Monetary Policy: Goals and Strategies

Chapter 17: Conduct of Monetary Policy

• Central banks use strategies and tactics in carrying out monetary policy.

Price Stability Goal

• Inflation creates economic and social costs.
• Price stability is achieved by maintaining low and stable inflation.
• A nominal anchor is used to tie down the price level to achieve stability.

Time-Inconsistency Problem

• Discretionary monetary policy can lead to higher inflation without increasing output.
• A nominal anchor limits the time-inconsistency problem.

Other goals of Monetary Policy

• Additional goals include:
  • High employment and output stability
  • Maintaining the natural rate of unemployment
  • Promoting economic growth
  • Ensuring stability of financial markets
  • Maintaining interest-rate stability
  • Stability in foreign exchange markets

Primary Goal Debate

• Hierarchical mandates prioritize price stability before other goals.
• Dual mandates consider price stability and maximum employment as coequal objectives.
• Long-run focus suggests that price stability should be the primary long-run goal.

Inflation Targeting

• Inflation targeting involves announcing a medium-term numerical target for inflation.
• Central banks must show institutional commitment to price stability.
• An information-inclusive approach uses multiple variables.
• Central banks promote transparency and accountability through public announcements

Examples of inflation targeting

• New Zealand has maintained inflation within target, while observing high growth and lower unemployment. It has been effective since 1990.
• Canada has seen decreased inflation since 1991, at some unemployment costs.
• The United Kingdom has kept inflation close to target, with strong growth and decreasing unemployment since 1992.

Advantages of Inflation Targeting

• Reduces time-inconsistency trap
• Enhances transparency and accountability
• Ensures consistency with democratic principles
• Can lead to improved performance

Disadvantages of Inflation Targeting

• Can cause delayed signaling
• May introduce rigidity
• Potential for output fluctuations
• Risk of low economic growth during disinflation

Lessons from the Global Financial Crisis

• The impact of the financial sector was greater than realized.
• The zero-lower-bound problem poses a serious issue.
• High cleanup costs occurred post-crisis.
• Price and output stability do not ensure financial stability.

Implications for Inflation Targeting

• Inflation target level typically around 2%.
• Zero-lower-bound problem raises questions about the target level.
• Flexibility is necessary for financial stability.

Asset-Price Bubbles

• Asset-price bubbles are characterized by pronounced increases in asset prices that depart from fundamental values.
• Credit-driven bubbles and those driven by irrational exuberance are two types of asset-price bubbles.

Debate on Central Bank intervention

• Arguments against intervention:
  • Bubbles are difficult to identify
  • Interest rate adjustments are ineffective
  • May cause harmful aggregate effects
  • Effects are manageable with timely response
• Arguments for intervention:
  • Credit-driven bubbles are costly and hard to clean up
  • Bubbles occur despite price and output stability
  • Leaning against credit booms is preferred to dealing with bubbles

Policies To Restrain Credit-Driven Bubbles

• Macroprudential policies are used to regulate credit markets.
• Central banks use monetary policy to react to credit-driven bubbles.

Choosing The Policy Instrument

• Types of instruments:
  • Reserve aggregates, including total reserves, nonborrowed reserves, monetary base
  • Interest rates, including overnight interest rate and short-term interest rates
• Criteria for instrument selection:
  • Observability and Measurability: Quick, accurate measurement
  • Controllability: Ability to set short-term real interest rates
  • Predictable Effect on Goals: Tight link between interest rates and inflation

Taylor Rule

• Overnight interest rate = inflation rate + equilibrium overnight rate + 1/2 (inflation gap) + 1/2 (output gap)
• Output gap is an indicator of future inflation.
• The NAIRU(Non-Accelerating Inflation Rate of Unemployment) is the rate of unemployment with no tendency for inflation change.

Chapter 26: Transmission Mechanisms of Monetary Policy

• Monetary policy affects the real economy through transmission mechanisms.

Transmission Mechanisms of Monetary Policy

• Monetary policy influences aggregate demand and the overall economy.

Traditional Interest-Rate Channels

• Lowering real interest rates increases investment spending, boosting aggregate demand: r↓→I↑→Yad↑ad↑
• Real interest rates, not nominal, influence consumer and business decisions.
• Real long-term interest rates significantly impact spending.
• Lower real short-term rates lead to lower real long-term rates, increasing investment and consumer spending.

Other Asset Price Channels

• Lower domestic real rates depreciate the currency, making domestic assets less attractive.
• Depreciation boosts net exports and aggregate demand by making domestic goods cheaper.
• Tobin's q Theory: q = market value of firms / replacement cost of capital
  • High q means new capital is cheap relative to market value, boosting investment: r↓→Ps↑→q↑→I↑→Yad↑ad↑
• Wealth Effects: Rising stock prices increase financial wealth, which boosts consumption and aggregate demand.

Credit View

• Asymmetric information in financial markets leads to financial frictions.
• Bank Lending Channel: Expansionary policy increases bank reserves and deposits, raising loan availability and investment spending.
• Balance Sheet Channel: Easing policy raises stock prices, increasing firms' net worth and reducing adverse selection and moral hazard.
• Cash Flow Channel: Lower nominal rates improve firms' cash flow, increasing liquidity and lending.
• Unanticipated Price Level Channel: Unexpected price rises increase real net worth, reducing adverse selection and moral hazard.
• Household Liquidity Effects: Lower rates increase consumer cash flow, reducing financial distress and boosting spending on durables and housing.

Importance of Credit Channels

-Financial frictions affect firms' employment and spending decisions.

• Small firms are more likely to be credit-constrained and hurt by tight monetary policy.
• Asymmetric information explains financial phenomena and the damaging effects of financial crises.

Historical Context

• Great Depression: Deterioration in consumers' balance sheets led to increased financial distress and reduced spending.
• Great Recession:
  • Aggressive easing by the Fed initially seemed effective.
  • Subprime meltdown led to negative effects on the economy through various channels.
  • Financial institutions' deleveraging increased financial frictions, slowing the economy.
  • Credit spreads and declining household wealth further weakened the economy.

Lessons for Monetary Policy

• It is dangerous to always associate easing/tightening with changes in short-term nominal rates.
• Asset prices provide important information about the stance of monetary policy.
• Monetary policy can revive a weak economy even if short-term rates are near zero.
• Avoiding unanticipated price fluctuations is crucial for price stability.

Application to Japan

• Declines in interest rates do not always mean easing policy.
• Pay attention to other asset prices.
• Policy can be effective near zero short-term rates.
• Price stability is an important objective.

Chapter 19: The International Financial System

• Understanding the international financial system

Intervention in the Foreign Exchange Market

• Unsterilized intervention: Selling domestic currency to purchase foreign assets increases international reserves and money supply, depreciating domestic currency.
• Sterilized intervention: Conducting offsetting open market operations to counter foreign exchange intervention has no effect on the monetary base or exchange rate.

Balance of Payments

• Definition: A bookkeeping system for international receipts and payments.
• Current Account: Transactions involving currently produced goods and services (exports, imports, investment income, service transactions, transfers).
• Capital Account: Net receipts from capital transactions.
• Net Change: Current account + capital account = net change in government international reserves.

Exchange Rate Regimes

• Fixed Exchange Rate: Currency pegged to another currency (anchor currency).
• Floating Exchange Rate: Currency value fluctuates against other currencies.
• Managed Float (Dirty Float): Attempt to influence exchange rates by buying and selling currencies.

Historical Exchange Rate Systems

• Gold Standard: Fixed exchange rates, no control over monetary policy, influenced by gold production.
• Bretton Woods System: Fixed exchange rates using U.S. dollar as reserve currency, established IMF, World Bank, GATT.
• European Monetary System (EMS): Exchange rate mechanism.

Fixed Exchange Rate Mechanism

• Overvalued Currency: Central bank purchases domestic currency, loses international reserves, or conducts devaluation.
• Undervalued Currency: Central bank sells domestic currency, gains international reserves or conducts revaluation.

Policy Trilemma

• The trilemma consists of free capital mobility, fixed exchange rate, and independent monetary policy.
• A country must choose two of these policies.

Monetary Unions

• Monetary unions denote groups of countries adopting a common currency.
• The United States (1787) and the European Monetary Union (1999) are examples.

Managed Float

• Managed float systems use small daily changes in response to the market, and interventions to prevent large fluctuations.
• Appreciation hurts exporters, and depreciation stimulates inflation.

Capital Controls

• Outflows promote financial instability, force devaluation, increase capital flight, and lead to corruption.
• Inflows lead to lending booms, excessive risk-taking, block funds for production, create distortions, and lead to corruption.

Role of the IMF

• The IMF functions an international lender of last resort.
• Challenges include limited ability for emerging markets with poor central bank credibility, and moral hazard problems

IMF Operations

• Criticisms: May not be tough enough, focuses on tight macroeconomic policies, and slow responses worsen crises.
• Recent Trends: Countries restrict borrowing until recent subprime financial crises.

International Considerations and Monetary Policy

• Foreign Exchange Effects: Monetary policy is easier with reserve currency.
• Balance of Payments: U.S. deficits suggest a strong dollar, leading to world inflation.
• Exchange Rate Considerations: Contractionary policy strengthens currency, and expansionary policy weakens currency.

Exchange-Rate Targeting

• Keeps inflation under control and presents an automatic rule for monetary policy, improving simplicity and clarity.
• Disadvantages: Cannot respond to domestic shocks, opens the system to speculative attacks, and weakens accountability.

Currency Boards

• Domestic currency is 100% backed by foreign currency with a fixed exchange rate.
• Effects include stronger commitment, loss of independent monetary policy, and the inability to create money or act as a lender of last resort.

Dollarization

• Definition: Adopting another country's currency (e.g., U.S. dollar).
• Effects include a stronger commitment, avoided speculative attacks, and the loss of independent monetary policy, the ability to create money, and seignorage.

Chapter 18: The Foreign Exchange Market

• The foreign exchange market and how exchange rates work

Foreign Exchange Market

• Exchange Rate: Price of one currency in terms of another.
• Market: Financial market determines exchange rates.
• Transactions:
  • Spot Transaction: Immediate (two-day) exchange of bank deposits
  • Forward Transaction: Exchange of bank deposits at a specified future date
• Appreciation: Currency rises in value relative to another
• Depreciation: Currency falls in value relative to another

Importance of Exchange Rates

• Relative Prices: Affects the price of domestic and foreign goods.
• French wine priced at 1000 Euros, exchange rate $1.50 CDN/EUR → price of wine is $1,500 in Canada.
• Effects of Appreciation:
  • Exported goods become more expensive abroad
  • Imported goods become cheaper locally

Trading Foreign Exchange

• Market Organization: Over-the-counter (OTC) market, mainly banks
• Retail Market: Higher prices than wholesale

Exchange Rates in the Long Run

• Purchasing Power Parity (PPP)
  • Theory: Exchange rate ensures a basket of goods costs the same in both countries
  • Real Exchange Rate: Price of domestic goods relative to foreign goods denominated in domestic currency
• PPP Prediction: Long-run real exchange rate equals 1.0
• Price Level Changes: If one country's price level rises, the other country's currency appreciates by the same percentage

Factors Affecting Exchange Rates in the Long Run

• Relative Price Levels: Higher prices lead to depreciation.
• Trade Barriers: Higher tariffs lead to appreciation.
• Preferences for Goods: Increased demand for exports leads to appreciation.
• Productivity: Higher productivity leads to appreciation.

Exchange Rates in the Short Run

• Supply and Demand Analysis:
  • Exchange Rate: Price of domestic assets in terms of foreign assets.
  • Supply Curve: Fixed amount of domestic assets (vertical).
  • Demand Curve: Determined by relative expected return of domestic assets.
• Equilibrium: Intersection of demand and supply curves.

Factors Shifting Demand Curve for Domestic Assets

• Domestic Interest Rate: Increase leads to appreciation.
• Foreign Interest Rate: Increase leads to depreciation.
• Expected Future Exchange Rate: Increase leads to appreciation.

Application: Effects of Changes in Interest Rates

• Domestic Real Interest Rates: Rise leads to appreciation.
• Expected Inflation: Rise leads to depreciation.
• Money Supply: Increase leads to depreciation.

Historical Context

• Global Financial Crisis: Lower U.S. interest rates led to depreciation, followed by appreciation due to "flight to quality".
• Brexit: Lowered expected return on British pound assets, leading to depreciation.

Chapter 14: Central Banks and the Bank of Canada

• Overview and functions of central banks, specifically the Bank of Canada.

Origins of the Bank of Canada

• Established by the Bank of Canada Act in 1934 and operations started in 1935.
• Initially private, nationalized in 1938.
• The Bank of Canada is a federal agency responsible for monetary policy and other tasks.

Structure of the Bank of Canada

• Governor: Chief Executive Officer, leads operations and Governing Council, chairs Board of Directors
• Governing Council: Policy-making body responsible for monetary policy and financial system stability
• Board of Directors: Oversight of management and administration, appoints governor and senior deputy governor

Functions of the Bank of Canada

• Currency: Sole issuer of bank notes since 1945 and adopted a paper standard in 1976
• Funds Management: Fiscal agent for the federal government to manage debt and foreign exchange reserves
• Financial System: Lender of last resort, regulatory oversight of national payments systems, holder of deposit accounts.
• Monetary Policy: Seeks goal to keep inflation low using tools like open market operations.

Independence of the Bank of Canada

• Central Bank Independence: Insulated from bureaucratic and political pressure.
• Instrument Independence: High degree of independence in implementing policy tools.
• Goal Independence: Evolved over time, joint responsibility system since 1961.

Transparency and Accountability

• Increased transparency and accountability, publishes Monetary Policy Report, more press conferences/releases, comprehensive website.

Arguments for Independence

• Long-Run Objectives: Focuses on stable price levels, avoids short-term political pressure.
• Political Business Cycles: Prevents expansionary policies before elections.
• Technical Expertise: Monetary policy requires accumulated experience.

Arguments Against Independence

• Undemocratic: Lack of accountability.
• Coordination Issues: Difficult to coordinate fiscal and monetary policy.
• Effectiveness: Mixed results in using independence successfully.

Explaining Central Bank Behavior

• Public Interest View: Behavior reflects public interest.
• Theory of Bureaucratic Behavior: Maximizes welfare, autonomy, and independence, avoids controversy.

Federal Reserve System

• Structure: Board of Governors, Federal Reserve Banks, Federal Open Market Committee (FOMC), Federal Advisory Council, member commercial banks.
• Independence: High degree of independence, limited political pressure.

European Central Bank (ECB)

• Establishment: Maastricht Treaty (1992), conducts monetary policy for the Euro Area.
• Independence: Most independent central bank, follows charter, long terms for Executive Board members.

Other Foreign Central Banks

• Bank of England: Some instrument independence, government can overrule
• Bank of Japan: Some degree of instrument and goal independence, government can request delays

Chapter 15: The Money Supply Process

• The money supply process involves interactions between three key players.

Three Players in the Money Supply Process

• The central bank oversees the banking system and conducts monetary policy.
• Banks accept deposits and make loans.
• Depositors hold deposits in banks.

Bank of Canada's Balance Sheet

• Liabilities:
  • Currency in Circulation: Bank notes in public hands
  • Reserves: Deposits of LVTS-associated banks held at the Bank of Canada.
• Assets:
  • Securities: Primarily government-issued.
  • Loans to Financial Institutions: Advances made to banks.

Monetary Base

• The monetary base is defined as reserves + currency in circulation.
• Monetary base is controlled through open market operations and advances to banks.

Open Market Operations

• Purchase from a Bank increases reserves, and the monetary base increases.
• Sale has the opposite effect.

Loans to Financial Institutions

• Similar to an open market purchase, it increases reserves and monetary base.

Shifts from Deposits into Currency

• Effect: Public's preference for currency affects reserves but not the monetary base.

Other Factors Affecting the Monetary Base

• BoC has significant control but not absolute due to external factors like government deposits and foreign exchange interventions.

Multiple Deposit Creation

• Single Bank: Banks loan out excess reserves, increasing money supply
• Banking System: Loans create deposits in other banks, leading to further lending

Factors Determining the Money Supply

• Nonborrowed Monetary Base: Positively related to money supply
• Borrowed Reserves: Positively related
• Desired Reserve Ratio: Negatively related.
• Currency Holdings: Negatively related
• Excess Reserves: Negatively related

Money Multiplier

• Refers to the relationship between money supply and monetary base.
• M = m × MB

Intuition Behind the Money Multiplier

• Example: Reserve ratio 10%, currency in circulation $400 billion, checkable deposits $800 billion, excess reserves $0.8 billion, money supply $1200 billion
• Money multiplier value indicates the increase in money supply per increase in the monetary base

Application: Quantitative Easing and the Money Supply (2007–2020)

• Observation: Monetary base grew significantly, but money supply rose less due to changes in currency ratio and excess reserves ratio.

Chapter 16: Tools of Monetary Policy

• Explores the policy tools used for monetary supply.

The Large Value Transfer System (LVTS)

• Operation: Managed by Payments Canada for real-time balance of large-value transactions
• Settlement: End-of-day multilateral netting
• Systemic Risk: Eliminated by requiring positive settlement balances, posted collateral, or lines of credit

Non-LVTS Transactions

• ACSS is an Automated Clearing Settlement System for paper-based items like checks.
• Direct Clearers are a subset of LVTS participants in ACSS.

Bank of Canada's Policy Rate

• Overnight Interest Rate: Rate at which banks borrow/lend overnight funds.
• Policy Rate: Target for the overnight rate announced by the BoC.

Operating Band for the Overnight Rate

• Objective: Keep the rate within a 50 basis points band
• Exceptions: Narrowed band during financial crises and COVID-19 pandemic
• Announcement: Eight fixed dates for changes

Bank of Canada's Standing Facilities

• End-of-Day Balances: LVTS participants must bring balances to zero
• Lending Facility: Provides overnight liquidity for negative balances
• Deposit Facility: Absorbs positive balances

Market for Reserves

• Demand Curve: Quantity demanded increases as the rate paid on reserves decreases
• Supply Curve: Vertical for non-borrowed reserves, flat for borrowed reserves at the bank rate

Limiting Fluctuations in Overnight Interest Rate

• Operating Procedures: Establish limits between deposit rate and bank rate

Bank of Canada's Approach to Monetary Policy

• Inflation Target: Maintain inflation between 1-3%, ideally close to 2%
• Impact on Economy: Changes in the overnight rate influence longer-term rates and exchange rates

Conventional Monetary Policy Tools

• Open Market Operations:
  • Purchases: Expand reserves, lower short-term rates, and raise money supply
  • Sales: Shrink reserves, raise short-term rates, and lower money supply
• Settlement Balances Management: Maintain policy rate through standing facilities
• Standing Facilities: Lending and deposit facilities to manage liquidity

Open Market Operations in Practice

• Repos and Specials: Special PRAs to reduce upward pressure, SRAs to reduce downward pressure.

Bank of Canada Lending

• Standing Facilities: Lend overnight balances to LVTS participants with negative balances.

Beyond Monetary Policy: Lender of Last Resort

• Prevents bank failures and financial panics through Emergency Lending.

Nonconventional Monetary Policy Tools

• Liquidity Provision: Introduce new tools during crises to address liquidity issues
• Large-Scale Asset Purchases: Used significant buying programs during the COVID-19 pandemic
• Forward Guidance: Commitment to future policy actions to lower long-term rates
• Negative Interest Rates: Charge banks for depositing funds to encourage lending

Monetary Policy Tools of the Federal Reserve

• Federal Funds Rate: Primary indicator of monetary policy stance
• Open Market Operations: Make purchases and sales to influence reserves and interest rates
• Discount Lending: Loans to banks at the discount rate
• Required Reserves: Establish reserve requirements for banks
• Interest on Reserves: Pay interest on reserves held by banks

Monetary Policy Tools of the European Central Bank

• Open Market Operations: Main and longer-term refinancing operations
• Lending to Banks: Marginal lending facility and rate
• Deposit Facility: Used for excess reserves
• Reserve Requirements: 2% of checking and short-term deposits, pays interest