1. Monetary Policy Macroeconomic Policy in the Asia-Pacific GECO 6400
Slide 1
Monetary 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; and
Cash 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 RateSm 10
7.5 5
2.5 Dm
Equilibrium
Interest Rate ie
Rate 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 Payment
Bond Yield =
x 100
Bond Price

7. The price of a bond and its yield are inversely related.
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.

8. 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.

9. Yield Curve Maturity Yield (% pa) Treasury Bonds 3 yrs
Cash rate
Overnight Swaps
Maturity

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 RateSm Dm 10
7.5 5
2.5 ie
Equilibrium
Interest Rate
Rate 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. Sm 10
7.5 5
2.5 Dm ie
Equilibrium
Interest Rate
Rate of interest, i (per cent)
Amount of money demanded
(billions of dollars)

13. Revisiting the Interest rate effectSm
If price level or GDP rises then Transactions Dm will rise. All else equal, the interest rate will rise. 10
7.5 5
2.5 ie
Rate of interest, i (per cent)
Dm1
Dm2
Amount 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 public
Currency held by the banks
Private Banks’ demand deposits with the Central Bank
Banks are responsible for deposit expansion
Monetary 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 SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
Bank B
R 100
D 1000
R 50
D 500
L 900
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 …

19. Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
Bank B
-$20
+$20
R 100
D 1000
R 50
D 500
-20
+20
Settlement will reduce Bank A’s Reserves and increase Bank B’s reserves.

20. Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
Bank B
R 100
D 1000
R 50
D 500
-20
-20
+20
+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.

21. Exchange Settlement Accounts
PAYMENTS SYSTEM
BANKING SYSTEM
ESA Accounts
Bank A
Bank B
Bank A
Bank B
R 98
D 980
R 52
D 520
L 882
L 458
These 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 money D2
Dm2 D1
Dm1
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.

24. Monetary Policy Objectives
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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. ESA Funds and Money S1 S2 Cash rate SM1 D2 DM2 D1 DM1 ESA Funds
Opportunity cost of money
SM1 D2
DM2 D1
DM1
ESA Funds
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.

33. 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

34. Easy Monetary Policy S1 S2 SM1 Cash rate SM2 D1 DM1 ESA funds
Opportunity cost of money
SM2 D1
DM1
ESA funds
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.

35. Easy Monetary Policy S1 S2 SM1 Cash rate % SM2 D1 DM1 SF1 SF2 I DF
Opportunity cost of money
Cash rate %
SM2 D1
DM1
ESA funds
Money Balances
Easy Monetary Policy
SF1
SF2
Real rate of interest %
Cost of funds % I DF
Market for Investment Funds
Investment Demand

36. I Real rate of interest % Investment Demand AD1 AS Price level AD2
Real domestic output, GDP

37. 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

38. Tight Monetary Policy S2 S1 SM2 Cash rate SM1 D1 DM1 ESA funds
Opportunity cost of money
SM1 D1
DM1
ESA funds
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.

39. Tight Monetary Policy S2 S1 SM2 Cash rate % SM1 D1 DM1 SF2 SF1 I DF
Opportunity cost of money
Cash rate %
SM1 D1
DM1
ESA funds
Money balances
Tight Monetary Policy
SF2
SF1
Real rate of interest %
Cost of funds % I DF
Market for Investment Funds
Investment demand

40. I Real rate of interest % Investment Demand ASLR AD2 AS Price level
Real domestic output, GDP

41. 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.

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 money
Cash rate %
Sm2 D1 D2
Dm1
Dm2
ESA funds
Money Balances
AD3
AD2
AD1 AS
Price level
Real rate of interest % I
Investment Demand
Real domestic output, GDP

45. S1 S2 S3 SM1 Cash rate % SM3 SM2 D2 DM1 DM2 D1 I
Opportunity cost of money
SM3
Cash rate %
SM2 D2 D1
DM1
DM2
ESA funds
Money balances
AD2 AS
AD1
Price level
Real rate of interest % I
Investment Demand
Real 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. AD1 AS
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.
AD2 S1 S2
SM1
DM2
DM1 D1 D2
ESA funds
Money balances

48. S1
SM2
SM1 D1 I D2
Dm1
Dm2
ESA funds
AD2
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. AS
AD3
AD1
Real domestic output, GDP

49. 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.

50. Evaluating MP & FP MP short comings: FP shortcomings:
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

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 policy
FP lags & politics:
Lags in planning & implementation
Subject to political interference – see political business cycle
Can be tailored to suit particular regions or sub-groups.

52. 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).

53. 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.

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.

55. References
Mc Taggart et al. Chapter 27
Jackson & McIver, Chapter 12.