ec3115monetaryeconomics - anuar d. ushbayev€¦ · the interest rate control (endogenous money)...

EC3115 :: L.6 : Monetary policy tactics Almaty, KZ :: 9 October 2015

EC3115 Monetary EconomicsLecture 6: Monetary policy tactics

Anuar D. Ushbayev

International School of EconomicsKazakh-British Technical University

https://anuarushbayev.wordpress.com/teaching/ec3115-2015/

Tengri Partners | Merchant Banking & Private [email protected] – www.tengripartners.com

Almaty, Kazakhstan, 9 October 2015

ISE – KBTU A.D. Ushbayev (2015)

https://anuarushbayev.wordpress.com/teaching/ec3115-2015/

EC3115 :: L.6 : Monetary policy tactics - 2 / 31 -

Relevant reading

Book treatment

F. Mishkin. (2013). The Economics of Money, Banking and Financial Mar-kets, 10th edition, Pearson Education, Chapter 17.

S. Gray, N. Talbot. (2006). "Monetary Operations", Handbooks, Centrefor Central Banking Studies, Bank of England.

Must-read articles

Bank of England. (1999). “The transmission mechanism of monetarypolicy”, Bank of England Quarterly Bulletin, Vol. 30, No. 2.

D. Blenck, H. Hasko, S. Hilton and K. Masaki. (2001). “The main featuresof the monetary policy frameworks of the Bank of Japan, the FederalReserve and the Eurosystem”, BIS Papers, No. 9, Bank for InternationalSettlements.

Bank of England. (2015). “The Bank of England’s Sterling MonetaryFramework (the ’Red Book’)”.


http://www.bankofengland.co.uk/education/Documents/ccbs/handbooks/pdf/ccbshb24.pdf

http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf

http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf

http://www.bis.org/publ/bppdf/bispap09b.pdf



http://www.bankofengland.co.uk/markets/Documents/money/publications/redbook.pdf

http://www.bankofengland.co.uk/markets/Documents/money/publications/redbook.pdf

EC3115 :: L.6 : Monetary policy tactics - 3 / 31 -

Must-read articles (cont.)

M. King. (1994). “The Transmission Mechanism of Monetary Policy”,Bank of England Quarterly Bulletin, Vol. 34, No. 3

B. Bernanke. (2005). “Remarks by Governor Ben S. Bernanke”, Speechdelivered at the Redefining Investment Strategy Education Symposium,Dayton, Ohio, March 30.

S. Fullwiler. (2008). “Modern Central Bank Operations – The GeneralPrinciples”, SSRN.

R. Farmer. (2013). “The Natural Rate Hypothesis: an idea past its sell-bydate”, Bank of England Quarterly Bulletin, Vol. 53, No. 3.


http://www.bankofengland.co.uk/archive/Documents/historicpubs/qb/1994/qb940301.pdf

http://www.federalreserve.gov/boarddocs/speeches/2005/20050330/default.htm

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1658232


http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130306.pdf


EC3115 :: L.6 : Monetary policy tactics - 4 / 31 - The monetary transmission mechanism

Section 1

The monetary transmission mechanism



The interest rate control (endogenous money) approach to thetransmission mechanism in six steps1:

1. The central bank determines and sets the short-term interest rate dependingon its reaction function.

2. The private sector determines the volume of borrowing it wishes to undertakefrom the banking sector at the current set of interest rates.

3. Banks adjust their own relative interest rates, marketable assets, andinter-bank and wholesale borrowing to meet the credit demands upon them.

4. These bank actions determine the money stock and its varioussub-components (e.g. demand, time and wholesale deposits). This, in turn,determines the volume of bank reserves needed, taking into account anyrequired reserve ratios.

5. This determines how much the banks need to borrow from, or pay back to,the central bank in order to meet their demand for reserves.

6. In order to sustain the level of interest rates set under Step 1, the central bankuses open market operations to satisfy the banks’ demand for reservesestablished under Step 5.

1Based on C. Goodhart, (2002), “The endogeneity of money”, in Arestis P, Desai M andDow S (eds) Money, Macroeconomics and Keynes: Essays in Honour of Victoria Chick, Vol. 1,London: Routledge.



Fed view



ECB view


EC3115 :: L.6 : Monetary policy tactics - 8 / 31 - The Taylor rule story

Section 2

The Taylor rule story



Choosing a Policy Instrument

Observable and MeasurableQuick observation and accurate measurability are necessary to quicklysignal the central bank’s policy stance.

Reserve aggregates are reported with lag as opposed to short-term interestrates.

Real interest rates, however, are hard to estimates given the unobservablenature of inflation expectations (r = i −πe ).

ControllableCB’s ability to directly the policy instrument is necessary.

Both reserves and short-term nominal rates are under control of the CB.

Real interest rates are not, however.

Predictable in its effect on the policy goalLink between interest rates and inflation are much morewell-established than link between monetary aggregates and inflation.



Should price stability be the primary goal?

Long-run: no conflict between the goals of inflation and e.g. growth,employment and stable financial markets.

Short-run: price stability may conflict with full employment2.

Thus various central banks have different style of mandates:Hierarchical (e.g. ECB, Bank of England, Bank of Canada, Reserve Bank ofNew Zealand): primary objective is price stability, and as long as it isachieved, other goals can be pursued.

Dual (e.g. Fed): two objectives – price stability and maximumemployment. This can lead to a time consistency problem.

2This point is disputed in the post-Keynesian literature, with important ideas such as e.g.Abba Lerner’s “Functional Finance” – to be covered later.


http://k.web.umkc.edu/keltons/Papers/501/functional%20finance.pdf


The Phillips curve

In 1958, William Phillips3 identified an inverse relationship betweenunemployment and rate of change of nominal wages.

3A. W. Phillips. (1958). “The Relationship between Unemployment and the Rate of Changeof Money Wages in the United Kingdom 1861-1957”, Economica, 25 (100): 283–299.


http://people.virginia.edu/~lc7p/202/Phillips58.pdf

http://people.virginia.edu/~lc7p/202/Phillips58.pdf


Phillips believed that since money wage costs represent a high proportion of totalcosts, movements in money wage rates will thus drive movements in the generalprice level.

Phillips recognised that the direction of change in the economy, and not just thelevel, is a factor in wage bargaining between employers and workers. Some of hisarguments left out from later New Keynesian analysis actually reinforced Keynes’original argument that the real wages are not determined in the labour market andthat workers cannot directly manipulate the prevailing real wage rate.

Nevertheless, he extrapolated from the money wages-unemployment relationshipto a price inflation-unemployment one, although in reality even the link betweenrate of change of money wages and unemployment is highly nonlinear.

The introduction of the Phillips curve, as a fundamental structural relationship thatcharacterises the wage adjustment process, into economic analysis marked a shiftfrom the original Keynesian definition of full employment in terms of job openingsto job seekers ratio to one that assumed an existence of trade-off betweeninflation and unemployment.

The original Phillips curve is no longer used because of its over-simplification ofreality, but expectations-augmented Phillips curve-like relations figure in modernNew Keynesian DSGE models.



The Time Inconsistency Problem

Ex-ante, wages W are set based on inflation expectations4:expected real wage= (W/P e)

Higher ex-post inflation lowers the real wage:P > P e → (W/P)< (W/P e)

Lower ex-post real wage (W/P) boosts employment.

Thus the central bank can achieve higher employment by generating“surprise inflation”.

The public may expect the central bank to ex-post generate surpriseinflation to boost employment:

P e ↑→ P < P e → (W/P)> (W/P e) which can decrease employment.

Thus the CB may be forced to generate ex-post inflation to avoid adrop in employment.

4Assumes wage bargaining power.ISE – KBTU A.D. Ushbayev (2015)


The above incentive to ex-post cause surprise inflation to boostemployment introduces an inflation bias.

How to minimize the inflation bias:1. Central independence: non-politicians are more credible in not caring

about unemployment.

2. Stricter focus: price stability as primary/only objective.

3. Rules: predetermined central bank behavior patterns for morecredibility (however less flexibility).

4. Reputation: credible commitment to low inflation policies.



The Taylor Rule

How should the interest rate target be chosen?John Taylor (1993)5 provided one answer to the above question using arules-based approach to interest rate setting:

it = πt + r∗t +α�

πt −π∗t�

+ β�

yt − yt

�

i.e. the central bank should set the short term nominal interest rate based on:πt – the current rate of inflation,r∗t – the presumed equilibrium real interest rate (which would prevail at fullemployment), anda weighted average of

the inflation gap – the difference between current (πt ) and desired inflation (π∗t ),andthe output gap (the difference between the logarithmic levels of actual output(yt ) and full employment output ( yt )) – which, according to the Phillips curve, isan indicator of future inflation.

5J. Taylor. (1993). “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester ConferenceSeries on Public Policy, 39, pp. 195–214.

J. Taylor. (1999). “A Historical Analysis of Monetary Policy Rules,” in Monetary Policy Rules,ed., John B. Taylor (Chicago: University of Chicago Press, 1999), pp. 319–341.



Is the Taylor rule an accurate description of central bank behaviour?

United States (1960-2011)

United Kingdom (1976-2011)

Canada (1991-2009)ISE – KBTU A.D. Ushbayev (2015)


Given that the Taylor rule seems to do a good job of describing the variouscentral banks’ interest rate setting process, does this mean that the job ofthe central banker can be assigned to a computer?6

The answer, of course, is – no, and for several reasons:1. Monetary policy has long lags – it takes a long time for policy actions to affect

the economy and thus policy needs to be forward looking. Central bankforecasts of inflation and economic activity will require much broaderinformation sets than simply the current inflation rate and output gap.

2. No one knows the true model of the economy is, and thus monetary policy isboth art and science beyond the simple mechanics of Taylor rule.

3. The economy is changing all the time, so the Taylor rule coefficients cannotbe constant.

4. Financial crises break down the parity between central bank and commercial“money”, and the changes in credit spreads may alter the relationship betweenthe short term rate and other interest rates more relevant to investmentdecisions, and therefore to economic activity.

6The Taylor rule has received both wide acclaim and wide critique over the last 20 years,and we will return to a deeper discussion of this later on in this course.



The NAIRUAs mentioned above, the interpretation of the presence of the output gapin the Taylor rule is that it is an indicator of future inflation according to thePhillips curve. A related concept is the NAIRU7, or the nonacceleratinginflation rate of unemployment - the rate of unemployment at which thereis no tendency for inflation to change.In simple formulation, the natural rate hypothesis says that:

When the unemployment rate is above the natural rate, with output belowpotential, inflation will fall, andWhen the unemployment rate is below the natural rate, with output abovepotential, inflation will rise.

In modern day, the notion of the NAIRU has been largely discredited8 –among many empirical examples is the fall of unemployment in the USafter the great financial crisis of 2008 with no rise in inflation that wouldsatisfy the Phillips curve.

7Due to M. Friedman, (1968), “The role of monetary policy”, The American Economic Review,Vol. 58, No. 1, pp. 1–17.

8For one exposition of the flaws of the NAIRU, read R. Farmer. (2013). “The Natural RateHypothesis: an idea past its sell-by date”, Bank of England Quarterly Bulletin, Vol. 53, No. 3.




EC3115 :: L.6 : Monetary policy tactics - 19 / 31 - Interest rate management in practice

Section 3

Interest rate management in practice



“[I]t is an illusion to think that [...] the market controls the interest rate.”

– Marriner Stoddard Eccles1, (1947), in “Direct purchases of governmentsecurities by federal reserve banks”, Hearing before the Committee onBanking and Currency, House of Representatives, Eightieth Congress, Firstsession, on H.R. 2233, superceded by H.R. 2413, an act to amend the FederalReserve act, and for other purposes. March 3, 4, and 5, 1947, United StatesGovernment Printing Office, Washington.

1Chairman of the Federal Reserve (1934-1948).



“The conventional textbook view is that the Trading Desk buys andsells securities in response to easings and tightenings [i.e., the liquidityeffect]. From the [Trading] Desk’s perspective, however, the supply-demand balance is primarily a function of the demand for requiredbalances, which is almost completely insensitive to small changes inpolicy. Consequently, any change in the target has no effect on excesssupply or demand in the funds market.”

– Sandra Krieger2, (2002), “Recent trends in monetary policy imple-mentation: a view from the desk”, Federal Reserve Bank of New YorkEconomic Policy Review, Vol. 8, No. 1, pp. 73-76.

2Executive Vice-president, chief risk officer and head of the Risk Group (2008-present),previously Senior Vice-president, head of domestic reserve management and discountwindow operations (1987-2002), Federal Reserve Bank of New York.


http://www.fednewyork.org/research/epr/02v08n1/0205krie.pdf

http://www.fednewyork.org/research/epr/02v08n1/0205krie.pdf


“The costs of reserves, both intraday and overnight, are policy vari-ables. Consequently a market for reserves does not play the traditionalrole of information aggregation and price discovery. In fact [...] manydemand-management features determined by central bank policy areintended to dampen price variability in the market for reserves.”

– Antoine Martin and James McAndrews, (2008), “Should there be in-traday money markets?”, Federal Reserve Bank of New York Staff Re-port,No. 337.


http://www.ny.frb.org/research/staff_reports/sr337.pdf



“When individual banks need money [that is, reserve balances] to meettheir commitments at the daily clearing, they usually raise it from otherbanks in the wholesale money market. And when the banking systemas a whole needs money, that money is usually raised by selling secu-rity holdings into liquid markets. Both channels are backstopped ul-timately by the Fed’s commitment to stabilize the federal funds ratearound a chosen target, and by its intervention to make good on thatcommitment by lending in the Treasury repo market.”

– Perry Mehrling, (2011), The New Lombard Street – How the Federal Re-serve Became the Dealer of Last Resort, Princeton, NJ: Princeton UniversityPress.



“A similarly confused criticism often heard is that the Fed is somehowdistorting financial markets and investment decisions by keeping in-terest rates “artificially low.” Contrary to what sometimes seems to bealleged, the Fed cannot somehow withdraw and leave interest ratesto be determined by “the markets”. The Fed’s actions determine themoney supply and thus short-term interest rates; it has no choice butto set the short-term interest rate somewhere. So where should thatbe? The best strategy for the Fed I can think of is to set rates at a levelconsistent with the healthy operation of the economy over the mediumterm, that is, at the (today, low) equilibrium rate. There is absolutelynothing artificial about that! Of course, it’s legitimate to argue aboutwhere the equilibrium rate actually is at a given time, a debate that Fedpolicymakers engage in at their every meeting.”

– Ben Bernanke3 (2015), “Why are interest rates so low?”, BrookingsInstitution Blog, March 30, 2015.

3Chairman of the Federal Reserve (2006-2014).




In most advanced countries, the value of daily payments settlement is avery significant figure.

E.g. in the US, in the year 2014, the average daily value of Fedwire transferswas $3.5 trillion, or 20% of the US GDP in that year.

This means that, within the scope of 5-10 days, the value of paymentssettlement using reserve balances can exceed the annual gross domesticproduct of the country.

Clearly, this makes one fact obvious – ensuring the smooth functioning ofthe national payments system is an inevitable daily responsibility of acentral bank, if it wants to protect the stability of the national economy.

“Overall, then, the operating target in modern central banking is necessarilyan interest rate target given a central bank’s obligation to the paymentssystem, its responsibilities associated with regulatory oversight of reserverequirements (where applicable), and the need to minimize volatility inmoney market rates.”9

9S. Fullwiler. (2008). “Modern Central Bank Operations – The General Principles”, SSRN.ISE – KBTU A.D. Ushbayev (2015)



US Fedwire Funds Service (real-time gross settlement)



KZ Inter-bank transfer system + System of inter-bank clearing



As we noted earlier, reserve balances exist exclusively on the balancesheet of the central bank.

Central banks that operate under an floating exchange rate regimeaccommodate any demand for reserve balances at the target interestrate, and offset any changes to their balance sheets that would beinconsistent with such accommodation.

Reserve requirements are related to interest rate targets, not controlof monetary aggregates, and do not change the accomodative natureof central bank interest rate management operations.

Central bank that operate under a floating exchange rate regime mustnecessarily set an interest rate at some target level.

There is no liquidity effect related to target rate changes, if the reservepositions of the banking system and hence its liquidity needs areforecast accurately.



In case of no reserve requirements:Banks hold overnight only that quantity of reserve balances that they believethey need for settling payments and meeting customer withdrawals.Demand for reserve balances is roughly (to the degree that the central bankaccurately estimates the demand for reserve balances to achieve a target rate)vertical at this quantity – although the exact quantity can change daily – asthere is no reason to hold more or less than this quantity.Loans create deposits and additional reserve balances do not increase thebanks’ ability to extend credit.

With reserve requirements:Banks hold overnight only that quantity of balances they believe they needfor settling payments, meeting customer withdrawals and meeting reserverequirements.Demand for reserve balances is roughly vertical at this quantity by the end ofthe maintenance period – again there is no use for more or less than thisquantity.

In either case, if the central bank provides too little (too many) reserves to thesystem at the announced target rate, the overnight rate will be towards thediscount lending rate (deposit rate).



Interest rate targeting with no reserve requirements

The demand for reserve balances is horizontal at both the central bank discount lending anddeposit rates, as no bank would borrow in the interbank market at a rate higher than thediscount rate or lower than the deposit facility rate. The demand curve is roughly verticalbetween these rates at the quantity of reserve balances banks desire to hold at the target rate.

“More than a trivial deviation from this quantity sends the interbank rate to the penalty orremuneration rates, which is itself de-facto interest rate targeting”.– quote and graphs from S. Fullwiler. (2013). “An endogenous money perspective on the post-crisismonetary policy debate”, Review of Keynesian Economics, Vol. 1, No. 2, pp. 171–194.


http://www.rokeonline.com/roke/post%20crisis%20monetary%20policy%20debate.pdf

http://www.rokeonline.com/roke/post%20crisis%20monetary%20policy%20debate.pdf


Interest rate targeting with reserve requirements

Kinks in the demand for reserve balances line appear since the maintenance period formeeting reserve requirements usually more that one day, i.e. banks average their reservebalances held to meet reserve requirements across longer period. Reserve requirements, thushelp central banks achieve the interest rate target more easily, decreasing the need forprecision in estimating banks’ reserve positions. The flat section holds until the end of themaintenance period arrives, at which point the flatter portion shrinks. By the end of theperiod, similar to the case of no reserve requirement, any non-trivial deviation in the quantityof reserves supplied will drive the overnight rate to either the discount lending or the depositfacility rate.
