Principles of economicsCentral banking and Monetary policy

Tomislav Herceg, PhD

Central Bank

• The most important macroeconomic policy maker

• Banks of all the banks, monopolist in the money issue

• Croatian National Bank (Hrvatska narodna banka) was founded in 1990.

Other central banks:• EU: ECB (European Central Bank)

– www.ecb.europa.eu• USA: FED (Federal Reserve District)

– www.federalreserve.gov

Central bank properties

• One of 4 pillars of the state, autonomous towards central government

• Council of governors set by the parliament, not by the government

• Its activities form national monetary policy• Governed by the Council (for HNB):1. Executive board – governor and 4 vice

governors.2. External members – 8 councilors

Monetary policy

• Macroeconomic policy created by the central bank using supply of money management

• 3 forms:– Expansive (M grows faster than GDP)– Restrictive (M grows slower than GDP)– Neutral (M grows at the same pace as GDP)

Policy objectives of the CB

• Economic growth (gy) in line with the economy’s potential to expand

• High employment (low u)• Low inflation (Π)• Moderate interest rates (i)

CB operations

• Open-market operations: buying and selling government securities (bonds and bills)

• Discount-rate policy (setting discount rate at which banks can borrow money)

• Reserve requirement policy (setting legal requirement on deposits in banks)

• Forex operations (buying and selling foreign exchange)

=> These operations alter supply of money M, in other words, these are tools of monetary policy

Open market operations

• By buying and selling government bonds and bills supply of money changes: when CB sells bonds, M falls, when CB buys bonds, M rises.

• Open market operations are conducted in the REPO auctions.

• The most used monetary instrument

Discount-Rate policy

• CB announces discount rate at which commercial banks can borrow money from CB.

• Rarely used in Croatia, banks rather borrow one from another due to tight controls of banks that use CB loans.

• Currently at 7%

Reserve requirements

• By changing reserve rate r monetary multiplier changes: m = 1/r.

• Monetary aggregates in Croatia:• M1: cash and deposits on current accounts• M1a: M1 + state deposits• M4: all liquid assets

(Mill. HRK) Sept. 2014Reserve money 62.746,1

Money M1 63.824,1Money M1a 65.231,6

Broadest money M4 282.533,6

Open economy monetary policy

• Domestic currency is affected by foreign holding of domestic currency. If too much money enters economy central bank has sterilize it by contracting supply of money M.

• Exchange rate mechanism is crucial in that process:• Fixed exchange rate: country pegs against other currency at

fixed exchange rate and has to adjust its economy so as to keep that rate.

• Floating exchange rate: exchange rate freely changes• Operated floated exchange rate (snake in the tunnel):

exchange rate floats between certain endpoints

HRK/€

• Croatian kuna pegs against Euro in an operated floating exchange regime (mostly between 7.2 HRK and 7.6 HRK per EUR):

1994. 1995. 1996. 1997. 1998. 1999. 2000. 2001. 2002. 2003. 2004. 2005. 2006. 2007. 2008. 2009. 2010. 2011. 2012. 2013.6.200000

6.400000

6.600000

6.800000

7.000000

7.200000

7.400000

7.600000

7.800000

Monetary transmission mechanism

• MTM is the route by which changes of money supply M affect output Y, employment E, prices P and inflation Π.

• MTM with restrictive monetary policy:1. Sale of government securities (or increase in the

reserve requirement, or sale of foreign currency)2. Money supply is reduced3. Interest rates go up4. Investment falls5. Reduction of aggregate demand, output and

employment and inflation𝒓 ↑→𝑴 ↓→𝒊↑→ 𝑰 ,𝑪 , 𝑰𝑴 ↓→ 𝑨𝑫↓ ,𝒀 ↓ ,𝝅↓ ,𝒖↑

Money market

• Demand for money is deducted from (a) need to conduct transaction and (b) desire to save

• Supply of money is created by CB operations in the commercial bank system

• The intercept of L and M determine interest ratei

M0

M = supply of money

L = demand for money

Money market shifts• Restrictive monetary policy effect

-money supply contracts -i rises, M falls

• Input price rise which causes inflation: -L rises -i rises

i

M0

M

L

M’

i

M0

ML’

L

Monetary transmission mechanism graph (expansive monetary policy)

i

M0

M’

L

M i

I0

I(i)

Id = investment demand

Y0

AD’I

I0

45°45°

AD

TE P

Y0

ASAD’

AD

Potential output

𝒓 ↓→𝑴 ↑→𝒊↓→ 𝑰 ,𝑪 , 𝑰𝑴 ↑→ 𝑨𝑫↑ ,𝒀 ↑ ,𝝅↑ ,𝒖↓

When Y approaches potential output monetary expansion leads only to inflation

Effects of monetary expansion in the long run

• Milton Friedman and his monetaristic school of economic thought believe that in the long run monetary expansion leads only to higher level of prices and output goes back to its previous level

• Why? Because AS tends to be vertical in the long run and because inflation caused by ME causes a shift of money demand L causing i to rise, thus reducing I and AD and everything goes back. i

M0

ML’L

Phillips curve

π

u0

NAIRU = long run Phillips curve

short run Phillips curves

• Phillips curve shows relation between inflation and unimployment.• In the short run lower unimployment can be „bought” by higher

inflation (negatively sloped short run Phillips curve).• Higher inflation leads to rise in interest rates which causes I and

thus AD to fall which lifts Phillips curve upwards=>In the long run Phillips curve is equal to the NAIRU – Non Accelerated Inflation Rate of Unemployment

Okun’s law

• Okun’s law is empirical rule observed in the USA. It says that 1% increase in the unemployment above its natural level (NAIRU) causes a gap between current and potential GDP to increase by 2%.

• Natural rate of unemployment is the rate of unemployment at potential level of output.

• Cyclical unemployment is the difference between current and natural u.

1 2 3GDPgrowth

4

2

2

changeinunemployment

Okun’s law in USA and EU

USA:

EU:

Exercise 1

• Liabilities of Croatian National Bank were:

Find M1 and and share of cash in M1

IX/2005 XI/2007Cash 589 Bill. 3194 Bill.Current account deposits1413 Bill. 5090 Bill.M1Share of cash in M1

solution

• M1 = cash + current account deposits• Share of cash in M1: Cash/M1

IX/2005 XI/2007Cash 589 Bill. 3194 Bill.Current account deposits1413 Bill. 5090 Bill.M1 2002 Bill. 8284 Bill.Share of cash in M1 29,42% 38,56%

Exercise 2:

• CNB buys 50 Mill. HRK of national bonds. M1 was 4000 Mill. HRK, cash 1400 Mill. HRK, and required reserves (OR) were 800 Mill. HRK. Calculate:

• a) current account deposits• b) required reserve rate• c) money supply mupltiplier• d) new deposits• e) M1 after multiplication proces

Solution

• M1 = 4000, Cash = 1400, OR = 800

• a) Current account deposits: D = M1 – Cash = 4000 – 1400 = 2600 Bill. HRK

• b) Required reserve rater = OR/D * 100 = 800/2600 * 100 = 30,77%

• c) Money supply multiplier• m = 1/r = = 1/0,3077 = 3,25

• d) new depositsND = m * deposit increasedeposits increase = 50 Mill. HRKND = 3,25×50 = 162,5 Mill. HRK

• e) New M1M1’ = M1 + ND= 4000 + 162,5 = 4162,5 Mill. HRK