Updates

Demand Functions

• An algebraic equation representing demand as a function of the price plus consumer income levels and other factors

• Example:Linear: QD = a – b × PExponential: QD = A × P-b

,DQ Q P Other Factors

A demand curve is classified as INELASTIC if the elasticity is between 0 and 1

A demand curve is classified as ELASTIC if the elasticity is greater than 1

Unit elasticity (elasticity equal to 1) is the cutoff point

Monetary Policy & Exchange Rates

• The central impact of the foreign currency intervention is on domestic interest rates.

• Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves.

• Monetary policy that does not shift interest rates will not shift exchange rates.

Notes on Price Indices: Quality

• Some categories of goods (computers, cars) observe marked changes in quality over time.

• Price growth rates for these components often reflect the price growth for certain characteristics (e.g. MHz,GB HD, etc.). These are referred to as hedonic price indices.

Problem

• You are a Chinese multinational that wants to construct salaries to be paid to employees in Canada that will provide same living standard as salary of RMB20,000.

• Canada PPP in 2005 is 1.21.

• Some (Anglophone) developed countries have high job separation rates but high job finding rates.

• Developed Asian markets typically have lower job separation rates and lower natural unemployment.

finding seperationJapan 19.30% 0.60%

Germany 6.00% 0.50%Italy 4.10% 0.40%France 7.80% 0.80%

Australia 22.30% 1.70%USA 57.50% 3.60%

Unemployment Dynamics in the OECD, 2008

Michael Elsby, Bart Hobijn, Aysegul Sahin http://www.nber.org/papers/w14617

Continental countries have low job separation rates but very low job finding rates.

St. Louis Fred Dataset

Business Cycles

Chapter 27, 29 p.711-712

P

Y

ASt

Dynamic AS-AD Model: Trend Path

ADt

Yt*

YtP YP

t+1

ADt+1

ASt+1

Y*t+1

Pt*

P*t+1

Demand expansion matches supply expansion

Average Inflation

Ch. 29, 711-712

Chapter 25, 31

Money, Central Banking, and Inflation

Evolution of Money

In more advanced societies with sophisticated banking systems, broad money may be used for transactions.

• Currency: Paper assets issued by central bank• Checking Accounts: Paper promises to pay

definitive money on demand. • Savings Accounts: Electronic Transfers, Credit

Cards, Debit Cards and ATM Cards can be used to transfer funds to.

Interbank Market

Supply

Demand

iIBR

Reserves

i*

Ch. 31, 759-768

Money Supply Multiplier

• The money multiplier can be derived by the ratio of aggregate money to the monetary base.

• As long as the reserve ratio is less than 1, the money multiplier is greater than 1.

• Multiplier is decreasing in reserve-deposit ratio and decreasing in cash-deposit ratio.

1S

CM C D DmmC RMB C R

D D

Open Market Operations

• In an Open Market PURCHASE, the central bank purchases government securities from banks and credits their reserve accounts. This increases the aggregate supply of reserves.

• In an Open Market SALE, the central bank sells government securities from banks and debits their reserve accounts. This reduces the aggregate supply of reserves.

Capital Markets

Chapter 24

Government Surplus• Government surplus is gap between govt

revenue and spending and can be positive or negative.

• If net positive, it adds to the supply of loanable funds.

• If net negative, it adds to the demand for loanable funds.

Consumers become less thrifty(r does not fall, gap made up by capital inflows)

LF

rW

r

1

2 KA

DLF SLF

SLF'

Central Bank Policy Makers reduce interest target- Open Market Purchase

S

D'

iIBR

Reserve Accounts

iTGT'

1

S'

2

D

iTGT

Monetary Policy

Chapter 31

Open Market Practice

• On a daily basis, a central bank will provide instructions to engage in defensive transactions that will adjust supply to keep the interbank interest rate near the target rate.

• Example: If there is an excess demand for reserves, the traders might engage in an open market purchase of bills, increasing the supply of reserves pushing down the rate until it is near the target.

P

Y

AD

An Expansionary Cycle Driven by monetary policy

P*

SRAS

YP

AD′1

2

Output Gap

1. Economy at LT YP.

2. Monetary Policy Cuts Interest Rate

3. Expenditure rises. The AD curve shifts out.

4. Tight labor markets. SRAS returns to long run equilibrium

3

Interest Rate Management

• In most economies around the world, the central bank does not simply act to maintain a fixed interest rate.

• Rather, they manage interest rate changes in response to business cycle conditions.

List of Inflation Targeting CountriesRose A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

HKMA Link KEY GOAL OF CENTRAL BANKS: PRICE STABILITY

Policy Feedback: Taylor Principle• Real interest rate impacts demand for goods in

economy.• Real interest rate is rt = it - E[πt+1]

• When E[πt+1] rises, central bank should increase it

more than 1-for-1 to raise real interest rate, limit demand and limit inflation.

• When E[πt+1] falls, central bank should reduce it

more than 1-for-1 to drop real interest rate, raise demand and avoid deflation.

Learning Outcomes

• Use the model of bank reserves and the forex market to describe the effect of Hong Kong’s monetary policy.

• Use the model of the bank reserves market to qualitatively derive and describe the impact of defensive and dynamic transactions on interbank rate and quantity of reserves.

• Use the model of the money market and AS-AD to qualitatively derive and describe the impact of monetary policy transactions on the economy.

• Use the Taylor rule to quantitatively describe the impact of economic conditions