Notesale: Turn your study into money

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Monetary Policy
The primary goal is to achieve price stability but a secondary goal of keeping production close to its
natural level is also pursued
...

IS: 𝑌 = 𝐶 ( 𝑌, 𝑌 𝑒 , 𝑖 − π 𝑒 , 𝐴) + 𝐼(𝑖 − π 𝑒 , 𝑌 𝑒 , 𝐾)
LM:

𝑀
𝑃

=

𝑌
𝑉(𝑖)

PC: π = π 𝑒 +

𝛽(𝑌−𝑌 𝑛 )
𝑌𝑛

+ 𝑧

An exogenous increase in money demand:
Suppose that there is an increase in money demand for exogenous reasons - that is, an exogenous
decrease in velocity
...
Lenders want their money back and there is an upward pressure on the interest rate
...
If the central bank allows this to happen by holding the money
supply constant there will be an increase in the interest rate and production will fall below the
natural level
...
It does
through the buying and selling government bonds at a particular rate
...
We assume that expected inflation does not change but remains equal to the inflation
target
...
The IS curve shifts out; if the interest rate is kept unchanged, production will increase and
inflation will increase
...
In this way it prevents
inflationary pressure from building up
...
This is consistent with analysis in Chapter 4
...
In this case the central bank's
action can be described as follows: In order to stabilize inflation and production, the central bank
should adjust the nominal interest rate so as to keep the real interest rate equal to the natural rate of
interest
...
Let us assume that this shock is perceived as a permanent, one-off occurrence
...
It is less clear
how the IS curve may be affected; if oil is imported, the IS curve may shift inward because an
increase in the world price of oil makes the oil-importing country poorer
...

For simplicity, we assume that the natural level of production and the IS curve remain unchanged
...
They
must now make a decision; they could increase interest rates, creating a negative output gap and
putting enough downward pressure on wages in order to decrease other prices and return inflation
to target or they must temporarily accept higher inflation
...
In such a scenario, the actions of the central bank
may be determined by the credibility of their inflation target, and therefore its ability to anchor long
term inflation expectations, as well as the importance that the central bank places on keeping
production as close to the natural level as possible
...
From consumption theory we know that
a permanent increase in production should lead to an increase in consumption of similar magnitude,
and the accelerator effect will lead to an increase in investment
...

Depending on the shift in the IS curve and the increase in the natural level of production, either and
increase or a decrease in the interest rate may be required
...
On the other
hand, the unexpected increase in productivity increase has a negative effect on inflation, which calls
for a lower interest rate
...
In the case illustrated below the IS curve shifts more than the
natural level of production and therefore an increase in the interest rate would be called for
...

Effectively, we assumed that the inflation target of the central bank was known and credible
...
In
response to an increase in the expected level of inflation the central bank must raise rates but it
faces a dilemma; increasing the interest rate to 𝑟 𝑛 + 𝜋 𝑒 will bring production back to the natural
level but leave inflation running at π 𝑒 which is above target however raising rates to i₁, the level
required to return inflation to target, will create a large negative output gap
...
The likely result is that the central bank will adopt a rate
somewhere inbetween these two levels in order to restablish the credibility of its inflation target
while at the same time preventing the creation of an excessively large negative output gap
...
This is because an increase in real interest rates is
required to create the negative output gap
...

The Taylor Rule
In 1993, the American economist John Taylor shows that US monetary policy in the period 19821991 could be described reasonably well by following the simple decision rule:
̂
𝑖 = 𝑟̅ + 𝜋 + 0
...
5𝑌
Here 𝑟̅ is an estimate of the normal real rate of interest and 𝜋 ⊗ is the inflation target of the central
bank
...
5(𝜋 − 𝜋 ⊗ ) + 0
...
Taylor assumed that the normal real
interest rate and the inflation target were both 2%, leading to the decision rule:
̂
̂
𝑖 = 0
...
5 (𝜋 − 0
...
5𝑌 = 0
...
5𝜋 + 0
...
It also shows how nominal
rates must rise a level greater than one to one with inflation in order to create the increase in real
interest rates required to bring about a negative output gap and lower aggregate demand
...
This means that expectations will depend on how policy is actually
conducted
...

The macroeconomic implications of rational expectations were formulated in the 1970s
...
The reason is that any
predictable monetary policy will affect inflation expectations and hence it will be incorporated into
wage and price setting
...
This may

seem like bad news for stabilization policy that pursues a specific target but even if wage setters
have rational expectations, monetary policy can still be effective because it can respond to
unexpected shocks while wages and prices may be somewhat rigid
...
In this way, monetary policy can help to
stabilize production and employment and compensate for the lack of flexibility in wages and prices
...
But exactly how does the central bank go about controlling
interest rates?
In short, the central bank controls the short-term interest rate by offering to lend money at an
interest rate which is decided by the decision-making board at a central bank
...

The interbank market for overnight borrowing:
The monetary base includes currency and banks' accounts in the electronic payment system that is
managed by the central bank and used to transfer money between banks
...
Depending on the amount of withdrawals and deposits that
come in, a bank may end up with a deficit or a surplus on its account in the payment system
...

Therefore banks that are in deficit at the end of the day must borrow money overnight to bridge the
gap
...
In the US, this is
known as the Federal funds market
...
This is usually seen as an unattractive option as the central bank will normally charge a
higher interest rate than what is on offer in the interbank market
...
Banks with excess reserves that have been unable to lend during the day can also
deposit money at the central bank and they are paid an interest rate on this money by the central
bank, again below the market level
...
Together the interest rates
on these facilities define an interest rate corridor within which the overnight bank rate must be
...

The central bank can influence the interbank rate further through open market operations, that is
the buying and selling of government securities
...
Repurchase agreements are a more sophisticated form
of open market operation whereby the central bank agrees to purchase a government security off of
a bank on the condition that bank repurchase the security from the central bank at a set date in the
future
...
This cost is converted to an annualized rate
and is called the refinancing rate by the ECB and the repo rate by the BoE
...
The decision about the
refinancing/repo rate is the main policy decision of the central bank
...
The main advantage of such an operation is that it reduces the risk
taken by the central bank
...
Since this is an alternative to borrowing in the
interbank market the interbank rate will often track the repo rate and this is how the central bank is
able to exercise further control over this rate in addition to the interest rate corridor it had already
created
...

In a situation where there is a general excess of liquidity in the market, where all banks have excess
reserves and will be forced to deposit them in the central bank, the central bank has another option
that it can use
...

Reserve requirements:
Some central banks require banks to hold a certain proportion of their deposits in the form of cash
or deposits with the central bank
...
However if the central bank targets interest rates then the reserve requirement will
have little to no impact on monetary policy, the monetary base will adjust to meet demand
...

The correlation between the interbank rate and other interest rates:
The connection is that expectations about the interbank rate determine other market interest rates
...
If banks expect the interbank rate
to increase in the coming months they will require higher returns from the loans they make to
consumers and to firms
...
The spreads between
different interest rates depend on the credit risk, time to maturity and other differences between
assets
...
The key is that the change must be unexpected, if the change was expected
the market will have already priced these changes in to the three and six month interest rates
...
Central banks mainly operate on
the short side of the market however they do also purchase government securities with longer
maturities and in this way they can affect the longer term interest rate by affecting the supply and
demand of such products although the correlation between central bank action and interest rates
remains far stronger in the short term
...

It is an indicator of perceived credit risk in the general economy since US T-Bills are considered to be
'risk-free' while LIBOR reflects the credit risk of lending to commercial banks
...
Interbank lenders, therefore, demand a higher rate of interest, or
accept lower returns on safe investments such as T-Bills

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