1

MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT

Monetary Policy

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth IngramUniversity of Iowa

2nd edition

15-2

Key Concepts

Targets Inflation Intermediate Policy Goals

Open Market Operations LM Curve Transmission Mechanism

15-3

Goal of Monetary Policy

Price stability Low unemployment Real GDP growth

Policy Targets

15-4

Federal Reserve System“High employment consistent with stable prices”

Organization Board of Governors – 7 Members 12 Federal Reserve District Banks Federal Open Market Committee (FOMC)

Instrument Short term market interest rates (Discount rate) Reserve Requirements Open Market Operations

Federal Funds rate Rate charged on interbank loans

15-5

European Central BankPrice stability with inflation under 2%

Organization The European System of Central Banks (ESCB) -- 6

members of the executive board and 15 national Central Banks of the European Union.

Interest rate decisions are made at fortnightly council meetings

 Instruments Repo rate – overnight interest rate Discount rate and Lombard rate (rates at which

commercial banks acquire or deposit reserves) Intermediate Target – Inflation and M3

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Bank of EnglandKeep inflation at rate set by government (2.5%)

Organization The Monetary Policy Committee (MPC) 9 members, 5 full time Bank of England employees

and 4 external experts Instruments

Repo rate No reserve requirement, but no bank overdrafts

Intermediate target: An Inflation target based on a two-year-ahead inflation forecast

15-7

Elements of Monetary Policy

Instruments Targets Goals

15-8

Monetary Policy Elements

Price StabilityUnemployment

Real Growth

Interest RatesMoney growth

Discount WindowOpen Market Operations

Reserve Requirements

15-9

LM Curve

Equilibrium in the money market Demand for money

Opportunity cost of holding money Interest rate increase means hold less money

Supply of money Role of Federal Reserve Role of banks

15-10

Recall quantity theory

MV = PY

Md/P = (1/V)Y

Real Money DemandVelocity, depends on interest rate

15-11

Money MarketN

omin

al I

nter

est

Rat

e

Quantity of Money

Money Supply

Money Demand

R

M0

R0

15-12

Money MarketIncrease in Income

Nom

inal

Int

eres

tR

ate

Quantity of Money

Money Supply

Money Demand

R0

M0

R1

15-13

Money MarketIncrease in Money Supply

Nom

inal

Int

eres

tR

ate

Quantity of Money

Money Supply

Money Demand

R

M0

R0

M1

R1

15-14

LM curve

Increase in income is associated with rise in interest rates

For a fixed interest rate, increase in money supply increases income

15-15

IS-LM Model

Interest Rate

Output

LM Curve

Increase in Money SupplyIncrease in Money SupplyDecrease in Money SupplyDecrease in Money Supply

15-16

IS-LM Model

Interest Rate

Output

LM Curve

IS Curve

R0

Y0

15-17

Increase in money

Interest Rate

Output

LM Curve

IS Curve

R0

Y0

R1

Y1

Lowers the interest rate and increases income

15-18

IS-LM ModelMoney Supply Targeting

Interest Rate

Output

LM Curve

IS Curve

R0

Y0

R1

Y1

15-19

IS-LM ModelInterest Rate Targeting

Interest Rate

Output

LM Curve

IS Curve

R0

Y0 Y1

15-20

Monetary Policy Targets

GDP growth Unemployment Price Stability

New Zealand England European Central Bank

Why not target zero inflation?

15-21

Intermediate Targets

Variable which Tracks policy goal (e.g., inflation) Over which central bank has reasonable

control Three main targets

Money supply Exchange rate Inflation

15-22

Money Supply Targeting

Quantity Theory implies direct relationship between money supply growth and inflation Assume velocity constant Assume real output controlled by real factors

US: money targeting used in early 1980s

15-23

Difficulties in targeting money

Which aggregate to use? Is velocity constant or at least predictable? Can central bank control the money supply? What role do banks play (is money supply

vertical)? What about supply shocks?

15-24

Money Growth, US

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1959-Jan.

1962-Jan.

1965-Jan.

1968-Jan.

1971-Jan.

1974-Jan.

1977-Jan.

1980-Jan.

1983-Jan.

1986-Jan.

1989-Jan.

1992-Jan.

1995-Jan.

1998-Jan.

2001-Jan.

M1

M3

M2

15-25

Growth rate, monetary aggregates

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

1960 1965 1970 1975 1980 1985 1990 1995 2000

M1M2M3

Source: Federal Reserve Board, Current release. http://www.federalreserve.gov/releases/ Monthly growth rate converted to annual rate and smoothed with moving average filter.

15-26

Exchange Rate Targets

Fix exchange rate against another currency Will tie domestic inflation to foreign inflation

Cost is lack of flexibility in influence on domestic economy

15-27

Inflation Targeting

Specified a target range for realized inflation Allows for discretion in implementation Discretion comes at a price

15-28

Operational Instruments

Short term interest rate Base money Central bank can supply money to or drain

money from the monetary system

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Open market operations

Expand money supply Buy treasury bonds from public Supply public with cash

Decrease money supply Sell treasury bonds to public Remove cash from circulation

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Federal Funds Target

2004

June 30 25 ... 1.25

2003 

June 25 ... 25 1.00

2002 

November 6 ... 50 1.25

2001 

December 11 ... 25 1.75

November 6 ... 50 2.00

October 2 ... 50 2.50

September 17 ... 50 3.00

August 21 ... 25 3.50

June 27 ... 25 3.75

May 15 ... 50 4.00

April 18 ... 50 4.50

March 20 ... 50 5.00

January 31 ... 50 5.50

January 3 ... 50 6.00

Intended federal funds target, 2001 - 2004

Date Decrease Increase Rate

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Money supply or interest rates?

Money Supply Interest rate

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Money MarketMoney targeting

Inte

rest

Rat

e

Quantity of Money

Money Supply

Money Demand

R

M0

R0

R1

Increase in Money Demand produces rise in interest rate if Money Supply is fixed

15-33

Money MarketMoney targeting

Inte

rest

Rat

e

Quantity of Money

Money Supply

Money Demand

R

M0

R0

R1

Increase in Money Demand produces no rise in interest rate if Money Supply is allowed to increase

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Transmission Mechanism

Official Rate

Market Rates

Asset Prices

Expectations and

Confidence

Exchange Rate

Domestic Demand

Net External Demand

Domestic Inflationary Pressure

Import Prices

Inflation

15-35

Taylor Rules

Nominal Interest Rate

= Equilibrium Nominal Interest Rate

+ λ x Output Gap

+ α x (Inflation – Inflation Target)

15-36

US Interest Rates

Actual Interest Rate Simple Taylor Rule

Source: EcoWin

87 88 89 90 91 92 93 94 95 96 97 98 99 00 012

3

4

5

6

7

8

9

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UK Interest Rates

Actual Interest Rate Simple Taylor Rule

Source: EcoWin

88 89 90 91 92 93 94 95 96 97 98 99 00 01456789

10111213141516

15-38

Summary

Targets Intermediate Instrumental Policy

IS-LM model Intermediate targeting (money supply,

exchange rate and inflation) Transmission mechanism

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.