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Anthony Byett Economist fxmatters.co.nz November 2006 Money and Monetary Policy Interest Rates Exchange Rates.

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Presentation on theme: "Anthony Byett Economist fxmatters.co.nz November 2006 Money and Monetary Policy Interest Rates Exchange Rates."— Presentation transcript:

1 Anthony Byett Economist fxmatters.co.nz November 2006 Money and Monetary Policy Interest Rates Exchange Rates

2 Money and Banking  Definition of money  NZ banking system  Money in NZ

3 Review Introducing a stock into the flow model  Money is a stock concept –measured at a point in time  Income is a flow concept –per annum concept Households Firms Goods & services produced from capital & labour Refer Callander 2nd Ed p360

4 Forms of Money  Utu, favour exchange  Gold, greenstone, cigarettes  Notes & coins  Transaction accounts –access by cheque, EFT-POS, telephone  Savings accounts –NB some accessible by ATM, telephone  Debit cards (as opposed to credit cards) Refer: * The Economist 22-Dec-01 pp85-87

5  Medium of exchange. In order to function it must have the following properties: - acceptable - scarce - portable - divisible - durable  Store of value  Unit of account  Means of deferred payment Functions of Money Why hold money? Refer Callander 2nd Ed p533

6 Money in NZ How much?  Recent figures put money = $171 billion –I.e. Jun-06 “M3 money supply” reported by RB –including $2.8 billion notes & coins –remainder were bank deposits  Had been $93b in Mar-99 –breakdown of this figure to come in following slides

7 Banking in NZ Institutions  Government > collects taxes & borrows money > buys goods & services, pays benefits  Reserve Bank> banker to Government & banks > supervises registered banks > implements monetary policy > issues currency  DMO> Government’s Treasury  Registered banks> accept deposits/makes loans > manage pooled investments > process transactions  Other financial institutions

8 M3 Financial Institutions Owners, assets ($b) and S&P credit ratings 1 ANZ NationalANZ, Aus87AA- 2 WestpacTrust*Westpac, Aus48AA- 3 BNZNAB, Aus46AA- 4 ASB BankCBA, Aus42AA- 5 Hong Kong*HK Shanghai6AA- 6 Deutsche Bank*DB, Germany6AA- TSBNZ trust3BBB- Others (3 banks/sub & 2 non-bank)13 TOTAL (at Dec-05)251 * Branches Note: Kiwibank ($2.5b) is a bank but not within M3 survey (yet) Source: and

9 Balance Sheets of Banks A ssets L iabilities + Loans - Deposits + Reserves - Capital (or liquids) NB: deposit is –customer’s asset, and –bank's liability (as owed customer) Refer Callander 2nd Ed p535

10 NZ “M3” Balance Sheet ASSETS (Mar-99 total=$143b)$b NZD claims (lending)122 Non-NZD claims5 NZ Government securities7 Claims on RBNZ/notes & coins1 Other assets9 LIABILITIES NZD funding (deposits)100 Non-NZD funding28 Capital8 Other liabilities7 Source: or RBNZ Financial Statistics

11 Definitions of money supply LIABILITIES ($billion at Mar-99) NZD funding (deposits)100 Transaction accounts (net*)12 Other call accounts (net)27 Other deposits (net)52 * the netting involves the deduction of inter-institutional deposits and government deposits Source: or RBNZ Financial Statistics

12 Monetary Aggregates  Move from narrow to broad definition of money –as per The Economist, Financial Indicators M3M1M2

13 LIABILITIES ($billion at Mar-99) $2 billion NZD funding (deposits)100notes & coins held by public Transaction accounts (net)+12 14= M1 Other call accounts (net)+27 41= M2 Other deposits (net)+52 93= M3 Source: or RBNZ Financial Statistics Definitions of Money Supply

14 Money Supply Note that …….  Unexercised overdrafts –not part of money supply  Debit cards and cheques –not themselves money  Credit cards –accumulate debt to be settled with M1 money

15 Financial Assets and Liquidity Money just one asset  Spectrum of liquidity (See Callander, p536) Cash Physical/human assets NB liquidity may incur opportunity costs Liquidity the ease with which an asset can be converted into an M1 asset (i.e. money ) without loss of capital value

16 Money Creation  The creation process –bank asset & liability growth  Limits on natural growth –Daily settlement –Government does not create money –Government flows offset  Money and inflation  Money and growth

17 Where Does Money Come From?  Primitive Bankers –acted as custodians –issued receipts for gold deposits –receipts used for transaction purposes  Banking Evolved –bankers made loans (for interest) by issuing more receipts –assumed not all holders of deposits would want gold at the same time  reserves only needed to be a fraction of their deposits (liabilities) Refer Callander 2nd Ed p535

18 Initial Goldsmith’s Balance Sheet Assets$Liabilities$ Gold Reserves100Deposits100 See Callander, Fig A.2, p538, Balance Sheet A

19 Goldsmith’s Balance Sheet after Lending Assets$Liabilities$ Gold Reserves100 Loans400 Deposits500 Compare Callander, Fig A.2, p538, Balance Sheet B Reserves = 20% of deposits

20 Fractional Reserve Banking  A banker holds only a fraction of the outstanding deposits in reserve funds  In New Zealand –up to mid 1980’s a system of compulsory reserve ratios operated (Reserve Ratio) –‘Prudential reserve ratios’ are used today

21 Banking pre-80s  Regulated Reserve Ratios –only replaced in the mid-1980s Assets$Liabilities$ Loans Reserves of Govt. Securities Deposits Capital

22 Banking Today  Self-imposed liquidity management –includes government, bank & corporate securities  Minimum capital ratios by regulation Assets$Liabilities$ Loans Liquids Deposits Capital

23 Assets$Liabilities$ Loans Liquids Deposits Capital Money Creation more deposits >>> more lending  Often associated with government spending –Gov’t spends money that it does not have  Banks will on-lend (or repay other funding)

24 Assets$Liabilities$ Loans Liquids Deposits Capital Money Creation more lending >>> more deposits  More likely the cause today –A bank lends money during day (which it may not have) –Loan money is deposited in bank –Loan becomes “self-funding”

25 Managing Money Growth in NZ  Government issues debt to fund any revenue shortfall (I.e. does not create money) –Long-term: Government Stock issued monthly (approx.) –Short-term: Treasury Bills issued weekly  RBNZ also smoothes daily government flows –through daily and now intra-day settlement –through open market operations

26 The Settlement Process  Settlement banks bank with the RBNZ –non-settlement banks bank with settlement banks  At end of day*, the net daily inter-bank flows are known (* next morning actually) –money owed to other banks paid with RBNZ balances –i.e. settlement cash –if bank has no “cash” –tries to borrow from other bank –can borrow from 0.25% over cash target –or +0.30% if rolling intra-day bank bill repo Refer Callander 2nd Ed p473

27 Smoothing Settlement Cash  RBNZ conduct daily “open market operations” (OMO) to smooth flows –largely to offset government flows  Too much cash forecast  RBNZ sells T-Bills for cash  Not enough cash forecast  RBNZ lends cash –banks borrow cash using Bills and Bonds as security –actually sell bills/bonds and forward purchase (repo)

28 Does Money Matter?  Remember week 6 and GDP…  The quantity equation MV = PY M= stock of money ($) P= price level ($) V= velocity of circulation (times per year) Y= volume of production (number of “things”)  if velocity steady, money growth will match nominal production growth more money > more output and/or more inflation Refer: * Sherwin, “Inflation”, Economic Alert, Apr-99

29 The Output Gap Linking money to AD/AS model  More “money” leads to greater aggregate demand  We cannot satisfy all this demand with new products/services  Feeds through to higher prices AS Price Level Real Output ADAD1 Inflation Refer Callander 2nd Ed p420, Fig 20.6

30 Money and Inflation

31 Money and House Prices

32 Summary  Money typically is bank deposits  Can be created from thin air  Growth constrained by capital requirements –and source of funding –And by government financing with debt  Also volatility reduced by RBNZ cashflow smoothing  Some loose connection between money and inflation/growth exists

33 Monetary Policy

34 Monetary Policy Process NZ monetary policy a three step process: 1.An inflation target is set by the Reserve Bank Governor (Bollard) & Treasurer (Cullen) 2.An inflation forecast is formed by the RBNZ 3.The RBNZ adjusts short-term interest rates to bring the forecast into line with the target »via cash rate target

35 Inflation  In theory, inflation a momentum –the ongoing rise of prices, wages, money supply  In practice, inflation is the change in CPI –goods & services that households consume –weighted according to proportion of spending  Inflation high late 70s, low now –vicious cycle: higher wages, prices & devaluations –tried to contain with wage/price freeze early 80s –eventually moved to independent Reserve Bank –also tight gov’t control, competitive economy, floating exchange rate

36 Inflation

37 “The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices”  Inflation target set for term of Governor’s office  RBNZ actions to be consistent with policy target  RBNZ to consult & advise Gov’t (and others)  Governor-General can set another objective for 12 month periods  Policy statements every 6 months RBNZ Act 1989 Part II

38 The Inflation Target  Contract between RBNZ Governor and Treasurer –Governor appointed to September 2007  Stability agreed to as CPI inflation between 1-3% p.a. on average over the medium term  Exceptions allowed (if >0.25 was rule of thumb): –terms of trade shock –changes to indirect taxes –natural disaster shock –changes to government levies (see Policy Targets Agreement, September 2002)

39 Consumer Price Index As at June 2006  Annual rate 4.0% –Large contributions from housing & petrol  But inflation? –To what extent will rises be ongoing?  Tradable vs Non- tradable Inflation

40 The inflation forecast  RBNZ forecasts inflation  look at annual CPI forecast out 24 months  in RBNZ model, inflation determined by: –exchange rate movements –international price of exports & imports –unit labour costs –output gap –inflation expectations  influential factors are TWI & unit labour costs

41 Implementation of Policy  If forecast inflation does not match the target –then some policy response is required  Policy signalled via interest and exchange rate forecasts  Policy acts through short-term interest rates  Policy is implemented through the official cash rate target –from 17 March 1999

42 RBNZ Transmission Path Diagram Fig 27.3, p490

43  Forecast annual CPI of 3.9% p.a. (falling to 2.4%)  Cash rate unchanged on the day (7¼%)  Assumes growth slowing –GDP Mar 04/ % to 06/ % “Growth to remain low … headline CPI inflation above 3% well into 2007 … do not expect to tighten … no scope for easing of the OCR this year” Source: Current Monetary Policy RBNZ Jun-06 Projections

44 No imminent change expected

45 Monetary Theory and Practice General  Theory links money growth with inflation  Correlation between money and nominal output exists in long-run (Quantity equation again) –in short-run, relationship is not evident  Chronic and acute inflation has been associated with money-financed government budget deficits

46 Monetary Theory and Practice NZ experience  NZ Government debt-finances  Money growth plays small role  Early 90s fall in inflation coincided with international recession and fiscal tightening  There exist long and uncertain lags between changes to monetary conditions and inflation  Large changes in interest rates are needed to change exchange rates & inflation rates –Low elasticity with respect to interest rates.

47 Interest Rates  Many interest rates –primary & secondary markets –wholesale & retail (say <$1m)  Short-term yields (or rates)  set in money market  where cash, bills and notes are traded  Long-term yields (or rates)  set in bond market  where bonds, gov’t stock & notes are traded

48 90 Day Bank Bill

49 Retail Floating Rates

50 Retail Floating Rates and Wholesale Rates

51 A 90-day bank bill what is it?  A “bank bill” in NZ now is typically a certificate stating the bank will pay a fixed sum (the face value) to the holder at a set date –in essence, a tradeable bank deposit –called a Negotiable Certificate of Deposit (NCD)  More traditionally (and still traded today) a “bank bill” was a Bank Accepted Bill (BAB) –two parties set up a loan which a bank then endorses –bank guarantees payment in case of default

52 A 90-day Bank Bill some characteristics  Returning to Negotiable Certificate of Deposit –typically issued by banks for days –e.g. bank will pay holder $0.5m in 90-days –holder can sell to another party if they wish –banks initially receive market value  Market value of bill determined by bill rate –NB the rate is a discount rate –Value = 500,000/(1+rate*90/365) –e.g. rate=6.0% implies value =$492,710

53 Major Money Market Instruments NameIssuer Treasury BillsGovernment Promissory NotesCorporates Bank BillsBanks Derivatives linked to Bank Bills: –Futures, Forward Rate Agreements (FRAs) –Options –Interest rate swaps

54 Fixed Lending Rates

55 Major Market Instruments  Securities promising the holder a defined cashflow –Bill (short term) –e.g. pay $100,000 to holder on 10-Aug-2005 –no coupon or interest rate –Bond (long term) –includes coupon rate as well –e.g. pay $100,000 to holder on plus $3,000 on the 15th of each May & Oct –can get zero coupon bonds

56 Major Bond Market Instruments NameIssuer Government StockGovernment Medium Term NoteCorporates/Banks BondCorporates/Banks Derivatives linked to Government Stock: –futures (3yr only) –options

57 Wholesale Yield Curve

58 The Yield Curve Differing theories  Segmented markets –different people operate in different markets –rates loosely connected  Expectations –longer-term rates as series of expected short-term rates  Liquidity or risk premium –premium required to induce people to hold longer-term investment  Element of all in NZ, strong expectation influence

59 Interest Rates Influences  Inflation (real rate)  Monetary policy  Offshore interest rates  Exchange rate expectations  Extent of borrowing  Next: –some graphical evidence –some theory Refer National Bank, Sep 1996

60 NZ Inflation

61 NZ Inflation & Interest Rates

62 OCR and Other Rates

63 Offshore & Local Interest Rates

64 Long-term Interest Rates

65 Interest rates Theories  Interest rates as a price reflecting decisions about flows savings = investment  Interest rates as a price reflecting decisions about stocks (I.e. a portfolio decision) demand for bonds = supply of bonds  These decision processes may be independent!

66 Interest rates Savings & investment  People require a positive return to save –i.e. give up current consumption for future consumption –savings are expected to rise should rates rise  People willing to pay now to invest –i.e. pay funding cost now in expectation of future return –the higher the return, the higher the interest rate –clouded by ‘return-insensitive investment’ –e.g. government investment  Interest rate a balance of productivity & time preference

67 The equilibrium interest rate Bringing together savings and investment Interest rate Amount of savings/investment Savings Investment Refer “How low can they go?” The Economist, 2-Dec-95

68 The equilibrium interest rate A model of the current account deficit Interest rate Amount of savings/investment Savings Investment Rate set low BOP deficit

69  Motives for holding bonds –spare cash not needed for transaction purposes –as a store of wealth in general  Bond supply –Corporates issues to get cash for investment –either into physical assets or financial assets  Interest rate a balance of demand and supply for bonds Interest Rates Demand & supply of bonds

70 Bond Supply Curve SUPPLY (borrowers) Rate of interest Bond Stock

71 Bond Demand Curve DEMAND (lenders) Rate of interest Bond Stock

72 The Equilibrium Interest Rate Bringing together bond supply and money demand SUPPLY Rate of interest Bond Stock DEMAND r

73 The Equilibrium Interest Rate Balancing portfolio decisions  Bonds are just one financial asset  Interest rates are also set in other markets –e.g. money market  In general, returns are established in many financial markets –e.g. share markets  “interest rates” are the result of portfolio decisions

74 Summary  Interest rates result from the interaction of many decisions –both about production/saving –and about asset allocation  In the short-run, RBNZ policy is the major determinant of short-term rates –longer-term, savings and investment issues will be more influential  Long-term rates are strongly influenced by offshore rates

75 Banking References  “The banking system in NZ”, Chris Moore, Economic Alert, May 1996  “NZ banks...”, David Tripe, Massey University, quarterly  Chapter 9 in “Structure & dynamics of NZ industries”, Pickford & Bollard, Dunmore Press, 1988  Chapter in Overview of NZ Economy, NZDMO, see  “Liberalisation of the financial markets in NZ”, Arthur Grimes, RBNZ Bulletin, December 1998  “Developments in the banking industry”, RBNZ Bulletin, Each June quarter  “Consolidated table of KIS”, RBNZ Bulletin, June 1997

76 Banking Web Sites         

77 Monetary Policy References  Various RBNZ publications –see  Critics of monetary policy –“Prosperity denied”, Bob Jones, Canterbury University Press, 1996 –Chapter 7 in “The NZ experiment”, Jane Kelsey, Auckland University Press, 1995

78 Interest Rate References general  “Interest rates and money markets in Australia”, Tom Valentine, Financial Training & Analysis Services, 1991  “The Reuters guide to official interest rates”, Ferris & Jones, Probus Publishing, 1995  “NZ’s money revolution”, Edna Carew, Allen & Unwin, 1987  Reserve Bank Bulletins incl. “An overview of the money and bond markets in NZ”, Sep & Dec l Some more websites bloomberg.com yahoo.com dismal.com worldeconomist.com thepaperboy.com yardeni.com imf.org stats.govt.nz treasury.govt.nz

79 Exchange rates

80 Currency newsletter For those with an interest in currency markets …  What would you like to read in a weekly currency newsletter? See

81 Exchange rate determinants Some generalisations  in the short-run, high interest rates will lead to a strong currency  in the medium term, large current account deficits will lead to depreciations  in time, low inflation rates will lead to an appreciating currency

82 Exchange rate volatility  rates are more volatile than fundamentals  fundamentals matter in the long run –but not in short run  herding as a response to uncertainty –Refer A Kirman, Bank of England Bulletin, Aug 95

83 Exchange rates and interest rates

84 Exchange rates and inflation

85 Exchange rates and the current account

86 NZ dollar NZD/AUD & interest rate differential

87 NZ dollar Large influence of AUD

88 Other currencies versus the US dollar

89 US dollar

90 Australian dollar Following commodity prices

91 Australian dollar Or is it?

92 Currency Supply and demand USD Per NZD Amount of currency Supply Demand Refer Callander 2nd Ed p340

93 Summary  Exchange rates result from the interaction of many decisions –both about trading goods and services –and about investing in assets  In the short-run, interest rates are often the key determinant –longer-term, any trade imbalance will impact  In NZ, the AUD is a large influence


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