1. Monetary Policy
Chapter 31

2. Orientation/Objectives
Domestic
Price, Output Stability
External
Forex Rate Stability
Source Link

3. Hong Kong’s Exchange Rate Regime

4. Convertibility Undertaking
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.

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

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

7. Passive Forex Intervention
Agents want more Hong Kong dollars and excess supply of US dollars at exchange rate.
Rather than sell US dollars at falling prices, sell to HKMA at Strong Side price
HKMA purchase of forex increases M and reduces i. i i* 1 2
i**

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

9. Fixed Exchange Rate
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.

10. HIBOR vs. Fed Funds Rate

11. 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.

12. Iron Triangle of International Finance
Monetary Policy that Controls The Interest Rate
Open to International Capital Flows
Fixed Exchange Rates
Pick 2 items from this menu

13. Domestically Oriented Monetary Policy

14. 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
Fed
Federal Funds Rate
BoJ
Uncollateralized Call Money Rate
ECB
Main Refinancing Rate
BoK
Overnight Call Rate UK
Official Bank Rate

15. Open Market Practice
On a daily basis, a central bank will provide instructions to engage in defensive transactions that will adjust supply to keep the interbank interest rate near the target rate.
Example: If there is an excess demand for reserves, the traders might engage in an open market purchase of bills, increasing the supply of reserves pushing down the rate until it is near the target.

16. Interbank Market: OMO to meet demand for reserves
iIBR D i* 2 3
iTGT 1 D'
Reserve Accounts

17. 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.

18. Dynamic Transactions and Policy Changes
Central bankers shift monetary policy by changing the interest rate target.
In order to enact the change, the bank’s traders are instructed to engage in dynamic transactions.
A dynamic purchase of bills will be implemented to reduce interest rates.
A dynamic sale of bills will be implemented to increase interest rates.

19. Central Bank Policy Makers reduce interest target- Open Market Purchase
iIBR D 1
iTGT 2
iTGT' D'
Reserve Accounts

20. Monetary Policy: Money Supply Expands1
i** 2 M

21. Expansionary Monetary Policy
ΔC, ΔNX
AD′ AD Y

22. 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.
Lower interest rates increase demand for US$ in forex market depreciating the exchange rate.
Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

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

24. Bank of England Estimates of Effect of Interest Rate

25. Monetary Policy – Short-term vs. Long Term
In the short-run, expansionary monetary policy can boost economic growth.
But in the long-run, expansionary monetary policy only leads to rising prices (i.e. inflation).

26. Interest Rate Management
In most economies around the world, the central bank does not simply act to maintain a fixed interest rate.
Rather, they manage interest rate changes in response to business cycle conditions.

27. Policy Framework Price Stability
Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “
ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”
Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

28. 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.

29. Inflation Targeting

30. List of Inflation Targeting Countries Rose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

31. KEY GOAL OF CENTRAL BANKS: PRICE STABILITY
HKMA Link
KEY GOAL OF CENTRAL BANKS:
PRICE STABILITY

32. Demand Driven Recession w/ Counter-cyclical monetary policy
Economy in a recession. Ctl Bank detects deflationary pressure
Monetary Policy Cuts Interest Rate
Investment increases spending to shift the AD curve back to long run equilibrium YP P
SRAS
AD′ 1 3 P* 2 AD Y
Gap < 0

33. Demand Driven Expansion w/ Counter-cyclical monetary policy
Economy in expansion. Ctl Bank detects inflationary pressure
Monetary Policy Raises Interest Rate
Decreased spending to shift the AD curve back to long run equilibrium
Demand Driven Expansion w/ Counter-cyclical monetary policy YP P
SRAS 2 P* 1
AD′ 3 AD Y
Gap > 0

34. U.S. Central bank cuts interest rates during recessions

35. Price Stability
Counter-cyclical monetary policy stabilizes output near potential output, YP, 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.
In the face of supply shocks, central banks must make a trade-off between output gap and inflation.

36. Stagflation w/ Counter-cyclical monetary policy
Economy experiences stagflation
Monetary Policy Cuts Interest Rate
Investment increases spending to shift the AD curve to long run equilibrium with higher prices. YP P
SRAS 3
P** 2 P*
AD′ 1 AD Y

37. Stagflation w/ Price Stabiliztion
Economy experiences stagflation
Monetary Policy Raises Interest Rate
Investment decreases spending to shift the AD curve to equilibrium with lower output. YP P
SRAS 2 3 P* 1 AD
AD′ Y

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

39. Policy Feedback: Taylor Principle
Real interest rate impacts demand for goods in economy.
Real interest rate is rt = it - E[πt+1]
When E[πt+1] rises, central bank should increase it more than 1-for-1 to raise real interest rate, limit demand and limit inflation.
When E[πt+1] falls, central bank should reduce it more than 1-for-1 to drop real interest rate, raise demand and avoid deflation.

40. Zero Lower Bound
Interest rate cannot be set below zero.
Link

41. The Taylor Rule Download

42. Question: Problem with Central Bank Stabilization
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.

43. Great Inflation of the 70’s & 80’s

44. A Bias toward Expansionary monetary policy
Central Bank repeatedly expands the money supply
Inflation recurs YP P 5 4 P* 3 2
SRAS′
AD′ 1
SRAS AD Y
YPhantom

45. Demand Driven Recession w/ Counter-cyclical fiscal policyYP P
Economy in LT equilibrium
Demand shifts in
Government increases spending to shift the AD curve back 3
SRAS 1 2 P* AD
AD′ Y* Y
Recessionary Gap

46. Demand Driven Expansion w/ Counter-cyclical fiscal policyYP P
Economy in LT equilibrium
Demand shifts out
Government cuts spending to shift the AD curve back
SRAS 2 P* 1
AD′ 3 AD Y* Y
Inflationary Gap

47. Monetary Policy Lags
Counter-cyclical fiscal policy beset by lags between the time a recession is recognized and the time the government can form consensus to act.
Monetary policy beset by lags between the time policy shifts and time for private sector to respond to lower interest rates.

48. Lags and Fiscal Policy
Administrative lags for fiscal policy may likely be large.
Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.
If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

49. Learning Outcomes
Use the model of bank reserves and the forex market to describe the effect of Hong Kong’s monetary policy.
Use the model of the bank reserves market to qualitatively derive and describe the impact of defensive and dynamic transactions on interbank rate and quantity of reserves.
Use the model of the money market and AS-AD to qualitatively derive and describe the impact of monetary policy transactions on the economy.
Use the Taylor rule to quantitatively describe the impact of economic conditions