1. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-1 Chapter 8 The Reserve Bank and the economy

2. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-2 Learning objectives 1.What is the relationship between the price of a bond and the interest rate on a bond? 2.How does the Reserve Bank target the overnight cash interest rate? 3.What are the effects of the Reserve Bank changing the target for the overnight cash interest rate? 4.How does a change in the target rate for the overnight cash interest rate affect base money? 5.Under what circumstances can the Reserve Bank affect the real interest rate? 6.How does the Reserve Bank’s monetary policy affect the equilibrium level of GDP in the short run? 7.What is meant by a monetary policy reaction function?

3. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-3

4. Bonds Bonds are a type of financial asset; the issuer of a bond is, in effect, seeking to borrow money. –Bonds are a legal promise to repay a loan, usually including a principal amount and regular interest payments. –On issue, the agreed interest rate is called the coupon rate and the interest payments are called the coupon payments. –The borrower promises to pay annual coupon payments as well as the principal at the end of the agreed term. –The bond’s term, the credit risk and the tax treatment all influence the level of the coupon rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-4

5. Example: Bond pricing structure Tanya purchases a two-year bond with a principal amount of $1000. It has a coupon rate of 5% per annum, so she will receive coupon payments of $50 at the end of year 1 and $50 at the end of year 2, plus her $1000 principal. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-5

6. Market price of bonds Bonds do not have to be kept to maturity, and can be sold in the bond market. The prices paid for bonds depends on current (not historical) market interest rates. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-6

7. Example: Bond pricing structure Tanya wants to sell her bond at the end of year 1 after receiving her first coupon payment. How much can she expect to get if the prevailing interest rate is now 6%? How about 4%? –If current interest rates on similar securities are 6%, her bond needs to return 6% too or no-one would buy it. –The coupon rate and principal payout on the bond are given, so the only thing she can alter is the bond price. –She would price the bond so that the principal the buyer pays will receive 6% and yet receive $1050 at maturity. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-7

8. Example: Bond pricing structure (cont.) At current interest rates of 6% the principal to earn 6% over the year and be paid is: –$1050 = Bond price x 1.06; that is a bond price of $990.57. If current interest rates are 4%, the principal to earn 4% over the year and be paid is: –$1050 = Bond price x 1.04; that is a bond price of $1010. A general principle is that bond prices and interest rates are inversely related. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-8

9. Interest rates, bond prices and money market equilibrium Why are interest rates and bond prices inversely related? –If the interest rate is below the equilibrium market price for money, the demand for money is greater than the supply. –To increase money holdings, the public will start to sell off their bonds. –An increase in the supply of bonds leads to a reduction in their price, which is equivalent to an increase in interest rates. –At higher interest rates, the demand for money will decline, until equilibrium is reached where the money demand is equal to the amount of money available at that interest rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-9

10. Example: The market for 90-day bills Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-10 Figure 8.1 The market for 90-day bills

11. How does the Reserve Bank affect nominal interest rates? Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-11 Figure 8.2 The effect of an increase in the cash rate on the 90-day bill market

12. The demand for money Households and businesses need money for transactions. Holding money pays very little or no interest compared to other financial assets, i.e. holding money has an opportunity cost. How much money households and firms hold to cover transactions varies widely according to their circumstances. –The opportunity cost of holding money increases if the nominal interest rate increases, therefore less money is held. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-12

13. The supply for money The money supply is influenced by the Reserve Bank and consists of notes and coins in circulation plus deposits in the banking system. It does not depend on interest rates, so the money supply curve is vertical with respect to interest rates. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-13

14. The overnight cash market Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-14 Figure 8.3 The demand and supply of base money i

15. The implication of a change in monetary policy for the money supply The Reserve Bank conducts monetary policy by setting the overnight cash rate to a target and allowing all the other interest rates in the economy to adjust. Assume the Reserve Bank achieved a target cash rate and a specific target money supply: –If demand for money increased, the demand for money function would shift to the right. –If the Reserve Bank left the money supply unchanged, people would start to sell bonds to do so. –The price of bonds would decrease, which would increase the interest rate. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-15

16. A change in the target cash interest rate Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-16 Figure 8.4 A change in the target cash interest rate

17. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-17

18. Nominal versus real interest rates The Reserve Bank controls the nominal interest rate through open-market operations. However, many important decisions such as saving and investing are based on the real interest rate. The real interest rate, r, is the nominal rate, i, minus the inflation rate, ¶ : Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-18

19. Can the Reserve Bank control the real interest rate? The inflation rate changes relatively slowly in the short run, therefore changing the nominal rate tends to change the real rate. Can the Reserve Bank control the real interest rate? –In the short run: The Reserve Bank controls real rates through control of nominal rates. –In the long run: The Reserve Bank has less control because real rates are determined by the supply and demand for saving and investment. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-19

20. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-20

21. Planned consumption expenditure and the real interest rate The level of real interest rates in the economy affects planned aggregate expenditure. A rise in interest rates reduces household consumption expenditure through: 1.encouraging households to save more as the reward for saving increases 2.discouraging household spending that would be financed by credit. A rise in interest rates reduces investment expenditure through: 1.increasing the cost of borrowing, reducing the profitability of business investment in capital equipment 2.increasing the cost of mortgages for residential housing. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-21

22. Planned consumption expenditure and the real interest rate (cont.) At any given level of output, both investment and consumption spending decline when real interest rates increase. The converse is true when real interest rates decrease. Therefore, the Reserve Bank can use changes in the real interest rate to eliminate output gaps and stabilise the economy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-22

23. Example: PAE and the real interest rate In an economy described by: C d = 640 + 0.8 (Y – T) – 400 r I p = 250 – 600 r G = 300 X = 20 T = T = 250 Both C d and I p are affected by the interest rate, r. PAE = C d + I p + G + X = [640 + 0.8( Y – 250) – 400 r ] + [250 – 600 r ] + 300 + 20 = [1010 – 1000 r ] + 0.8 Y Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-23

24. Example: PAE and the real interest rate (cont.) PAE = [1010 – 1000r] + 0.8 Y The exogenous expenditure in this economy is [1010 – 1000 r ] and depends on the real interest rate, r. If the real interest rate is 5%, the equilibrium output is given by: PAE = [1010 – 1000 x (0.05)] + 0.8 Y and we know that PAE = Y e, so: Y e = 960 + 0.8 Y = 4800 Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-24

25. The Reserve Bank fights a recession Suppose the potential output for this economy is 5000. Then it faces a recessionary gap which we can calculate as: Y* – Y e = 5000 – 4800 = 200 If the multiplier in the economy is 5, exogenous spending needs to increase by 200/5 = 40. The Reserve Bank needs to lower the real interest rate to increase exogenous spending by 40, therefore: –exogenous spending = [1010 – 1000 r ] = 40 Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-25

26. The Reserve Bank fights a recession (cont.) The Reserve Bank needs to lower the real interest rate by 4 percentage points, from 5% to 1%, to increase exogenous spending by 40, which will raise output by 200 with a multiplier of 5. This would close the recessionary gap and bring the economy to potential output. A reduction in interest rates made by the Reserve Bank to close a recessionary gap is an expansionary monetary policy, or monetary easing. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-26

27. The Reserve Bank fights a recession (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-27 Figure 8.5 The Reserve Bank fights a recession

28. The Reserve Bank fights inflation One important cause of inflation is an expansionary output gap, so the Reserve Bank will act to close it. Suppose in our previous economy, potential output was at Y* = 4600. At a real interest rate of 5%, our short-run Y e = 4800 so there is an expansionary gap of 200. With a multiplier of 5, exogenous expenditure needs to reduce by 200/5 = 40. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-28

29. The Reserve Bank fights inflation (cont.) Exogenous expenditure = [1010 – 1000 r ] = 40. The Reserve Bank needs to increase real interest rates by 4 percentage points, from 5% to 9%, to decrease exogenous spending by 40, which will lower output by 200 with a multiplier of 5. An increase in interest rates made by the Reserve Bank to close an expansionary gap is a contractionary monetary policy, or monetary tightening. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-29

30. The Reserve Bank fights inflation (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-30 Figure 8.6 The Reserve Bank fights inflation

31. Example: The Reserve Bank fights the global financial crisis Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-31 Figure 8.8 The use of monetary policy to fight the crisis

32. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-32

33. Policy reaction function The role of the Reserve Bank: –Recessionary gaps: Reducing the real interest rate –Expansionary gaps: Increasing the real interest rate Policy reaction function is a simple mathematical representation of how the Reserve Bank adjusts interest rates in light of the state of the economy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-33

34. Taylor rule Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-34 Taylor (1993) found that a rule that linked the output gap and the inflation rate to the real interest rate for the US. Federal Reserve Bank under Alan Greenspan worked well: r t = 0.01 + 0.5 + 0.5 Example: If inflation is 3% and output gap is zero, the Federal Reserve should set the real interest rate = r = 0.01 + 0.5 x 0 + 0.5 x 0.03 = 0.025 = 2.5%, and nominal rates at 2.5% + 3% = 5.5%. y – y * y *

35. Policy reaction function for the RBA This rule has not predicted the Australian situation well. The RBA has committed to a target inflation rate of 2–3% since 1993, and it is likely the inflation rate has a greater weighting than for the US. We will assume the RBA relies on only one factor, the inflation rate, in setting the real interest rate. This is a simplification, but captures a key element. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-35

36. A hypothetical policy reaction function for the RBA Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-36 Figure 8.9 An example of a Reserve Bank policy reaction function

37. How does the RBA set its reaction function? In practice, the RBA takes into account a range of statistical analysis of the economy, and human judgement. However, we can get some insight from the simple policy reaction function: –If the long-run value of the real interest rate is 4%, the policy reaction function implies an inflation rate of 2% at this value. This only makes sense if the long-run target rate of inflation is 2%. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-37

38. Aggressiveness of RBA reaction function Therefore, one important determinant of the policy reaction function is the long-run inflation target. Secondly, the policy reaction function shows how aggressively the RBA intends to pursue the target. A very flat line means the RBA would make very modest responses to the real interest rate when inflation increased, as compared to a steep upward slope when there was a large change in real interest rates in response to higher inflation. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-38

39. Example: A shift in the policy reaction function Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-39 Figure 8.10 A shift in the policy reaction function

40. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-40

41. Monetary policy making: Art or science? In reality, monetary policy, like fiscal policy, is not as easy as our analysis makes it look. The real world economy is much more complex, difficult to measure and our knowledge of its workings imperfect. Consequently, the RBA tends to move cautiously and tries to avoid large changes in the interest rate, often making changes of only 0.25% at any one time. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-41

42. Chapter organisation 8.1The Reserve Bank, interest rates and monetary policy 8.2Can the Reserve Bank control real interest rates? 8.3The effects of the Reserve Bank’s actions on the economy 8.4The Reserve Bank’s policy reaction function 8.5Monetary policy making: Art or science? Summary Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-42

43. Summary The Reserve Bank operates monetary policy by targeting the overnight cash interest rate. Open-market operations are used to keep the cash rate at its target. A change in the target is brought about through changing the interests paid on exchange settlement accounts. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-43

44. Summary In the short run, the Reserve Bank can control the real interest rate as well as the nominal interest rate. The Reserve Bank’s actions affect the economy because changes in the real interest rate affect planned spending. A policy reaction function describes how the action a policy maker takes depends on the state of the economy. Copyright © 2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 8-44