Lecture 16 1

Macroeconomic Analysis 2003

Monetary Policy: Transmission Mechanism

http://www.bankofengland.co.ukhttp://www.bis.org

Lecture 16 2

Learning Objectives

• Objectives, instruments and targets of monetary policy

• Transmission Mechanism of Monetary Policy• Keynesian Model

– Impact on output

– Impact on interest rate

• Money Market – Supply and Demand

Lecture 16 3

Basic Points About MoneyOrigin of money with Goldsmiths; Bank of England -1994 What is money?

Currency, Demand and time deposits, Financial assets and other liquid assets

Why do people want money?

Medium of Exchange

Unit of account

Standard for differed payment

Store of Value

Value of Money P1

Classical view Keynesian

and Monetarist View

Lecture 16 4

Objective Targets and Instruments of Monetary PolicyUltimate objective: stability (P, r, E), high growth rate of

output, low unemployment rate Targets: inflation only; or money supply only; or exchange

rate only; all of them; or two of them; or none of them. Instruments: Open market operation on treasury bills -

rediscounting Fixing the interest rate, credit control Money supply rule, reserve requirement Deposit insurance Effectiveness of monetary policy depends upon

Central bank independence and credibility ie, who appoints the governor?

Moral hazards - bank panics, systematic risk, regulation - bank supervision

Lecture 16 5

Officialrate

Marketrate

Assetprices

Exchangerate

Expectationsand confidence

Domesticdemand

Net externaldemand

Domesticinflationary pressure

Importprices

Inflation

Total demand

Bank of England’s View on Transmission Mechanisms of Monetary Policy: How Does Money Supply Affect the Price Level?

Two Conditions to have real effect of Monetary policyCentral bank controls monetary base M1 = R + CuPrices do not adjust instantaneously

riP

MPYGXICriM ,,,,,

YC+I+G

i,r,er,Pe

π

P

X,M

MS

Lecture 16 6

Effects of Changes in the Rate of Interest First round effects

Households: saving, housing, wealth,foreign asset, portfolio allocationsFirms: cost of capital, debt-equity,portfolio allocations

Second round effects: consumptionspending, additional demand for goods

Time lags: anticipated and unanticipatedpolicy changes.

iP

PPiP

1

1 2112

Lecture 16 7B&W Figure 9.7

Percentage increase in prices on a year earlier

Source: Inflation Report, Bank of England, November 2000

Bank of England’s Fan Chart for Forecast of an Economic Variable

Lecture 16 8

nT ri

nri 0

timet00

r

i

T

An Increase in Money Supply Can Lower Real and Nominal Interest Rates in the Short but not in the Long Run

riP

MPYGXICriM ,,,,,

Monetary policy can have some real effect in the short run but not in the long run. Short runs become shorter with more accurate expectations

Fisher Equation

Lecture 16 9

Transmission Mechanisms of Monetary Policy

• Interest rate Channel– Lower interest rate

– More borrowing and Spending

– More aggregate demand

Open Market Operation

• Credit Channel– Lower interest

– More reserves

– More lending

– Higher aggregate demand

Deficit financing

Rediscounting of Treasury Bills

• Exchange Rate Channel– Lower interest rate– Depreciation of domestic currency– More exports and less imports– Higher aggregate demand

Buy back own currencies selling some foreign assets to avoid depreciation - sterilisation

selling its currency to avoid appreciation

• Balance Sheet Channel– Lower interest rate– Increase in prices of stocks,

bonds and other assets– More wealth– More aggregate demand

Moral hazards - bank panics, systematic risk, regulation - bank supervision

Lecture 16 10

Open Market Operation: Interest Rate Channel

Expansionary Monetary PolicyShort run:

Central bank reduces the repo rateCommercial banks and financial institutions

find it profitable to sell bonds to the central bankCentral bank raises their reservesCommercial banks have more money to lendFirms and households find it cheaper to borrowThey borrow and create more depositsDemand for goods and services risesMoney supply expands

Long run:Prices will eventually rise following higher demandReal money supply (M/P) shrinksInterest rises back to natural position

Lecture 16 11

Open Market Operation: Interest Rate Channel• Contractionary Monetary PolicyShort run:

Central bank raises the repo rateCommercial banks and financial institutions find it profitable to buy bonds from the central bank

Central bank sell bonds and reduces reserves of the financial institutions

Commercial banks have less money to lendFirms and households find it expensive to borrowThey pay back loans and close deposits accountsDemand for goods and services fallsMoney supply contracts

Long run:Prices will eventually fallReal money supply increasesInterest rises back to natural position

Lecture 16 12

Central bank Assets Liabilities

Loans to the government Loans to the commercial banks Foreign asset (currency) Gold and other precious metals

Currencies in circulation Reserves of the commercial banks Deposit of the government Claim by foreigners and Net worth

Commercial banks Assets Liabilities

Loans to the government Loans to the private sector Reserves and deposit at the central bank Claim on foreign assets

Deposits of private sector Deposit of the government sector Obligation to foreigners Network

Government Sector Assets Liabilities

Deposit with the commercial banks Deposit with the central banks Loans to foreigners Other assets

Borrowing from the central bank Borrowing from the private sector Foreign debt Network

Private sector Assets Liabilities

Deposit at commercial banks Tangible wealth Currency and precious metal

Loans from the banking system Payment due to the government Network

Assets and Liabilities of the Financial System of An Economy

M4RESERVE

MonetaryBase

Lecture 16 13

Retail Deposits and CashNotes & Coins 30 745

NIB Bank Deposits 44 908Other Bank Deposits 497 768

Building Society Deposits 134 898Total 708 319

Wholesale Deposits

Bank Deposits 285 386Building Society Deposits 10 632

Total 296 018

M4 1 004 337M3 1064 571

Components of M4 in the UK in January 2003 (Million £)

Source: Bank of England

Lecture 16 14

Consolidated Balance Sheet of the Banking System in the UK in January 2003 (Million £)

Source: Bank of England

Asset Type Assets Liability Type LiabilitiesPublic sector loans Sterling 1 186 575 Public sector (CDMMI) Sterling 989 464

Foreing currency 208 764 Foreing currency166 644Private sector loans Sterling 35 554 Private sector (CDMMI) Sterling 29 132

Foreing currency 921 Foreing currency 564Non residents loans Sterling 140 798 Non residents (CDMMI) Sterling 246 211

Foreing currency 1 068 516 Foreing currency1 377 205Public sector Securities Sterling 77 668 Financial derivatives Sterling -3 361

Foreing currency 19 954 Foreing currency11 151Private sector Securities Sterling -2 683 Other Securities Sterling 10 194

Foreing currency 543 Foreing currency28 190Non residents Securities Sterling 24 817 Other liabilities Sterling 238 642

Foreing currency 332 903 Foreing currency82 454Other Assets Sterling 58 384

Foreing currency 23 775Total Sterling 1521 113 Total Sterling 1510 282

Foreing currency 1655 376 Foreing currency1666 208Total Assets 3 176 489 Total Liabilities 3 176 490

CDMMI=Currency deposits and money market instruments.

Lecture 16 15

Quantity Theory of Demand for Money: Classical View

Cambridge equation of money demand: kYP

M =>

PYk

M

1

If Y and V are constants how does the relation between prices and money supply look like? MV=PY P

M Classical dichotomy: Price level is proportional to the

supply of money; no link between monetary and real sectors.

No link between supply of money and the interest rate and the real side of the economy; missing link for Keynes.

Lecture 16 16

MoneySupply

MoneyDemand

Price Level Inflation NominalInterestrate

Link between Money Stock Price Level, Inflation, Nominal interest Rate in the Classical Model

Missing Link for Keynes

Lecture 16 17

Keynesian View on Monetary Policy : Main Points

Monetary affects real economy through the interestrate.

Interest rate is determined by the supply and demandin the money market.

Three kinds of demandSpeculative DemandTransaction DemandPrecautionary Demand

Demand for money is not stable because of chaningvelocity of money. People do not spend and thevelocity is low in depression and high in the boom.

Lecture 16 18

Keynesian View on Monetary Policy : Main Points

rkYP

M

Bonds = Financial Wealth – (M/P)

Money supply is controlled by the policy maker

Interest Interest rate Rate Demand for and Supply of Money Demand for bonds

Increase in MSLower interest rateReduced cost of InvestmentMore investmentMore Aggregate DemandButKeynes Favours Fiscal Policy

Lecture 16 19

Basic Structure of the Keynesian Static Model for Monetary PolicyConsumption: dbYaC (1)

Disposable income: TYY d (2)

Investment: rqIrI 0 (3)

Demand for real balances: rkYP

M (4)

National income identity: GICY (5)

Money Market Equilibrium:

P

MkYr

1

(6)

Aggregate Demand Consistent with Goods and Money Market Equilibrium:

b

GP

MkYqIbTa

Y

1

10

; kq

b

GP

MqIbTa

Y

1

0

(7)

Equilibrium Interest Rate:

P

M

kq

b

GP

MqIbTa

kr

1

0

(8)

Lecture 16 20

Multiplier Effect of Increase in Money Supply on Output and Interest Rate

Shortcoming of the Keynesian Model: Missing Supply Side

PTGMkqbahY ,,,,,,,, (9) Impact on Output from Increase in Money Supply :

0

1

kq

b

q

M

Y

(10)

Impact on Output from Increase in Public Spending:

0

1

1

kq

bG

Y

(11)

Impact on Interest rate from Increase in Money Supply :

011

kq

b

qk

P

Mr

(12)

Impact on Interest rate from Increase in Public Spending:

01

1

kq

b

k

G

r

(13)

Lecture 16 21

Keynesian ModelFiscal Policy is more effective

Monetarist Model:Monetary policy moreEffective

Small Change in public Spendinghas a larger output effect than aLarger change in money supply

Small Change in money supplyhas a larger output effect than abigger change in public spending

Controversy Over Macroeconomic Impacts of Fiscal and Monetary Policies

Is0IS1

LM0

LM1a

b

c IS0

IS1

LM0

LM1

b

GqrIbTaY

1

0

P

MkYr

1

YrDrbrerkP

M

,,,

i

Y

i

Y

Lecture 16 22

Money SupplyVarious types of money: M0, M1, M2, M3, M4 ;

Money multiplier: rm 1 where D

Rr

If we considering a leakage in the currency holding:

crcm

1 where

D

Rr D

Cc

CRM 0 (a)

DCM 4 (b)

then dividing (b) by (a) rcc

RCCD

MM

1

04 .

If people held more currency then multiplier becomes smaller.

What is the value of the money multiplier ifr = 10% and c = 20 %? m = 4.

Lecture 16 23

Money DemandQuantity theory of Money (QTM): MV = PT

Cambridge equation of money demand:

kYPM => PY

kM

1

Keynesian money demand

rkYP

M

Friedman type money demand

kPYM => PYrDrbrerkM

,,,

Lecture 16 24

Friedman (1968) on Monetary Policy

Given the natural rates of interest and unemployment,monetary policy cannot be pegged to lower the interestrate or the unemployment. Is so it only raises inflationaryexpectation and increase in price level. There will be noimpact on real magnitudes.

Monetary authority can control nominal quantities suchas it liabilities, M0, M3 or M4. By controlling them itcan stabilise the price level.

Price mechanism in the market system works better whenprices are stable and relative prices can adjust accordingto the dynamics of the economic system.

Lecture 16 25

Contribution of Monetarism in Macroeconomic Policy

• Supply of money is the determinant of the national income

• In the long run, the influence of money is primarily on the price level and other nominal magnitudes. Real output and employment are not determined by monetary factors.

• In the short run the supply of money does affect the output. Money is the dominant factor in causing cyclical fluctuations in output and employment in the short run.

• Private sector is inherently stable and instability is primarily the result of the government policy.

Lecture 16 26

Exercises• Transmission mechanism of monetary policy:

impact of of interest decision in the economy

• An Open Economy with the interest rate and exchange rate

• Why low interest keeps house prices rising despite fall in the stock prices?

• Money demand: substitution between money and bond.

• Money multipliers