Monetary Policy Chapter 31 Orientation/Objectives Orientation Objectives Domestic Price, Output Stability External Forex Rate Stability IMF Exchange Rate Classification50 Source Link 200 No Currency Currency Board Fixed Exchange Rate Band Crawling Peg Managed Float Free Float.
Download ReportTranscript Monetary Policy Chapter 31 Orientation/Objectives Orientation Objectives Domestic Price, Output Stability External Forex Rate Stability IMF Exchange Rate Classification50 Source Link 200 No Currency Currency Board Fixed Exchange Rate Band Crawling Peg Managed Float Free Float.
Monetary Policy Chapter 31 Orientation/Objectives Orientation Objectives Domestic Price, Output Stability External Forex Rate Stability IMF Exchange Rate Classification 60 50 40 Source Link 30 20 10 0 No Currency Currency Board Fixed Exchange Rate Band Crawling Peg Managed Float Free Float Hong Kong’s Exchange Rate Regime Convertibility Undertaking • May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weakside 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 of US Dollars S** Demand Demand ' Hong Kong Interbank Market: HIBOR higher than US interest rate. iHIBOR i* iFedFunds Supply' Supply Banks convert US$ to Clearing Balances to take advantage of higher interest rates in Hong Kong 1 2 D Reserve Accounts Passive Forex Intervention i M P Agents want more Hong Kong dollars and excess supply of US dollars at exchange rate. D i* 1 Rather than sell US dollars at falling prices, sell to HKMA at Strong Side price 2 i** M MS M S P P P HKMA purchase of forex increases M and reduces i. Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically S Supply Supply' 1 S=7.8 Excess Supply of US Dollars S** Demand Demand ' Fixed Exchange Rate If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then . StE1 St 0 it itF St 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. Fed Funds HIBOR Jun-04 Jun-03 Jun-02 Jun-01 Jun-00 Jun-99 Jun-98 Jun-97 Jun-96 Jun-95 Jun-94 Jun-93 Jun-92 Jun-91 Jun-90 Jun-89 Jun-88 Jun-87 Jun-86 % HIBOR vs. Fed Funds Rate Interbank Rates 20 18 16 14 12 10 8 6 4 2 0 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 Iron Triangle of International Finance Open to International Capital Flows Monetary Policy that Controls The Interest Rate Pick 2 items from this menu Fixed Exchange Rates Domestically Oriented Monetary Policy 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 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. Interbank Market: OMO to meet demand for reserves S iIBR S' D 2 i* 3 iTGT 1 D' Reserve Accounts 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. 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. Central Bank Policy Makers reduce interest target- Open Market Purchase S iIBR S' D iTGT 1 2 iTGT' D' Reserve Accounts Monetary Policy: Money Supply Expands i i* MS M S P P 1 M P i** D 2 M Expansionary Monetary Policy P ΔI ΔC, ΔNX AD AD′ Y 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. An Expansionary Cycle Driven by monetary policy 2. Monetary Policy Cuts Interest Rate YP P 3 1. Economy at LT YP. SRAS 2 P* AD′ 1 AD Output Gap Y 3. Expenditure rises. The AD curve shifts out. 4. Tight labor markets. SRAS returns to long run equilibrium Bank of England Estimates of Effect of Interest Rate 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). 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. 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 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 List of Inflation Targeting Countries Rose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed KEY GOAL OF CENTRAL BANKS: PRICE STABILITY HKMA Link Demand Driven Recession w/ Counter-cyclical monetary policy YP P SRAS AD′ 1 2. Monetary Policy Cuts Interest Rate 3 P* 2 AD Gap < 0 1. Economy in a recession. Ctl Bank detects deflationary pressure Y 3. Investment increases 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 Gap > 0 Y 1. Economy in expansion. Ctl Bank detects inflationary pressure 2. Monetary Policy Raises Interest Rate 3. Decreased spending to shift the AD curve back to long run equilibrium U.S. Central bank cuts interest rates during recessions 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. Stagflation w/ Counter-cyclical monetary policy YP P SRAS 3 P** P* 2 1 AD′ AD Y 1. Economy experiences stagflation 2. Monetary Policy Cuts Interest Rate 3. Investment increases spending to shift the AD curve to long run equilibrium with higher prices. Stagflation w/ Price Stabiliztion YP P 1. Economy experiences stagflation SRAS 2 3 P* 1 AD′ AD Y 2. Monetary Policy Raises Interest Rate 3. Investment decreases spending to shift the AD curve to equilibrium with lower output. Taylor Rule Economist named John Taylor argues that US target interest rate is well represented by a function of 1. 2. 3. current inflation Inflation GAP: current inflation vs. target inflation Output Gap: % deviation of GDP from long run path Function: Inflation Target π* = .02 itTGT .02 t 12 ( t * ) 12 Output Gapt 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. Zero Lower Bound Link Interest rate cannot be set below zero. The Taylor Rule Download 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. Great Inflation of the 70’s & 80’s CPI Inflation, % Annual Rate 35 30 25 20 15 10 5 OECD East Asia Subsaharan Africa 20 09 20 05 20 01 19 97 19 93 19 89 19 85 19 81 19 77 19 73 19 69 19 61 -5 19 65 0 Latin America A Bias toward Expansionary monetary policy 1. Central Bank repeatedly expands the money supply YP P 2. Inflation recurs 5 4 3 P* 2 SRAS′ AD′ 1 SRAS AD YPhantom Y Demand Driven Recession Counter-cyclical fiscal policy YP P 3 P* 1 2 Y* Recessionary Gap SRAS w/ 1. Economy in LT equilibrium 2. Demand shifts in 3. Government increases AD spending to shift the AD curve back AD′ Y Demand Driven Expansion Counter-cyclical fiscal policy YP P SRAS 1. Economy in LT equilibrium 2. Demand shifts out 2 P* 3. Government cuts spending to shift the AD AD′ curve back 1 3 Y* w/ AD Inflationary Gap 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. 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. 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