1

MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT

Monetary Policy

2nd edition

15-2

Key Concepts

Central Banks Monetary Policy Targets and Goals Transmission Mechanism

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Central Banks

Central Banks Monetary authority: conduct monetary policy and act as a

lender of last resort Sometimes a bank regulator Ideal is an independent central bank

Independent from Finance ministry and political pressures For most countries, central banks are a 20th century

phenomenon Prior gold standard = little need for central banks Similar to dollarization today

Steep learning curve for central banks in 20th century Fiat money and the “Great Inflation” of the the 1970s

Examples of independent central banks: U.S. Federal Reserve, EU Central Bank, Bank of England,

Bank of Mexico, Bank of Japan, Bank of Canada, Bank of New Zealand

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Central Banks

Three tools to implement monetary policy Open market operations Reserve requirements Direct lending facility

Closer look at open market operations Buy treasury bonds from public =>supply

reserves to banking system => increase money supply

Sell treasury bonds to public => remove reserves from banking system => decrease money supply

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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

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Federal Reserve System

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Elements of Monetary Policy

Operational Instruments Short-term interest rates, reserve

requirements, monetary base Intermediate Targets

Money supply, exchange rates, inflation targeting

Policy Goals (book calls them “ultimate targets”) Price stability Output and employment stability

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Operational Instruments

Short term interest rate Base money

Cash plus reserves of banks Also called monetary base, high-powered

money, reserve money Central bank can supply reserves to or drain

reserves from the financial system

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Effective Federal Funds Rate

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

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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 forecast

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Intermediate Target I: Money Supply Targeting

Quantity Theory implies direct relationship between money supply growth and inflation

MV=PY Assume velocity is relatively stable Assume real output controlled by real factors

US: money targeting used in early 1980s Difficulties with money supply targeting

Which aggregate to use? Is velocity stable or at least predictable? Can central banks control the money supply? What about supply shocks?

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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

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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.

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Intermediate Target II: 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

The Exchange Rate as a Tool of Monetary Policy When the exchange rate is flexible:

Tighter monetary policy reduces net exports. How?

higher interest rates => increased capital inflows => dollar appreciate => U.S. exports more expensive to foreigners (higher real exchange rate)

Easier monetary policy stimulates net exports. Monetary policy affects consumption, investment,

and net exports in open economy

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Intermediate Target III: Inflation Targeting

Specified a target range for realized inflation Common measure of 2% annual inflation

Specific targets for Bank of Canada, Bank of Canada, Bank of New Zealand

Some allow band around target Allows for discretion in implementation

Use inflation forecast which may incorporate many variables

Discretion comes at a price

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Recall Equation of Exchange

MV = PY

Md/P = (1/V)Y

Real Money Demand Velocity, depends on interest rate

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Money MarketN

omin

al I

nter

est

Rat

e

Quantity of Money

Money Supply

Money Demand

R

M0

R0

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Money MarketIncrease in Income

Nom

inal

Int

eres

tR

ate

Quantity of Money

Money Supply

Money Demand

R0

M0

R1

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Money MarketIncrease in Money Supply

Nom

inal

Int

eres

tR

ate

Quantity of Money

Money Supply

Money Demand

R

M0

R0

M1

R1

15-20

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

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

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Monetary Policy Goals

GDP growth Unemployment Price Stability

New Zealand England European Central Bank

Why not target zero inflation? Mismeasurement Lubricate the labor market Zero nominal interest rate lower bound

Nominal rate = real rate + expected inflation

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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