lecture 5 Targets, instruments, and transmission channels ...federation.ens.fr/wheberg/parischoeco/formation/master-ppd... · Targets, instruments, and transmission channels of monetary

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Lecture 5 Targets, instruments, and transmission channels of monetary policy

Anne Epaulard

Master PPD – M1 2008 / 2009

Macroeconomic Policies

Outline of the lecture

1. The role of banks (credit multiplier)

2. The aim of monetary policy: What can

monetary policy do?

3. Transmission channels: How does Monetary Policy work?

4. Direct instruments vs indirect instruments

Main reference : « The transmission mechanism of monetary policy » The Monetary Policy Committee ; Bank of England

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From « base money » to money supply

� The banking system demands money issued by the central bank (“base money”) to meet the public demand for currency, to clear interbank balances and to meet the requirements for minimum reserves that have to be deposited with the central bank.

� Given its monopoly over the creation of base money, the central bank can fully determine the interest rates on its operations.

� Since the central bank thereby affects the funding cost of liquidity for banks, banks need to pass on these costs when lending to their customers.

The role of banks / The Central bank in the banking system

Monetary aggregates

The role of banks / Monetary aggregates

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Monetary aggregates

The role of banks / Monetary aggregates

Money multiplier

� - Reserve money (RM) = CY + R

- M1 = CY + DD

R = deposits of deposit money banks with the Central Bank

� Money multiplier = ratio of money stock to reserve money:

mm = M1/ RM = (CY+DD)/ (CY+R) (1)

� Divide numerator and denominator in (1) by DD

mm = (c+1) / (c+r) mm>1

where c= CY/DD; r= R/DD

The role of banks / Money multiplier

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Money multiplier

RMcr

c1M1

++=

Factors affecting the money multiplier:- Reserve on deposits (r) → reserve requirements determined by Central Bank; excess reserves determined by banks.- Currency to deposit ratio (c) → determined by public

The role of banks / Money multiplier

Money supply

RESERVE MONEY

MONEY MULTIPLIER

MONEY STOCK

Net Foreign Assets

Net Claims on Govern-ment

Claims on Commer-cial Banks

Other Items, net

Reserve Requirements (also excess r eserves to deposit ratio)

Ratio of Currency to Demand Deposit

The role of banks / Money supply

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monetary policy do?



Main reference :

� Be used in an expansionary way to sustain higher long run growth

Over the long run, economic growth is

determined by fundamentals: productivity, technological innovation, human resources, institutions, protection of property rights...

What monetary policy cannot do

The aim of monetary policy

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What monetary policy cannot do

� Be used to sustain lower levels of unemployment in the long run

The “Phillips curve”: led to the belief of a trade-off between inflation and unemployment. A.W. Phillips using 97 years of UK data. Data for US showed the same up to 1969. :

u = u*- α (π), or, y = y* + β (π)

The aim of monetary policy / The Phillips curve story

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10 12

Unemployment Rate

CPI Inflation

1960s

1970s

1980s

1990s


Phillips curve in the US

What happened when this relationship was used for policy purposes?

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Phillips curve

u = u*- α (π ) , y = y*+ β (π )

Augmented Phillips curve

u = u*-α (π-πe), y = y*+ β (π-πe)Why does monetary policy have real short run effects?

i) price and wage rigidities,

ii) incomplete information and surprises


The augmented Phillips curve

What Monetary Policy can do

� Produce price stability (low and steady inflation)

� Reduce business cycle fluctuations

� May also be concerned with:

i. interest rate and financial stability

ii. exchange rate stability

� May lead to higher sustained long-run growth by promoting stability, not through expansionary policies

The aim of monetary policy / what monetary policy can do

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Time

GDP

Current GDP

Potential GDP

reduce business cycle


0.020

0.025

0.030

0.035

0.040

0.045

0.050

1 2 3 4

Log (π) (5-year average)GD

P G

row

th (

5-ye

ar

ave

rage

)

Source Khan and Senhadji (2000), IMF working Paper

Sustain long-run growth (through price stability)


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Empirical evaluation of the impact of inflation on economic growth

� Barro, Fischer (1993) estimated that an increase in inflation by ten percentage points is associated with a decrease in the rate of growth of the capital stock by 0.4 percentage point, a comparatively large effect.

� Similar results have been obtained by De Gregorio (1993) based on a sample of 12 Latin American countries.

� Fischer (1993) estimated an increase of inflation by ten percentage points to lead to a decrease in the rate of growth of productivity by 0.2 percentage point per year.




monetary policy do?



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Monetary

Policy?

Inflation

&

Output

Transmission Mechanism

The transmission mechanisms

a. Money channel

b. Credit channel

c. Asset price channel

d. Exchange rate channel

e. Expectations channel

Transmission Channels

The transmission mechanisms

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a. Money Channel

� An increase in money supply leads to excess money in the economy. This is used partly to buy bonds or provide credit and drive down interest rates.

� The increased availability of liquidity (seen through the reduction in rates) leads to higher consumption and investment.

The transmission mechanisms / the money channel

IS-LM Model Closed Economy: Determination of Equilibrium

IS(Equilibrium in Goods Market)

LM(Equilibrium in Money Market)

Interest Rater

Output Y

r*

Y*


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IS-LM Closed Economy: Monetary Expansion

Interestrate

Real GDP

LM

IS

r0

y0

LM’

r1

y1


IS-LM Closed Economy: Monetary Expansion

� At the original r*, in the new LM’, there is excess supply in the money market

� The monetary expansion allows interest rates to fall, making more private sector activity feasible. At the new equilibrium, real GDP is higher, reflecting higher investment and interest-sensitive consumption.

� If the IS curve were vertical, meaning that investment and consumption were not sensitive to interest rates, monetary policy could not expand real GDP.


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IS-LM Model with Perfect Capital Mobility

IS(Equilibrium in Goods Market)

LM(Equilibrium in Money Market)

Interest Rater

Output Y

r*

Y*

BP(Equilibrium in the Balance of Payments)


Perfect Capital Mobility, Flexible Exchange Rate: After Money Expansion

IS

LM

Interest Rater

Output Y

r*

Y*

BP

IS’

LM’

Y**


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Monetary Policy with Flexible Exchange Rate

� Expansionary monetary policy reduces interest rates, triggering a depreciation of the exchange rate

� At a depreciated exchange rate (e1), exports rise and imports contract, raising aggregate demand

� Supply expands, completing the rise in real GDP


Perfect Capital Mobility, Fixed Exchange Rate: Monetary Policy Has No Impact

Interestrate

Real GDP

LM

IS

r0

y0

LM’

BP


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Why Monetary Policy Is Impotent with a Fixed Exchange Rate

� Expansionary monetary policy lowers interest rates, triggering a capital outflow that depreciates the exchange rate

� To offset the depreciation, the authorities must raise interest rates by tightening monetary policy

� The exchange rate returns to its original level only when interest rates return to their original levels


b. Credit Channel: Additional effect due to constraints in bank lending

1. Due to bank capital requirements or large amount of non-performing loans

At lower interest rates, loans become less risky, non-performing loans can fall, easier to raise capital

2. Due to collateral requirements for new loans

Lower rates can lead to increases in the value of collateral and thus make it easier for firms and households to obtain credit

The transmission mechanisms / the credit channel

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How important are Money and Credit Channels ?

The transmission mechanisms / size of money and credit channels

Factors affecting the importance of the money and credit channels:

i. Low financial development (weak money and credit channels)

ii. Degree of development of capital markets (increases money and reduces credit channels)

iii. Degree of dependence on bank credit (increases credit and reduces money channels)

iv. Poor supervision of banks (credit expands more as soon as liquidity increases)

v. Lack of legal protection of creditors (money channel less relevant, credit ch. more so)

The transmission mechanisms / size of money and credit channels

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c. Asset price channel

� The excess liquidity can also be used to acquire other assets such as equities and real estate

1. In the case of households, this generates a positive wealth effect for previous holders of these assets, as their prices increase and their balance sheets improve

2. In the case of firms, equity prices affect investment decisions through Tobin’s q

� These effects can feedback into the credit channel

The transmission mechanisms / asset price channel

d. Exchange rate channel

� When the exchange rate is floating, changes in monetary policy could have systematic effects on the exchange rate

� Tighter monetary policy leads to an exchange rate appreciation which reduces the prices of tradable goods. (In addition to an aggregate demand effect due to a reduction in net exports)

� With a fixed or semi-fixed exchange rate, and higher domestic than foreign inflation, the implied appreciation of the real exchange rate has similar effects

The transmission mechanisms / exchange rate channel

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e. Expectations channel

� Price and wage increases imbedded in contracts depend on expected inflation, in addition to aggregate demand and supply conditions. This is also true for financial contracts

� This channel depends strongly on the reputation of the central bank. If this is credible, it can reduce the costs from disinflation

The transmission mechanisms / expectations channel

Additional Factors

� Balance Sheets and Financial Fragility

� Exchange rate changes (depreciation worsens the balance sheet in case of debts denominated in foreign currency)

� Financial market access: small vs. big firms

� Flight to quality during recessions

� Credit crunches

The transmission mechanisms / additional factors

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Thus, during tranquil periods:

� Looser monetary policy leads to

– Higher aggregate demand /output

– Weaker exchange rates

– Higher inflation

� Tighter monetary policy leads to

– Lower aggregate demand /output

– Stronger exchange rates

– Lower inflation

Additional Conditioning Factors


When faced with confidence and financial crisis:

� Looser monetary policy may lead to

– Concerns of inflation/exchange rate spiral

– Fears of default

– Declines in investor confidence

� Tighter monetary policy may lead to

– A recovery of the currency

– Improved confidence

– Eventually, recovery in output

Additional Conditioning Factors (cont.)


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How long does it take for monetary policy to have real effects on the economy ?

The transmission mechanisms / delays

Asset prices

The Transmission Mechanism (in England)

Market rates

Expectations/confidence

Exchange rate

Official rate

Domestic demand

Net external demand

Total demand

Domesticinflationary

pressure

Importprices

Inflation

Time = 0 6-12 months 12-24 months


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The transmission mechanisms / delays and size

The ECB version !


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The transmission mechanisms / delays and size

The ECB version !

� It takes time for monetary policy to have an impact on real economy and inflation

� Part of the job of a Central Bank is to forecast what would be the state of the economy in few months/quarters

� And to react to this forecast ……and not necessarily to what is happening now in the economy !


Delays in Monetary policy

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monetary policy do?



Main reference :

Direct Instruments� Interest rate controls

� Non-competitive pricing when entry into banking is limited

� Limit adverse selection

� Credit ceilings

� Reliable in controlling credit aggregate during transition

� Directed credit policies

� Credit allocation process is discretionary (e.g., finance particular sectors)

� Implications of direct instruments

� Powerful, but lead to disintermediation

� Inefficient resource allocation

� Financial repressions

� Allow political factors to influence monetary policy decisions

Direct instruments vs indirect instruments

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Indirect Instruments

� Focus on system-wide liquidity

� Transmit policy signals also to the parallel market

� Allow (optimal) allocation on the basis of risk and

return

� Reduce political interference and political

sensitivity to changes in interest rates

� Allow management of liquidity at the CB’s initiative

and discretion


Main Indirect Instruments

Credit Auctions / RPs

(price or

quantity/design)

• Pricing central bank credit• Repurchase agreement for short-term liquidity controls

Discount Windows

(price)

• Transmission of policy stance through announcement effect • Provide liquidity facilities

Open Market Operations

(quantity)

• Flexible for short-term liquidity management• Primary market sales of CB paper or government securities

Reserve Requirements

(quantity)

• Induce reserve demand• Accommodate (infrequent) structural changes in demand for reserves


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Transition to indirect instruments requires:

� well-developed competitive financial markets

� proper legal and regulatory framework

� stable macroeconomic policies

� credibility of government: primary markets for

issuing government debt

� safe and efficient clearing and payments

mechanisms

Most industrial countries moved from direct to

indirect instruments in 1970s and 1980s.


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lecture 5 Targets, instruments, and transmission channels ...federation.ens.fr/wheberg/parischoeco/formation/master-ppd... · Targets, instruments, and transmission channels of monetary