Introductory Macroeconomics Lecture 9: Monetary Policy I PDF

Introductory Macroeconomics Lecture 9: Monetary Policy I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Monetary Policy, Part One – Basic Monetary Policy Concepts – Monetary Policy in the Lon...

Introductory Macroeconomics Lecture 9: Monetary Policy I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Monetary Policy, Part One – Basic Monetary Policy Concepts – Monetary Policy in the Long Run - the ’quantity theory of money’ – Monetary Policy in the Short Run - implementation in Australia – Monetary Policy Transmission Mechanism BOFAH chapters 9 and 10 2 Basic Monetary Policy Concepts 3  Basic Monetary Policy Concepts Monetary authority (e.g., central bank) decisions to change monetary instruments such as – short-term nominal interest rates – narrow measures of the money supply – exchange rates (e.g., fixed vs. floating) In most countries, underlying goals of monetary policy usually include some combination of – price stability – full employment – financial stability 4  Monetary Policy in Australia Reserve Bank of Australia (RBA), our central bank Legislative objectives of monetary policy in Reserve Bank Act 1959 (1) ‘ stability of the currency (purchasing power of currency) ’ (2) ‘ maintenance of full employment ’ (3) ‘ economic prosperity and welfare of the people of Australia ’ Current interpretations of these legislative goals (1) low and stable inflation (2) unemployment at the natural rate (3) broadly stable macro environment, including financial stability 5  Inflation Target (Goal (1)) Since early 1990s, ‘ low and stable inflation ’ operationalised as an explicit inflation target Statement on Conduct of Monetary Policy between Treasurer and RBA Governor sets out this target – ‘ inflation rate of 2-3 percent on average over time ’ Key points – low average level of inflation – allows for variation over time (temporarily below 2% or above 3% in response to unusual shocks) 6  Reasons for Inflation Target Economic reasons: – average inflation low enough not to significantly distort decisions – provides ‘anchor’ for inflation expectations Institutional reasons: – transparency and accountability – in particular, provides criterion against which to evaluate monetary policy success or failure 7  Natural Rate Hypothesis (Goal (2)) Question: Why interpret ’maintenance of full employment’ as ’unemployment at the natural rate’ ? Answer: The natural rate hypothesis – Theory due to Friedman (1968) and Phelps (1968). – Basic idea is that attempts to push actual unemployment ut far below natural rate u⋆t simply end up increasing inflation without further reducing unemployment. – This threatens the inflation target without delivering a sustained reduction in actual unemployment 8  Monetary Neutrality and Non-Neutrality Another way to conceptualize the natural rate hypothesis is that monetary stimulus is non-neutral in the ’short run’ but neutral in the ’long run’ – Neutrality refers to effect on real variables (real GDP, real interest rates, real wages etc) Key Idea: monetary stimulus in – the ’short run’ increases inflation, nominal GDP and real GDP – the ’long run’ increases inflation, nominal GDP, but not real GDP We should not expect to generate permanent increases in living standards by changing the amount of money in circulation – a very old idea that goes back to philosophers like Hume. 9  Monetary Neutrality and Non-Neutrality Term ‘neutrality’ is used because if all prices increase by the same proportion, π say, then relative prices remain unchanged (1 + π)p1 p1 = (1 + π)p2 p2 Adding or subtracting 000s to prices has no effect on what is actually scarce and what is abundant 10 Monetary Policy in the Long Run (’Quantity Theory of Money’) 11  Quantity Theory of Money Makes precise the implications of long-run monetary neutrality Starting point is the observation that a given amount of money can be used to execute multiple transactions per period We refer to this number as the velocity of money, defined by Pt Yt Vt ≡ Mt So far, this is just a definition. To get the quantity theory of money, we need to add three assumptions: (i) long-run monetary neutrality, Yt = Yt⋆ , independent of Mt (ii) velocity is constant, Vt = V̄ (iii) money supply Mt , is controlled by the central bank 12  Long Run Inflation Given these assumptions we can write the long-run price level as Mt V̄ Pt⋆ = Yt⋆ Growth of a product is the sum of the growth rates so can write π = gP⋆ = gM + gV̄ − gY⋆ Growth rate of V̄ is zero by assumption so long run inflation is π = gM − gY⋆ 13  Long Run Inflation: Examples Example: suppose potential output grows at gY⋆ = 0.02 and the money supply grows at gM = 0.06 then the quantity theory predicts long run inflation is π = gM − gY⋆ = 0.06 − 0.02 = 0.04. Example: suppose potential output grows at gY⋆ = 0.02 and the bank wants to maintain long-run inflation euqal to target, π = π ⋆ = 0.02. Then it needs to ensure gM = 0.04 in the long run. 14  Difficulties with the Quantity Theory Some difficulties with the Quantity Theory of Money include: – Monetary policy does influence output in the short run. It’s a mistake to use the quantity theory to predict short run changes in inflation based on short run changes in the money supply – Velocity is not constant, changes over time due to technologies – The Mt in quantity theory is a broad measure of money supply, proportional to all transactions Pt Yt. But central banks control cash and bank reserves, a narrow measure of the money supply For these reasons, most central banks have abandoned the use of money growth targeting in the conduct of monetary policy 15 Monetary Policy in the Short Run Implementation in Australia 16  Back to the Natural Rate Hypothesis Recall from Lecture 5 that natural rate of unemployment u⋆t is the amount of unemployment when real GDP at potential Yt⋆ – long run monetary neutrality then means we should not expect monetary policy to affect Yt⋆ or u⋆t – short run non-neutrality means that we should expect monetary policy to change output gap and cyclical unemployment Makes estimating u⋆t one of the most controversial topics in macro! 17  Monetary Policy and Demand Management In other words, – should not expect monetary policy to change long run supply-side trend in economic activity – should expect monetary policy to be useful in managing short run demand-driven cyclical fluctuations in economic activity (when there is a shortfall in demand for some reason, interest rates can be cut to stimulate consumption and investment demand) Both monetary and fiscal policy can be use to manage demand – monetary policy more nimble, can change interest rates overnight – fiscal policy is more powerful, more direct but slower (fiscal policy comes more to the fore in deep recessions) 18  Money Demand and Supply in Australia Exchange Settlement Accounts (ESAs) – ESAs used to manage daily transactions, essentially like cash – Banks and financial institutions credit/debit ESAs to settle payment obligations (via RBA’s Information and Transfer System, RITS) ESA balances must be in credit by settlement (usually end of day). – shortfalls require funds borrowed from the overnight cash market – overnight cash is supplied by banks with excess ESA balances/RBA 19  Monetary Policy in Australia RBA targets the cash rate, the interest rate in overnight unsecured (no collateral) interbank loans Actual cash rate managed by a corridor system – floor: 10 basis points (.10%) below target incentive to lend ESA balances above floor, closer to target – ceiling: 25 basis points (.25%) above target incentive to borrow ESA balances below ceiling, closer to target Outside corridor, RBA takes (demands) ESA balances at the floor rate and supplies ESA balances at the ceiling rate Within corridor, prevailing cash rate depends on demand and supply for ESA balances 20 Corridor System 21  Demand and Supply for ESA Balances Net demand for ESA balances from banks themselves and on behalf of customers – RBA forecasts daily demand for ESA balances Net supply of ESA balances controlled through open market operations where ESA balances are traded in exchange for government bonds (i) outright purchases or sales of government bonds e.g., buy government bond, pay with ESA balances, increase supply sell government bond, receive ESA balances, decrease supply (ii) repurchase agreements (repos) e.g. today lend ESA balances collateralised by government bond, temporarily increase supply reversed say 14 days later, return bond, reclaim ESA balances, decrease supply 22 Cash Rate Target 23 Monetary Policy Transmission Mechanism 24  Connection to Other Rates Movements in short-term rates transmit to long-term rates – Consider class of safe assets e.g., bonds with fixed risk characteristics like government bonds – Within this class, short-term and long-term interest rates are linked by arbitrage opportunities. e.g., roll-over short-term position to synthesis a long-term position Rates on riskier assets can be thought of as a rate on safe asset plus risk premium – By moving long-term safe rate, monetary policy also transmits to long-term risky assets, e.g., mortgage rates In this way, changes in short term rates transmit to the most important rates facing households and firms – Longer chain: more links where transmission can break down 25 Monetary Policy Transmission 26 Monetary Policy Transmission 27  Learning Outcomes 1 Be familiar with monetary policy concepts, including the goals of monetary policy and their current interpretation. 2 Understand and explain the concept of money neutrality and its applicability in the long run and short run. 3 Understand and critically evaluate the quantity theory of money. 4 Understand and describe the implementation of monetary policy in Australia, including the use of ESAs and the corridor system. 5 Understand and explain the relationship between the overnight cash rate and its connection with longer term and/or riskier interest rates. 28  New Formula(s) and Notation   PY V the velocity of money = M M quantity of money gx growth of variable x (e.g. gY is the growth in output Y ) 29  Next Lecture Monetary Policy, Part Two – unconventional monetary policy – response to the pandemic – ongoing challenges for monetary policy BOFAH Chapter 10 30