MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2 nd

MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2 nd edition Monetary Policy 1

15 -2 Key Concepts n Central Banks n Monetary Policy Targets and Goals n Transmission Mechanism 2

15 -3 Central Banks n Monetary authority: conduct monetary policy and act as a lender of last resort n Sometimes a bank regulator n Ideal is an independent central bank n Independent from Finance ministry and political pressures n For most countries, central banks are a 20 th century phenomenon n n Prior gold standard = little need for central banks Similar to dollarization today n Steep learning curve for central banks in 20 th century n Fiat money and the “Great Inflation” of the 1970 s n Examples of independent central banks: n U. S. Federal Reserve, EU Central Bank, Bank of England, Bank of Mexico, Bank of Japan, Bank of Canada, Bank of 3 New Zealand

15 -4 Central Banks n Three tools to implement monetary policy n Open market operations n Reserve requirements n Direct lending facility n Closer look at open market operations n Buy treasury bonds from public =>supply reserves to banking system => increase money supply n Sell treasury bonds to public => remove reserves from banking system => decrease money supply 4

15 -5 Federal Reserve System “High employment consistent with stable prices” n Organization n Board of Governors – 7 Members n 12 Federal Reserve District Banks n Federal Open Market Committee (FOMC) n Instrument n Short term market interest rates (Discount rate) n Reserve Requirements n Open Market Operations n Federal Funds rate n Rate charged on interbank loans 5

15 -6 Federal Reserve System 6

15 -7 Elements of Monetary Policy n Operational Instruments n Short-term interest rates, reserve requirements, monetary base n Intermediate Targets n Money supply, exchange rates, inflation targeting n Policy Goals (book calls them “ultimate targets”) Price stability n Output and employment stability n 7

15 -8 Operational Instruments n Short term interest rate n Base money n Cash plus reserves of banks n Also called monetary base, high-powered money, reserve money n Central bank can supply reserves to or drain reserves from the financial system 8

15 -9 9

15 -10 Intermediate Targets n Variable which n Tracks policy goal (e. g. , inflation) n Over which central bank has reasonable control n Three main targets n Money supply n Exchange rate n Inflation forecast 10

15 -11 Intermediate Target I: Money Supply Targeting n Quantity Theory implies direct relationship between money supply growth and inflation MV=PY Assume velocity is relatively stable n Assume real output controlled by real factors n n US: money targeting used in early 1980 s n Difficulties with money supply targeting n Which aggregate to use? n Is velocity stable or at least predictable? n Can central banks control the money supply? n What about supply shocks? 11

15 -12 Money Growth, US M 3 M 2 M 1 12

15 -13 Growth rate, monetary aggregates M 1 M 2 M 3 Source: Federal Reserve Board, Current release. http: //www. federalreserve. gov/releases/ Monthly growth rate converted to annual rate and smoothed with moving average filter. 13

15 -14 Intermediate Target II: Exchange Rate Targets n Fix exchange rate against another currency n Will tie domestic inflation to foreign inflation n Cost is lack of flexibility in influence on domestic economy n The Exchange Rate as a Tool of Monetary Policy n When the exchange rate is flexible: n Tighter monetary policy reduces net exports. § How? § higher interest rates => increased capital inflows => dollar appreciate => U. S. exports more expensive to foreigners (higher real exchange rate) n n Easier monetary policy stimulates net exports. Monetary policy affects consumption, investment, and net exports in open economy 14

15 -15 Intermediate Target III: Inflation Targeting n Specified a target range for realized inflation n Common measure of 2% annual inflation n n Specific targets for Bank of Canada, Bank of New Zealand Some allow band around target n Allows for discretion in implementation n Use inflation forecast which may incorporate many variables n Discretion comes at a price 15

15 -16 Recall Equation of Exchange MV = PY Md/P = (1/V)Y Real Money Demand Velocity, depends on interest rate 16

15 -17 Money Market Nominal Interest Rate Money Supply R 0 Money Demand M 0 Quantity of Money 17

15 -18 Money Market Increase in Income Nominal Interest Rate Money Supply R 1 R 0 Money Demand M 0 Quantity of Money 18

15 -19 Money Market Increase in Money Supply Nominal Interest Rate Money Supply R 0 R 1 Money Demand M 0 M 1 Quantity of Money 19

15 -20 Money supply or interest rates? Money Supply Interest rate 20

15 -21 Money Market Interest Rate Money targeting Money Supply R 1 R 0 Money Demand Increase in Money Demand M 0 produces rise in interest rate if Money Supply is fixed Quantity of Money 21

15 -22 Money Market Interest Rate Money targeting Money Supply R 1 R 0 Money Demand Increase in Money Demand M 0 produces no rise in interest rate if Money Supply is allowed to increase Quantity of Money 22

15 -23 Monetary Policy Goals n GDP growth n Unemployment n Price Stability n New Zealand n England n European Central Bank n Why not target zero inflation? n Mismeasurement n Lubricate the labor market n Zero nominal interest rate lower bound n Nominal rate = real rate + expected inflation 23

15 -24 Transmission Mechanism Market Rates Asset Prices Domestic Demand Net External Demand Official Rate Expectations and Confidence Exchange Rate Import Prices Domestic Inflationary Pressure Inflation 24