Chapter 19 Interest rates and monetary transmission ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The central bank acts as banker to the commercial banks in a country and is responsible for setting interest rates. In the UK, the Bank of England fulfils these roles. Two key tasks: to issue coins and bank-notes to act as banker to the banking system and the government ©McGraw-Hill Companies, 2010 2

The central bank and the money supply Three ways in which the central bank MAY influence money supply: Reserve requirements central bank sets a minimum ratio of cash reserves to deposits that commercial banks must meet Discount rate the interest rate that the central bank charges when the commercial banks want to borrow setting this at a penalty rate may encourage commercial banks to hold more excess reserves Open market operations actions to alter the monetary base by buying or selling financial securities in the open market ©McGraw-Hill Companies, 2010 3

©McGraw-Hill Companies, 2010 The repo market A gilt repo is a sale and repurchase agreement. e.g. A bank sells you a bond with a simultaneous agreement to buy it back at a specified price at a specified future date. This uses the outstanding stock of long-term assets as backing for new short-term loans. Used by central banks in carrying out open market operations in order to alter cash in circulation ©McGraw-Hill Companies, 2010 4

Other functions of the Bank of England Lender of last resort The bank stands ready to lend to banks and other financial institutions when financial panic threatens. Banker to the government The bank ensures that the government can meet its payments when running a budget deficit. Setting monetary policy to control inflation more of this later ©McGraw-Hill Companies, 2010 5

Prudential regulation It may also be the job of the central bank to ‘police the financial system’. If not then some other financial agency should do this. Capital adequacy ratios are one way of doing this. A capital adequacy ratio is a required minimum value of bank capital relative to its outstanding loans and investments. ©McGraw-Hill Companies, 2010 6

Prudential regulation (2) There should also be an element of self-regulation. If a bank makes large losses it may go bankrupt. Typically, governments then compensate depositors but not shareholders. The knowledge that depositors are unlikely to suffer helps prevent unjustified financial panics. The knowledge that shareholders are likely to suffer helps keep management on its toes. ©McGraw-Hill Companies, 2010 7

Three things went wrong leading up to 2008/9 The magnitude of the initial shock was very large. Banks had borrowed billions to speculate on securitized products which subsequently proved a very bad investment. Capital adequacy regulations had been poorly designed. What was adequate financial backing by shareholders in good times turned out to be grossly inadequate capital reserves in a big crisis. Many banks had become ‘too big to fail’. This became apparent when Lehman Brothers failed. If the bank is large enough it causes massive ripples through the financial system. ©McGraw-Hill Companies, 2010 8

Structural solutions to prevent a future banking crisis? The separation of retail banking and investment banking. Alternatively allow all banks to undertake all types of transactions, but place an absolute limit on the size of banks that are eligible for deposit guarantees and fiscal bailouts. A third possibility is to rely on stronger prudential supervision by regulatory agencies, particularly in the enforcement of tougher capital adequacy ratios. ©McGraw-Hill Companies, 2010 9

Competing financial centres But if some financial centres regulate more than others, private business may tend to migrate to the least intrusive location. London might have regulated earlier if it had been less frightened of losing business to Frankfurt and New York. This suggests that any real reforms may have to be negotiated at the level of the top 10 global countries, not merely a country at a time. ©McGraw-Hill Companies, 2010 10

Money market equilibrium LL Other things being equal, the demand for real money balances will be lower when the opportunity cost (the rate of interest) is relatively high. Interest rate When money supply is L0, money market equilibrium occurs when the rate of interest is at r0. L0 r0 The position of this schedule depends upon real income and the price level. Real money holdings ©McGraw-Hill Companies, 2010 11

Reaching money market equilibrium Real money holdings Interest rate LL L0 r0 If the rate of interest is set below the market equilibrium – say at r1 r1 – there is excess demand for money (the distance AB). A B This implies an excess supply of bonds – which reduces the price of bonds and thus raises the rate of interest until equilibrium is reached. ©McGraw-Hill Companies, 2010 12

©McGraw-Hill Companies, 2010 Monetary control Given the money demand schedule: The central bank can ... Interest rate EITHER set the interest rate at r0 and allow money supply to adjust to L0 r0 OR set money supply at L0 and allow the market rate of interest adjust to r0 LL BUT cannot set both money supply and interest rate independently. L0 Real money holdings ©McGraw-Hill Companies, 2010 13

Monetary control – some provisos Monetary control cannot be precise unless the authorities know the shape and position of money demand and can easily manipulate the money multiplier. Controlling money supply is especially problematic, and the Bank of England has preferred to work via interest rates. This involves fixing the interest rate and accepting (i.e. supplying) the equilibrium level of money. ©McGraw-Hill Companies, 2010 14

©McGraw-Hill Companies, 2010 The economic crisis We show again the collapse of the ratio of broad money to bank reserves. If reserves had remained constant, broad money would have fallen to a sixth of its previous level! The complete drying up of bank lending transmitted a huge shock to the real economy. ©McGraw-Hill Companies, 2010 15

©McGraw-Hill Companies, 2010 Quantitative easing House prices fell, industrial production fell and increasing numbers of bankruptcies were reported. To accomplish quantitative easing, the Bank announced that it would buy ‘safe’ bonds from private firms or government, in enormous amounts. This put narrow money into the system. Then having circulated round the system a few times, this ended up being held by banks as reserves at the Bank of England. ©McGraw-Hill Companies, 2010 16

Quantitative easing (2) The reserves of UK banks rose sixfold between May 2008 and July 2009 as the Bank of England took action. From May 2008 to July 2009, banks’ reserves increased from £27bn to £152bn, whereas broad money increased from £1737bn to £2001bn, so the £264bn increase in broad money was caused not merely by the £125bn increase in bank reserves. As banks felt a little safer, they lent a little more, thereby raising bank deposits. ©McGraw-Hill Companies, 2010 17

Targets and instruments of monetary policy Monetary instrument the variable over which the central bank exercises day to day control e.g. interest rate Intermediate target the key indicator, used as an input to frequent decisions about how to set interest rates The financial revolution has reduced the reliability of money supply as an indicator, and central banks increasingly use inflation forecasts as the intermediate target. ©McGraw-Hill Companies, 2010 18

The transmission mechanism … is the channel through which monetary policy affects output and employment. In a closed economy, monetary policy works through the impact of interest rates on consumption and investment demand. ©McGraw-Hill Companies, 2010 19

©McGraw-Hill Companies, 2010 Consumption demand A simple version of the consumption function is: C = a + bYd monetary policy can affect household wealth this is called a wealth effect ©McGraw-Hill Companies, 2010 20

Consumption demand - the wealth effect The wealth effect occurs in two ways: directly, through an increase in the real money supply (part of wealth is kept in the form of money) indirectly, through the effect of interest rates on share prices: as interest rates fall, the price of bonds and shares rises making stock holders feel wealthier ©McGraw-Hill Companies, 2010 21

Consumption demand - consumer credit and durable goods Consumption is affected by two aspects of consumer credit the quantity of credit: an increase in the quantity of credit increases autonomous consumption shifting the consumption function up and vice versa the cost of credit: households will borrow less at higher interest rates, thus reducing consumption and vice versa These points are well illustrated by the UK housing market. ©McGraw-Hill Companies, 2010 22

Consumption and the life-cycle Income varies over an individual's lifetime. Actual income B Saving (B) occurs during middle age Individuals try to smooth their consumption, based on expected lifetime (or permanent) income. Permanent income D Income, consumption B A and dissaving (A) in youth and old age. A Death Age ©McGraw-Hill Companies, 2010 23

Consumption, wealth and the life-cycle Given the household’s initial estimation of their wealth, permanent income is OD. Actual income A’ B’ D’ Income, consumption B Say the household consumes its permanent income. Then the two A’s (plus any interest) would be offset by B. D A A Permanent income With higher wealth, permanent income is revised upwards to OD’ so that 2(A+A’) exceeds B’ Death Age This shortfall can be met from the extra wealth. Thus wealth and interest rates may influence consumption. ©McGraw-Hill Companies, 2010 24

©McGraw-Hill Companies, 2010 Investment demand Investment spending includes: fixed capital Transport equipment Machinery & other equipment Dwellings Other buildings Intangibles working capital stocks (inventories) work in progress and is undertaken by private and public sectors ©McGraw-Hill Companies, 2010 25

The demand for fixed investment Investment entails present sacrifice for future gains firms incur costs in the short run but reap gains in the long run Expected returns must outweigh the opportunity cost if a project is to be undertaken. So, at relatively high interest rates, fewer investment projects are viable. ©McGraw-Hill Companies, 2010 26

The investment demand schedule The investment demand schedule suggests that ceteris paribus higher interest rates reduce the volume of investment projects and vice versa. investment demand Interest rate II I0 r0  II’ Changes in the price of capital goods and expectations about profit streams at given interest rates shift the schedule up or down. I1  ©McGraw-Hill Companies, 2010 27

The credit channel of monetary policy Recent research emphasizes that interest rates are not the only channel through which monetary policy affects consumption and investment. The credit channel affects the value of collateral for loans, and thus the supply of credit. There are two ways this can happen: changes in goods prices alter the real value of nominal assets policy induced changes in the interest rate alter the market value of assets which may be used as collateral ©McGraw-Hill Companies, 2010 28