1. 1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Monetary Policy Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth Ingram University of Iowa 2 nd edition

2. 15-2 Key Concepts Targets Inflation Intermediate Policy Goals Open Market Operations LM Curve Transmission Mechanism

3. 15-3 Goal of Monetary Policy Price stability Low unemployment Real GDP growth Policy Targets

4. 15-4 Federal Reserve System “High employment consistent with stable prices” Organization Board of Governors – 7 Members 12 Federal Reserve District Banks Federal Open Market Committee (FOMC) Instrument Short term market interest rates (Discount rate) Reserve Requirements Open Market Operations Federal Funds rate Rate charged on interbank loans

5. 15-5 European Central Bank Price stability with inflation under 2% Organization The European System of Central Banks (ESCB) -- 6 members of the executive board and 15 national Central Banks of the European Union. Interest rate decisions are made at fortnightly council meetings Instruments Repo rate – overnight interest rate Discount rate and Lombard rate (rates at which commercial banks acquire or deposit reserves) Intermediate Target – Inflation and M3

6. 15-6 Bank of England Keep inflation at rate set by government (2.5%) Organization The Monetary Policy Committee (MPC) 9 members, 5 full time Bank of England employees and 4 external experts Instruments Repo rate No reserve requirement, but no bank overdrafts Intermediate target: An Inflation target based on a two-year-ahead inflation forecast

7. 15-7 Elements of Monetary Policy Instruments Targets Goals

8. 15-8 Monetary Policy Elements Price Stability Unemployment Real Growth Interest Rates Money growth Discount Window Open Market Operations Reserve Requirements

9. 15-9 LM Curve Equilibrium in the money market Demand for money Opportunity cost of holding money Interest rate increase means hold less money Supply of money Role of Federal Reserve Role of banks

10. 15-10 Recall quantity theory MV = PY M d /P = (1/V)Y Real Money Demand Velocity, depends on interest rate

11. 15-11 Money Market Nominal Interest Rate Quantity of Money Money Supply Money Demand R M0M0 R0R0

12. 15-12 Money Market Increase in Income Nominal Interest Rate Quantity of Money Money Supply Money Demand R0R0 M0M0 R1R1

13. 15-13 Money Market Increase in Money Supply Nominal Interest Rate Quantity of Money Money Supply Money Demand R M0M0 R0R0 M1M1 R1R1

14. 15-14 LM curve Increase in income is associated with rise in interest rates For a fixed interest rate, increase in money supply increases income

15. 15-15 IS-LM Model Interest Rate Output LM Curve Increase in Money Supply Decrease in Money Supply

16. 15-16 IS-LM Model Interest Rate Output LM Curve IS Curve R0R0 Y0Y0

17. 15-17 Increase in money Interest Rate Output LM Curve IS Curve R0R0 Y0Y0 R1R1 Y1Y1 Lowers the interest rate and increases income

18. 15-18 IS-LM Model Money Supply Targeting Interest Rate Output LM Curve IS Curve R0R0 Y0Y0 R1R1 Y1Y1

19. 15-19 IS-LM Model Interest Rate Targeting Interest Rate Output LM Curve IS Curve R0R0 Y0Y0 Y1Y1

20. 15-20 Monetary Policy Targets GDP growth Unemployment Price Stability New Zealand England European Central Bank Why not target zero inflation?

21. 15-21 Intermediate Targets Variable which Tracks policy goal (e.g., inflation) Over which central bank has reasonable control Three main targets Money supply Exchange rate Inflation

22. 15-22 Money Supply Targeting Quantity Theory implies direct relationship between money supply growth and inflation Assume velocity constant Assume real output controlled by real factors US: money targeting used in early 1980s

23. 15-23 Difficulties in targeting money Which aggregate to use? Is velocity constant or at least predictable? Can central bank control the money supply? What role do banks play (is money supply vertical)? What about supply shocks?

24. 15-24 Money Growth, US M1 M3 M2

25. 15-25 Growth rate, monetary aggregates M1 M2 M3 Source: Federal Reserve Board, Current release. http://www.federalreserve.gov/releases/ Monthly growth rate converted to annual rate and smoothed with moving average filter.

26. 15-26 Exchange Rate Targets Fix exchange rate against another currency Will tie domestic inflation to foreign inflation Cost is lack of flexibility in influence on domestic economy

27. 15-27 Inflation Targeting Specified a target range for realized inflation Allows for discretion in implementation Discretion comes at a price

28. 15-28 Operational Instruments Short term interest rate Base money Central bank can supply money to or drain money from the monetary system

29. 15-29 Open market operations Expand money supply Buy treasury bonds from public Supply public with cash Decrease money supply Sell treasury bonds to public Remove cash from circulation

30. 15-30 Federal Funds Target 2004 June 30 25...1.25 2003 June 25...251.00 2002 November 6...501.25 2001 December 11...251.75 November 6...502.00 October 2...502.50 September 17...503.00 August 21...253.50 June 27...253.75 May 15...504.00 April 18...504.50 March 20...505.00 January 31...505.50 January 3...506.00 Intended federal funds target, 2001 - 2004 DateDecreaseIncreaseRate

31. 15-31 Money supply or interest rates? Money SupplyInterest rate

32. 15-32 Money Market Money targeting Interest Rate Quantity of Money Money Supply Money Demand R M0M0 R0R0 R1R1 Increase in Money Demand produces rise in interest rate if Money Supply is fixed

33. 15-33 Money Market Money targeting Interest Rate Quantity of Money Money Supply Money Demand R M0M0 R0R0 R1R1 Increase in Money Demand produces no rise in interest rate if Money Supply is allowed to increase

34. 15-34 Transmission Mechanism Official Rate Market Rates Asset Prices Expectations and Confidence Exchange Rate Domestic Demand Net External Demand Domestic Inflationary Pressure Import Prices Inflation

35. 15-35 Taylor Rules Nominal Interest Rate = Equilibrium Nominal Interest Rate + λ x Output Gap + α x (Inflation – Inflation Target)

36. 15-36 US Interest Rates

37. 15-37 UK Interest Rates

38. 15-38 Summary Targets Intermediate Instrumental Policy IS-LM model Intermediate targeting (money supply, exchange rate and inflation) Transmission mechanism Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.