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Transcript
Monetary Policy Chap. 31 • Central Bank: A special governmental organization or quasigovernmental institution within the financial system that controls the medium of exchange. Economy Central Bank HK ? USA ? Eurozone ? PRC ? UK, Canada, Japan, Korea ? 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 increases the aggregate supply of reserves. Open Market Purchase iIBR SBR SBR' i* i** 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. Ju l-0 No 1 v0 M 1 ar -0 2 Ju l-0 No 2 v0 M 2 ar -0 3 Ju l-0 No 3 v0 M 3 ar -0 4 Ju l-0 No 4 v0 M 4 ar -0 5 Ju l-0 No 5 v0 M 5 ar -0 6 Ju l-0 No 6 v0 M 6 ar -0 7 Fed Funds & Money Market Rates 6.000 5.000 4.000 3.000 2.000 1.000 0.000 Fed Funds NCD CP-Fincl CP-NonFincl Tbill Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down S Supply Supply' Domestic Currency Appreciates 1 S* Excess Supply S** 2 Demand Demand' Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up S 2 S** Domestic Currency Depreciates 1 S* Excess Demand Supply' Supply Demand ' Demand Monetary Policy Expectations and Exchange Rates • Future exchange rates affect the expected profitability of holding bank accounts in a country’s currency. • Current level of the exchange rate guided by the future path of interest rates. Expectation of St+1 Increases S 2 S** Domestic Currency Depreciates 1 S* Excess Demand Supply' Supply Demand' Demand Hong Kong’s Exchange Rate Regime Clearing Accounts Reserves • May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side 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 Excess Supply of US Dollars S** Demand Demand' Hong Kong Interbank Market: HIBOR higher than US interest rate. iHIBOR i* iFedFunds SBR ' SBR Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 2 DBR Reserve Accounts Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically S Supply Supply' 1 Excess Supply of US Dollars S=7.8 Demand Demand' Fixed Exchange Rate • If the central bank undertakes to keep the exchange rate fixed and that is a credible E S undertaking, then t 1 St 0 i i F . St t t • 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. 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. S S itHIBOR itFF E t 1 t St Overnight US$ and HK$ Interest Rates 20.000 18.000 16.000 14.000 12.000 10.000 8.000 6.000 4.000 2.000 0.000 Interbank Offered Rate: Overnight (Hong Kong) Federal Funds Rate: Month Average (United States) Iron Triangle of International Finance Open International Capital Flows Independent Interest Rate Stable Exchange Rates Pick 2 items from this menu 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 BoJ Federal Funds Rate Uncollateralized Call Money Rate ECB Main Refinancing Rate/Euribor 29 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 Extra Liquidity Creates Extra Loanable Funds r SLF S′LF DLF r* r** LF LF* LF** Expansionary Monetary Policy P ΔI ΔC, ΔNX AD AD′ Y An Expansionary Cycle Driven by monetary policy YP SRAS′ P P*** 3 SRAS 2 P** P* 1 AD Output Gap 1. Economy at LT YP. 2. Monetary Policy Cuts Interest Rate. The AD curve shifts out. 3. Tight labor markets. AD′ SRAS returns to long run Y equilibrium 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. Demand Driven Recession w/ Counter-cyclical monetary policy 1. Economy in a recession. Fed detects deflationary pressure YP P SRAS AD′ 1 2. Monetary Policy Cuts Interest Rate 3 P* P** 3. AD curve shifts back to original equilibrium 2 AD Y Gap < 0 Demand Driven Expansion w/ Counter-cyclical monetary policy YP P SRAS P** 2. Monetary Policy Raises Interest Rate 2 3 P* 1 AD′ AD Gap > 0 1. Economy in expansion. Fed detects inflationary pressure 3. AD curve shifts back to original Y equilibrium U.S. Central bank cuts interest rates during recessions 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 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. 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 Dyn. AS-AD Model: IT YPt+1 YtP SRASt+1 SRASt P Demand expansion matches supply expansion P*t+1 Average Inflation Pt* ADt+1 ADt Yt* Y*t+1 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. Inflation Reports • Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty. 47 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 50 List of Inflation Targeting Countries Rose, 2006 A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed M1 2010 M9 2008 M5 2007 M1 2006 M9 2004 M5 2003 M1 2002 M9 2000 M5 1999 M1 1998 M9 1996 M5 1995 M1 1994 M9 1992 M5 1991 M1 1990 % 51 Japanese Monetary Policy CALL MONEY RATE 9.000 8.000 7.000 6.000 5.000 4.000 3.000 2.000 1.000 0.000 Zero Lower Bound SBR′ SBR SBR′ ′ SBR′ ′ ′ iIBR When nominal interest rate reaches zero, SBR′ ′ demand ′′ for money turns infinite since money pays just as good an interest rate as bonds. DBR i* i** i*** 1 2 3 4 5 Reserves Zero Lower Bound • Interest rate cannot be set below zero. Link 54 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. rt it Et t 1 With zero interest rates, real borrowing rates will fall when inflation rises. The newly-introduced "price stability target" is the inflation 55 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 BoJ index. Abenomics Quantitative Easing/Forward Guidance • Commit to future liquidity to raise expectations of future inflation to bring down real interest rates. 57 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 Link 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 supply and demand model of exchange rates to demonstrate the effects of either current or future monetary policy on exchange rates. Final Exam • When: Sunday, February 9th. 2-5pm. • Where: Lecture Theater K • What: Cover Materials in lectures on Supply& Demand, Macro Indicators, Exchange Rates, Loanable Funds, Business Cycles, Monetary Policy. • How: Format similar to practice final. • Bring writing materials, calculator, 1 A4 paper with handwritten notes on both sides. • Office Hours: Saturday, February 8th, 12:30-2