Short runs become shorter with more accurate expectations
Lecture 16
8
Transmission Mechanisms of Monetary Policy
• Interest rate Channel
– Lower interest rate
– More borrowing and
Spending
– More aggregate demand
Open Market Operation
• Exchange Rate Channel
– Lower interest rate
– Depreciation of domestic
currency
– More exports and less imports
– Higher aggregate demand
• Credit Channel
– Lower interest
– More reserves
– More lending
– Higher aggregate demand
Deficit financing
Rediscounting of Treasury Bills
• Balance Sheet Channel
– Lower interest rate
– Increase in prices of stocks,
bonds and other assets
– More wealth
– More aggregate demand
Buy back own currencies selling some foreign
Moral hazards - bank panics, systematic
assets to avoid depreciation - sterilisation
selling its currency to avoid appreciation Lecture 16 risk, regulation - bank supervision 9
Open Market Operation: Interest Rate Channel
Expansionary Monetary Policy
Short run:
Central bank reduces the repo rate
Commercial banks and financial institutions find
it profitable to sell bonds to the central bank
Central bank raises their reserves
Commercial banks have more money to lend
Firms and households find it cheaper to borrow
They borrow and create more deposits
Demand for goods and services rises
Money supply expands
Long run:
Prices will eventually rise following higher demand
Real money supply (M/P) shrinks
Interest rises back to natural
position
Lecture 16
10
Open Market Operation: Interest Rate Channel
• Contractionary Monetary Policy
Short run:
Central bank raises the repo rate
Commercial banks and financial institutions
find it profitable to buy bonds from the
central bank
Central bank sell bonds and reduces reserves of the
financial institutions
Commercial banks have less money to lend
Firms and households find it expensive to borrow
They pay back loans and close deposits accounts
Demand for goods and services falls
Money supply contracts
Long run:
Prices will eventually fall
Real money supply increases
Lecture 16
Interest rises back to natural position
11
Assets and Liabilities of the Financial System of An Economy
Central bank
Assets
Loans to the government
Loans to the commercial banks
Foreign asset (currency)
Gold and other precious metals
Monetary
Base
Assets
Loans to the government
Loans to the private sector
Reserves and deposit at the central bank
Claim on foreign assets
Assets
Deposit with the commercial banks
Deposit with the central banks
Loans to foreigners
Other assets
Assets
Deposit at commercial banks
Tangible wealth
Currency and precious metal
Liabilities
Currencies in circulation
Reserves of the commercial banks
Deposit of the government
Claim by foreigners and Net worth
Commercial banks
Liabilities
Deposits of private sector
Deposit of the government sector
Obligation to foreigners
Network
Government Sector
Liabilities
Borrowing from the central bank
Borrowing from the private sector
Foreign debt
Network
Private sector
Liabilities
Loans from the banking system
Payment due to the government
Network
Lecture 16
M4
RESERVE
12
Components of M4 in the UK in January 2003 (Million £)
Retail Deposits and Cash
Notes & Coins
NIB Bank Deposits
Other Bank Deposits
Building Society Deposits
Total
30 745
44 908
497 768
134 898
708 319
Wholesale Deposits
Bank Deposits
Building Society Deposits
Total
M4
M3
285 386
10 632
296 018
1 004 337
1064 571
Source: Bank of England
Lecture 16
13
Consolidated Balance Sheet of the Banking System
in the UK in January 2003 (Million £)
Asset Type
Public sector loans
Assets
Sterling
1 186 575
Foreing currency
208 764
Private sector loans
Sterling
35 554
Foreing currency
921
Non residents loans
Sterling
140 798
Foreing currency 1 068 516
Public sector Securities
Sterling
77 668
Foreing currency
19 954
Private sector Securities
Sterling
-2 683
Foreing currency
543
Non residents Securities Sterling
24 817
Foreing currency
332 903
Other Assets
Sterling
58 384
Foreing currency
23 775
Total
Sterling
1521 113
Foreing currency 1655 376
Liability Type
Public sector (CDMMI)
Liabilities
Sterling
989 464
Foreing currency
166 644
Private sector (CDMMI)
Sterling
29 132
Foreing currency 564
Non residents (CDMMI) Sterling
246 211
Foreing currency
1 377 205
Financial derivatives
Sterling
-3 361
Foreing currency11 151
Other Securities
Sterling
10 194
Foreing currency28 190
Other liabilities
Sterling
238 642
Foreing currency82 454
Total
Total Liabilities
CDMMI=Currency deposits and money market instruments.
Total Assets
3 176 489
Sterling
1510 282
Foreing currency
1666 208
3 176 490
Source: Bank of England
Lecture 16
14
Quantity Theory of Demand for Money: Classical View
M
Cambridge equation of money demand: P  kY =>
1
M    PY
k
If Y and V are constants how does the relation between
prices and money supply look like?
MV=PY
P
M
 Classical dichotomy: Price level is proportional to the
supply of money; no link between monetary and real
sectors.
No link between supply of money and the interest rate and
the real side of the economy; missing link for Keynes.
Lecture 16
15
Link between Money Stock Price Level, Inflation,
Nominal interest Rate in the Classical Model
Money
Supply
Price Level
Inflation
Money
Demand
Nominal
Interest
rate
Missing Link for Keynes
Lecture 16
16
Keynesian View on Monetary Policy : Main Points
Monetary affects real economy through the interest
rate.
Interest rate is determined by the supply and demand
in the money market.
Three kinds of demand
Speculative Demand
Transaction Demand
Precautionary Demand
Demand for money is not stable because of chaning
velocity of money. People do not spend and the
velocity is low in depression and high in the boom.
Lecture 16
17
Keynesian View on Monetary Policy : Main Points
Increase in MS
M
 kY    r
Lower interest rate
P
Reduced cost of Investment
Bonds = Financial Wealth – (M/P)
Interest
Rate
More investment
More Aggregate Demand
But
Keynes Favours Fiscal Policy
Interest rate
Demand for and Supply of Money
Demand for bonds
Money supply is controlled Lecture
by the16policy maker
18
Basic Structure of the Keynesian Static Model for Monetary Policy
Consumption: C  a  bY
d
Disposable income: Y  Y  T
I r   I 0  q  r
Investment:
d
(1)
(2)
(3)
M
Demand for real balances: P  kY    r
National income identity: Y  C  I  G
(4)
(5)
1
M
r

kY



Money Market Equilibrium:

P
(6)
Aggregate Demand Consistent with Goods and Money
Market Equilibrium:
1 
M 
a  bT  I 0  q   kY 
  G
P 
 
Y 
;
1 b
q M
G
 P
q
1 b  k
a  bT  I 0 
Y 

(7)
Equilibrium Interest Rate:
q M


a

bT

I


G
0
k
M
 P
r 


q

P

1 b  k



Lecture 16
(8)
19
Multiplier Effect of Increase in Money Supply on Output and Interest Rate
Y  ha, b, q,, k , M , G, T , P
(9)
Impact on Output from Increase in Money Supply :
q 
Y

0
q
M
(10)
1 b  k

Impact on Output from Increase in Public Spending:
Y

G
1
1 b 
q
0
(11)
k

Impact on Interest rate from Increase in Money Supply :
q



r
k 

 
 1  0
 M   1  b  q k






 P 
(12)
Impact on Interest rate from Increase in Public Spending:



r
k 
1
 
0
q
G  1  b  k 

 
(13)
Shortcoming of the Keynesian Model: Missing Supply Side
Lecture 16
20
Controversy Over Macroeconomic Impacts of Fiscal and Monetary Policies
Monetarist Model:
Monetary policy more
Effective
Keynesian Model
Fiscal Policy is
more effective
Y
i
i
M
 k  r e, rb , r D , r Y


P
a  bT  I 0  qr  G
1 b
LM0
b
a
r
IS1
1
M
 kY  

P
LM1
c
IS0
LM0
LM1
IS1
Is0
Y
Y
Small Change in public Spending Small Change in money supply
has a larger output effect than a has a larger output effect than a
Larger change in money supply bigger change in public spending
Lecture 16
21
Money Supply
Various types of money: M0, M1, M2, M3, M4 ;
Money multiplier:
m1
r
where
r  DR
If we considering a leakage in the currency holding:
c
m1
r c


C
R
c

r

where
D
D
M  R C
0
M C  D
4
(a)
(b)
What is the value of the
money multiplier if
r = 10% and c = 20 %?
m = 4.
M
4  D  C  1 c .
 then dividing (b) by (a)
M
C  R cr
0
If people held more currency then multiplier becomes
Lecture 16
22
smaller.
Money Demand
Quantity theory of Money (QTM): MV = PT
Cambridge equation of money demand:
M  kY
P
=>





1
M   PY
k
Keynesian money demand
M
 kY    r
P
Friedman type money demand
M  kPY





e
b
D
 PY
M

k
r
,
r
,
r
,
r
=>

Lecture 16

23
Friedman (1968) on Monetary Policy
Given the natural rates of interest and unemployment,
monetary policy cannot be pegged to lower the interest
rate or the unemployment. Is so it only raises inflationary
expectation and increase in price level. There will be no
impact on real magnitudes.
Monetary authority can control nominal quantities such
as it liabilities, M0, M3 or M4. By controlling them it
can stabilise the price level.
Price mechanism in the market system works better when
prices are stable and relative prices can adjust according
to the dynamics of the economic system.
Lecture 16
24
Contribution of Monetarism in
Macroeconomic Policy
• Supply of money is the determinant of the national
income
• In the long run, the influence of money is primarily
on the price level and other nominal magnitudes.
Real output and employment are not determined by
monetary factors.
• In the short run the supply of money does affect the
output. Money is the dominant factor in causing
cyclical fluctuations in output and employment in
the short run.
• Private sector is inherently stable and instability is
primarily the result of the government policy.
Lecture 16
25
Exercises
• Transmission mechanism of monetary
policy: impact of of interest decision in the
economy
• An Open Economy with the interest rate
and exchange rate
• Why low interest keeps house prices rising
despite fall in the stock prices?
• Money demand: substitution between
money and bond.
Lecture 16
• Money multipliers
26