Chapter 21 Conduct of Monetary Policy

Goals of Monetary Policy Stability Price Stability: Low and predictable of inflation Business Cycle Stability: Stable GDP and unemployment level. Financial Market Stability: Interest rate stability, exchange rate stability, stock market stability, banking system stability.

Monetary Policy Framework 1.Policy Tools are the direct procedures available to the central bank. 2.Operating Targets are the prices and quantities directly determined by policy tools. 3.Intermediate Targets are the objectives for financial variables that the central bank will help it to achieve its ultimate goals. [Possibly outdated concept] 4.Goals are the ultimate macroeconomic outcomes that the policy is meant to achieve.

Monetary Policy Tools Open Market Operations Discount Policy Convertibility Undertaking Reserve Requirements Operating Target Reserves Interbank Rate Exchange Rate IntermediateTarget Monetary Aggregates Interest Rates Goals Stability Price Business Cycle

Monetary Policy in USA Federal Open Market Committee (FOMC) consists of a group of Federal Reserve officials. After regular meetings the FOMC selects a Federal Funds target. Fed trading desk will set open market operations to maintain that policy regimes.

Policy Shift Defensive Transactions Reserve Demand Shifts. Fed traders are instructed to purchase securities to keep the Fed funds rate within a narrow band of policy target. –Many short-term defensive transactions are undertaken using reverse transactions. If demand for reserves rise short-term, central bank may engage in repo operation. Simultaneously purchase securities and promise to resell them at a later date. If demand for reserves fall short-term, central bank may engage in reverse repos: simultaneously selling securities and promise to rebuy them at later date.

Defensive Transactions Response to Increase in Demand for Reserves S D i FFP NBR i FF D’ NBR’ 1 2

Defensive Transactions Response to Decrease in Demand for Reserves S D i FFP NBR´ i FF D’ NBR 1 2

Adjusting Policies Dynamic Transactions: If the FOMC decides to have a policy shift to reduce the Fed Funds target, they will instruct their traders to engage in an open market purchase of securities to drive down the Fed Funds target. If they shift the policy to raise Fed Funds Target, they will have an open market sale.

Dynamic Transactions FOMC decides to increase the interest rate S D i FFP NBR i FF D’ NBR’ 1 2 i FFP

Dynamic Transactions FOMC decides to increase the interest rate S D i FFP NBR i FF D’ NBR’ 1 2 i FFP

Change in U.S. Discount Policy

Transmission Channel The central bank attempts to control the macroeconomy through adjusting the monetary base. The transmission mechanism occurs through the money market. Our model of the money market will examine the trade-off between holding short-term assets which pay interest and liquid money which pays no interest but is useful for transactions.

Money Market: Demand Demand: People hold liquid assets to engage in transactions at the cost of earning interest. –Money Demand is a negative function of the interest rate. –Money Demand curve is shifted by changes in nominal economic activity (i.e. the number of transactions)

Money Market: Supply We will treat the money supply as determined by policy. Draw this as a vertical line. This approach will incorporate two possibilities: –Money Supply is the Intermediate Target. Money supply curve only shifts as a direct policy. –Money Supply curve shifts endogenously as a response to keeping an interest rate target.

Money Market M i MSMS MDMD i*i*

Equilibrium in the Money Market If interest rate is less than i *, savers will keep their wealth in the form of liquid assets and withdraw their funds from savings accounts and bonds. In order to maintain their own liquidity, banks higher interest rates on deposits. If interest rate is greater than i *, savers will deposit more funds in savings accounts. Banks will have too much liquidity and lower the interest rate.

Asset Transactions If the central bank engages in an asset market purchase, they will increase reserves and increase the available money supply. Savers will have an excess amount of money relative to their liquidity needs. Savers will attempt to acquire low liquidity interest paying assets. Increase in demand for bonds will push down interest rates until money demand equals money supply.

Money Market: Asset Market Purchase M i MSMS MDMD i*i* i ** MSMS 1 2

Money Market: Asset Market Sale M i MSMS MDMD i ** i*i* MSMS 1 2

Maintaining Policy Target There is a connection between demand for reserves and money demand. The more transactions that people undertake, the more reserves banks will need to keep in their reserve accounts. –Holding reserves constant, this would push up interest rates.

Increase in Money Demand (Money Money Supply Fixed) M i MSMS MDMD i*i* M D’ i ** 1 2

Increase in Reserve Demand S D i IBOR NBR i FF D’ NBR’ i IBOR 1 2

Operating Target: Interest Rate Interest Rate: If the intermediate target is the Interbank lending rate, then the Fed must increase supply of reserves (through a defensive OMO purchase). This (through the money multiplier) will increase the money supply stabilizing the money market interest rate..

US Dollar Money Market

Increase in Money Demand/ Interest Rate Target M i MSMS MDMD i*i* M D’ M S’ 1 2

Defensive Transactions Response to Increase in Demand for Reserves S D i FFP NBR i FF D’ NBR’ 1 2

The Money Market and Fixed Exchange Rate Under perfect credibility, the HK$ money market interest rate should be equal to the US$ money market interest rate. Equilibrium –If equilibrium HK$ interest rate is greater than US$ interest rate, it will attract flow of funds into HK. Bank reserves will increase, increasing the money supply until interest rate is equal to US rate. –If equilibrium HK$ interest rate is lower than the US$ rate, funds will flow out of HK, reducing reserves and the money supply.

Increase in Money Demand/ Exchange Rate Target M i MSMS MDMD i*i* M D’ M S’ i US 2 1

Cut in US Interest Rate on HK$ Money Market M i MSMS MDMD i US i US ’ 2 1

Fixed Exchange Rates From the standpoint of monetary policy, a fixed exchange rate monetary policy might be thought of as an implicit interest rate target. The interest rate target will always be the interest set by the anchor country. In times of imperfect credibility, the interest rate target is the interest in the anchor country minus expected interest rate appreciation.

Post-war Monetary Policy Prior to 1971, most countries adopted an exchange rate target with the United States. In return, US maintained a fixed exchange rate with gold. In 1971, US abandoned gold standard. Many large economies including USA, Germany, Japan, UK, and Canada operated monetary targets for some time. Almost all of these economies (plus the European Central Bank) have adopted interbank interest rates as an intermediate targets.

Intermediate Targets Prior to the 1990’s, or so, central banks would assess their level of operating target with respect to the money market performance. Central bank would announce some interest rate or monetary quantity that they would like to see prevail in the money market.

Problem with Monetary Targets Money demand is volatile and unpredictable. –Economies with monetary targets have often had volatile interest rates leading to instability in financial markets. Money supply is hard to control because the money multiplier is subject to fluctuations. Effect of money supply on real economy or inflation is difficult to predict. Monetary targets have been largely abandoned

Simple Model of Macroeconomics Supply: Firms have pricing strategies which makes inflation essentially exogenous overtime. Demand: Negative relationship between high prices and demand for goods. –Demand affected by fiscal policy, consumer and business confidence, and interest rates. Potential Output: Profit maximizing level of output. In long run, firms will adjust pricing strategies until demand equals this level.

To achieve stabilization, central bank should set interest rates to keep AD-AS intersection near potential output level. GDP AD(i) AS π Potential Output If AD is not shifted back, inflation will rise.

Demand Curve/Supply Curve GDP AD(i) AS π Potential Output

Challenges of Monetary Policy Most interest sensitive parts of economy (autos, capital equipment, housing) are affected by long-term interest rates. Central bank has very strong control of short-term interest rates but can only affect long-term rates indirectly. Even the effect of interest rates on the economy occurs through long and variable lags.

US Monetary Policy

Using monetary policy to manage AD Curve during a recession To reduce long-term rate, the central bank must display commitment to low short- term rates for a persistent period of time. Persistently expansionary monetary policy will lead to money growth and inflation and high interest rates through the Fischer effect.

Commitment and Consistency Central bank must commit to having low short-term rates for long-enough to stimulate economy out of a recession, but not so long it leads to increase in inflationary expectations. Managing market expectations is an important part of monetary policy. To manage expectations, central bank policy must be predictable and consistent.

Price Stability Many central banks make price stability, (interepreted to mean a low and steady inflation rate). When central bank perceives downward pressure on inflation, cut interest rates until disinflationary pressure eases. When central bank perceives upward pressure on cut interest rates until inflationary pressure eases.

Inflation Targeting Rules Under inflation targeting, the central bank announces some target level of goods price inflation that they are aiming to achieve. In 1990, New Zealand moved to an inflation targeting rule. Australia, Canada, UK have an explicit, announced inflation target. ECB has a commitment toward price stability defined as inflation between 0-2% per year.

Inflation Targeting in New Zealand

Inflation Target Rule In a recession, a central bank with a strong commitment to an inflation target will keep interest rates low as long as it takes to get the economy (giving best chance of reducing long-term rates) out of a recession but no longer. A credible low inflation target will reduce inflationary expectations and minimize Fisher effects.

U.S. Approach to price stability. John Taylor of Stanford argues that interest rate target in the USA is a systematic function of inflation and real output. Federal Reserve commitment to price stability is embodied in the person of central bank chairman, Alan Greenspan Some economists advocate more formal rules for price stability that will stay in place after Dr. Greenspan retires.