Money and Stabilization Policy

Students should be able to:• Distinguish between money base and other definitions of money, and

explain the relationship between the reserve ratio and the potential and actual money multiplier.

• Describe the tools the central bank can use to change the monetary base and the money supply.

• Discuss the determinants of velocity and money demand.• Identify the equation of exchange and discuss its implications for long-run

inflation • Compare and contrast the short-run and long-run impact of anticipated

and unanticipated monetary policy on prices output and real and nominal interest rates.

• Compare the benefits and costs of activist vs. non-activist stabilization policies.

• Discuss the benefits of a monetary regime that targets stable prices.

Money

• Money is a tool for conducting transactions and, like all tools, is subject to technological advance.

• Barter was replaced by commodity money, precious metal with intrinsic value.

• Problems (Issues) with commodity money– Commodities used as money can’t be used for other

purposes.– Supply of money determined by availability of resources.– Government must share the revenues from the creation of

money (Perhaps only a problem from governments point of view).

Fiat Money

• Fiat money is intrinsically valueless commodity (typically paper) widely accepted as payment rendered (by government command.

• First paper money circulated in Szechwan province during the Northern Sung dynasty. Szechwan had iron coins which are heavy and rusty. Banks issued receipts for the coins called chiao-tzu which circulated as the origins of paper money.

• In 1161, under the Southern Sung dynasty, the government developed a paper called hui-tzu which eventually developed into first nationwide paper money.

Role of Money

• Money has 3 roles

1. Medium of Exchange – Money is a technology for engaging in transactions.

2. Unit of Account – Value of most goods and assets is measured in money.

3. Store of Value – Money is an asset. It can be exchanged for goods in the future.

Central Bank• Governments in most countries create quasi-

governmental semi-independent organization called Central Bank – Hong Kong: Hong Kong Monetary Authority– USA: Federal Reserve Bank– Bank of England, Bank of Japan, Bank of Canada etc. – European Central Bank

• Central Bank will typically print currency and clear check transactions.

• Central Bank accepts deposits (clearing balances) by private sector banks that issue checks.

Monetary Base

• Monetary Base is Cash + Bank Reserves• Monetary Base is the cash directly under the

control of the central bank.• Monetary Base is the money used for final

settlement. – When the customer of Bank A receives (as

payment for goods) a check drawn on Bank B, that transaction is finalized by debiting Bank B’s clearing balances in favor of Bank A’s.

Monetary Base of HKMA

Jul-05: Total Monetary Base 279682: Cash (Certificates of Indebtedness) 146075Coins 6768Clearing Balances 1355Exchnange Fund Bills 125484

Definitions

• Clearing Balances: The sum of balances maintained by banks in reserve accounts and clearing accounts at the central bank. In Hong Kong, this refers to the sum of the balances in the clearing accounts.

Definitions Pt. 2

• Certificates of Indebtedness Certificates issued by the Financial Secretary to be held by note-issuing banks as cover for the banknotes they issue. “When the three NIBs issue banknotes, they are required

to submit US dollars (at HK$7.80=US$1) to the HKMA for the account of the Exchange Fund in return for Certificates of Indebtedness (which are required by law as backing for the banknotes issued).”

Certificates of Indebtedness: Spike every January

7-Sep-1999 19-Jan-2001 3-Jun-2002 16-Oct-2003

140000

135000

130000

125000

120000

115000

110000

105000

100000

95000

90000

85000

80000

HK: Monetary Base: Before Discount Window: Certificates of IndebtednessHKD mn

In HK, Secondary Reserves are part of the monetary base.

• Exchange Fund Bills and Notes Debt Instruments issued by the HKMA for the account of the Exchange Fund. These instruments are fully backed by Foreign Reserves. The HKMA has undertaken that new Exchange Fund paper will only be issued when there is an inflow of funds.

Hong Kong Exchange Fund Bills &Notes

0 20000 40000 60000 80000 100000 120000 140000

Total

Banks

Nonbanks

HK

$ M

illi

on

Exchange Fund Notes

Series1

Types of Money

1. Monetary Base: Cash + Bank Reserves

2. M1 – Cash + Demand Deposits

3. M2 – M1 + Savings Deposits & ‘Some’ Time Deposits & CD’s

4. M3- M2 + Other Time Deposits &CD’s

Monetary Aggregates in HK(Nov. 2002)HK Money Supply Jun 2005

0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

M1 M2 M3

HK

$ M

illi

on

Monetary Aggregates• Real world Different assets

have different levels of usefulness in transactions.

• Money is measured in sums of these assets.

• M2 & M3 include less liquid assets and are called broad money.

• M1 is the most liquid type of money and is sometimes called narrow money.

• The difference between M2 and M1 is called quasi-money.

Assets

M1 Currency in Circulation+ Checking Deposits

M2 M1 + Other Deposits (Savings, Time, CD’s) at Fully Licensed Banks

M3 M2 + Deposits at Finance Companies

Changing the Monetary Base

• Monetary Base is changed by the central bank through transactions which change the level of liabilities and assets of central bank.

1. Open Market Operations: Central Bank buys or sells securities in financial markets.

2. Discount Window: A Loan of Domestic Currency to Domestic Bank

3. Currency Market Intervention: Central Bank buys or sells currency.

Open Market Operations

• Central banks typically (though not in HK) change the money supply through open market operation (OMO). An OMO is the purchase or sale of government bonds by the central bank.

• In an open market purchase, the central bank prints new money and uses it to buy bonds from banks. This increases the supply of money in the short run.

• In an open market sale, the central bank sells some of its stock of bonds and receives existing money in exchange. This reduces the supply of money in the short run.

Currency Board

• Central bank in HK adjusts the monetary base automatically through a currency board.

• When banks want to hold more HK dollars, the central bank will sell them clearing balances as many US dollars as they would like at fixed exchange rate.

• When banks want to hold fewer HK dollars, the central bank will buy balances them in exchange for HK dollars. – In long term, the HKMA will convert clearing balances into

Exchange Fund paper and vice versa.

Money Multiplier

• The overall money supply is a multiple of the monetary base.

• The central bank adjusts the monetary base directly.

• A $1 adjustment in the monetary base will result in a multiple of $1 adjustment in overall money supply.

Fractional Reserve Banking

• Money supply mostly consists of bank deposits.

• Since the earliest days of banking at the armories of goldsmiths, bankers have kept only a fraction of deposits as reserves and lent out the rest.

• Define bank reserves to deposit ratio as rd. Reserves

Depositsrd

Money multiplier: Monetary Expansion

• A central bank buys government bonds from banks increasing their reserves.

• They keep only a fraction and lend out the rest. • Borrowers will spend the money which will (in large

part) then be put back into the banking system creating additional bank deposits.

• This money will then be lent out again and money will be returned to the banking system.

• The feedback loop will repeat ad infinitum

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

Example: rd = .1, Cash holdings zero

• Central Bank increase reserves by $1.

• Step 1

• Bank lends $1. Comes back in deposits.

• Bank keeps $rd in reserves and lends out $1-rd. Comes back in deposits. Bank keeps $rd(1-rd) in reserves. Lends out (1-rd)^2. Comes back in deposits.

Money Multiplier Process

OMO 1Reserve Loan

1st Deposit 1 0.1 0.92nd Deposit 0.9 0.09 0.813rd Deposit 0.81 0.081 0.7294th Deposit 0.729 0.0729 0.65615th Deposit 0.6561 0.06561 0.590496th Deposit 0.59049 0.059049 0.531441

Total Money 4.68559 Sun of Reserves +Final Loan1

Process Keeps Going

Money Multiplier (aka Deposit Multiplier)

• Money is generically cash plus bank deposits.

• Monetary base is cash plus reserves

• Money multiplier is determined by the reserve ratio and the cash to deposit ratio.

• Both cash and reserves are leakages to money multiplier process.

Reserve

1

Reserves

CashDeposits

Cash sDeposits Deposits

Money Cash Deposits

Base Cash

Monetary Feedback

BorrowerBorrower

DepositorDepositor

BanksBanks

Central BankCentral Bank

ReservesReserves

rdrd

CashCash

Required Reserves

• In many banking systems (though not HK), the bank regulators will require a minimum fraction of reserves be kept for every $1 of deposits, rr.

• Banks may keep excess reserves beyond minimum requirements for their own reasons.

Excessrd rr

Deposits

Reserves

Potential Deposit Multiplier

• If no one holds any cash, the money/deposit multiplier is

• If the excess reserve ratio or the cash-deposit ratio go up, the actual money multiplier will be lower.

1

rr

Velocity/Liquidity

• Define the ratio of transactions to the supply of money as ‘Velocity’, the speed with which money circulates.

• The value of transactions is nominal GDP.• The inverse of velocity is the willingness to

hold money between transactions or the willingness to hold a liquid position, L

Nominal 1

PriceGDP

V Money Demand GDPMoney Velocity

Equation of Exchange

• We can rewrite the definition of velocity as

• Quantity Theory of Money says that velocity is constant.

Money Velocity Nominal GDP Price Quantity

Keynes Insight

• Demand for liquidity is determined by the interest rate.

• If interest rate is high, the opportunity cost of holding low interest paying liquid assets is high.– Households are willing to give up the convenience of

money if transactions costs are high.

• If interest rate is low, low cost to hold non- interest paying money.

• Velocity is an increasing function of the interest rate.

Money Demand

Q: Why does the money demand curve slope down?

A: The greater is the nominal interest rate, the greater is the opportunity cost of holding money.

Q: What shifts the money demand curve?

A: An increase in the nominal GDP will increase the need for money for transactions. This will shift the demand curve out. A reduction in nominal GDP will shift the demand curve in.

Money Market

i

L

Money Demand

i*

Money*

Money Supply

Channel of Monetary Policy

• When the central bank increases the money supply, banks have excess liquidity which they use to make more loans.

• The supply of loanable funds increases pushing down interest rates.

• Lower interest rates implies an increase in borrowing and demand for consumer durables, housing and capital goods.

• Aggregate demand shifts out. Given fixed input prices this increase in demand stimulates output.

Dynamics of Monetary Transmission

• It is often said that there are long and variable lags in the monetary transmission mechanism in that it might take several quarters for the strongest effects of monetary policy on demand to appear plus it is difficult to predict how long exactly it will take for monetary policy to have its intended effects.

Money Market: Monetary Expansion

i

Liquidity

Money Demand

i*

Money*

Money Supply

i*

1122

Loanable Funds Market: Expansionary Monetary Policy

i

L

LD

LS

i*

L*

11

22

Holding Holding inflation inflation expectations expectations constant, real constant, real interest rate interest rate declinesdeclines

P

GDP

GDPLR

AD

Short-run Response to a Positive Monetary Shock

AS

PE

P**

AD′

Q2

11

22

Decline in real interest rate Decline in real interest rate stimulates investment stimulates investment spending. spending.

Interest Rate Policy

• Many central banks, including the US Federal reserves set their policy in terms of interest rate targets.

• The central bank uses its money printing power to determine interest rates.– When the central bank lowers the interest rate,

they engage in open market purchase.– When the central bank raises the interest rate,

they engage in an open market purchase.

HK Monetary Policy

• Under HK’s monetary policy of a fixed exchange rate, the central bank commits to keeping the interest rate at the level of the US$.

• When demand for money in HK goes up, HKMA must increase the money supply.

• When demand for money in HK goes down HKMA decreases money supply.

HK Money Market: Money Demand Expansion

i

L

Money Demand

iUS$

Money*

Money Supply

HK Money Market: Money Demand Contraction

i

L

Money Demand

iUS$

Money*

Money Supply

HK Money Market: Money Demand Contraction

i

L

Money Demand

iUS$

Money*

Money Supply

Long Run Effects

• With prices above the expectations that were priced into input contracts, input providers are unhappy. When they can redo their contracts, they will update their expectations according to market conditions.

• Over time higher input prices will be priced into output prices, resulting in less supply at any price.

• Price expectations keep rising as long as market prices are greater than expected.

• SRAS keeps shifting up until price expectations are in line with actual conditions.

P

GDP

GDPLR

AD

Over time prices shift up and equilibrium output reverts to trend.

AS

PE

Q2

P2

AD′

PE2

P3

22

33

P

GDP

GDPLR

AD

Ultimately, only an increase in the price level.

AS

PE

Q2

AD′

PE 4433

22

∞∞

11

Persistent Money Growth

• A government may persistently increase the money supply. We know that perpetual increases in money will lead to perpetual increases in price levels.

• Assume that money demand is proportional to number of tranactions.

• Given money supply is equal to money demand

Money Demand = ×Nominal GDP

Money = ×Price×Real GDP

P

GDP

GDPLR

AD

When monetary expansion is expected it will only lead to higher prices

AS

PE

AD′

PE

11

22

Inflation and Money Growth

• In long run, the Quantity Theory tends to hold true as velocity does not grow over time.

• Approximately speaking, the growth rate of a product is equal to the sum of the growth rates of a product.

• Long-term inflation will keep up with money supply growth.

Money Growth Rate = Inflation Rate+Output Growth Rate

Long Term Inflation & Money GrowthCross Country Comparisons

Long Run Effects of Money Expansion on Interest Rates

• In long run, since money demand increases due to higher inflation, increasing money supply does not increase funds available in loanable funds market in long run but…

• High persistent inflation means high interest rates due to high inflation and the Fischer Effect

Rising Expected Inflation

i

L

LD

LS

i*

L*

πA πA

πA

r*

Monetary Policy and Interest Rates

• In the short-run, an increase in the level of the money supply will increase liquidity and push down the nominal and real interest rate (liquidity effect).

• In the long-run, persistent expansion in money supply will lead to high inflation and inflation expectations (Fisher effect).

Stabilization policy

• In an economy subject to shocks to aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism.

• However, if this self-correction mechanism takes a long time to work because contracts are long-lasting or expectations take a long time to adjust to reality, then central bank can use monetary policy to speed adjustment.

P

GDP

GDPLR

AD

Negative Demand Shock

SRAS

PE

P2

AD′

Q2

22

11

P

GDP

GDPLR

AD′′

During the recession, the central bank expands money supply.

SRAS

PE

P2

AD′

Q2

221,31,3

Expansionary Policy in Recessions

• By expanding the money supply when the economy is below trend, the central bank will stimulate investment when other types of demand are low.

• The central bank can reduce unemployment with out increasing long-term price expectations and leading to long-term inflation.

P

GDP

GDPLR

AD

Positive Demand Shock

SRAS

PE

P2

AD′

Q2

22

11

P

GDP

GDPLR

AD′′

During the boom, the central bank contracts the money supply.

SRAS

PE

P2

AD′

Q2

22

1,31,3

Contractionary Policy During Booms

• The job of the central banker is to take away the punch bowl just when the party is getting started.

• By raising interest rates when the economy is booming the central bank can offset high demand and avoid inflation.

Activism Debate

• Activists believe that the government should examine the state of the economy and conduct monetary policy.

• Nonactivists believe that the governments power to intervene should be limited.

ActivistsActivistsNonNon

ActivistsActivists

US Recessions are becoming shorter as stabilization policies were adopted.

Average Length of Contraction

0

5

10

15

20

25

1854-1919 1919-1945 1945-2001

Mo

nth

s

Zero Lower Bound on Interest Rates

• Nominal interest rates cannot go below zero – no one will lend money at an interest rate below that of money itself.

• In Japan, central bank increased money supply to get the economy out of a recession. Pushed the interest rate to zero.

• Once the zero lower bound was reached monetary policy has no effect.

Money Market

i

Liquidity

Money Demand

i*

Money*

Money Supply

0

11

22 33

Problems with Stabilization

• Monetary policy has effect with a lag. If lags are long enough, they may act to destabilize the economy.– The economy is booming so the Central bank

contracts money supply.– But the self-correction mechanism kicks in before

the effect on AD. – Economy is sent into a recession

P

GDP

GDPLR

AD′′

During the boom, the central bank contracts the money supply.

SRAS

PE

P2

AD′

Q2

SRAS′

Q3Q4

11

22

33

Policy Lags

• There are a number of types of lags for implementing monetary policy stabilization

1. Recognition Lags – It takes time for info about the economy to be obtained to allow the central bank to act.

2. Administrative Lags – It takes time for the institutional structure of the central bank to agree on the policy and implement.

3. Impact Lags – Once interest rates drop it takes time for firms and households to adjust investment expenditure and housing investment. It takes time for policy to have an effect on demand.

Reducing Recognition Lags

• Central Banks closely monitor economic conditions to minimize time to recognize business cycle shocks.

• Central banks construct large computer models of the economy in order to forecast the economy and predict the effects of certain events.

• Central banks collect economic measurements of various series. Movements in some series may be good predictors of the economy.

Using financial market data to predict business cycles

• It has been joked that stock markets have predicted 7 out of the last 5 recession.(In fact there does seem to be a moderately strong, positive

correlation between cyclical variation in stock prices and business cycles)

• In the USA, some financial market indicators have been shown to predict business cycles.– Default Spread : Interest rates on lower rated bonds vs.

Interest rates on better rated bonds.– Term Spread: Interest rates on long-term bonds vs. short-

term bonds (when this is inverted, recession is likely)

Policy Mistakes

• During the 1960’s and 1970’s in USA and elsewhere, the central bank habitually underestimated the natural rate of unemployment.

• Attempted policy interventions to stimulate economy which resulted in accelerating inflation.

P

GDP

True

When true potential output was below estimate

AS

PE

AD′

PE↑

EstimateEstimate

11

22

AD

AD′′

33

AD′′′

44

55

66

Discretion vs. Rules

• Some economists argue that policy makers should have the freedom to set the best possible policy at any point in time.

• Others argue that the government is likely to abuse stabilization power for short-term advantage. Therefore, government policy should be bound by strict rules which limits its freedom

Inflation Bias

• Government may want popularity in the short-term, such as for an upcoming election.

• If popularity can be obtained through an economic boom, there may be a tendency to push up the economy which would be inflationary.

Prices in the USA

Dec-1923 Dec-1943 Dec-1963 Dec-1983 Dec-2003

200

180

160

140

120

100

80

60

40

20

0

US: Consumer Price Index: Urban1982-84=100

Rational Expectations Revolution• Standard business cycle theory built around the idea that

price expectations and long-term contracts adapt over time to observable business cycle conditions.

• Economist Robert Lucas argues that this assumption underestimates the intelligence of people.– If you observe the economy operating above full employment, you

know that prices will be accelerating in the future. You should take this into account in setting your expectations.

– Self-correcting mechanism of the economy should kick in relatively quickly.

– Systematic policies to expand the economy should be anticipated and have no effect on output even in the short-run.

P

GDP

GDPLR

AD

Under rational expectations, systematic policy to expand demand should be fully anticipated.

AS

PE

AD′

PE

11

22

Not rational Not rational to expect to expect this price to this price to continue.continue.

Inflation Targeting Rules

• In modern era, most central banks commit themselves to price stability by announcing predictable and low levels of target inflation.

• This is done explicitly by Bank of NZ, Bank of England, ECB and implicitly by the US Federal Reserve.

Advantages of Inflation Targets• Price stability in effect acts as cyclical

stablization policy.– When prices are pushed upward by business cycle

forces, the money supply contracts through an inflation target policy and interest rates rise, pushing aggregate demand down.

– When prices are pushed downward by business cycle forces, the money supply expands as

• No inflationary bias.• Financial markets find it easier to predict

inflation and less inflation risk in long-term bonds.

P

GDP

GDPLR

AD

Positive Demand Shock requires counter-veiling policy to stabilize prices.

SRAS

P=PE

P2

AD′

Q2

TargetTarget

AD

11

22

P

GDP

GDPLR

AD

Negative Demand Shock requires counter-veiling policy to stabilize prices.

SRAS

P=PE

P2

AD′

Q2

TargetTarget

AD

22

11