Download Chapter 9

Chapter 9
The Reserve Bank and the Economy
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–1
Chapter 9: The Reserve Bank
and the Economy
• The Reserve Bank, interest rates and the money
supply
• The supply of money and money market
applications
• How the Reserve Bank affects nominal interest
rates
• Implications of interest rate targeting for the supply
of money
• The effects of the Reserve Bank’s actions on the
economy
• The Reserve Bank’s policy reaction function
• Monetary policy making: art or science?
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–2
The Personal Demand for Money
• The anticipated value of my transactions – this
depends on my income
• The rate of interest – because money bears no
interest, holding money means I incur the
opportunity cost of interest forgone on other
financial assets
• Higher interest rates mean lower demand for
money
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–3
Macroeconomic Money Demand
• Nominal interest rate (i) [on the vertical axis]
• Real income or output (Y) affects the total volume
of transactions in the economy
• The price level (P): the higher the price level, the
more dollars are needed to finance a given volume
of transactions
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–4
The Money Demand Curve
9–5
Shifts in Money Demand Curve
• An increase in real income shifts the curve to the
right because there is a greater volume of
transactions and more money demanded at each
interest rate
• A rise in the price level shifts the curve to the right
because more money is needed to finance a given
volume of transactions
(The introduction of the GST raised the price level)
• Seasonal factors, such as spending for Christmas
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–6
Supply of Money & Equilibrium
• Money supply determined by the RBA
• Does not depend on interest rates
• So money supply curve is vertical with respect to
interest rates
• Equilibrium interest rate occurs where money
demand and supply curves intersect
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–7
Money Market Equilibrium
9–8
Bonds
• Are IOUs issued by borrowers
• Borrower promises to pay annual interest as well
as principal on maturity – the maturity value
• Borrowers supply bonds
• Lenders demand bonds
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–9
Coupon Rate of Interest
• The coupon rate of interest is the dollar amount of
annual interest promised as a percentage of the
principal amount borrowed
• Term of bond raises coupon rates
• Credit risk of borrower (bond issuer) raises coupon
rates
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–10
Market Price of a One-Year Bond
• How much would you pay now for a risk-free bond
promising you a principal repayment of $1000 and
a coupon of $50, both in one year’s time, a total
maturity value of $1050?
• It depends on current (not historical) market
interest rates
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–11
Bond Price (cont.)
• If current interest rates on similar securities such
as bank deposits are 5%, you would pay $1000
because $1000 deposited at 5% would grow to
$1000(1.05) = $1050
• But if current interest rates are 6%, you would pay
only $990.57 because at 6% a smaller amount is
needed to grow to $990.57(1.06) = $1050
• And if current interest rates are 4%, you would pay
more – $1009.62 – because at 4% this higher
amount would be needed to grow to
$1009.62(1.04) = $1050
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–12
Bond Price (cont.)
• Paying these prices means you earn market
interest rates on the bond
• If market interest rates are 5%, you will pay
1050/1.05 = $1000; gain of $50 = 5%
• If market interest rates are 6%, you will pay
1050/1.06 = $990.57; gain of $59.43 = 6%
• If market interest rates are 4%, you will pay
1050/1.04 = $1009.62; gain of $40.38 = 4%
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–13
Interest Rates and Bond Prices
• Bond prices are inversely related to market interest
rates
• When market interest rates rise (fall), the prices of
existing bonds fall (rise)
• Conversely, when bond prices rise (fall), it means
that market interest rates have fallen (risen)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–14
Market Price of a One-Year Bond
• Suppose a bond has a maturity value of MV in one
year’s time. What is its market value now – its
present value (PV)?
• In one year’s time this PV will grow to a maturity
value of PV(1 + i), where i is the current market
interest rate.
• So MV = PV(1 + i)
• It follows that PV = MV/(1 + i)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–15
Bond Prices & Market Rates
• If we know the maturity value (MV) of a bond and
its current market price (PV), what is the implied
interest rate?
• If PV = MV/(1 + i)
then i = [MV/PV] – 1
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–16
Money Market Equilibrium
• Suppose the demand for money exceeds the
supply …
• People will sell some of their bonds
• Bond prices will fall
• Market interest rates will rise
• The rise in interest rates reduces the quantity of
money which is demanded: shift along curve
• Demand for money now equals supply, and bond
prices and interest rates are stable
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–17
RBA Influences the Cash Rate
• When the RBA sells government bonds, money is
taken out of the money market as these bonds are
paid for
• The interest rate on 24-hour or overnight loans
rises
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–18
A Rise in the Cash Rate Spreads
• Lenders have a choice between lending in the
overnight market at the cash rate, and lending for
a longer term, such as 90 days, at higher rates
• Borrowers face similar choices
• When the cash rate rises, lenders demand higher
rates in the 90-day market while borrowers offer
higher rates in that market
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–19
The 90-Day Bill Market
• The demand for 90-day securities by lenders shifts
to the left
• The supply of 90-day securities offered by
borrowers shifts to the right
• The price of 90-day securities falls and the rate of
interest rises
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–20
Rise in Cash Rate Spreads
9–21
Targeting Interest Rates
• If the RBA targets the cash rate, it can only
achieve this by setting the money supply
consistent with this target
• The money demand curve tells us the demand for
money at the target interest rate
• So the RBA has to set the money supply equal to
this level of demand in order to achieve the target
• If there is a change (shift) in the demand for
money, the interest target can only be maintained
if the supply of money is also allowed to change
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–22
Interest Rate Target of 5%
9–23
The GST and Money Demand
•
•
•
•
When the GST was introduced, the price level rose
This increased the demand for money
Demand for money shifted to the right
The RBA could only maintain its interest rate target
by increasing the supply of money in line with the
demand
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–24
Targeting the Money Supply
• If the RBA targeted the money supply, instead of
the interest rate, it would have to accept the
interest rate at which the demand for money is
equal to that target supply
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–25
Nominal vs Real Interest Rates
• The RBA controls the nominal interest rate
• The real interest rate is the nominal rate minus the
inflation rate
• The inflation rate is ‘sticky’ in the short run
because it depends on inflation expectations of
workers and employers
• So in the short run, the RBA controls real rates
through control of nominal rates
• In the long run, the RBA has less control because
real rates are determined by the supply and
demand for saving
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–26
How Monetary Policy Works
• A rise in interest rates reduces consumption and
investment spending because it raises the cost of
borrowing, and the attraction of lending own funds
rather than investing them in investment projects
• It may also encourage saving
• Conversely, a fall in interest rates has the reverse
effects
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–27
Equilibrium GDP When Spending is
Real Interest Rate (r) Sensitive
• C = C + c[Y –T ] – ar
• Ip = I – br
• G =G
• NX = NX
(Where bars signify exogenous spending)
• PAE = sum of these components of spending
• Set PAE = Y (demand = supply) and solve for Ye
• Ye = [C + I + G + NX – c T – ar – br]/[1 – c]
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–28
Recession is Fought by Lowering r
9–29
Inflation is Fought by Raising r
9–30
RBA’s Policy Reaction Function
• The RBA is concerned with cyclical unemployment
and the inflation rate
• When GDP is close to potential, the emphasis is
on the acceptable ‘core’ inflation rate, in the region
of 2–3%
• The policy reaction function tries to explain/predict
by how much the RBA raises the cash rate when
the core inflation rate exceeds the target by 1%
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–31
The Taylor Rule
• In theory, the RBA responds to the ‘output gap’
(the difference between GDP and potential) and to
the inflation rate
• A rise in the output gap will lead the RBA to raise
nominal and real interest rates
• A rise in the inflation rate will lead the RBA to raise
nominal and real interest rates: that is, nominal
interest rates will be raised by more than the rise in
the inflation rate
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–32
By How Much?
• If GDP exceeds potential by 1%, by how much will
interest rates be raised?
• If inflation rises by 1%, by how much will interest
rates be raised?
• This is difficult to predict because it depends on
the respective weights or importance which the
RBA attaches to these undesirable outcomes
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–33
Hypothetical Reaction Function
9–34
RBA May Be Proactive
• The RBA may be proactive rather than reactive,
and may raise the cash rate to forestall an
expected, unacceptable but unquantified rise in the
inflation rate to prevent it from eventuating
• The RBA may also threaten to raise interest rates
to forestall higher expected inflation, not actually
raising them if the threat is believed and has the
desired effect
• Central banking, like any form of leadership and
crowd control, is not an exact science
Copyright  2005 McGraw-Hill Australia Pty Ltd
PowerPoint® Slides t/a Principles of Macroeconomics
by Bernanke, Olekalns and Frank
9–35
Recent History of Cash Rates
9–36