1 macroeconomics and the global business environment monetary policy 2 nd edition
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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
Monetary Policy
2nd edition
15-2
Key Concepts
Central Banks Monetary Policy Targets and Goals Transmission Mechanism
15-3
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
15-4
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
15-5
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
15-6
Federal Reserve System
15-7
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
15-8
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
15-9
Effective Federal Funds Rate
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
15-10
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
15-11
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?
15-12
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
15-13
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.
15-14
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
15-15
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
15-16
Recall Equation of Exchange
MV = PY
Md/P = (1/V)Y
Real Money Demand Velocity, depends on interest rate
15-17
Money MarketN
omin
al I
nter
est
Rat
e
Quantity of Money
Money Supply
Money Demand
R
M0
R0
15-18
Money MarketIncrease in Income
Nom
inal
Int
eres
tR
ate
Quantity of Money
Money Supply
Money Demand
R0
M0
R1
15-19
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
15-21
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
15-22
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
15-23
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
15-24
Transmission Mechanism
Official Rate
Market Rates
Asset Prices
Expectations and
Confidence
Exchange Rate
Domestic Demand
Net External Demand
Domestic Inflationary Pressure
Import Prices
Inflation