Money and Stabilization Policy

Monetary Policy In the US (and Euroland and Japan and most OECD economies), the central bank sets monetary policy by picking a short-run interest rate they would like to prevail. In HK, the central bank sets monetary policy by picking a fixed exchange rate.

Taylor Rule Economist named John Taylor argues that US target interest rate is well represented by a function of 1.current inflation 2.Inflation GAP: current inflation vs. target inflation 3.Output Gap: % deviation of GDP from long run path Function: Inflation Target π * =.02

The Taylor Rule

What should be the current Fed Funds rate? Will they be increasing it soon? Step 1. Find Inflation Rate Step 2. Find Output Gap Step 3. Calculate Taylor Rule implied rate and compare with current rate.

Channel of Monetary Policy When the central bank increases the monetary base, the money supply will increase. Banks have excess liquidity which they use to make more loans. The supply of liquidity will exceed demand and banks must compete to attract borrowers who will hold this liquidity only at a lower interest rate. Lower interest rates increase demand for US$ in forex market depreciating the exchange rate.

Question Use S & D model of the exchange rate to show the impact of expansionary monetary policy on the exchange rate.

Dynamics of Monetary Transmission Money supply expansion reduces interest rates Lower interest rates implies an increase in borrowing and affects demand for interest sensitive goods. –Corporate Investment –Residential Housing Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

P Y Y*Y* AD Demand Driven Recession w/ Counter-cyclical monetary policy P*P* SRAS YPYP AD ′ Economy in a recession. Fed detects deflationary pressure 2.Monetary Policy Cuts Interest Rate 3.Investment increases spending to shift the AD curve back to long run equilibrium Recessionary Gap

P Y AD Expansionary Monetary Policy AD ′ ΔIΔIΔC, ΔNX

P Y AD Demand Driven Expansion w/ Counter-cyclical monetary policy P*P* SRAS YPYP AD ′ 1 2 Inflationary Gap 1.Economy in expansion. Fed detects inflationary pressure 2.Monetary Policy Raises Interest Rate 3.Investment decreases spending to shift the AD curve back to long run equilibrium

U.S. Central bank cuts interest rates during recessions

Lags, Mistakes and Monetary Shocks It is often said that there are long and variable lags in the monetary transmission mechanism in that it might take several quarters for the strongest effects of monetary policy on demand to appear plus it is difficult to predict how long exactly it will take for monetary policy to have its intended effects. Also difficult to know what exactly is potential output level. What happens if a monetary expansion destabilizes the economy?

P Y AD An Expansionary Cycle Driven by monetary policy P*P* SRAS YPYP AD ′ 1 2 Output Gap 1.Economy at LT Y P. 2.Monetary Policy Cuts Interest Rate 3.Investment rises. The AD curve shfits out. 4.Tight labor markets. SRAS returns to long run equilibrium 3

An Expansionary Cycle Driven by monetary policy r Money Demand i*i* Money Supply 1 Money Supply' 2 i ** 1.Increase in money supply pushes down interest rates 2.Rising price level increases demand for money balances increasing rates. 3 M

Zero Lower Bound on Interest Rates Nominal interest rates cannot go below zero – no one will lend money at an interest rate below that of money itself. In Japan, central bank increased money supply to get the economy out of a recession. Pushed the interest rate to zero. Once the zero lower bound was reached monetary policy has no effect.

Question Situation: Economy is in long-run equilibrium, but central bank overestimates potential output. Draw outcome if central bank believes that the potential output is higher than it is.