1 macroeconomics and the global business environment monetary policy copyright © 2005 john wiley...
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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
Monetary Policy
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth IngramUniversity of Iowa
2nd edition
15-2
Key Concepts
Targets Inflation Intermediate Policy Goals
Open Market Operations LM Curve Transmission Mechanism
15-4
Federal Reserve System“High employment consistent with stable prices”
Organization Board of Governors – 7 Members 12 Federal Reserve District Banks Federal Open Market Committee (FOMC)
Instrument Short term market interest rates (Discount rate) Reserve Requirements Open Market Operations
Federal Funds rate Rate charged on interbank loans
15-5
European Central BankPrice stability with inflation under 2%
Organization The European System of Central Banks (ESCB) -- 6
members of the executive board and 15 national Central Banks of the European Union.
Interest rate decisions are made at fortnightly council meetings
Instruments Repo rate – overnight interest rate Discount rate and Lombard rate (rates at which
commercial banks acquire or deposit reserves) Intermediate Target – Inflation and M3
15-6
Bank of EnglandKeep inflation at rate set by government (2.5%)
Organization The Monetary Policy Committee (MPC) 9 members, 5 full time Bank of England employees
and 4 external experts Instruments
Repo rate No reserve requirement, but no bank overdrafts
Intermediate target: An Inflation target based on a two-year-ahead inflation forecast
15-8
Monetary Policy Elements
Price StabilityUnemployment
Real Growth
Interest RatesMoney growth
Discount WindowOpen Market Operations
Reserve Requirements
15-9
LM Curve
Equilibrium in the money market Demand for money
Opportunity cost of holding money Interest rate increase means hold less money
Supply of money Role of Federal Reserve Role of banks
15-10
Recall quantity theory
MV = PY
Md/P = (1/V)Y
Real Money DemandVelocity, depends on interest rate
15-12
Money MarketIncrease in Income
Nom
inal
Int
eres
tR
ate
Quantity of Money
Money Supply
Money Demand
R0
M0
R1
15-13
Money MarketIncrease in Money Supply
Nom
inal
Int
eres
tR
ate
Quantity of Money
Money Supply
Money Demand
R
M0
R0
M1
R1
15-14
LM curve
Increase in income is associated with rise in interest rates
For a fixed interest rate, increase in money supply increases income
15-15
IS-LM Model
Interest Rate
Output
LM Curve
Increase in Money SupplyIncrease in Money SupplyDecrease in Money SupplyDecrease in Money Supply
15-17
Increase in money
Interest Rate
Output
LM Curve
IS Curve
R0
Y0
R1
Y1
Lowers the interest rate and increases income
15-20
Monetary Policy Targets
GDP growth Unemployment Price Stability
New Zealand England European Central Bank
Why not target zero inflation?
15-21
Intermediate Targets
Variable which Tracks policy goal (e.g., inflation) Over which central bank has reasonable
control Three main targets
Money supply Exchange rate Inflation
15-22
Money Supply Targeting
Quantity Theory implies direct relationship between money supply growth and inflation Assume velocity constant Assume real output controlled by real factors
US: money targeting used in early 1980s
15-23
Difficulties in targeting money
Which aggregate to use? Is velocity constant or at least predictable? Can central bank control the money supply? What role do banks play (is money supply
vertical)? What about supply shocks?
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Money Growth, US
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
1959-Jan.
1962-Jan.
1965-Jan.
1968-Jan.
1971-Jan.
1974-Jan.
1977-Jan.
1980-Jan.
1983-Jan.
1986-Jan.
1989-Jan.
1992-Jan.
1995-Jan.
1998-Jan.
2001-Jan.
M1
M3
M2
15-25
Growth rate, monetary aggregates
-0.1
-0.05
0
0.05
0.1
0.15
0.2
0.25
1960 1965 1970 1975 1980 1985 1990 1995 2000
M1M2M3
Source: Federal Reserve Board, Current release. http://www.federalreserve.gov/releases/ Monthly growth rate converted to annual rate and smoothed with moving average filter.
15-26
Exchange Rate Targets
Fix exchange rate against another currency Will tie domestic inflation to foreign inflation
Cost is lack of flexibility in influence on domestic economy
15-27
Inflation Targeting
Specified a target range for realized inflation Allows for discretion in implementation Discretion comes at a price
15-28
Operational Instruments
Short term interest rate Base money Central bank can supply money to or drain
money from the monetary system
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Open market operations
Expand money supply Buy treasury bonds from public Supply public with cash
Decrease money supply Sell treasury bonds to public Remove cash from circulation
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Federal Funds Target
2004
June 30 25 ... 1.25
2003
June 25 ... 25 1.00
2002
November 6 ... 50 1.25
2001
December 11 ... 25 1.75
November 6 ... 50 2.00
October 2 ... 50 2.50
September 17 ... 50 3.00
August 21 ... 25 3.50
June 27 ... 25 3.75
May 15 ... 50 4.00
April 18 ... 50 4.50
March 20 ... 50 5.00
January 31 ... 50 5.50
January 3 ... 50 6.00
Intended federal funds target, 2001 - 2004
Date Decrease Increase Rate
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Money MarketMoney targeting
Inte
rest
Rat
e
Quantity of Money
Money Supply
Money Demand
R
M0
R0
R1
Increase in Money Demand produces rise in interest rate if Money Supply is fixed
15-33
Money MarketMoney targeting
Inte
rest
Rat
e
Quantity of Money
Money Supply
Money Demand
R
M0
R0
R1
Increase in Money Demand produces no rise in interest rate if Money Supply is allowed to increase
15-34
Transmission Mechanism
Official Rate
Market Rates
Asset Prices
Expectations and
Confidence
Exchange Rate
Domestic Demand
Net External Demand
Domestic Inflationary Pressure
Import Prices
Inflation
15-35
Taylor Rules
Nominal Interest Rate
= Equilibrium Nominal Interest Rate
+ λ x Output Gap
+ α x (Inflation – Inflation Target)
15-36
US Interest Rates
Actual Interest Rate Simple Taylor Rule
Source: EcoWin
87 88 89 90 91 92 93 94 95 96 97 98 99 00 012
3
4
5
6
7
8
9
15-37
UK Interest Rates
Actual Interest Rate Simple Taylor Rule
Source: EcoWin
88 89 90 91 92 93 94 95 96 97 98 99 00 01456789
10111213141516
15-38
Summary
Targets Intermediate Instrumental Policy
IS-LM model Intermediate targeting (money supply,
exchange rate and inflation) Transmission mechanism
Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.