1. Monetary Policy
Chap. 31

2. Implementing Monetary Policy

3. Economy Central Bank HK USA Eurozone PRC UK, Canada, Japan, Korea ?
A special governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

4. Interbank Payment Systems
Commercial banks keep accounts at the central bank for interbank payments. referred to generally as reserves, specifically as clearing balances in Hong Kong.
These accounts, along with cash, constitute the monetary base.
Hong Kong Interbank Clearing Limited

5. Interbank Market
Individual banks will face a short-fall in reserves if they have too many outflows and borrow funds from other banks facing a surplus.
Banks will keep an inventory of reserves to meet their own liquidity needs but the interest rate is the opportunity cost of holding reserves.
Desire to hold reserves is a declining function of the interest rate.
Central bank controls the total supply of reserves available to banks.

6. Interbank Market
iIBR
SBR i*
DBR
Reserves

7. Equilibrium in the Interbank Market
If interest rates are too low, banks will want to hold more reserves than available. Banks facing a shortfall of reserves will be willing to bid up interest rates until all banks are content with reserves available.
If interest rates are too high, banks will want to lend out their excess reserves. To do so in a liquid market, they must lower interest rates.

8. Equilibrium
SBR
iIBR i* i
DBR
Reserves

9. Monetary Policy Under Floating Exchange Rates

10. Open Market Operations
In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves.
In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This decreases the aggregate supply of reserves.

11. Open Market Purchase
SBR
SBR'
iIBR i*
i**
DBR
Reserves

12. Open Market Sale
SBR'
SBR
iIBR
i** i*
DBR
Reserves

13. Money Supply and Interest Rates
If the central bank engages in an open market PURCHASE, they will increase the reserve holdings of counter-party commercial banks.
This will increase liquidity in the reserve funds market.
Banks with excess reserves can lend them out pushing down interest rates in broader money market.

14. Fed Funds & Money Market Rates

15. Domestic Monetary Policy Causes D. C
Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down E
Supply
Supply'
Domestic Currency Appreciates 1 E*
Excess Supply
E** 2
Demand
Demand'

16. Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up2
E**
Domestic Currency Depreciates 1 E*
Excess Demand
Supply'
Demand '
Supply
Demand

17. Monetary Policy Expectations and Exchange Rates
Future exchange rates affect the expected profitability of holding bank accounts in a country’s currency.
Current level of the exchange rate guided by the future path of interest rates.

18. Expectation of Et+1 Increases2
E**
Domestic Currency Depreciates 1 E*
Excess Demand
Supply'
Demand'
Supply
Demand

19. Monetary Policy Under Fixed Exchange Rates
Hong Kong’s Exchange Rate Regime

20. Clearing Accounts Reserves
May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.

21. US Monetary Policy Causes US Interest Rates Go Down, Strengthening Pressure on HK$
Supply
Supply' 1
E=7.8
Excess Supply
Appreciation Pressure on HK$
Demand
Demand'

22. Hong Kong Interbank Market: HIBOR higher than US interest rate.
iHIBOR
SBR '
SBR
Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 i*
iFedFunds 2
DBR
Reserve Accounts

23. Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically1
Hong Kong Interest Rate Falls
E=7.8
Excess Supply
Demand ' '
Demand'

24. Fixed Exchange Rate
If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then
If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high.

25. Loss of Credibility
A fixed exchange rate will lose credibility if people come to believe that the central bank will:
devalue the currency, (ie. raise S in the future)
revalue the currency (ie. reduce S in the future)
If market expects an exchange rate change, commercial banks will adjust comparison rate for the expectations of devaluation.

27. Iron Triangle of International Finance
Open International Capital Flows
Independent Interest Rate
Stable Exchange Rates
Pick 2 items from this menu

28. Monetary Policy and Business Cycle

29. Operating Instruments: Target Interest Rates
Fed
Federal Funds Rate
BoJ
Uncollateralized Call Money Rate
ECB
Main Refinancing Rate/Euribor
In many economies, on a day to day basis, central banks express their policy in terms of the interest rate in interbank market as an operating instrument
RBI Report of the Working Group on Monetary Policy...

30. Dynamics of Monetary Transmission
Open market purchase reduces interest rates
Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods.
Lower interest rates increase demand for US$ in forex market depreciating the exchange rate.
Lower interest rates tend to increase asset prices which makes consumers feel wealthier.
Aggregate demand shifts out. Given fixed wages this increase in demand increases equilibrium output.
Ultimately, wage demands will increase and prices will rise.

31. Consumption Increases
Cut
Bond
Yields
Cheaper to Borrow
Investment increases
Raise Asset Prices
People Wealthier
Consumption Increases
Cut Money Market Rate
Cut Policy Rate
Weaken
Forex
Rate
Improved Competitiveness
Net Exports Increases
Reduce Cost of ST
Finance
Consumer Purchases and Inventory Investment Increase

32. Extra Liquidity Creates Extra Loanable Funds
SLF
S′LF
DLF r r*
r** LF
LF*
LF**

33. Expansionary Monetary Policy
ΔC, ΔNX
AD′ AD Y

34. An Expansionary Cycle Driven by monetary policy
Economy at LT YP.
Monetary Policy Cuts Interest Rate. The AD curve shifts out. YP P
SRAS′
P*** 3
SRAS 2
P**
Tight labor markets. SRAS returns to long run equilibrium P* 1
AD′ AD Y
Output Gap

35. A Contractionary Cycle Driven by monetary policy
Economy at LT YP.
SRAS
Monetary Policy Raises Interest Rate. The AD curve shifts in. YP P P* 1
SRAS′ 2
P**
Slack labor markets. SRAS returns to long run equilibrium
P*** 3 AD
AD′ Y
Output Gap<0

36. Bank of England Estimates of Effect of Interest Rate

37. Interest Rate Management
In most economies around the world, the central bank does not simply act to maintain a fixed money supply.
Rather, they adjust interest rates in response to business cycle conditions.
U.S. Central bank cuts interest rates during recessions

38. Demand Driven Recession w/ Counter-cyclical monetary policy
Economy at LT YP. YP P
SRAS
Economy in a recession. Fed detects deflationary pressure
AD′ 1 3 P*
P** 2
Monetary Policy Cuts Interest Rates. AD curve shifts back to original equilibrium AD Y
Gap < 0

39. Demand Driven Expansion w/ Counter-cyclical monetary policy
Economy at LT YP.
Economy in a expansion. Fed detects inflationary pressure YP P
SRAS
P** 2
Monetary Policy Raises Interest Rates. AD curve shifts back to original equilibrium P* 3 1
AD′ AD Y
Gap > 0

40. Taylor Rule
Economist named John Taylor argues that US target interest rate is well represented by a function of
current inflation
Inflation GAP: current inflation vs. target inflation
%Output Gap: % deviation of GDP from long run path
Function: Inflation Target π* = .02

41. The Taylor Rule Download

42. Price Stability
Counter-cyclical monetary policy stabilizes output near potential output, YP, but also stabilizes the price level near P*.
Central banks may pursue price stability as a goal and also stabilize output as well if business cycles are caused by demand shocks.

43. Monetary Policy Problems
Monetary Policy Lags
Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates. Monetary policy must be forward looking.
Zero Lower Bound
Money market rates cannot be reduced below zero, because interest rate on cash is always zero.

44. Inflation Targeting
A growing number of central banks, beginning in New Zealand in the 1980’s conduct monetary policy under the framework of “inflation targeting”
Bank states an explicit target for inflation and publishes inflation forecasts under current conditions. Policy is set in order to bring actual inflation within a range around the target.
Central bankers are judged by their ability to hit target and repeated failures may result in policymakers losing their jobs.

45. Inflation Reports
Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty.

46. Inflation Pressure P Pt* Y Yt* Y*t+1 Forecast ADt+1 ADt YPt+1 SRASt+1
YtP
SRASt+1 P
SRASt
P*t+1
Target Inflation
Pt*
Forecast ADt+1
ADt Y
Yt*
Y*t+1
Raise Interest Rate Target at time t

47. Dynamic AS-AD Model: Recession, Inflation Deceleration
ASt+1
YPt+1
YtP
ASt P
Demand expands slower than expected
P*t+1
Target Inflation
Forecast Inflation
Pt*
Cut interest rates to hit inflation
target
Forecast ADt+1
ADt
Negative Output Gap
Gap Y
Yt*
Y*t+1

48. Zero Lower Bound
When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.
SBR′ ′
SBR′ ′ ′
SBR
SBR′
SBR′ ′ ′ ′
iIBR
DBR i* 1
i** 2 3
i*** 4 5
Reserves

49. Japanese Monetary Policy

50. Zero Lower Bound
Interest rate cannot be set below zero.
Link

51. Raise Inflation Target
The newly-introduced "price stability target" is the inflation rate that the Bank judges to be consistent with price stability on a sustainable basis. … Based on this recognition, the Bank sets the "price stability target" at 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) -- a main price index.
Cost of borrowing (in terms of purchasing power) is the interest rate adjusted by the inflation rate between the time a loan is made and the time is repaid.
With zero interest rates, real borrowing rates will fall when inflation rises.

52. Quantitative Easing/Forward Guidance
Commit to future liquidity to raise expectations of future inflation to bring down real interest rates.
Monetary Policy Statement April, 2012
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014

53. Learning Outcomes Students should be able to:
Use the supply and demand model of interbank markets to demonstrate the effect of monetary policy on interest rates.
Use the AS-AD model to demonstrate the effect of monetary policy on the price level and the output gap.
Use the supply and demand model of exchange rates to demonstrate the effects of either current or future monetary policy on exchange rates.