Transcript Interest Rates and the Money Market

Monetary Policy
Chap. 31
• Central Bank:
A special
governmental
organization or
quasigovernmental
institution
within the
financial system
that controls the
medium of
exchange.
Economy
Central Bank
HK
?
USA
?
Eurozone
?
PRC
?
UK,
Canada,
Japan,
Korea
?
Interbank Payment Systems
• Commercial banks keep accounts at the central
bank for interbank payments. referred to
generally as reserves, specifically as clearing
balances in Hong Kong.
• These accounts, along with cash, constitute the
monetary base.
Hong Kong Interbank Clearing Limited
Interbank Market
• Individual banks will face a short-fall in reserves if
they have too many outflows and borrow funds from
other banks facing a surplus.
• Banks will keep an inventory of reserves to meet
their own liquidity needs but the interest rate is the
opportunity cost of holding reserves.
• Desire to hold reserves is a declining function of the
interest rate.
• Central bank controls the total supply of reserves
available to banks.
Interbank Market
iIBR
SBR
i*
DBR
Reserves
Equilibrium in the Interbank Market
• If interest rates are too low, banks will want to
hold more reserves than available. Banks facing
a shortfall of reserves will be willing to bid up
interest rates until all banks are content with
reserves available.
• If interest rates are too high, banks will want to
lend out their excess reserves. To do so in a
liquid market, they must lower interest rates.
Equilibrium
iIBR
SBR
i
i*
i
DBR
Reserves
Open Market Operations
• In an Open Market PURCHASE, the central
bank purchases government securities from
banks and credits their reserve accounts. This
increases the aggregate supply of reserves.
• In an Open Market SALE, the central bank sells
government securities from banks and debits
their reserve accounts. This increases the
aggregate supply of reserves.
Open Market Purchase
iIBR
SBR
SBR'
i*
i**
DBR
Reserves
Money Supply and Interest Rates
• If the central bank engages in an open market
PURCHASE, they will increase the reserve
holdings of counter-party commercial banks.
• This will increase liquidity in the reserve funds
market.
• Banks with excess reserves can lend them out
pushing down interest rates in broader money
market.
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Fed Funds & Money Market Rates
6.000
5.000
4.000
3.000
2.000
1.000
0.000
Fed Funds
NCD
CP-Fincl
CP-NonFincl
Tbill
Domestic Monetary Policy Causes D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
S
Supply
Supply'
Domestic Currency
Appreciates
1
S*
Excess Supply
S**
2
Demand
Demand'
Foreign Monetary Policy Causes
Foreign Interest Rates Go Up/Relative Demand
for US$ Goes Up
S
2
S**
Domestic Currency
Depreciates
1
S*
Excess Demand
Supply'
Supply
Demand '
Demand
Monetary Policy
Expectations and Exchange Rates
• Future exchange rates affect the expected
profitability of holding bank accounts in a
country’s currency.
• Current level of the exchange rate guided by the
future path of interest rates.
Expectation of St+1 Increases
S
2
S**
Domestic Currency
Depreciates
1
S*
Excess Demand
Supply'
Supply
Demand'
Demand
Hong Kong’s Exchange Rate Regime
Clearing Accounts Reserves
• May 2005 Under the strong-side Convertibility
Undertaking, the HKMA undertakes to buy US
dollars from licensed banks at 7.75. Under the
weak-side Convertibility Undertaking, the HKMA
undertakes to sell US dollars at 7.85.
US Monetary Policy Causes US Interest Rates Go
Down, Strengthening Pressure on HK$
S
Supply
Supply'
1
S=7.8
Excess Supply
Excess Supply of US
Dollars
S**
Demand
Demand'
Hong Kong Interbank Market:
HIBOR higher than US interest rate.
iHIBOR
i*
iFedFunds
SBR '
SBR
Banks convert
US$ to Clearing
Balances to take
advantage of
higher interest
rates in Hong
Kong
1
2
DBR
Reserve Accounts
Convertibility Undertaking Stabilizes Forex
Demand and Supply Curves Automatically
S
Supply
Supply'
1
Excess Supply of US
Dollars
S=7.8
Demand
Demand'
Fixed Exchange Rate
• If the central bank undertakes to keep the
exchange rate fixed and that is a credible
E
S
undertaking, then t 1  St  0  i  i F .
St
t
t
• 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.
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.
HIBOR
t
i
i
FF
t
 St 1  St  
E

S
t


Overnight US$ and HK$ Interest Rates
20.000
18.000
16.000
14.000
12.000
10.000
8.000
6.000
4.000
2.000
0.000
Interbank Offered Rate: Overnight (Hong Kong)
Federal Funds Rate: Month Average (United States)
Iron Triangle of International Finance
Open
International
Capital Flows
Independent
Interest Rate
Stable Exchange
Rates
Pick 2 items from this menu
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
BoJ
Federal Funds Rate
Uncollateralized
Call Money Rate
ECB Main Refinancing
Rate/Euribor
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RBI Report of the Working Group on Monetary Policy...
Dynamics of Monetary Transmission
• Open market purchase 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.
• Lower interest rates tend to increase asset prices
which makes consumers feel wealthier.
• Aggregate demand shifts out. Given fixed wages this
increase in demand increases equilibrium output.
• Ultimately, wage demands will increase and prices
will rise.
Cut
Bond
Yields
Cut
Policy
Rate
Cut
Money
Market
Rate
Cheaper to Borrow
Investment increases
Raise
Asset
Prices
People Wealthier
Consumption Increases
Weaken
Forex
Rate
Improved Competitiveness
Net Exports Increases
Reduce
Cost of
ST
Finance
Consumer Purchases and
Inventory Investment
Increase
Extra Liquidity Creates Extra Loanable
Funds
r
SLF S′LF
DLF
r*
r**
LF
LF*
LF**
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
An Expansionary Cycle Driven by
monetary policy
YP
SRAS′
P
P***
3
SRAS
2
P**
P*
1
AD
Output Gap
1. Economy at
LT YP.
2. Monetary
Policy Cuts
Interest
Rate. The
AD curve
shifts out.
3. Tight labor
markets.
AD′
SRAS
returns to
long run
Y
equilibrium
Bank of England Estimates of Effect of
Interest Rate
Interest Rate Management
• In most economies around the world, the central
bank does not simply act to maintain a fixed
money supply.
• Rather, they adjust interest rates in response to
business cycle conditions.
Demand Driven Recession
w/ Counter-cyclical monetary policy
1. Economy in
a recession.
Fed detects
deflationary
pressure
YP
P
SRAS
AD′
1
2. Monetary
Policy Cuts
Interest Rate
3
P*
P**
3. AD curve
shifts back
to original
equilibrium
2
AD
Y
Gap < 0
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
SRAS
P**
2. Monetary
Policy
Raises
Interest Rate
2
3
P*
1
AD′
AD
Gap > 0
1. Economy in
expansion.
Fed detects
inflationary
pressure
3. AD curve
shifts back
to original
Y
equilibrium
U.S. Central bank cuts
interest rates during recessions
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
TGT
t
i
Output Gapt
 .02   t  2  ( t   )  2 
Yt P
1
*
1
The Taylor Rule Download
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.
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.
Inflation Targeting
Dyn. AS-AD Model: IT
YPt+1
YtP
SRASt+1
SRASt
P
Demand
expansion
matches supply
expansion
P*t+1
Average Inflation
Pt*
ADt+1
ADt
Yt*
Y*t+1
Y
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.
Inflation Reports
• Central bank publishes
its inflation forecast
with probability
distributions to
indicated degree of
uncertainty.
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Inflation Pressure
YPt+1
YtP
SRASt+1
SRASt
P
P*t+1
Target Inflation
Pt*
Forecast ADt+1
ADt
Raise Interest Rate
Target at time t
Yt*
Y*t+1
Y
Dynamic AS-AD Model: Recession, Inflation Deceleration
YtP
P
P*t+1
Pt*
ASt+1
YPt+1
ASt
Demand expands
slower than
expected
Target Inflation
Forecast Inflation
Cut
interest
rates to
hit
inflation
target
Forecast
ADt+1
ADt
Gap
Yt*
Y*t+1
Negative
Output Gap
Y
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List of
Inflation
Targeting
Countries
Rose, 2006
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
M1 2010
M9 2008
M5 2007
M1 2006
M9 2004
M5 2003
M1 2002
M9 2000
M5 1999
M1 1998
M9 1996
M5 1995
M1 1994
M9 1992
M5 1991
M1 1990
%
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Japanese Monetary Policy
CALL MONEY RATE
9.000
8.000
7.000
6.000
5.000
4.000
3.000
2.000
1.000
0.000
Zero Lower Bound
SBR′
SBR
SBR′ ′
SBR′ ′ ′
iIBR
When nominal
interest rate
reaches zero,
SBR′ ′ demand
′′
for money
turns infinite since
money pays just
as good an interest
rate as bonds.
DBR
i*
i**
i***
1
2
3
4
5
Reserves
Zero Lower Bound
• Interest rate cannot be set below zero.
Link
54
Raise Inflation Target
• Cost of borrowing (in terms of purchasing power)
is the interest rate adjusted by the inflation rate
between the time a loan is made and the time is
repaid.
rt  it  Et t 1
With zero interest rates, real borrowing rates
will fall when inflation rises.
The newly-introduced "price stability target" is the inflation 55
rate
that the Bank judges to be consistent with price stability on a
sustainable basis. … Based on this recognition, the Bank sets the
"price stability target" at 2 percent in terms of the year-on-year
rate of change in the consumer price index (CPI) -- a main price
BoJ
index.
Abenomics
Quantitative Easing/Forward Guidance
• Commit to future liquidity to raise expectations
of future inflation to bring down real interest
rates.
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Monetary Policy Statement April, 2012
• To support a stronger economic recovery and to
help ensure that inflation, over time, is at the rate
most consistent with its dual mandate, the
Committee expects to maintain a highly
accommodative stance for monetary policy. In
particular, the Committee decided today to keep
the target range for the federal funds rate at 0 to
1/4 percent and currently anticipates that
economic conditions--including low rates of
resource utilization and a subdued outlook for
inflation over the medium run--are likely to
warrant exceptionally low levels for the federal
funds rate at least through late 2014
Link
Learning Outcomes
Students should be able to:
• Use the supply and demand model of interbank
markets to demonstrate the effect of monetary
policy on interest rates.
• Use the AS-AD model to demonstrate the effect
of monetary policy on the price level and the
output gap.
• Use the supply and demand model of exchange
rates to demonstrate the effects of either current
or future monetary policy on exchange rates.
Final Exam
• When: Sunday, February 9th. 2-5pm.
• Where: Lecture Theater K
• What: Cover Materials in lectures on Supply&
Demand, Macro Indicators, Exchange Rates,
Loanable Funds, Business Cycles, Monetary
Policy.
• How: Format similar to practice final.
• Bring writing materials, calculator, 1 A4 paper
with handwritten notes on both sides.
• Office Hours: Saturday, February 8th, 12:30-2