ECON1102:Week8
MonetaryPolicyReadChapter8
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Unit8:MonetaryPolicy1. Moneysupplyandmonetarypolicy2. MoneymarketEquilibrium3. TransmissionMechanism4. PolicyReactionFunction
MoneySupplyvInterestRatetargeting
Therearetwopolarcasesthatwecanconsider;
1. ThesupplycurveformoneyanditspositionisinfluencedbytheactionsoftheRBA
2. ThesupplycurveformoneyishorizontalandtheRBAsuppliesmoneyondemand(atagiveni)
ThedifferentapproachestotheimplementationofmonetarypolicyRBAtargetsmoneysupply
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interestrate(i)
money
0
MD
MSsetMSori*
i*
RBAtriestocontrolthemoneysupply(currencyanddeposits)by(openmarketoperations)OMO
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interestrate(i)
money
0
MD
MSsetMSori*
i*
CanRBAControlMoneySupply? CaninfluencemoneysupplybyOpenMarketOperations
Bankscancreatemoneybyissuingloans,andwilldosowhenprofitable.
RBAcaninfluenceBUTNOTcontrolmoneysupply
Mscurveisneververtical
RBAtargetstheinterestrate(onbonds)
Giventhedemandformoneyfunction,theRBAwillsupplywhateverquantityofmoneyrequiredtoachieveitstargetvaluefortheinterestrate.
ShiftsinmoneydemandareaccommodatedbytheRBAattheinterestratetarget.
RBATargetscashrate
i
0i Ms Md 0M M
Usingopenmarketoperations(OMO)totargettheCASHRATE
BanksholdaccountswithRBA:exchangesettlementaccounts
Thebalanceintheexchangesettlementaccountsarecalledexchangesettlementfundsorcash
TheCASHRATEistheinterestratewhichbringstogetherthesupplyanddemandforexchangesettlementfundsintobalance
RBAusesOMOtoinfluencetheCASHRATE
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OpenMarketOperationsinvolve..
TheRBAbuyingandsellingshorttermgovernmentbonds- Sellinggovernmentbondsmeansbankreservesfall,asthebuyerspayforthemanddrawontheirbankdeposits
-cashraterises- Buyinggovernmentsecuritiesmeansbankreservesrise,astheRBApaysforthemandthesellersdeposittheproceedsinbanks
-cashratefallsMoneysupplyiswhateverisrequiredtomaintainthe cashrate
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RBATargetstheCashRate
AtitsmonthlymeetingtheRBAboarddecideswhatchanges,ifany,shallbemadetothecashrate
http://www.rba.gov.au/monetarypolicy/rbaboardminutes/2014/01042014.html
RBAthenconductsopenmarketoperationstoachievethisrate
RBAisalsorequiredtointerveneonanongoingbasistokeepthecashrateatitstargetlevel
FlowontootherinterestratesRBAcaninfluence overalllevelofinterestratesineconomy
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TheFinancialSystemAwellfunctioningfinancialsystemimprovestheallocationofsavingintwoways:1. Itprovidesinformationtosaversabout
possibleusesof,andreturnsto,theirfunds.
2. Ithelpssaverstosharetherisksofindividualinvestmentprojects.
Bonds
Abondisalegalpromisetorepayadebt,usuallyincludingboththeprincipalamountandregularinterest,orcoupon,payments.
Bonds Thecouponratedependson: Thetermofthebond(thelengthoftimeuntilthebondsmaturationdate).
Creditrisk(theriskthattheborrowerwillgobankruptandthusnotrepaytheloan).
Taxtreatmentofcouponpayments. Bondownersarenotrequiredtoholdtheirbondsuntiltheirmaturationdates.
Theyarealwaysfreetoselltheirbondsinthebond market.
Bondpricesandinterestrates
Themarketvalueofaparticularbondatanygivenpointintimeiscalledthepriceofthebond.
Thepriceofabondcanbegreaterthan,lessthan,orequaltotheprincipalamountofthebond,dependingonhowthecurrentorprevailinginterestrateinfinancialmarketscompareswiththeinterestrateatthetimethebondwasissued.
Interestrates,bondpricesandmoneymarketequilibrium
Whyareinterestratesandbondpricesinverselyrelated? Iftheinterestrateisbelowtheequilibriummarketpriceformoney,thedemandformoneyisgreaterthanthesupply.
Toincreasemoneyholdings,thepublicwillstarttosellofftheirbonds.
Anincreaseinthesupplyofbondsleadstoareductionintheirprice,whichisequivalenttoanincreaseininterestrates.
Athigherinterestrates,thedemandformoneywilldecline,untilequilibriumisreachedwherethemoneydemandisequaltotheamountofmoneyavailableatthatinterestrate.
Marketfor90DayBills:DemandandSupply
Borrowfor90days=SupplyofBills
BorrowmorewheninterestrateonBillsislow.
BUT,lowinterestrateimpliesahighpriceforBills
So,SupplycurveforBillsisincreasingintheirprice
Marketfor90DayBills:DemandandSupply
Lendfor90days=DemandforBills
LendmorewheninterestrateonBillsishigh.
BUT,highinterestrateimpliesalowpriceforBills
So,DemandcurveforBillsisdecreasingintheirprice
Example:Themarketfor90daybillsFigure8.1Themarketfor90daybills
TheEffectofanIncreaseintheCashRateonthe90DayBillMarket
InthepreviousfigurePerepresentstheequilibriumpricefor90daybills.Thiswillalsocorrespondtoanequilibriuminterestratefor90daybills.
NowsupposetheRBAraisesitstargetlevelforthecashrate.Howdoesthisaffectthemarketfor90daybills?
Banksareabletoparticipateinboththeovernightcashmarketandinthecommercialbillmarket.
TheEffectofanIncreaseintheCashRateonthe90DayBillMarket
WhenCashRateIncreases. Thedemandforcommercialbills(thewillingnesstolendtofirms)willtendtofall:Demandcurvewillshifttotheleft. Thisoccursbecausesomebankswillleavethebillmarketinfavourofthehigherreturnsintheovernightcashmarket.
Thesupplyofcommercialbills(thedemandfor90dayloans)willtendtorise:Supplycurvewillshiftoutwards. Someborrowersintheovernightcashmarketwillnowseek fundsinthe90daybillmarket,duetothehigher cashrate
HowdoestheReserveBankaffectnominalinterestrates?Figure8.2Theeffectofanincreaseinthecashrateonthe90daybillmarket
Arbitrage WhileRBAtargetsaveryshortinterestrate,changesincashrateeventuallyleadtochangesinlongerterminterestrates.(Aswesawlastweek)
MarketRates=CashRate+Premium Premiumwilltendtoreflectriskorliquidityfactors.
CantheRBAtargettherealinterestrate?
RBAtargetnominalinterestrate(i)thecashratethroughOMO
Decisionstosaveandinvestdependontherealinterestrate(r)
Recall,r=i (wherer=realinterestrate, i=nominalinterestrate =inflationrate)
sinceinflationrateadjustsreasonablyslowly,RBAcanchangetherealinterestrate(r)inshortrunbychangingthenominalinterestrate(i) Inlongrunrdependsonthesupplyanddemandforsavings
andinterestratedifferential(ascomparedtooverseasinterest rates)
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7.Howchangingmonetaryconditionsaffecttheeconomythetransmissionmechanism
Currentmonetarypolicyworksbychangingthecashrate
TheRBAsells/buysgovernmentsecuritiestoachievetargetedcashrate
Thebanksbuy/sellgovernmentsecuritiestoaccommodatetheRBAandreserveschange
Asbankreservesfall/rise,banksreduce/increaseloans Theincrease/reductioninthecashratefeedsthroughtoothershortterminterestrates
Impactsgenerallevelofspendingandthebroadereconomy
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Monetarypolicyandtheeconomy
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cashrateotherrates
realinterestrate
spending(I,C)exchangerate
(NX)
outputemploymentinflationarypressures
PAEandtheRealInterestRate InourmodelofincomedeterminationwehaveallowedPAEtodependonthelevelofrealoutput.
WenowwanttoallowarolefortherealinterestratetoinfluencePAE.
2mainchannels1. Higherrealinterestrateswillleadhouseholdsto
reducecurrentconsumptioneg.Duetohighermortgagepayments
2. Higherrealinterestrateswillraisethecostofborrowingandreduceinvestmentbyfirms
TheRBAfightsarecession
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cashrateotherrates
realinterestrate
spending(IC)depreciation$A
(NX)
outputEmployment
inflationarypressures
TheRBAfightsarecession
r SandC Investment Depreciationof$Alowerrealexchangerate increaseininternationalcompetitiveness demandforXanddemandforM
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ModelforPAE
Consumption arTYcCC d )( Investment brII P Assume (for simplicity) other variables are exogenous
GG XX TT
PlannedAggregateExpenditurearTYcCCd )(
brIIP GG XX TT
NXGICPAE Pd Substitute and collect terms
cYrbaXGITcCPAE ])([
Implications
Exogenousexpenditurenowdependsontherealinterestrate
Foranygivenlevelofoutput,PAEwillfallwithariseintherealinterestrate.
IfweassumethattheRBAcansettherealinterestrate,thenwehaveamechanismbywhichmonetarypolicycanaffectPAEandequilibriumoutput
Whyloweringinterestratesdoesnotalwayswork
Accordingtotheprecedingdiscussion,alowerrealinterestratewillbeassociatedwithincreasedplannedaggregateexpenditurebyhouseholds.
However,lowrealinterestrateneednotalwaysstimulateexpenditure.
Consumption Householdsmayraisesavingforprecautionaryreasons. Thewilltoreducenetdebtandtorebuildwealthpersists Investment Especiallyinrecessions,investmentmaybeinterestinelastic
Example:PAEandtherealinterestrate Inaneconomydescribedby: Cd=640+0.8(YT)400r Ip=250600r G=300 X=20 T=250 BothCdandIpareaffectedbytheinterestrate,r. PAE=Cd+Ip+G+X =[640+0.8(Y250)400r]+[250600r]+300+20
=[10101000r]+0.8Y
PAEandtherealinterestrate
PAE=[10101000r]+0.8Y Theexogenousexpenditureinthiseconomyis
[10101000r]anddependsontherealinterestrate,r.
Iftherealinterestrateis5%,theequilibriumoutputisgivenby:
PAE=[10101000x(0.05)]+0.8Y PAE=Ye,so: Ye=960+0.8Y=4800
TofightarecessionbyhowmuchshouldtheRBAlowerinterestrates(from5%)?
Weknowatr=5%,Ye=4,800,howeverifY*=5,000Wehavearecessionarygapof200Byhowmuchshouldrbereduced?
Recall,Exogenousexpenditure=(1,0101,000r)(Eq1)Witharecessionaryoutputgapof200,andamultiplierof5,
exogenousexpendituremustriseby40FromEq1,each1%reductioninrwouldincreaseexogenous
expenditureby10A4%reductioninrwouldincreaseexogenousexpenditureby
40rshouldfallfrom5%to1%
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TheRBAfightsarecession
.
0Y(=GDP)
PAE(plannedaggregateexpenditure)
PAE(r=5%)
4,800 Y*=5,000
PAE(r=1%)
AreductioninrshiftsPAEupward
SupposeinsteadY*=4,600wehaveanexpansionarygapbyhowmuchshouldtheRBAraiseinterestrates(from5%)toclosetheoutputgap?
Weknowatr=5%,Ye=4,800,howeverY*=4,600Wehaveanexpansionarygapof200,byhowmuchshouldrbe
increased?Recall,Exogenousexpenditure=(1,0101,000r)(Eq2)Withanexpansionaryoutputgapof200,andamultiplierof5,
exogenousexpendituremustfallby40FromEq2,each1%increaseinrwouldreduceexogenous
expenditureby10A4%increaseinrwouldreduceexogenousexpenditureby40rshouldincreasefrom5%to9%
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TheRBAfightsinflation
.
0Y(=GDP)
PAE(plannedaggregateexpenditure)
PAE(r=5%)
4,800Y*=4,600
PAE(r=9%)
AnincreaseinrshiftsPAEdown
8.ModellingthebehaviouroftheRBA thePolicyReactionFunction TheRBAattemptstostabilisetheeconomybymanipulating
therealinterestrateinresponsetotheoutputgapandtheinflationrate
Apolicyreactionfunctiontriestoexplain/predictbyhowmuchtheRBAchangesthecashratewhentherearechangesinthestateoftheeconomy(egoutputgap,inflationrate)
THETAYLORRULEhasbeendevelopedtodescribethebehaviouroftheUSFederalReserve
r=0.010.5[(Y*Y)/Y*]+0.5=>SuggestsFederalReserverespondstobothoutputgapsand
rateofinflation
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Policyreactionfunction
Example
UsingtheTAYLORRULEr=0.010.5[(Y*Y)/Y*]+0.5a1%increaseininflation()leadsto
anincreaseinrof0.5x0.1=0.005(or0.5percentagepoints)
ApplicationtobehaviourofRBA Notdirectlyapplicableduetodifferentweightsontheoutputgap
[(Y*Y)/Y*]andinflation(). Untilrecentlylikelyhigherweightoninflation(duetospecific
inflationtargetof23%),althoughglobalfinancialcrisishasrequiredconsiderationofrecessionaryoutputgap.
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AhypotheticalRBApolicyreactionfunctionsimplifyingassumptionthatRBAreactsonlytoinflation*
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Inflation()
realinterestratesetbyRBA(r)
RBAspolicyreactionfunction
0.02
0.04
0.06
0.03
0.05
00.01 0.02 0.03 0.04
*Capturestendencytoraisecashratewheneconomyisoverheating(expansionarygap)andreducecashratewheneconomyissluggish (recessionarygap)
MovementalongpolicyreactionfunctionIfchangeinrinresponsetochangeinShiftofpolicyreactionfunctionIfchangeinrinabsenceofchangein
RBAmonetarypolicyinpractice
RBAreactstochangesinactualinflationrates,inflationaryexpectationsandabroadrangeofdomesticandinternationaleconomicvariables
Decisionsmadeusingbothformalpolicyreactionfunctionsandjudgement Doesnothaveaprecisemeasureoftheoutputgap Onlyhasanapproximateideaoftheimpactofinterestratechangesonplannedspending(orthelagbeforeimpactswilloccur)
Changesinmonetarypolicysettingscanbetakenfrequently,butRBAhastendedtobecautious
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