Presentation on theme: "Monetary Policy Macroeconomic Policy in the Asia-Pacific GECO 6400"— Presentation transcript:
1 Monetary Policy Macroeconomic Policy in the Asia-Pacific GECO 6400 Slide 1Monetary Policy
2 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.
3 This week The major focus is on Monetary Policy (MP). New concepts include:Exchange Settlement Accounts;Open Market Operations; andCash Rate.We will evaluate MP & FP.
4 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?
5 Equilibrium Interest Rate Sm107.552.5DmEquilibriumInterest RateieRate of interest, i (per cent)Amount of money demanded(billions of dollars)
6 Bonds Annual Payment x 100 Bond Yield = Bond Price 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 PaymentBond Yield =x 100Bond Price
7 The price of a bond and its yield are inversely related. BondsFor 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.
8 The Yield CurveYield 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.
10 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:Financial assets of similar maturities are substitutable for each other. So we would expect them to have similar interest rates.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.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.
11 Finding Equilibrium Interest Rate SmDm107.552.5ieEquilibriumInterest RateRate of interest, i (per cent)Excess Dm, sell bonds, push price of bonds down & i rate up.Amount of money demanded(billions of dollars)
12 Finding Equilibrium Interest Rate Excess Sm, buy bonds, push price of bonds up & i rate down.Sm107.552.5DmieEquilibriumInterest RateRate of interest, i (per cent)Amount of money demanded(billions of dollars)
13 Revisiting the Interest rate effect SmIf price level or GDP rises then Transactions Dm will rise. All else equal, the interest rate will rise.107.552.5ieRate of interest, i (per cent)Dm1Dm2Amount of money demanded(billions of dollars)
14 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 publicCurrency held by the banksPrivate Banks’ demand deposits with the Central BankBanks are responsible for deposit expansionMonetary base * money multiplier.
15 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.
16 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.
17 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.
18 Exchange Settlement Accounts PAYMENTS SYSTEMBANKING SYSTEMESA AccountsBank ABank BBank ABank BR 100D 1000R 50D 500L 900L 450Suppose 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 …
19 Exchange Settlement Accounts PAYMENTS SYSTEMBANKING SYSTEMESA AccountsBank ABank BBank ABank B-$20+$20R 100D 1000R 50D 500-20+20Settlement will reduce Bank A’s Reserves and increase Bank B’s reserves.
20 Exchange Settlement Accounts PAYMENTS SYSTEMBANKING SYSTEMESA AccountsBank ABank BBank ABank BR 100D 1000R 50D 500-20-20+20+20Bank 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.
21 Exchange Settlement Accounts PAYMENTS SYSTEMBANKING SYSTEMESA AccountsBank ABank BBank ABank BR 98D 980R 52D 520L 882L 458These transactions have shifted funds between banks but they have not changed the whole banking system.
22 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.
23 ESA Funds and Money S1 S2 Sm1 Cash rate D2 Dm2 D1 Dm1 ESA funds Opportunity cost of moneyD2Dm2D1Dm1ESA fundsMoney balancesThe 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.
24 Monetary Policy Objectives Influencing interest rates and credit availability to:Encourage real GDP growth;Promote employment; andStabilise the price levelFundamental objectivesfull employmentnon-inflationary level of total outputCentral banks have responsibility for managing monetary policy
25 Monetary Policy ToolsMajor 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 marketRediscount rate & repurchase agreements
26 Foreign Exchange Swaps RBA may use foreign exchange swaps to supplement or substitute for OMOForeign exchange market intervention—either selling or buying Australian dollarspurchase/sale of dollars is equivalent to purchase/sale of government securities, and has similar impact on banks’ ESA funds
27 Rediscount Rate and Monetary Policy The rate at which the RBA buys or sells short-term securities under repurchase agreementCan be used as a central tool of monetary policy
28 Open-Market Operations Buying and selling of Commonwealth government securities by the RBA in the cash or short-term money marketThe 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
29 Open-Market Operations Buying and selling of Commonwealth government securities by the RBA affects the cash rateCash rate provides an indication of the RBA’s monetary policy stanceSustained increases in cash rate target level: tightening of monetary policySustained decreases in cash rate target level: easing of monetary policy
30 Open-Market Operations: Buying Securities Banks sell some of their securitiesExpansionary Monetary PolicyRBA pays for securities by increasing banks’ exchange settlement accounts (ESAs)Bank reserves increaseCausing the monetary base and the banks’ lending ability to increase
31 Open-Market Operations: Selling Securities The RBA sells securities to the banksContractionary Monetary policyBanks pay for securities by decreasing their exchange settlement accounts (ESAs)Bank reserves decreaseCausing the monetary base and the banks’ lending ability to decrease
32 ESA Funds and Money S1 S2 Cash rate SM1 D2 DM2 D1 DM1 ESA Funds Opportunity cost of moneySM1D2DM2D1DM1ESA FundsMoney BalancesTo 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.
33 Easy Monetary PolicyImplemented when the economy is faced with the prospects of:substantial unemployment;or deflationary pressureCentral Bank announces its intention to reduce the cash rateCentral Bank acts to bring the ESA funds market into balance
34 Easy Monetary Policy S1 S2 SM1 Cash rate SM2 D1 DM1 ESA funds Opportunity cost of moneySM2D1DM1ESA fundsMoney BalancesTo run an easy MP, Central Banks buy more bonds than needed to meet day to day transactions & cash rate falls to new targeted level.
35 Easy Monetary Policy S1 S2 SM1 Cash rate % SM2 D1 DM1 SF1 SF2 I DF Opportunity cost of moneyCash rate %SM2D1DM1ESA fundsMoney BalancesEasy Monetary PolicySF1SF2Real rate of interest %Cost of funds %IDFMarket for Investment FundsInvestment Demand
36 I Real rate of interest % Investment Demand AD1 AS Price level AD2 Real domestic output, GDP
37 Tight Monetary PolicyEnacted when the economy is facing significant inflationary pressuresCentral Bank announces its intention to increase the target cash rateESA funds are brought into balance at this new target cash rate
38 Tight Monetary Policy S2 S1 SM2 Cash rate SM1 D1 DM1 ESA funds Opportunity cost of moneySM1D1DM1ESA fundsMoney balancesTo 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.
39 Tight Monetary Policy S2 S1 SM2 Cash rate % SM1 D1 DM1 SF2 SF1 I DF Opportunity cost of moneyCash rate %SM1D1DM1ESA fundsMoney balancesTight Monetary PolicySF2SF1Real rate of interest %Cost of funds %IDFMarket for Investment FundsInvestment demand
40 I Real rate of interest % Investment Demand ASLR AD2 AS Price level Real domestic output, GDP
41 MP and Exchange RatesInternational 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.
42 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.
43 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.
44 S1 S2 Sm1 Sm3 Cash rate % Sm2 D1 D2 Dm1 Dm2 I Opportunity cost of moneyCash rate %Sm2D1D2Dm1Dm2ESA fundsMoney BalancesAD3AD2AD1ASPrice levelReal rate of interest %IInvestment DemandReal domestic output, GDP
45 S1 S2 S3 SM1 Cash rate % SM3 SM2 D2 DM1 DM2 D1 I Opportunity cost of moneySM3Cash rate %SM2D2D1DM1DM2ESA fundsMoney balancesAD2ASAD1Price levelReal rate of interest %IInvestment DemandReal domestic output, GDP
46 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.
47 AD1ASIncrease 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.AD2S1S2SM1DM2DM1D1D2ESA fundsMoney balances
48 S1SM2SM1D1ID2Dm1Dm2ESA fundsAD2Increase 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.ASAD3AD1Real domestic output, GDP
49 Evaluating MP & FP MP will be more effective: the less interest elastic is the money demandthe more interest elastic is the investment demand curvethe more price elastic is SRASFP will be more effective if:RBA accommodates demand for money ORmore interest elastic is the money demandthe less interest elastic is the investment demand curve.
50 Evaluating MP & FP MP short comings: FP shortcomings: Cyclical asymmetryConflict with Treasury goalsInvestment may be relatively insensitive to interest rate changesDoes not address cost-push inflationFP shortcomings:Tax changes may have supply side effects
51 Evaluating MP & FP MP lags & politics: FP lags & politics: Easy to implement & flexible.Subject to long impact lags (up to 12 months)Less subject to political interference.Blunt, indiscriminate policyFP lags & politics:Lags in planning & implementationSubject to political interference – see political business cycleCan be tailored to suit particular regions or sub-groups.
52 Policy co-ordinationBoth 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).
53 Policy conflictSometimes 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.
54 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.