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Homework Assignment 2
Economics 4334: Money and Banking
Assigned: September 29th, 2015
Due: October 6th, 2015
1. Monetary Policy Framework Review the Monetary Policy Framework of the
Bank of Thailand (Website: Link ) which can be found at this under MPC
Knowledge.
i.
What is the principal goal in terms of the broad objective of monetary
policy?
According to the website, “The main objective of the Bank of Thailand (BoT) is to ensure
price stability in the economy, which is defined as low and stable inflation..”
ii.
What are the tools of monetary policy? What is the policy interest rate
used by the BoT (Link)? How wide is the interest rate corridor
The central bank uses reserve requirements, open market operations, and standing
facilities. The central bank policy rate is the “1-day bilateral repurchase rate” which is
used as the rate for the daily refinancing operation. The central bank also implements
other open market operations to control liquidity. The central bank has a lending and
deposit facility set ±.5% so the corridor is 1% wide.
iii.
What is the nominal anchor used by the BoT? What is the exact
inflation rate targeted by the BoT? Identify the measure of inflation
targeted, the level of the target, and the acceptable range for inflation.
.
The BoT has adopted an inflation targeting framework since 2000. The current inflation
target is set at 2.5% with a tolerance range of ±1.5%. The BoT has recently adopted
headline inflation.
iv.
Review the most recent monetary policy statement. What was the
decision of the monetary policy committee? Review the inflation
forecast in the latest Monetary Policy Report. How does this forecast
guide the monetary policy decision?
The BoT decided to maintain the policy interest rate at a level of 1.5%. Though headline
inflation is below the target range (actually below zero), the BoT forecast that inflation
will accelerate back into the target range by 2016. Since monetary policy is set to target
the future path of inflation and they think that the deflation is temporary, they did not cut
interest rates.
v.
What is the accountability mechanism of the central bank (Link)?
The central bank must offer a public explanation if inflation comes out below target.
2. Monetary Policy An economy can be represented as a linear function of gaps.
The aggregate expenditure curve represents the output gap as a linear function of
the difference between the inflation rate and the long-term level,
Y Y P
Output Gapt  t P  a  d   t  e  itP where a is an intercept, d is the
Y
inflation sensitivity of demand, and e is the interest sensitivity of demand. The
supply curve is given by Output Gapt  f   t   tE  where f is the inflation
sensitivity of supply. Assume that a is .05, d is .5, e is 1 and f is 2.
Inflation expectations are at 2%,  tE =.02, and the policy interest rate is
A.
4%, itP = .04. Calculate inflation and the output gap.
f   t   tE   Output Gapt  a  d   t  e  itP
 f  d    t  a  f   tE  e  itP 
t 
1
f
e
a 
  tE 
 iP
 f d
 f d
 f d t

 f d E
Output Gapt  f   t 

 f d t 

I
 1
 f d E
f
e
 f 
a 
  tE 
 itP 

 f d
 f d
 f d t 
 f  d 
 1

d
e
 f 
a 
  tE 
 itP 
 f d
 f d 
 f  d 
Output inflation
1
f
e
2
4
2
t 
a 
  tE 
 itP   a    tE   itP
5
5
5
 f d
 f d
 f d
 1
 4
d
e
2
4
Output Gapt  f  
a 
  tE 
 itP    a    tE   itP
5
5
 f d
 f d  5
 f  d 
If a = .05,  tE =.02, itP = .04.
2
5
4
5
2
5
 t   a    tE   itP  .02
.05
.02
.04
4
2
4
Output Gapt   a    tE   itP  0
.05
5
5 .02 5 .04
Consider if demand autonomously shifts out and a = .06.
i.
Solve for inflation and the output gap when the central bank keeps
policy constant, itP = .04.
2
5
4
5
2
5
 t   a    tE   itP  .024
ii.
.06
.02
.04
4
2
4
Output Gapt   a    tE   itP  0.008
5 .06 5 .02 5 .04
If the central bank wants to keep inflation targeted at 2%, how do they
need to adjust the policy rate? Solve for the policy rate needed to set
 t  0 . What is the output gap under inflation stabilization?
2
5
4
5
2
5
2
5
2
5
4
5
 TGT  0.02   a    tE   itP   itP   a    tE   TGT
.06
.02
.06
.02
.02
5
itP  a  2   tE   TGT  .05
.06
2 .02
.02
4
2
4
Output Gapt   a    tE   itP  0
5 .06 5 .02 5 .05
If  TGT =0, then
5
itP  a  2   tE   TGT  .1
.06
2 .00
.02
4
2
4
Output Gapt   a    tE   itP  0.04
5 .06 5 .02 5 .1
iii.
If the central bank wants to keep the output gap is zero, how do they
need to adjust the policy rate? Solve for the policy rate needed to set
Yt  Y P
 0 . What is inflation under output gap stabilization?
YP
4
2
4
Output Gapt  0   a    tE   itP
.06
5
5 .02 5
4 P 4
2
1
 it   a    tE  itP  a    tE  .05
.06 2
5
5 .06 5 .02
.02
2
4
2
 t   a    tE   itP  .02
5 .06 5 .02 5 .05
B.
Consider instead, if inflation expectations are suddenly shifted upward,
E
 t  .03. [Note, set a = .05].
i.
Solve inflation and the output gap when the central bank keeps policy
constant itP = .04.
2
5
4
5
2
5
 t   a    tE   itP  .028
ii.
.05
.03
.04
4
2
4
Output Gapt   a    tE   itP  0.004
.05
5
5 .03 5 .04
If the central bank wants to keep inflation target at 2%, how do they
need to adjust the policy rate? Solve for the policy rate needed to set
 t  0 . What is the output gap under inflation stabilization?
2
5
4
5
2
5
 TGT  0.02   a    tE   itP 
.05
.03
5
itP  a  2   tE   TGT  .06
.05
2 .02
.03
4
2
4
Output Gapt   a    tE   itP  0.02
.05
5
5 .03 5 .06
If  TGT =0, then
iii.
5
itP  a  2   tE   TGT  .11
.05
2 .00
.03
4
2
4
Output Gapt   a    tE   itP  0.06
5 .05 5 .03 5 .11
If the central bank wants to keep the output gap is zero, how do they
need to adjust the policy rate? Solve for the policy rate needed to set
Yt  Y P
 0 . What is inflation under output gap stabilization?
YP
4
2
4
Output Gapt  0   a    tE   itP
5 .05 5 .03 5
1
 itP  a    tE  .035
.05 2
.03
2
4
2
 t   a    tE   itP  .03
5 .05 5 .03 5 .035
3. Yield Curve. A central bank has set the policy rate at 1% and the economy has
had a flat yield curve at least 4 years in the future. The central bank announces an
increase in the short-term policy rate to 2%. Under Scenario A, the public expects
the interest rate to be 2% indefinitely. Under Scenario B, the public expects the
policy move to be the beginning of a tightening cycle in which interest rates will
be raised by 1% in each year for four successive years.
Path of Expectations of Policy
Yield Curve
Rates
Scenario
Scenario
Original A
Original A
B
B
i1
.01
.02
.02
i1
.01
0.02 0.02
i1,+1 .01
.02
.03
i2
.01
0.02 0.025
i1,+2 .01
.02
.04
i3
.01
0.02 0.03
i1,+3 .01
.02
.05
i4
.01
0.02 0.035
a. Assume that the expectations theory of the term structure is true. Construct
the post-announcement yield curve under each scenario.
b. Consider a preferred stock certificate that will pay $100 at the end of every
year for 4 years then cease making payments forever. The fundamental value
$100
$100
$100
$100



of the asset is
. Before the announcement
2
3
1  i1 1  i2  1  i3  1  i4 4
of the new policy, the value of the asset is about $390.20. Calculate the value
of the asset after the announcement under each scenario.
1.01
1.02
1.02
1.0201
1.0404 1.050625
1.030301 1.061208 1.092727
1.040604 1.082432 1.147523
Original
Scenario
A
Scenario
B
0.990099
0.980296
0.97059
0.96098
390.197
0.980392
0.961169
0.942322
0.923845
380.773
0.980392
0.951814
0.915142
0.871442
371.879