Monetary Policy

Chapter 31

Orientation/ObjectivesOrientation Objectives

Domestic Price, Output Stability

External Forex Rate Stability

IMF Exchange Rate Classification

0

10

20

30

40

50

60

No Currency CurrencyBoard

FixedExchange

Rate

Band CrawlingPeg

ManagedFloat

Free Float

Source Link

Hong Kong’s Exchange Rate Regime

Convertibility Undertaking

• May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.

US Monetary Policy CausesUS Interest Rates Go Down, Strengthening Pressure on HK$

S Supply

Demand

S=7.8

Supply'

Demand '

S**

Excess Supply of US Dollars

1

Hong Kong Interbank Market:HIBOR higher than US interest rate.

Supply

D

iHIBOR

Reserve Accounts

iFedFunds

i* 1

2

Supply'

Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong

Passive Forex Intervention

SMP

i

i*

i**

1

2

Agents want more Hong Kong dollars and excess supply of US dollars at exchange rate.

Rather than sell US dollars at falling prices, sell to HKMA at Strong Side price

HKMA purchase of forex increases M and reduces i.

SMP

MP

DM

P

Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically

S Supply

Demand

S=7.8

Supply'

Demand '

S**

Excess Supply of US Dollars

1

Fixed Exchange Rate

1 0E

Ft tt t

t

S Si i

S

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.

HIBOR vs. Fed Funds Rate

Interbank Rates

0

2

4

6

8

10

12

14

16

18

20

Jun-

86

Jun-

87

Jun-

88

Jun-

89

Jun-

90

Jun-

91

Jun-

92

Jun-

93

Jun-

94

Jun-

95

Jun-

96

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Jun-

04

%

Fed Funds HIBOR

Loss of Credibility

1t tHIBOR FFt t

t

S Si i E

S

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.

Iron Triangle of International Finance

Open to International Capital Flows

Monetary Policy that Controls The Interest Rate

Fixed Exchange Rates

Pick 2 items from this menu

Domestically OrientedMonetary Policy

Operating Instruments: Target Interest Rates

On a day to day basis, central banks express their policy in terms of a single easily observed, easily controlled financial market price or quantity.

In many economies, central banks use the interest rate in interbank market as an operating instrument

Fed Federal Funds Rate

BoJ Uncollateralized Call Money Rate

ECB Main Refinancing Rate

BoK Overnight Call Rate

UK Official Bank Rate

Open Market Practice

On a daily basis, a central bank will provide instructions to engage in defensive transactions that will adjust supply to keep the interbank interest rate near the target rate.

Example: If there is an excess demand for reserves, the traders might engage in an open market purchase of bills, increasing the supply of reserves pushing down the rate until it is near the target.

Interbank Market:OMO to meet demand for reserves

S

D'

iIBR

Reserve Accounts

iTGT

i*

1

2

S'

3

D

Channel of Monetary Policy

When the central bank increases the monetary base, the money supply will increase.

Banks have excess liquidity which they use to make more loans.

The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate.

Dynamic Transactions and Policy Changes

Central bankers shift monetary policy by changing the interest rate target.

In order to enact the change, the bank’s traders are instructed to engage in dynamic transactions. A dynamic purchase of bills will be

implemented to reduce interest rates. A dynamic sale of bills will be

implemented to increase interest rates.

Central Bank Policy Makers reduce interest target- Open Market Purchase

S

D'

iIBR

Reserve Accounts

iTGT'

1

S'

2

D

iTGT

Monetary Policy: Money Supply Expands

i

i*

M

i**

1

2

DM

P

SMP

SMP

P

YAD

Expansionary Monetary Policy

AD′ΔI ΔC, ΔNX

Dynamics of Monetary Transmission

Money supply expansion 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.

Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

P

Y

AD

An Expansionary Cycle Driven by monetary policy

P*

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

2. Monetary Policy Cuts Interest Rate

3. Expenditure rises. The AD curve shifts out.

4. Tight labor markets. SRAS returns to long run equilibrium

3

Bank of England Estimates of Effect of Interest Rate

Monetary Policy – Short-term vs. Long Term

In the short-run, expansionary monetary policy can boost economic growth.

But in the long-run, expansionary monetary policy only leads to rising prices (i.e. inflation).

Interest Rate Management In most economies around the world,

the central bank does not simply act to maintain a fixed interest rate.

Rather, they manage interest rate changes in response to business cycle conditions.

Policy FrameworkPrice Stability Fed Objective Humphrey Hawkins Act (1978): Fed

instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “

ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

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.

Inflation Targeting

List of Inflation Targeting CountriesRose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

HKMA Link KEY GOAL OF CENTRAL BANKS:

PRICE STABILITY

P

Y

AD

Demand Driven Recession w/ Counter-cyclical

monetary policy

P*

SRASYP

AD′1

2

Gap < 0

3

1. Economy in a recession. Ctl Bank detects deflationary pressure

2. Monetary Policy Cuts Interest Rate

3. Investment increases spending to shift the AD curve back to long run equilibrium

P

Y

AD

Demand Driven Expansion w/ Counter-cyclical

monetary policy

P*

SRASYP

AD′1

2

Gap > 0

1. Economy in expansion. Ctl Bank detects inflationary pressure

2. Monetary Policy Raises Interest Rate

3. Decreased spending to shift the AD curve back to long run equilibrium

3

U.S. Central bank cuts interest rates during recessions

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.

In the face of supply shocks, central banks must make a trade-off between output gap and inflation.

P

Y

AD

Stagflation w/ Counter-cyclical monetary policy

P*

SRASYP

AD′

1. Economy experiences stagflation

2. Monetary Policy Cuts Interest Rate

3. Investment increases spending to shift the AD curve to long run equilibrium with higher prices.

1

2

3

P**

P

Y

AD

Stagflation w/ Price Stabiliztion

P*

SRASYP

AD′

1. Economy experiences stagflation

2. Monetary Policy Raises Interest Rate

3. Investment decreases spending to shift the AD curve to equilibrium with lower output.

1

2

3

Taylor Rule Economist named John Taylor argues that

US target interest rate is well represented by a function of

1. current inflation2. Inflation GAP: current inflation vs. target

inflation3. Output Gap: % deviation of GDP from long run

path Function: Inflation Target π* = .02*1 1

2 2.02 ( )TGTt t t ti Output Gap

Policy Feedback: Taylor Principle Real interest rate impacts demand for

goods in economy. Real interest rate is rt = it - E[πt+1] When E[πt+1] rises, central bank should

increase it more than 1-for-1 to raise real interest rate, limit demand and limit inflation.

When E[πt+1] falls, central bank should reduce it more than 1-for-1 to drop real interest rate, raise demand and avoid deflation.

Zero Lower Bound Interest rate cannot be set below zero.

Link

The Taylor Rule Download

Question: Problem with Central Bank Stabilization

Situation: Economy is in long-run equilibrium, but central bank overestimates potential output.

Draw outcome if central bank believes that the potential output is higher than it is.

Great Inflation of the 70’s & 80’s

CPI Inflation, % Annual Rate

-5

0

5

10

15

20

25

30

35

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

OECD East Asia Subsaharan Africa Latin America

P

Y

AD

A Bias toward Expansionary monetary policy

P*

SRAS

YP

AD′

YPhantom

1. Central Bank repeatedly expands the money supply

2. Inflation recurs

SRAS′

4

5

1

2

3

P

YY*

AD

Demand Driven Recession w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′

1

2

1. Economy in LT equilibrium

2. Demand shifts in

3. Government increases spending to shift the AD curve back

3

Recessionary Gap

P

YY* AD

Demand Driven Expansion w/ Counter-cyclical fiscal policy

P*

SRAS

YP

AD′1

2

1. Economy in LT equilibrium

2. Demand shifts out

3. Government cuts spending to shift the AD curve back 3

Inflationary Gap

Monetary Policy Lags Counter-cyclical fiscal policy beset by lags

between the time a recession is recognized and the time the government can form consensus to act.

Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates.

Lags and Fiscal Policy

Administrative lags for fiscal policy may likely be large.

Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.

If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

Learning Outcomes Use the model of bank reserves and the

forex market to describe the effect of Hong Kong’s monetary policy.

Use the model of the bank reserves market to qualitatively derive and describe the impact of defensive and dynamic transactions on interbank rate and quantity of reserves.

Use the model of the money market and AS-AD to qualitatively derive and describe the impact of monetary policy transactions on the economy.

Use the Taylor rule to quantitatively describe the impact of economic conditions