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Macroeconomic Policy in the
Asia-Pacific
GECO 6400
Monetary Policy
Review
Last lecture we defined the concept of
money.
We looked at how banks can create
deposits and expand the money supply.
We introduced the money multiplier.
This week
The major focus is on Monetary Policy (MP).
New concepts include:
– Exchange Settlement Accounts;
– Open Market Operations; and
– Cash Rate.
We will evaluate MP & FP.
Let’s start with money market …
Last week discussed money supply & introduced
money demand.
Achieved equilibrium at that interest rate where
money demand equals money supply.
Saw that we hold money as an asset when
interest rate is low but what assets might we
hold when interest rate is high?
Equilibrium Interest Rate
Rate of interest, i (per cent)
Sm
10
7.5
Equilibrium
Interest Rate
ie 5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Bonds
Central banks use bonds in the operation of
Monetary Policy.
A bond represents a promise by the issuer of
the bond to make a sequence of future
payments & eventually redeem the bond.
The return on a bond in percentage terms is
called the Yield. This is the interest rate paid
on the investment in a bond.
Annual
Payment
Bond Yield =
Bond Price
x 100
Bonds
For example, suppose a bond is issued with an
annual payment of $10.
If the bond was sold for $100, then the yield (or
interest rate) will be:
$10/$100*100=10%
If price of the bond was $50, then the yield is 20%.
If price of bond was $200, then the yield is 5%.
Thus, we observe an important principle:
The price of a bond and its yield are inversely related.
The Yield Curve
Yield curve plots the interest rates that apply at a
point in time to securities of similar risk but
different terms.
In practice there are many different financial assets
that vary in their term to maturity, their liquidity and
their risk.
In general, the longer the term, the less liquid and
the more risky, the higher will be the interest rate.
The interest rates shown on yield curves are
connected to one another.
Yield (% pa)
Yield Curve
Maturity
Money Market and Interest Rates
Most central banks focus their Monetary Policy on the cash
rate and this rate in turn influences all other interest rates.
The cash rate and interest rates on other securities tend to
move together. This is due to 3 factors:
1. Financial assets of similar maturities are substitutable for
each other. So we would expect them to have similar
interest rates.
2. A change in the cash rate alters the cost of funds for
banks & this flows through to a change in the cost of credit
from banks.
3. If the cash rate is say 4% then any security that is more
risky or longer term must offer a higher interest rate to
induce people to hold those securities.
Finding Equilibrium Interest
Rate
Rate of interest, i (per cent)
Sm
10
7.5
ie
Equilibrium
Interest Rate
5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Excess Dm,
sell bonds,
push price
of bonds
down & i
rate up.
Finding Equilibrium Interest
Rate
Rate of interest, i (per cent)
Sm
10
Excess Sm, buy
bonds, push price of
bonds up & i rate
down.
7.5
ie 5
Equilibrium
Interest Rate
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Revisiting the Interest rate
effect
Rate of interest, i (per cent)
Sm
If price level or GDP
rises then
Transactions Dm will
rise. All else equal,
the interest rate will
rise.
10
7.5
ie 5
2.5
Dm1 Dm2
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Dissecting Money Supply …
Central banks and private banks influence the
money supply.
Central banks are responsible for monetary base
which consists of:
– Currency held by the public
– Currency held by the banks
– Private Banks’ demand deposits with the Central Bank
Banks are responsible for deposit expansion
Monetary base * money multiplier.
Exchange Settlement Accounts
Private Banks are obliged to hold funds with
the Central Bank.
These funds are called Exchange Settlement
Account funds in Australia.
The RBA requires banks to hold ESA as part
of the payment system to settle accounts
between banks & to manage flow of funds
between RBA & banks.
ESA pay very low rate of interest (below cash
rate) so there is no incentive for banks to hold
surplus funds in ESA.
Banks are required to ensure that there is a
positive balance in their ESA at all times.
Dissecting Money Supply …
Notice that private banks’ ESA deposits
with the RBA are both part of the
monetary base and part of private
banks’ reserves.
Private banks’ Reserves are cash in
their vaults plus their ESA deposits with
the RBA.
Exchange Settlement Accounts
If a bank finds its ESA headed towards deficit, it must top up
its account quickly with funds or cash - by obtaining funds
from short-term money market (STMM), selling some of its
government securities to the RBA or by taking out a
repurchase agreement (repo or RP) with the RBA.
If there are surplus funds in ESA, bank will move money into
STMM to earn higher interest.
The cash rate is the interest rate that brings the supply &
demand for funds in the STMM into equilibrium.
Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
R 100
L 900
D 1000
Bank B
R 50 D 500
L 450
Suppose you bank with Bank A & you write a cheque for $20
that is paid to a customer of Bank B and they deposit your
cheque with Bank B. Assuming a 10% Required Reserve Ratio,
then at the end of the day …
Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
-$20
+$20
Bank A
R 100
D 1000
-20
Bank B
R 50
D 500
+20
Settlement will reduce Bank A’s Reserves and increase Bank
B’s reserves.
Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
R 100
-20
D 1000
-20
Bank B
R 50
+20
D 500
+20
Bank A will lose reserves while Bank B will gain reserves.
There will then be flow on effects to loans, with Bank A
calling some in to restore required reserve ratio and Bank B
writing new loans.
Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
R 98
L 882
D 980
Bank B
R 52
D 520
L 458
These transactions have shifted funds between banks but they
have not changed the whole banking system.
ESA Funds, Money and
Investment Funds
There is a distinction between ESA funds, money
& investment funds.
ESA funds are the funds that are the subject of
ESA accounts and are closely connected to
money. Recall that ESA are part of monetary base
but not part of M3 or Broad Money.
Money here refers to M3 or Broad Money.
Market for investment funds represents all the
markets for funds on yield curve.
ESA Funds and Money
D1
D2
Opportunity cost of money
S2
Cash rate
S1
Sm1
Dm1 Dm2
ESA funds
Money balances
The RBA accommodates the demand for money (perhaps due to rise in
Transactions Demand) by increasing ESA funds and holding the cash
rate steady. How does it increase ESA funds? By buying government
securities.
Monetary Policy Objectives
Monetary policy
Influencing interest rates and credit availability to:
– Encourage real GDP growth;
– Promote employment; and
– Stabilise the price level
Fundamental objectives
full employment
non-inflationary level of total output
Central banks have responsibility for managing
monetary policy
Monetary Policy Tools
Major financial securities used by Central
Banks to determine the cash rate are:
– Open market operations (OMO)
– Foreign exchange swaps and intervention
in the foreign exchange market
– Rediscount rate & repurchase
agreements
Foreign Exchange Swaps
RBA may use foreign exchange swaps to
supplement or substitute for OMO
Foreign exchange market intervention—either
selling or buying Australian dollars
– purchase/sale of dollars is equivalent to purchase/sale
of government securities, and has similar impact on
banks’ ESA funds
Rediscount Rate and Monetary
Policy
The rate at which the RBA buys or sells
short-term securities under repurchase
agreement
Can be used as a central tool of monetary
policy
Open-Market Operations
Buying and selling of Commonwealth
government securities by the RBA in the
cash or short-term money market
The objective of OMOs is to ensure that
the demand and supply of ESA funds are
such that they are in balance at the target
cash rate
Open-Market Operations
Buying and selling of Commonwealth
government securities by the RBA affects the
cash rate
Cash rate provides an indication of the RBA’s
monetary policy stance
– Sustained increases in cash rate target level:
tightening of monetary policy
– Sustained decreases in cash rate target level:
easing of monetary policy
Open-Market Operations:
Buying Securities
Banks sell some of their securities
Expansionary Monetary Policy
RBA pays for securities by increasing
banks’ exchange settlement accounts
(ESAs)
Bank reserves increase
– Causing the monetary base and the banks’
lending ability to increase
Open-Market Operations:
Selling Securities
The RBA sells securities to the banks
Contractionary Monetary policy
Banks pay for securities by decreasing
their exchange settlement accounts
(ESAs)
Bank reserves decrease
– Causing the monetary base and the banks’
lending ability to decrease
ESA Funds and Money
D1 D2
ESA Funds
Opportunity cost of money
S2
Cash rate
S1
SM1
DM1 DM2
Money Balances
To maintain a steady MP, RBA buys just enough bonds to provide
extra funds and hold the cash rate at its targeted level. This process
can also be done in reverse.
Easy Monetary Policy
Implemented when the economy is faced
with the prospects of:
substantial unemployment;
or deflationary pressure
Central Bank announces its intention to
reduce the cash rate
Central Bank acts to bring the ESA funds
market into balance
Easy Monetary Policy
D1
ESA funds
Opportunity cost of money
S2
Cash rate
S1
SM1
SM2
DM1
Money Balances
To run an easy MP, Central Banks buy more bonds than needed to
meet day to day transactions & cash rate falls to new targeted
level.
D1
Opportunity cost of money
S2
Cash rate %
S1
Cost of funds %
SF1
SM2
DM1
Money Balances
SF2
DF
Market for Investment Funds
Real rate of interest %
ESA funds
SM1
Easy
Monetary
Policy
I
Investment Demand
AS
Price level
Real rate of interest %
AD1
I
Investment Demand
AD2
Real domestic output, GDP
Tight Monetary Policy
Enacted when the economy is facing
significant inflationary pressures
Central Bank announces its intention to
increase the target cash rate
ESA funds are brought into balance at this
new target cash rate
S1
Cash rate
S2
D1
ESA funds
Opportunity cost of money
Tight Monetary Policy
SM2
SM1
DM1
Money balances
To run a tight MP, Central Bank buys fewer bonds (or sells bonds)
than needed to meet day to day transactions & cash rate rises to
new targeted level.
D1
Opportunity cost of money
S1
Cash rate %
S2
Cost of funds %
SF2
SM1
DM1
Money balances
SF1
DF
Market for Investment Funds
Real rate of interest %
ESA funds
SM2
Tight
Monetary
Policy
I
Investment demand
ASLR
Price level
Real rate of interest %
AD2
AS
AD1
I
Investment Demand
Real domestic output, GDP
MP and Exchange Rates
International capital flows move around the world in
response to interest rate differentials.
When domestic interest rates rise, the interest rate
differential between domestic & overseas interest rates
widens and attracts capital inflow.
This causes the value of a freely-floating currency to
appreciate making imports more attractive and Net
Exports fall.
This will reinforce the shift to the left in AD.
This can also work in reverse.
Expansionary MP & Transmission
Mechanism
Central Bank announces cash rate target, buys
bonds, increases ESA funds.
Bank reserves increase, deposits created &
money supply expands.
Interest rates fall currency depreciates.
Investment (& consumption) increase; Net
Exports improve.
AD increases.
Equilibrium GDP increases & price level rises.
Second Round or Feedback Effects
The expansionary MP will shift AD to the right
as outlined but now we need to consider the
consequences of the rise in GDP.
Recall that the transactions demand for
money shifts to the right as GDP rises.
This increase in demand for money will
generate an increased demand for ESA
funds.
What will central bank do? It can do nothing &
allow the cash rate to rise OR it can
accommodate the change to keep the cash
rate at target.
D1 D2
Opportunity cost of money
S2
Cash rate %
S1
ESA funds
Sm1
Sm3
Sm2
Dm1
Money Balances
AD2
AS
Price level
AD1 AD3
Real rate of interest %
Dm2
I
Investment Demand
Real domestic output, GDP
S2 S3
SM3
SM2
D1 D2
DM1 DM2
Money balances
ESA funds
AD1
AD2
AS
Price level
Real rate of interest %
SM1
Cash rate %
Opportunity cost of money
S1
I
Investment Demand
Real domestic output, GDP
Second Round Effects & FP
Now we are in a better position to understand
the finance implications of budget deficits &
crowding out.
Expansionary FP has a first round effect of
shifting AD to the right.
Second round effects cause transactions
demand to shift to the right as GDP rises.
This increase in demand for money will
generate an increased demand for ESA funds.
What will central bank do? It can accommodate
the change to keep the cash rate at target OR it
can do nothing & allow the cash rate to rise.
AD1
AS
AD2
Increase in AD leads to upward
pressure on interest rates. If RBA
meets demand for ESA funds then
cash rate & Investment will not
change. There will be NO
Crowding Out.
S1 S2
SM1
DM1 DM2
D1 D2
ESA funds
Money balances
S1
SM2
SM1
D1 D2
Dm1 Dm2
I
ESA funds
AD1 AD3
AD2
AS
Real domestic output, GDP
Increase in AD leads to upward
pressure on interest rates. If RBA
does NOT accommodate then
cash rate will rise & Investment
will fall. Some Crowding Out will
occur and AD will shift back to
the left causing output and prices
to fall.
Evaluating MP & FP
MP will be more effective:
– the less interest elastic is the money demand
– the more interest elastic is the investment demand
curve
– the more price elastic is SRAS
FP will be more effective if:
– RBA accommodates demand for money OR
– more interest elastic is the money demand
– the less interest elastic is the investment demand
curve.
– the more price elastic is SRAS
Evaluating MP & FP
MP short comings:
– Cyclical asymmetry
– Conflict with Treasury goals
– Investment may be relatively insensitive to
interest rate changes
– Does not address cost-push inflation
FP shortcomings:
– Tax changes may have supply side effects
– Does not address cost-push inflation
Evaluating MP & FP
MP lags & politics:
– Easy to implement & flexible.
– Subject to long impact lags (up to 12 months)
– Less subject to political interference.
– Blunt, indiscriminate policy
FP lags & politics:
– Lags in planning & implementation
– Subject to political interference – see political
business cycle
– Can be tailored to suit particular regions or subgroups.
Policy co-ordination
Both FP & MP operate to influence AD and the
level of production & employment in an economy.
We have viewed each separately but they are in
practice inter-related.
Co-ordinating expansionary FP & MP can
increase AD with no change in the interest rate or
any desired change in the interest rate.
For example, expansionary FP with a small dose
of expansionary MP will increase the interest rate
(and the exchange rate).
Or expansionary FP with a significant easing in
MP can leave interest rates unchanged (and the
exchange rate).
Policy conflict
Sometimes the political imperatives that
governments respond to & the objectives of
central banks diverge.
Governments tend to have shorter (re-election)
time horizons. While central banks have longer
time frame centred on price stability.
Govt pursuing expansionary FP might desire
expansionary MP (to lower interest rates and
the currency) but if central bank is concerned
about inflation, it will not ease MP unless FP is
restrained.
Policy objectives & policy tools
MP objective is to ‘assist the economy to
achieve full-employment, non-inflationary level
of total output’.
Actually 2 objectives here – full employment &
price stability. Sometimes these objectives pull
in opposite directions.
Further MP has essentially one tool to achieve
its objectives – OMO.
A rule of thumb says that should have one
objective per tool.
Most recently MP, with its long lags, has focused
on achieving an inflation target.
References
Mc Taggart et al. Chapter 27
Jackson & McIver, Chapter 12.