ECON1102:Week8

MonetaryPolicyReadChapter8

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Unit8:MonetaryPolicy1. Moneysupplyandmonetarypolicy2. MoneymarketEquilibrium3. TransmissionMechanism4. PolicyReactionFunction

MoneySupplyvInterestRatetargeting

Therearetwopolarcasesthatwecanconsider;

1. ThesupplycurveformoneyanditspositionisinfluencedbytheactionsoftheRBA

2. ThesupplycurveformoneyishorizontalandtheRBAsuppliesmoneyondemand(atagiveni)

ThedifferentapproachestotheimplementationofmonetarypolicyRBAtargetsmoneysupply

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interestrate(i)

money

0

MD

MSsetMSori*

i*

RBAtriestocontrolthemoneysupply(currencyanddeposits)by(openmarketoperations)OMO

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interestrate(i)

money

0

MD

MSsetMSori*

i*

CanRBAControlMoneySupply? CaninfluencemoneysupplybyOpenMarketOperations

Bankscancreatemoneybyissuingloans,andwilldosowhenprofitable.

RBAcaninfluenceBUTNOTcontrolmoneysupply

Mscurveisneververtical

RBAtargetstheinterestrate(onbonds)

Giventhedemandformoneyfunction,theRBAwillsupplywhateverquantityofmoneyrequiredtoachieveitstargetvaluefortheinterestrate.

ShiftsinmoneydemandareaccommodatedbytheRBAattheinterestratetarget.

RBATargetscashrate

i

0i Ms Md 0M M

Usingopenmarketoperations(OMO)totargettheCASHRATE

BanksholdaccountswithRBA:exchangesettlementaccounts

Thebalanceintheexchangesettlementaccountsarecalledexchangesettlementfundsorcash

TheCASHRATEistheinterestratewhichbringstogetherthesupplyanddemandforexchangesettlementfundsintobalance

RBAusesOMOtoinfluencetheCASHRATE

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OpenMarketOperationsinvolve..

TheRBAbuyingandsellingshorttermgovernmentbonds- Sellinggovernmentbondsmeansbankreservesfall,asthebuyerspayforthemanddrawontheirbankdeposits

-cashraterises- Buyinggovernmentsecuritiesmeansbankreservesrise,astheRBApaysforthemandthesellersdeposittheproceedsinbanks

-cashratefallsMoneysupplyiswhateverisrequiredtomaintainthe cashrate

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RBATargetstheCashRate

AtitsmonthlymeetingtheRBAboarddecideswhatchanges,ifany,shallbemadetothecashrate

http://www.rba.gov.au/monetarypolicy/rbaboardminutes/2014/01042014.html

RBAthenconductsopenmarketoperationstoachievethisrate

RBAisalsorequiredtointerveneonanongoingbasistokeepthecashrateatitstargetlevel

FlowontootherinterestratesRBAcaninfluence overalllevelofinterestratesineconomy

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TheFinancialSystemAwellfunctioningfinancialsystemimprovestheallocationofsavingintwoways:1. Itprovidesinformationtosaversabout

possibleusesof,andreturnsto,theirfunds.

2. Ithelpssaverstosharetherisksofindividualinvestmentprojects.

Bonds

Abondisalegalpromisetorepayadebt,usuallyincludingboththeprincipalamountandregularinterest,orcoupon,payments.

Bonds Thecouponratedependson: Thetermofthebond(thelengthoftimeuntilthebondsmaturationdate).

Creditrisk(theriskthattheborrowerwillgobankruptandthusnotrepaytheloan).

Taxtreatmentofcouponpayments. Bondownersarenotrequiredtoholdtheirbondsuntiltheirmaturationdates.

Theyarealwaysfreetoselltheirbondsinthebond market.

Bondpricesandinterestrates

Themarketvalueofaparticularbondatanygivenpointintimeiscalledthepriceofthebond.

Thepriceofabondcanbegreaterthan,lessthan,orequaltotheprincipalamountofthebond,dependingonhowthecurrentorprevailinginterestrateinfinancialmarketscompareswiththeinterestrateatthetimethebondwasissued.

Interestrates,bondpricesandmoneymarketequilibrium

Whyareinterestratesandbondpricesinverselyrelated? Iftheinterestrateisbelowtheequilibriummarketpriceformoney,thedemandformoneyisgreaterthanthesupply.

Toincreasemoneyholdings,thepublicwillstarttosellofftheirbonds.

Anincreaseinthesupplyofbondsleadstoareductionintheirprice,whichisequivalenttoanincreaseininterestrates.

Athigherinterestrates,thedemandformoneywilldecline,untilequilibriumisreachedwherethemoneydemandisequaltotheamountofmoneyavailableatthatinterestrate.

Marketfor90DayBills:DemandandSupply

Borrowfor90days=SupplyofBills

BorrowmorewheninterestrateonBillsislow.

BUT,lowinterestrateimpliesahighpriceforBills

So,SupplycurveforBillsisincreasingintheirprice

Marketfor90DayBills:DemandandSupply

Lendfor90days=DemandforBills

LendmorewheninterestrateonBillsishigh.

BUT,highinterestrateimpliesalowpriceforBills

So,DemandcurveforBillsisdecreasingintheirprice

Example:Themarketfor90daybillsFigure8.1Themarketfor90daybills

TheEffectofanIncreaseintheCashRateonthe90DayBillMarket

InthepreviousfigurePerepresentstheequilibriumpricefor90daybills.Thiswillalsocorrespondtoanequilibriuminterestratefor90daybills.

NowsupposetheRBAraisesitstargetlevelforthecashrate.Howdoesthisaffectthemarketfor90daybills?

Banksareabletoparticipateinboththeovernightcashmarketandinthecommercialbillmarket.

TheEffectofanIncreaseintheCashRateonthe90DayBillMarket

WhenCashRateIncreases. Thedemandforcommercialbills(thewillingnesstolendtofirms)willtendtofall:Demandcurvewillshifttotheleft. Thisoccursbecausesomebankswillleavethebillmarketinfavourofthehigherreturnsintheovernightcashmarket.

Thesupplyofcommercialbills(thedemandfor90dayloans)willtendtorise:Supplycurvewillshiftoutwards. Someborrowersintheovernightcashmarketwillnowseek fundsinthe90daybillmarket,duetothehigher cashrate

HowdoestheReserveBankaffectnominalinterestrates?Figure8.2Theeffectofanincreaseinthecashrateonthe90daybillmarket

Arbitrage WhileRBAtargetsaveryshortinterestrate,changesincashrateeventuallyleadtochangesinlongerterminterestrates.(Aswesawlastweek)

MarketRates=CashRate+Premium Premiumwilltendtoreflectriskorliquidityfactors.

CantheRBAtargettherealinterestrate?

RBAtargetnominalinterestrate(i)thecashratethroughOMO

Decisionstosaveandinvestdependontherealinterestrate(r)

Recall,r=i (wherer=realinterestrate, i=nominalinterestrate =inflationrate)

sinceinflationrateadjustsreasonablyslowly,RBAcanchangetherealinterestrate(r)inshortrunbychangingthenominalinterestrate(i) Inlongrunrdependsonthesupplyanddemandforsavings

andinterestratedifferential(ascomparedtooverseasinterest rates)

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7.Howchangingmonetaryconditionsaffecttheeconomythetransmissionmechanism

Currentmonetarypolicyworksbychangingthecashrate

TheRBAsells/buysgovernmentsecuritiestoachievetargetedcashrate

Thebanksbuy/sellgovernmentsecuritiestoaccommodatetheRBAandreserveschange

Asbankreservesfall/rise,banksreduce/increaseloans Theincrease/reductioninthecashratefeedsthroughtoothershortterminterestrates

Impactsgenerallevelofspendingandthebroadereconomy

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Monetarypolicyandtheeconomy

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cashrateotherrates

realinterestrate

spending(I,C)exchangerate

(NX)

outputemploymentinflationarypressures

PAEandtheRealInterestRate InourmodelofincomedeterminationwehaveallowedPAEtodependonthelevelofrealoutput.

WenowwanttoallowarolefortherealinterestratetoinfluencePAE.

2mainchannels1. Higherrealinterestrateswillleadhouseholdsto

reducecurrentconsumptioneg.Duetohighermortgagepayments

2. Higherrealinterestrateswillraisethecostofborrowingandreduceinvestmentbyfirms

TheRBAfightsarecession

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cashrateotherrates

realinterestrate

spending(IC)depreciation$A

(NX)

outputEmployment

inflationarypressures

TheRBAfightsarecession

r SandC Investment Depreciationof$Alowerrealexchangerate increaseininternationalcompetitiveness demandforXanddemandforM

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ModelforPAE

Consumption arTYcCC d )( Investment brII P Assume (for simplicity) other variables are exogenous

GG XX TT

PlannedAggregateExpenditurearTYcCCd )(

brIIP GG XX TT

NXGICPAE Pd Substitute and collect terms

cYrbaXGITcCPAE ])([

Implications

Exogenousexpenditurenowdependsontherealinterestrate

Foranygivenlevelofoutput,PAEwillfallwithariseintherealinterestrate.

IfweassumethattheRBAcansettherealinterestrate,thenwehaveamechanismbywhichmonetarypolicycanaffectPAEandequilibriumoutput

Whyloweringinterestratesdoesnotalwayswork

Accordingtotheprecedingdiscussion,alowerrealinterestratewillbeassociatedwithincreasedplannedaggregateexpenditurebyhouseholds.

However,lowrealinterestrateneednotalwaysstimulateexpenditure.

Consumption Householdsmayraisesavingforprecautionaryreasons. Thewilltoreducenetdebtandtorebuildwealthpersists Investment Especiallyinrecessions,investmentmaybeinterestinelastic

Example:PAEandtherealinterestrate Inaneconomydescribedby: Cd=640+0.8(YT)400r Ip=250600r G=300 X=20 T=250 BothCdandIpareaffectedbytheinterestrate,r. PAE=Cd+Ip+G+X =[640+0.8(Y250)400r]+[250600r]+300+20

=[10101000r]+0.8Y

PAEandtherealinterestrate

PAE=[10101000r]+0.8Y Theexogenousexpenditureinthiseconomyis

[10101000r]anddependsontherealinterestrate,r.

Iftherealinterestrateis5%,theequilibriumoutputisgivenby:

PAE=[10101000x(0.05)]+0.8Y PAE=Ye,so: Ye=960+0.8Y=4800

TofightarecessionbyhowmuchshouldtheRBAlowerinterestrates(from5%)?

Weknowatr=5%,Ye=4,800,howeverifY*=5,000Wehavearecessionarygapof200Byhowmuchshouldrbereduced?

Recall,Exogenousexpenditure=(1,0101,000r)(Eq1)Witharecessionaryoutputgapof200,andamultiplierof5,

exogenousexpendituremustriseby40FromEq1,each1%reductioninrwouldincreaseexogenous

expenditureby10A4%reductioninrwouldincreaseexogenousexpenditureby

40rshouldfallfrom5%to1%

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TheRBAfightsarecession

.

0Y(=GDP)

PAE(plannedaggregateexpenditure)

PAE(r=5%)

4,800 Y*=5,000

PAE(r=1%)

AreductioninrshiftsPAEupward

SupposeinsteadY*=4,600wehaveanexpansionarygapbyhowmuchshouldtheRBAraiseinterestrates(from5%)toclosetheoutputgap?

Weknowatr=5%,Ye=4,800,howeverY*=4,600Wehaveanexpansionarygapof200,byhowmuchshouldrbe

increased?Recall,Exogenousexpenditure=(1,0101,000r)(Eq2)Withanexpansionaryoutputgapof200,andamultiplierof5,

exogenousexpendituremustfallby40FromEq2,each1%increaseinrwouldreduceexogenous

expenditureby10A4%increaseinrwouldreduceexogenousexpenditureby40rshouldincreasefrom5%to9%

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TheRBAfightsinflation

.

0Y(=GDP)

PAE(plannedaggregateexpenditure)

PAE(r=5%)

4,800Y*=4,600

PAE(r=9%)

AnincreaseinrshiftsPAEdown

8.ModellingthebehaviouroftheRBA thePolicyReactionFunction TheRBAattemptstostabilisetheeconomybymanipulating

therealinterestrateinresponsetotheoutputgapandtheinflationrate

Apolicyreactionfunctiontriestoexplain/predictbyhowmuchtheRBAchangesthecashratewhentherearechangesinthestateoftheeconomy(egoutputgap,inflationrate)

THETAYLORRULEhasbeendevelopedtodescribethebehaviouroftheUSFederalReserve

r=0.010.5[(Y*Y)/Y*]+0.5=>SuggestsFederalReserverespondstobothoutputgapsand

rateofinflation

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Policyreactionfunction

Example

UsingtheTAYLORRULEr=0.010.5[(Y*Y)/Y*]+0.5a1%increaseininflation()leadsto

anincreaseinrof0.5x0.1=0.005(or0.5percentagepoints)

ApplicationtobehaviourofRBA Notdirectlyapplicableduetodifferentweightsontheoutputgap

[(Y*Y)/Y*]andinflation(). Untilrecentlylikelyhigherweightoninflation(duetospecific

inflationtargetof23%),althoughglobalfinancialcrisishasrequiredconsiderationofrecessionaryoutputgap.

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AhypotheticalRBApolicyreactionfunctionsimplifyingassumptionthatRBAreactsonlytoinflation*

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Inflation()

realinterestratesetbyRBA(r)

RBAspolicyreactionfunction

0.02

0.04

0.06

0.03

0.05

00.01 0.02 0.03 0.04

*Capturestendencytoraisecashratewheneconomyisoverheating(expansionarygap)andreducecashratewheneconomyissluggish (recessionarygap)

MovementalongpolicyreactionfunctionIfchangeinrinresponsetochangeinShiftofpolicyreactionfunctionIfchangeinrinabsenceofchangein

RBAmonetarypolicyinpractice

RBAreactstochangesinactualinflationrates,inflationaryexpectationsandabroadrangeofdomesticandinternationaleconomicvariables

Decisionsmadeusingbothformalpolicyreactionfunctionsandjudgement Doesnothaveaprecisemeasureoftheoutputgap Onlyhasanapproximateideaoftheimpactofinterestratechangesonplannedspending(orthelagbeforeimpactswilloccur)

Changesinmonetarypolicysettingscanbetakenfrequently,butRBAhastendedtobecautious

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