Macroeconomics Lecture 8 (FEB 21022X) PDF

MACROECONOMICS (FEB 21022X) Lecture 8 Money, Interest Rates, and Monetary Policy  What Are we Talking About Today? First of all let me state the simple fact that when you deposit money in a bank, the bank does not put the money into a safe deposit vault. It invests your money in many di...

MACROECONOMICS (FEB 21022X) Lecture 8 Money, Interest Rates, and Monetary Policy  What Are we Talking About Today? First of all let me state the simple fact that when you deposit money in a bank, the bank does not put the money into a safe deposit vault. It invests your money in many different forms of credit—bonds, commercial paper, mortgages and many other kinds of loans. A comparatively small part of the money you put into the bank is kept in currency – an amount which in normal times is wholly sufficient to cover the cash needs of the average citizen. In other words the total amount of all the currency in the country is only a comparatively small proportion of the US President F. D. Roosevelt total deposits in all of the banks. 12 March 1933 Run on Banks in the Early 1930s… Bank run in Greece in 2015  Outline of Today’s Lecture 1. Definition of money & its aggregates 2. Money creation a. Central banks b. Commercial banks 3. Money market a. Short-run equilibrium 4. Monetary policy and the role of the central bank a. The Taylor Rule  Varieties of Money Recap: Three functions of money (lecture 5) 1. A store of value 2. Unit of account: makes all prices easily comparable 3. A medium of exchange Some forms of money fulfill these functions more readily than others ⇒ Money is categorized into different monetary aggregates  Monetary Aggregates M1: currency: banknotes and coins (C) + sight deposit accounts at banks (D) M2: M1 Liquidity + savings deposits (or time deposits) at banks M3: M2 + larger, fixed term deposits + accounts at non-bank institutions (e.g. money market fund accounts)  Outline of Today’s Lecture 1. Definition of money & its aggregates 2. Money creation a. Central banks b. Commercial banks 3. Money market a. Short-run equilibrium 4. Monetary policy and the role of the central bank a. The Taylor Rule  Money Creation by Central Bank Central Bank (CB) – legal mandate to control money and credit conditions – issues the currency in circulation (C) – issues reserves (R) that commercial banks hold ⇒ C + R = M0 (monetary base, high powered money, base money, CB money) – CB can use R as an instrument to influence commercial bank money creation (official reserve requirements)  Money Creation by Commercial Banks Commercial banks – issue (short-term) demand deposits (D) Maturity – make (long-term) loans (L) transformation ⇒ M1 = C + D (new deposits are created as new loans are granted) – D: liquid asset that (usually) yields higher return that cash – Maturity mismatch ⇒ bank run risk – Deposit insurance ⇒ bank supervision and regulation Proportion of Monetary Aggregates (Stock)  Fractional-Reserve Banking Money supply (M1) = currency (C) + deposits (D) M1 = C + D Central Bank àC Commercial Banks àD Fractional-reserve banking: commercial banks hold fraction of deposits as reserves at the central bank ⇒ CB can indirectly control D with reserve ratio requirement  Money Multiplier Example: initial cash deposit of 1000 & 10% reserve requirement Loan Loan Loan 1000 900 810 etc. Reserves Reserves 100 90 etc. Chain of deposit and credit creation converges to finite values: Deposits (D) = 10,000 Loans (L) = 9,000 Reserves (R) = 1,000 ⇒ Money Multiplier (also: Reserve Multiplier)  Multiplier Arithmetic What is the total increase in deposits (D) after an initial injection of x = 2,000€ into an economy with a reserve ratio (rr) of 5%? &! ! ! ! + 1 − %% ! + 1 − %% +⋯= = 1 − 1 − %% %% D = (1/rr) ) x ⇒ (1/0.05) ) 2,000 = 20 ) 2,000 = 40,000 R = rr ) D ⇒ 0.05 ) 40,000 = 2,000 Reserve Multiplier = 1/rr Increase in Deposits (D) = (1/rr) ) R Graphically: Reserves and Money Stock 1 R = rr × D Þ D = × R rr Reserves change in reserves ΔR = 2,000 rr = 5% Deposits change in deposits ΔD = 40.000  Balance Sheets Central bank: Commercial banks: Assets Liabilities Assets Liabilities Foreign assets Currency Vault cash and Liabilities to in circulation deposits at Central bank Central bank +2000 +2000 Deposits of Loans to commercial commercial Securities Deposits of banks banks customers +2000 +2000 Reserves +40.000 Deposits of Loans ΔD = 1/rr · ΔR government +40.000 Securities Net worth Net worth  Changes in the Money Multiplier M1= C + D M1 = C + 1/rr!R Change in rr can be a powerful policy tool; so powerful that rarely used Example: By how much do deposits (D) decrease if the reserve ratio (rr) increases from 5% to 6%? (1/0.06 ! R) / (1/0.05 ! R) = 0.83 ⇒ 17% fewer deposits! 30 PART III THE BUILDING BLOCKS OF MACR OECONOMICS Reserve Ratio Requirements: Various Countries Table 9.2 Reserve Ratio Requirements in Selected Countries, 2015 Country Deposits subject to reserve requirements Mandatory reserve ratio requirement Australia None Canada None Denmark None China Deposits at large financial institutions 18.5% Czech Republic Deposits with maturity up to 2 years 2.0% Euro area Deposits with maturity up to 2 years 1.0% Hungary All deposits 2.0% New Zealand None 3.5% Poland All deposits except funds from repurchase agreements Sweden None Switzerland Deposits with maturity up to 3 months 2.5% United Kingdom None Transaction accounts in excess of $15.2m but less than United States $110.2m 3.0% Transaction accounts in excess of $110.2m 10.0% Source: National central banks. Together with the amount of currency in circula- Our second story starts when Mr D requests a  Size of Reserve Ratio in the Euro Area? European Central Bank - Nov 2017 https://www.ecb.europa.eu/press/pr/stats/md/html/index.en.html M1 = 7768 billion euro C = 1110 billion euro R = 122 billion euro What was the reserve multiplier in the euro area in 2017? M1 = C + 1/rr · R ⇒ 1/rr = (M1 - C)/R 1/rr = (7768 – 1110)/122 = 54.57 ⇒ rr = 0.018 = 1.8%  Three Instruments of Monetary Policy How can the central bank control the money supply? M1 = C + D M1 = C + 1/rr · R 1. Reserve requirements: – rr # ⇒ M1$ and rr $ ⇒ M1# 2. Open-market operations: – central bank buys bonds ⇒ R# ⇒ M1# – central bank sells bonds ⇒ R$ ⇒ M1$ 3. Interbank rate (i): – Central bank lowers i $ ⇒ banks borrow more reserves R# & offer cheaper loans L# ⇒ D# ⇒ M1# – i# ⇒ R$, L$, D$ ⇒ M1$  Interest Rates in the Euro Area 2000-2022 EONIA: interbank interest rate steered by the ECB (since 2019 €STR) (Additional Material on Canvas: Digital Currencies and the Future of Central Banking)  Outline of Today’s Lecture 1. Definition of money & its aggregates 2. Money creation a. Central banks b. Commercial banks 3. Money market a. Short-run equilibrium 4. Monetary policy and the role of the central bank a. The Taylor Rule  Demand for Money and the Interest Rate Cambridge equation: MD=kPY Lecture 5: k constant (fraction of income for transactions) Here: k depends on the interest rate (i) = opportunity cost of holding money Demand for money is negatively related to the interest rate: MD=k(i)PY − Short Run Equilibrium on Money Market: Demand Derived demand for M0: Households and firms demand M1 ⇒ banks demand R Interbank rate ⇒ demand for M0 D: MD=k(i)PY M0 Short Run Equilibrium on Money Market: Supply M0s Interbank rate A Equilibrium point A iA D M0 Increase in GDP without Central Bank Reaction Y increases ⇒ money demand goes up: D à D’ For given M0S ⇒ interest rate goes up: A à C with iC > iA M0s C iC Interbank rate A iA D D’ M0 Increase in GDP Accommodated by Central Bank Y increases ⇒ money demand goes up: D à D’ M0S increases ⇒ interest rate constant: A à B M0s M0s’ Interbank rate A B iA D D’ M0  Central Bank Reaction Possibilities Central bank can choose any point along the new demand D‘ (between C and B would mean both M0s and i are higher) C Interbank rate A B iA D D’ M0  Choice of Monetary Policy Strategy Central bank can reach the same money market equilibrium by either setting the interbank rate or the money supply M0s Interbank rate i* D M0  Interest Rate versus Money Supply Two ways to determine the money market equilibrium: 1. Set interest rates (i) à must provide as much M0s as demanded at that rate 2. Set money supply (M0s) à let money demand determine interest rate Both options can lead to the same combination of i and M0s  Historical Example: U.S. before/after central bank Figure 8 Nominal Short-Term Interest Rates, 1890-1933 Before 1914: no central 14 bank; M-demand shocks (esp. after harvests) meet 12 inelastic M-supply (Gold 10 January 1914 Standard) 8 Percent ⇒ Volatile interest rates 6 From 1914 on: Fed sets 4 interest rate and 2 accommodates temporary money demand shocks 0 1890 1893 1896 1899 1902 1905 1908 1911 1914 1917 1920 1923 1926 1929 1932 Time Loans Commercial Paper ! Source: NBER, Macro History Database, www.nber.org. The Time Loan rate is the ⇒ Smooth interest rates interest on 90 day brokers (stock exchange) loans in New York City (Series m13003) and the Commercial Paper rate (Series m13002) is the interest on prime double name 60 to 90 day commercial paper until 1923 and 4 to 6 month paper thereafter. In addition to a “Greenspan put,” today’s Fed has been attacked for lax m  ECB Policy Rates 2012-2022: Zero Lower Bound Constrains Interest Rate Policy ⇒ Unconventional Monetary Policies  Monetary Policies at the Zero Lower Bound 1. Quantitative Easing (QE): – CB buys bonds of longer maturity (government and corporate) – Goal: lower long-term interest rates 2. Forward Guidance: – Central bank announces intentions about future policy – Goal: lower long-term interest rates 3. Monetary Financing (see lecture 15): – CB credits government account at the central bank with reserves – Goal: soften budget constraint for the government’s fiscal branch 4. Helicopter money – Hand out new money to citizens – Goal: income and demand stabilization  Outline of Today’s Lecture 1. Definition of money & its aggregates 2. Money creation a. Central banks b. Commercial banks 3. Money market a. Short-run equilibrium 4. Monetary policy and the role of the central bank a. The Taylor Rule  Objectives of Monetary Policy Objectives of the central bank – Price stability (ECB: 2% inflation) – Employment and economic growth Potential trade-off: – M ↑ ⇒ growth & employment↑ (short run) – M ↑ ⇒ inflation↑ (long run) ECB: price stability focus Fed: both objectives equally important  Instruments and Targets Central bank (CB) can use different instruments to achieve its goals (reserve requirements, open-market operations, interbank rates) – More generally CB can influence interest rates (i) or money supply (M0) Central banks often focus on intermediate targets to achieve their objectives of price stability and output stability: Fixing interest rate Monetary targeting Inflation targeting 1950’s – 1960’s 1970’s – 1980’s Today  Monetary and Inflation Targeting Monetary targeting – Money supply as an intermediate target – Requires stable money demand equation and stable relation between M0 and higher aggregates – Which monetary aggregate (M0, M1, M2, M3) to target? Inflation targeting – Explicit target for inflation – Inflation forecasts play an important role expected inflation high ⇒ increases policy rate expected inflation low ⇒ decreases policy rate Swedish Riksbank's Real and inflation Expected forecast, Inflation: Sweden June 2008 2008 Swedish Riksbank's Real and inflation Expected forecast, Inflation: Sweden June 2008 2012  The Taylor Rule Equation that summarizes central bank behaviour: Y -Y Taylor rule: i = i + a (p - p ) + b Y Price stability Output stability – "! desired inflation (inflation target) – #! desired output (potential output) – a & b objective weights – p > p or Y > Y ⇒ central bank increases i – p < p or Y < Y ⇒ central bank decreases i Natural interest rate ( %& ): – Equilibrium rate at which the economy operates at potential – Determined by structural factors: technological progress, demographics, inequality (Additional Material on Canvas: ECB Chief Economist on low natural interest rates)  Actual Policy Rate versus Taylor Rule Rate U.S. Federal Funds Rate vs Taylor Rule, 1985–2023  Estimates of the Natural Interest Rates Current Debate: What will the natural rate do?  Summary Money creation – Central banks – Commercial banks Short-run money market equilibrium – The augmented Cambridge equation – Money supply versus interest rate policies Monetary policy – Goals, targets, and instruments – Taylor rule – The natural rate and unconventional monetary policies