ECO 120 Macroeconomics

Week 9

Monetary Policy LecturerDr. Rod Duncan

Topics

• Who controls monetary policy?

• How does monetary policy work?

• What can monetary policy accomplish?

• A simple theory of money- The Quantity Theory of Money (QTM).

What is monetary policy?

• Typically we consider the problem of how the government can manipulate monetary policy so as to control economic variables such as output, inflation, interest rates, etc.

• Issues: how monetary policy can “stabilize” the economy? How will monetary policy affect interest rates or exchange rates?

• We want to use our AD-AS model to discuss monetary policy and its effects.

Who is this man?

Who is this man?

Who is more important?

• The first man was the first Australian captain to lose an Ashes contest in 16 years. [Ricky Ponting]

• The second man sets the interest rates on your home loans. [Ian Macfarlane]

• Ian Macfarlane is the Governor of the Reserve Bank of Australia (RBA).

• Ian Macfarlane is the most important Australian few Australians have ever heard of.

Does the RBA control bank rates?

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Who is more important?

• When the RBA raised cash rates by +0.25% on 2 March 2005, bank loan rates went from 7.05% to 7.30%.

• On a $250,000 20 year variable interest loan, that’s raising weekly repayments from $487 to $497. Ian Macfarlane cost every Australian family $10/week.

• So who is this Ian Macfarlane and why does he hate Australians so much?

Reserve Bank Act, Section 10(2)

It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:(a) the stability of the currency of Australia(b) the maintenance of full employment in Australia; and(c) the economic prosperity and welfare of the people of Australia.

Who is on the Reserve Bank Board?

• Ian Macfarlane, Governor • Glenn Stevens, Deputy Governor • Ken Henry, Secretary to the Treasury • Frank Lowy - businessman (Westfield shopping centres)• Hugh Morgan - Business Council of Australia• Jillian Broadbent - Bankers Trust• Donald McGauchie - National Farmers Federation (and

Telstra chairman)• Warwick McKibbin - economic researcher at ANU• Robert Gerard – Gerard Corporation and Liberal donor

The last 6 members are all appointed by the Treasury.

Goals of the RBA

• The goals stated in the Act say the Board is to:– Maintain the value of the Australian dollar;– Keep unemployment low; and– Keep GDP growth high.

• How do you do all three? • What happens if doing one hurts the others?

What if maintaining the A$ requires raising interest rates which will lower employment and growth?

Goals of the RBA

• It’s the same as saying: “Design a car which-1. Goes as fast as possible.2. Is as safe as a luxury car.3. Has high fuel efficiency.

• You could build a light car that satisfied 1 and 3, but would break 2. You could build a heavier car that satisfied 2 and 3, but would break 1.

• In practice, the RBA aims to keep inflation low. (Target band: 2-4%) And that’s all.

Tools of the RBA

• For fiscal policy, the government controls taxes and spending. Fiscal policy can be achieved by raising or lowering personal income or company taxes, or by raising or lowering spending across the economy, or in only one sector.

• Fiscal policy has some fine-tuned tools.• For monetary policy, the RBA only has control of

the cash rate- the rate on banks’ deposits at the RBA- called the Exchange Settlement Accounts (ESAs) is .25% below the cash rate.

Tools of the RBA

• The cash rate is the rate that banks lend to each other. The cash rate is the cost to banks of holding reserves.

• The higher the cash rate, the higher will be bank loan rates to borrowers, and the higher the interest rate that banks pay to savers.

• By controlling the cash rate, the RBA controls all interest rates in the economy, which all move in line with the cash rate.

Open market operations

• The government can control the supply of ESAs and thus the interest rate. These actions are called “open market operations”.

• “Open market operations” are the means of the government controlling the supply of ESAs. The RBA buys and sells securities to control the amount of ESAs, debiting or crediting the ESA accounts.

Open market operations

• If the RBA sells securities for ESAs, it decreases the supply of ESAs and raises the cash rate.

• Monetary policy shifts the ESA supply curve and so changes the equilibrium interest rate.

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From cash rate to interest rates

• As the cash rate rises, the supply of other types of securities shrinks, and interest rates for those funds rises as well.

• Borrowing becomes more expensive.

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Some “must know” definitions

• The RBA implements monetary policy through its control of the cash rate.

• Cash rate: The cash rate is the rate the RBA charges bank for loans within the RBA reserves system. The cash rate is the base interest rate for the economy, and all other interest rates are derived from it.

• Easy monetary policy: When the RBA lowers the cash rate to stimulate aggregate demand.

• Tight monetary policy: When the RBA raises the cash rate to cut off aggregate demand.

Interest rates and Investment

• As we saw in the Investment section, the profitability of investment projects depends on the nominal interest rate.

• The lower are interest rates, the more projects will be profitable, so the higher will be investment spending.

• Since the RBA controls the cash rate, and since all interest rates depend on the cash rate, the RBA controls I, and so can shift the AD curve.

Interest rates and Investment

• Interest rates are the cost that companies pay to make investments.

• As the cost of investing rises, fewer projects will be profitable, so desired investment drops.

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Brief aside: Nominal vs. real interest rates

• The nominal interest rate is the rate that you pay on a loan or that you get paid at a bank.

• Problem: You don’t eat money. What you care about is the buying power of your savings. If prices double from one year to the next, if nominal interest rates are less than 100%, you can buy less with your savings next year.

• The real interest rate is (roughly) the nominal rate of interest minus the rate of inflation.

How monetary policy works

Chain of causation for monetary policy:

1. Changing ESA supply impacts interest rates

2. Interest rates affect Investment

3. Investment is a component of AD

4.4. AD shifts and so equilibrium GDP is AD shifts and so equilibrium GDP is changed.changed.

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Monetary policy in operation

• The RBA uses monetary policy to keep inflation low (or to maintain prices). The RBA uses monetary policy to “steer against” the rest of the economy.

• For example, the RBA thinks the AD curve is shifting right because of increased export demand. Then the RBA will raise interest rates to shift AD left (or prevent AD from shifting at all).

• Or if the RBA thinks the AD curve is shifting left, then the RBA will lower interest rates.

Monetary policy in operation

• The RBA sees an upcoming shift to the right of the AD curve, leading to rising prices (inflation).

• The RBA counters this by raising interest rates and shifting AD left. If perfectly done, AD does not move.

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But…

• We have the same problems that we saw with fiscal policy.– Bad predictions: The RBA has to foresee the

upcoming changes. What if the RBA guesses wrong?

– Bad data: What is the information about the present or future is wrong?

– Lags: What if the RBA is late adjusting to upcoming changes? The economy may already have moved past.

Monetary policy and the open economy

• Net Export Effect– Changes in interest rate affect the value of the

exchange rate under floating exchange rate.An increase in interest rate appreciates the currency, resulting in lower net exports

– A decrease in interest rate leads to currency depreciation and a rise in net exports

• So an easy monetary policy is enhanced by the net export effect.

How do interest rates affect exchange rates?

• We will get into this topic in a lot more depth in Lecture 13.

• An increase in Australian interest rates makes Australia a better place to invest. But to invest in Australia you need to have A$.

• So an increase in i increases demand for A$, so raises the price of A$, which is simply the A$ exchange rate.

• Likewise a decrease in i decreases demand for A$, so the A$ exchange rate drops.

Economists and models

• A model is just a simplified view of the world. It’s just a way of thinking.

• Economists only have a few simple models in their heads. To become an economist, you have to learn to think within these models.

• Demand-supply, perfectly competitive company and monopoly would be three models from micro.

• From macro, AD-AS, Phillips Curve, IS-LM and Quantity Theory of Money would be some basic models.

Quantity theory of money

• There is a nice, simple model of money which explains many features of money supply and demand. This model is called the quantity theory of money.

• If we imagine that money is needed for all of the purchases made each year, then demand for money is the value of purchases. We only consider transactions demand for money.

• The nominal value of all purchases is simply the average level of prices (P) times the real GDP per year (Y): PY.

Quantity theory of money

• The supply of money for purchases is the amount of cash in the economy, M.

• But each piece of money in the economy can be used multiple times during a year in transactions. We call the number of transactions that each $1 enters into during a year as the velocity of money “v”.

• So the total supply of money for transactions in a year is v times M: vM.

Quantity theory of money

• So demand equals supply requires that:PY = vM

• When thinking about this model, we usually imagine that v is fixed by technology of money and buying habits. We imagine that Y is determined by the state of the economy.

• The government controls M, then the only variable that changing M affects will be P.

• The QTM says that inflation (changing P) is a result of changing M.

• So if Y goes up, but nothing else does, then average level of prices must fall.

• The QTM is good to use for thinking about money and inflation.

• Another view of QTM:(Growth in P) + (Growth in Y)

= (Growth in v) + (Growth in M)

QTM in an online game

• Example of QTM in a nearly-real world:• The online role-playing game “Ultima” has

hundreds of thousands of players. It is, in a sense, bigger than some countries.

• The game has an economy, where people buy and sell virtual goods for virtual cash “gold pieces”, M.

• Some players worked out how to “dupe gold” in Ultima, so they could create a huge amount of new gold over time.

QTM in an online game

• What happened to prices in this economy when all this new gold came in?

• Y and v were unaffected, so a big increase in M led to a big increase in P. There was massive inflation.

• The designers of the game fixed the dupe bug, but what to do about all this new gold in the economy?

• They created a new rare good “red hair dye”, for which the designers charged the players a lot of gold. The players handed over the gold, and the designers deleted it.