The Money Market & Monetary Policy

Demand for Money Transactions demand for money to pay for current transactions. Related mostly to the level of income. Asset demand for money to finance unanticipated transactions (precautionary) and to finance speculative purchases (speculative)

Demand for Money Fig 16.4 Money Interest rate MD An inverse relationship between the interest rate and the quantity of money that people are willing to hold at any given interest rate. Change in r = a movement along the demand curve

Why does the Demand for Money curve Slope Downwards As interest rates increase, the opportunity cost of holding money in non or low interest bearing forms increases. The incentive of not holding money increases or the incentive of holding money decreases.

Supply of Money At a point in time, the supply of money is fixed. It is not related to the interest rate. Money Interest rate Ms

Money Market Money Interest rate Md Ms r Market equilibrium interest rate (r) occurs where quantity demand for money equals quantity supplied. At interest rate above r, Ms > Md. Market forces drive interest rates lower. At interest rate below r, Ms < Md. Market forces drive interest rates higher.

Demand conditions change Money Interest rate Md Ms r Md Incomes increase. Price level increases Transactions demand for money increases. Interest rates increase. r

Supply conditions change Money supply is controlled by the RBNZ. Money supply is controlled through changes in the OCR and through OMO and through Moral Suasion.

NZ Monetary Policy Reserve Bank Act 1989 The administration of monetary policy was passed from the Minister of Finance to the Reserve Bank. The objectives of monetary policy were reduced to the single goal of obtaining and maintaining stability in the general level of prices.

NZ Monetary Policy Policy Target Agreement (PTA) defines price stability. The % is negotiated between the Government and the RBNZ. PTA defines price stability as annual increases in the CPI of between 1% and 3% on average over the medium term.

Official Cash Rate The Official Cash Rate (OCR) is an interest rate set by the Reserve Bank to implement monetary policy, so as to maintain price stability. By setting the OCR, the RBNZ is able to influence short term interest rates such as the 90 day bill rate

Official Cash Rate When an OCR is announced - it is a percentage number - the Reserve Bank undertakes to pay financial institutions an interest rate 0.25 per cent below the OCR for money deposited in Reserve Bank settlement accounts. The Reserve Bank also undertakes to provide overnight cash to banks, charging interest at 0.25 per cent above the OCR.

Official Cash Rate The effect of this is that no commercial bank is likely to offer short-term loans at a rate significantly higher than the Official Cash Rate. That's because other banks would undercut that, using credit from the Reserve Bank.

Open Market Operations The purpose of the Bank's liquidity management operations, which comprises the daily Open Market Operation (OMO), FX swaps and Bond repurchase window, is to offset the big day-to-day fluctuations in government spending and revenue. The Bank currently targets a daily settlement cash level of $20 million through its OMO.

Open Market Operations The Bank prepares and maintains forecasts on the influences to settlement cash and uses these to determine how much cash to inject or withdraw on any given day. These forecasts are prepared some months ahead and are then updated on an ongoing basis, as more information comes to hand.

Moral Suasion The RBNZ instructs the financial markets what it would like the markets to do. Financial markets usually respond to such suasion. These instructions can be expressed in periodic press releases or in released MPS (monetary policy statements).

Interest rate Money MD MS 1 Interest rate Money MD MS 1 LoweringOCRRaisingOCR MS 2 RBNZ OCR Changes Fig 16.6 & 16.7 MS 2

Loose Monetary Policy Decrease in OCR Decrease in OCR Bank reserves decrease Supply of money increasesInterest rates decrease I C ER XM Higher Aggregate Demand Increase in real GDP

Tight Monetary Policy Increase in OCR Increase in OCRBank reserves increase Supply of money decreasesInterest rates increase I C ER XM Lower Aggregate demand Reduced inflationary pressure Decrease in real GDP

The buying and selling of bonds by the central bank. Open Market Operations To increase the money supply, the central bank buys bonds. To decrease the money supply, the central bank sells bonds. Open Market Operations

Interest rate Money MD MS 1 Interest rate Money MD MS 1 Buying back bonds Selling Bonds MS 2 RBNZ OMO Changes Fig 16.6 & 16.7 MS 2

The Business Cycle & Monetary Policy %GDP change Time Economic boom In times of economic growth, inflationary pressures are usually high. Capacity is tight, resources are fully employed, the output gap is small and there is pressure for the price level to rise. The RBNZ employs a tight monetary policy increasing the OCR regularly. This tends to reduce inflationary pressures.

The Business Cycle & Monetary Policy %GDP change Time Economic Recession In times of economic recession, inflationary pressures are usually low. There is excess capacity, resources are unemployed, the output gap is high and real GDP is decreasing. The RBNZ employs a loose monetary policy decreasing the OCR regularly. This tends to boost spending and real GDP.