Monetary Policy Chap. 31

Central Bank: A special governmental organization or quasi- governmental institution within the financial system that controls the medium of exchange. EconomyCentral Bank HK ? USA? Eurozone? PRC? UK, Canada, Japan, Korea ?

Interbank Payment Systems Commercial banks keep accounts at the central bank for interbank payments. referred to generally as reserves, specifically as clearing balances in Hong Kong. These accounts, along with cash, constitute the monetary base. Hong Kong Interbank Clearing Limited

Interbank Market Individual banks will face a short-fall in reserves if they have too many outflows and borrow funds from other banks facing a surplus. Banks will keep an inventory of reserves to meet their own liquidity needs but the interest rate is the opportunity cost of holding reserves. Desire to hold reserves is a declining function of the interest rate. Central bank controls the total supply of reserves available to banks.

Interbank Market S BR D BR i IBR Reserves i*i*

Equilibrium in the Interbank Market If interest rates are too low, banks will want to hold more reserves than available. Banks facing a shortfall of reserves will be willing to bid up interest rates until all banks are content with reserves available. If interest rates are too high, banks will want to lend out their excess reserves. To do so in a liquid market, they must lower interest rates.

Equilibrium S BR D BR i IBR Reserves i i*

Open Market Operations In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves. In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This increases the aggregate supply of reserves.

Open Market Purchase S BR D BR i IBR Reserves i*i* S BR ' i **

Money Supply and Interest Rates If the central bank engages in an open market PURCHASE, they will increase the reserve holdings of counter-party commercial banks. This will increase liquidity in the reserve funds market. Banks with excess reserves can lend them out pushing down interest rates in broader money market.

Fed Funds & Money Market Rates

Domestic Monetary Policy Causes D.C. Interest Rates Go Up Relative Demand for US$ Goes Down S Supply Demand S* Supply' Demand' S** Domestic Currency Appreciates 1 2 Excess Supply

Foreign Monetary Policy Causes Foreign Interest Rates Go Up/Relative Demand for US$ Goes Up S Supply Demand S* Supply' Demand ' S** Domestic Currency Depreciates 2 1 Excess Demand

Monetary Policy Expectations and Exchange Rates Future exchange rates affect the expected profitability of holding bank accounts in a country’s currency. Current level of the exchange rate guided by the future path of interest rates.

Expectation of S t+1 Increases S Supply Demand S* Supply' Demand' S** Domestic Currency Depreciates 1 2 Excess Demand

Hong Kong’s Exchange Rate Regime

Clearing Accounts Reserves May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.

US Monetary Policy Causes US Interest Rates Go Down, Strengthening Pressure on HK$ S Supply Demand S=7.8 Supply' Demand' S** Excess Supply of US Dollars 1 Excess Supply

Hong Kong Interbank Market: HIBOR higher than US interest rate. S BR D BR i HIBOR Reserve Accounts i FedFunds i*i* S BR ' Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 2

Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically S Supply Demand S=7.8 Supply' Demand' Excess Supply of US Dollars 1

If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. Fixed Exchange Rate

Loss of Credibility A fixed exchange rate will lose credibility if people come to believe that the central bank will: ▫devalue the currency, (ie. raise S in the future) ▫revalue the currency (ie. reduce S in the future) If market expects an exchange rate change, commercial banks will adjust comparison rate for the expectations of devaluation.

Iron Triangle of International Finance Pick 2 items from this menu Open International Capital Flows Independent Interest Rate Stable Exchange Rates

Operating Instruments: Target Interest Rates On a day to day basis, central banks express their policy in terms of a single easily observed, easily controlled financial market price or quantity. In many economies, central banks use the interest rate in interbank market as an operating instrument FedFederal Funds Rate BoJUncollateralized Call Money Rate ECBMain Refinancing Rate/Euribor

Dynamics of Monetary Transmission Open market purchase reduces interest rates Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods. Lower interest rates increase demand for US$ in forex market depreciating the exchange rate. Lower interest rates tend to increase asset prices which makes consumers feel wealthier. Aggregate demand shifts out. Given fixed wages this increase in demand increases equilibrium output. Ultimately, wage demands will increase and prices will rise.

Cut Policy Rate Cut Money Market Rate Reduce Cost of ST Finance Weaken Forex Rate Raise Asset Prices Cut Bond Yields Cheaper to Borrow Investment increases People Wealthier Consumption Increases Improved Competitiveness Net Exports Increases Consumer Purchases and Inventory Investment Increase

P Y AD Expansionary Monetary Policy AD ′ ΔIΔIΔC, ΔNX

P Y AD An Expansionary Cycle Driven by monetary policy P ** SRAS YPYP AD ′ 1 2 Output Gap 1.Economy at LT Y P. 2.Monetary Policy Cuts Interest Rate. The AD curve shifts out. 3.Tight labor markets. SRAS returns to long run equilibrium 3 SRAS ′ P*P* P ***

Interest Rate Management In most economies around the world, the central bank does not simply act to maintain a fixed money supply. Rather, they adjust interest rates in response to business cycle conditions.

P Y AD Demand Driven Recession w/ Counter-cyclical monetary policy P*P* SRAS YPYP AD ′ 1 2 Gap < Economy in a recession. Fed detects deflationary pressure 2.Monetary Policy Cuts Interest Rate 3.AD curve shifts back to original equilibrium P **

P Y AD Demand Driven Expansion w/ Counter-cyclical monetary policy P*P* SRAS YPYP AD ′ 1 Gap > 0 1.Economy in expansion. Fed detects inflationary pressure 2.Monetary Policy Raises Interest Rate 3.AD curve shifts back to original equilibrium 3 P ** 2

U.S. Central bank cuts interest rates during recessions

Price Stability Counter-cyclical monetary policy stabilizes output near potential output, Y P, but also stabilizes the price level near P *. Central banks may pursue price stability as a goal and also stabilize output as well if business cycles are caused by demand shocks.

Inflation Targeting A growing number of central banks, beginning in New Zealand in the 1980’s conduct monetary policy under the framework of “inflation targeting” Bank states an explicit target for inflation and publishes inflation forecasts under current conditions. Policy is set in order to bring actual inflation within a range around the target. Central bankers are judged by their ability to hit target and repeated failures may result in policymakers losing their jobs.

P Y SRAS t Dynamic AS-AD Model: Ideal AD t Yt*Yt* YtPYtP Y P t+1 AD t+1 SRAS t+1 Y* t+1 Pt*Pt* P* t+1 Demand expansion matches supply expansion Average Inflation Ch. 29,

40 Japanese Monetary Policy

Zero Lower Bound S BR D BR i IBR Reserves i*i* S BR ′ i ** S BR ′ ′ i *** S BR ′ ′ ′ S BR ′ ′ ′ ′ When nominal interest rate reaches zero, demand for money turns infinite since money pays just as good an interest rate as bonds.

Learning Outcomes Students should be able to: Use the supply and demand model of interbank markets to demonstrate the effect of monetary policy on interest rates. Use the AS-AD model to demonstrate the effect of monetary policy on the price level and the output gap. Use the supply and demand model of exchange rates to demonstrate the effects of either current or future monetary policy on exchange rates.