Transcript Chapter 22 - McGraw Hill Higher Education

Chapter 22: Stabilizing the
Economy: The Role of the
Central Bank
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Learning Objectives
1. Describe the structure and responsibilities of the
central bank
2. Analyze how changes in real interest rates affect
planned aggregate expenditures and short-run
equilibrium output
3. Define what a monetary policy rule is and relate this
concept to the central bank's role in stabilization policy
4. Show how the demand for money and the supply of
money determine equilibrium nominal interest rate
5. Discuss how the central bank uses control of the
money supply to influence nominal and real interest
rates
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The Central Bank Watch
Analysts attempt to forecast the central
bank’s decisions about monetary policy
 Central
bank’s decisions have significant effects
on financial markets and the macro economy
Monetary policy is a major stabilization tool
 Quickly
decided and implemented
 More flexible and responsive
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The Central Bank
 Responsibilities of the central bank are
 Conduct
monetary policy
 Oversight and regulation of financial markets

Central to solving financial crises
 The Central Bank System dates back to
1668
 The
first institution recognized as a central bank
was established in Sweden under the name Riksens
Ständers Bank
 England established the Bank of England in 1694
 The United States created the Federal Reserve
(Fed) in 1913
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The Central Banks in MENA
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The Central Bank’s Role In Stabilizing
Financial Markets: Banking Panics
 Motivation for creating the central bank was to stabilize
the financial markets and the economy
 Banking panics occur when customers believe one or
more banks might be bankrupt


Depositors rush to withdraw funds
Banks have inadequate reserves to meet demand


Banks close
This is commonly described as a run on a bank or bank
run.
 Central bank prevents bank panics by


Supervising and regulating banks
Loaning banks funds if needed
 The U.S. Federal Reserve did not prevent the bank
panics of 1930 – 1933
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Bank Panics, 1930 - 1933
 One-third of the banks closed
 Increased
the severity of the Great Depression
 Difficult for small businesses and consumers to get
credit
 Money supply decreased
 With no federal deposit insurance, people
held cash
 Feared
banks would close and they would lose
their deposits
 Holding cash reduced banks' reserves

Lower reserves decreases the money supply by a
multiple of the change in reserves
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The Central Bank and the Economy
Eliminate output gaps by changing the
money supply
Changes in money supply cause
changes in nominal interest rate
Interest rates affect planned aggregate
expenditures, PAE
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Can the Central Bank Control The Real
Interest Rate?
 Central bank controls the money supply to
control nominal interest rates, i
 Investment
and saving decisions are based on the real
interest rate, r

Central bank has some control over the real interest rate
r=i-
where  is the rate of inflation
 The central bank has good control over i
 Inflation changes relatively slowly
 Changes
rates
in nominal rates become changes in real
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The Role of Interbank Rate in Monetary
Policy
 The interest rate that is most closely watched
by the public, politicians, the media, and the
financial markets is the interbank rate
 The
interbank rate is the interest rate
commercial banks charge each other for very
short-term (usually overnight) loans
 It is not an official government interest and
therefore not linked to the government
 However, enormous attention is paid to this
interest rate because most central banks express
their policies in terms of the interbank rate
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The Role of Interbank Rate in Monetary
Policy
 In practice the central bank affects the money
supply through its control of bank reserves
 Because open-market operations directly
affect the supply of bank reserves, the central
bank’s control over the interbank rate is
particularly tight
 Example:
if the central bank wants the interbank
rate to fall, it conducts open-market purchases,
which increase reserves
 However, the central bank could probably signal
their intended policies just as effectively in terms
of another short-term nominal interest rate, such
as the rate on short-term government debt
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The Turkish Interbank Rate, 1987–2010
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Planned Spending and Real Interest Rate
PAEs have components that are affected by
r
 Savings


decisions of households
More saving at higher real interest rates
Higher saving means less consumption
 Investment

by firms
Higher interest rates mean less investment
• Investments are made if the cost of borrowing is less than
the return on the investment
Both consumption and planned investment
decrease when the interest rate increases
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Interest in the Keynesian Model – An
Example
 Components of aggregate spending are
C = 640 + 0.8 (Y – T) – 400 r
IP = 250 – 600 r
G = 300
NX = 20
T = 250
 If r increases from 0.04 to 0.05 (that is, from
4% to 5%)
 Consumption
decreases by 400 (0.01) = 4
 Planned investment decreases by 600 (0.01) = 6
 A one percentage point increase in r reduces
planned spending by 10 – before the multiplier
is considered
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Planned Aggregate Expenditures
PAE = C + IP + G + NX
PAE = 640 + 0.8 (Y – 250) – 400 r + 250 – 600 r
+ 300 + 20
PAE = 1,010 – 1,000 r + 0.8 Y
In this example, planned aggregate expenditure
depends on both the real interest rate and the
level of output
 Equilibrium
output can only be found once we know
the value of r
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Planned Aggregate Expenditures
PAE = 1,010 – 1,000 r + 0.8 Y
Suppose the real interest rate is 5%, or 0.05
Planned aggregate expenditures becomes
PAE = 1,010 – 1,000 (0.05) + 0.8 Y
PAE = 960 + 0.8 Y
Short-run equilibrium output is PAE = Y
Y = 960 + 0.8 Y
0.2 Y = 960
Y = $4,800
The graphical solution is the same as before
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The Central Bank Fights A Recession:
Monetary Policy
Recessionary Gap
r
C, IP 
PAE 
Y  via the
multiplier
PAE 
Y  via the
multiplier
Expansionary Gap
r
C, IP
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Monetary Policy for a Recessionary Gap
PAE = 1,010 – 1,000 r + 0.8 Y
 The real interest rate, r, is 5%

Short-run equilibrium output is $4,800
 Potential output is $5,000

Recessionary gap is $200
 Multiplier is 5
 Monetary policy can be used to increase PAE

The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
 The central bank should decrease the real interest
rate to 1%
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Planned aggregate expenditure (PAE)
The Central Bank Fights a Recession
Y = PAE
Expenditure line (r = 1%)
Expenditure line (r = 5%)
F
E
4,800 5,000
Y*
A reduction in r shifts the
expenditure line upward and
closes the recessionary gap
Output (Y)
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The Central Bank Fights Inflation
 Expansionary gap can lead to inflation
 Planned
spending is greater than normal output
levels at the established prices
 Short-run unplanned decreases in inventories
 If gap persists, prices will increase
 The central bank attempts to close
expansionary gaps
 Raise
interest rates
 Decrease consumption and planned investment
 Decrease planned aggregate expenditures
 Decrease equilibrium output
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Monetary Policy for an Expansionary Gap
PAE = 1,010 – 1,000 r + 0.8 Y
 The real interest rate, r, is 5%

Short-run equilibrium output is $4,800
 Potential output is $4,600

Expansionary gap is $200
 Multiplier is 5
 Monetary policy can be used to decrease PAE

The first change in spending required is 200 / 5 = 40
1,000 (change in r) = 40
Change in r = 40 / 1,000 = 0.04
 The central bank should decrease the real interest
rate to 9%
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Planned aggregate expenditure (PAE)
The Central Bank Fights Inflation
Y = PAE
Expenditure line (r = 5%)
Expenditure line (r = 9%)
E
G
4,600 4,800
Y*
An increase in r shifts the
expenditure line down and
closes the expansionary gap
Output (Y)
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Monetary Policy Rule
Expansionary Gap
Recessionary Gap


r
r
Planned C and I 
Planned C and I 
PAE 
PAE 
Y
Y
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 The monetary policy rule
shows the action a central bank
takes in response to changes in
the economy
 Target inflation rate, *, is the
central bank's long-term goal
for inflation
 Target real interest rate, r*, is
the central bank's long-term
goal for the real interest rate
 If  > *, then r > r*
 If  < *, then r < r*
Real interest rate set by central
bank (r)
Monetary Policy Rule (MPR)
MPR
A
r*
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*
Inflation ()
24
Monetary Policy Rule Example
 The table describes the central bank's reaction function

The central bank's target interest rate is 4% and its target
inflation is 2%
Actual Inflation, 
Actual Real Interest Rate Set
by the central bank, r
0.00 (0%)
0.02 (2%)
0.01
0.03
0.02
0.04
0.03
0.05
0.04
0.06
 If the inflation rate reaches 3%, the central bank sets the
interest rates at 5%
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 The slope of the MPR
shows how aggressively
the central bank will
pursue inflation targets
 If MPR is quite flat, the
central bank responds to
a given change in
inflation with a small
change in interest rates
 Central
bank is not very
aggressive
Real interest rate set by Central
Bank, r
Monetary Policy Rule Example
MPR
0.06
0.05
0.04
0.03
0.02
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0.01 0.02 0.03 0.04
Inflation 
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The Central Bank and Interest Rates
Money supply and demand determine the
interest rate
 Central
bank manipulates supply to achieve its
desired interest rate
Portfolio allocation decisions allocate a
person's wealth among alternative forms
 Diversification
is owning a variety of different
assets to manage risk
The demand for money is the amount of
wealth held in the form of money
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Demand for Money
 Demand for money is sometimes called an
individual's liquidity preference

The Cost – Benefit Principle indicates people will
balance the marginal cost of holding money versus the
marginal benefit



Money's benefit is the ability to make transactions
Quantity of money demanded increases with income
Technologies such as online banking and ATMs have
reduced the demand for money


In Turkey, money holdings in the form of cash and checking
account balances (M1) were about 43 percent of M2 in 1986
and decreased to 23 percent in 2010
In contrast, Morocco money holdings were 84 percent in
2001 and increased to 85 percent in 2010
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Demand for Money
 The marginal cost of holding money is the
interest foregone
 Most


forms of money pay little or no interest
Assume the nominal interest rate on money is 0
Alternative assets such as stocks or bonds have a
positive nominal interest rate
 The higher the nominal interest rate, the
smaller the quantity of money demanded
 Business demand for money is similar to
individuals'
 Businesses
hold more than half of the money stock
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Macroeconomic Factors That Affect The
Demand For Money
Demand for money depends on
 Nominal

The higher the interest rate, the lower the quantity
of money demanded
 Real

income or output (Y)
The higher the level of income, the greater the
quantity of money demanded
 The

interest rate (i)
price level (P)
The higher the price level, the greater the quantity of
money demanded
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 Interaction of the aggregate
demand for money and the
supply of money determines
the nominal interest rate
 The money demand curve
shows the relationship
between the aggregate
quantity of money demanded,
M, and the nominal
interest rate

An increase in the
nominal interest rate
increases the
opportunity cost of
holding money

Negative slope
Nominal interest rate (i)
The Money Demand Curve
MD
Money (M)
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 Changes in factors other
than the nominal interest
rate cause a shift in the
money demand curve
 An increase in demand
for money can result from
 An
increase in output
 Higher price levels
 Technological advances
 Financial advances
 Foreign demand for
dollars
Nominal interest rate (i)
The Money Demand Curve
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MD'
MD
Money (M)
32
Demand for Dollars in Argentina
 The average Argentine holds more dollars than the
average US citizen
 In the 1970s and 1980s, Argentina had high rates of
inflation


Real returns on assets in pesos declined
Argentines switched to dollars as a store of value
 In 1990, the US dollar and Argentine peso traded
1:1

Both were accepted for transactions
 By 2001, inflation in Argentina caused the system to
break down

Peso was worth less than the dollar
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International Demand for Dollars
 Political instability in some countries also
increases the demand for dollars
 Avoids
confiscation and taxes
 Largest US bill is $100, popular with drug
dealers
 The
Euro is available in €500 bills, worth more
than $500

More compact way of storing a given amount of wealth
 If
drug dealers switch to holding their cash in
Euros, the demand for the US dollar will decrease
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Supply of Money
The Central bank primarily controls the supply
of money with open-market operations
open-market purchase of
bonds by the central bank
increases the money supply
 An open-market sale of
bonds by the central bank
decreases the money
supply
 Supply of money is vertical
 Equilibrium is at E
Nominal interest rate (i)
 An
MS
E
i
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MD
M
Money (M)
35
Equilibrium in the Money Market


Quantity of money demanded is
M1, more than the money
available
To get more money, people
sell bonds


Bond prices go down,
interest rates rise
Quantity of money
demanded decreases
from M1 to M
Nominal interest rate (i)
 Bond prices are inversely
related to the interest rate
 Suppose the interest rate is at
i1, below equilibrium
MS
i
i1
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E
MD
M M1 Money (M)
36
How The Central Bank Controls the
Nominal Interest Rate
 Central bank policy is stated
in terms of interest rates
tool they use is the supply
of money
 Initial equilibrium at E
 Central bank increases the
money supply to MS'
 New
equilibrium at F
 Interest rated decrease to i'
to convince the market
to hold the new, larger
amount of money
Nominal interest rate (i)
 The
MS
E
i
i'
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MS'
F
MD
M
M'
Money (M)
37
Central Bank Controls the Nominal Interest
Rate
To Decrease the Money Supply
CB sells
bonds to
public
Supply of
bonds
increases
Price of
bonds
decrease
Interest
rate
increases
Price of
bonds
increase
Interest
rate
decreases
To Increase the Money Supply
CB buys
bonds
from
public
Demand
for bonds
increases
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A Second Way the Central Bank Controls The
Money Supply: Discount Window Lending
 Open market operations are the main tool of
money supply
 Central bank offers lending facility to banks,
called discount window lending
 If
a bank needs reserves, it can borrow from the
central bank at the discount rate

The discount rate is the rate the central bank charges
banks to borrow reserves
 Lending increases reserves and ultimately
increases the money supply
 Changes in the discount rate signal tightening
or loosening of the money supply
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The Egyptian Discount Rate, 1960-2010
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The Egyptian Discount Rate
 The Egyptian central bank did not use the
discount rate as a monetary policy tool until
1976.
 The discount rate increase of 1976 coincided
with the introduction of a resident import
exchange rate allowing Egyptian firms to
import using Egyptian pounds and the
enactment of a new law allowing Egyptian
expatriates to hold foreign exchange.
 Discount rate increases were likely designed
to “offset” money supply increases resulting
from higher post-1976 remittances.
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A Third Way the Central Bank Controls The
Money Supply: Changing Reserves Requirements
 The central bank can also change the reserve
requirement for banks
 The
reserve requirement is the minimum
percentage of bank deposits that must be held in
reserves
 The reserve requirement is rarely changed
 The central bank could increase the money
supply by decreasing the reserve requirement
 Banks
would have excess reserves to loan
 The central bank could decrease the money
supply by increasing the reserve requirement
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Monetary Policy Responses to the Global
Financial Crisis in the GCC
 Saudi Arabia
 $5
billion in liquidity injections to the interbank
market
 Lower reserve requirements (from 13 to 7
percent)
 Deposit insurance guaranteed by the government
 $2.5 billion deposit in Saudi Credit Bank
 Kuwait
 Had
already abandoned the dollar peg
 Lower benchmark interest rate
 Deposit insurance guaranteed by the government
 $5.2 billion economic stimulus
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Monetary Policy Responses to the Global
Financial Crisis in the GCC
 Qatar


Acquired 20 percent stakes in local banks.
Commitment to using large monetary reserves to satisfy
any potential economic shortfall
 UAE
Reduced interest rates (consistent with those in the US)
Deposit insurance guaranteed by the government for 3
years
 Guaranteed interbank lending
 $13.5 billion emergency lending facility to banks
 $19 billion in federal government deposits



Abu Dhabi Commercial Bank received $1.8 billion in fixed
deposits
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Chapter 22
Appendix
Monetary Policy in
the Basic Keynesian Model
Interest and the Basic Keynesian Model
 Two changes to the model
–
C = C + (mpc) (Y – T) – a r
–
P
I =I–br
where
a measures the strength of the interest rate effect
on consumption, a > 0
b measures how strongly changes in the real
interest rate affect planned investment, b > 0
 As before
–
G=G
–
T=T
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––
NX = NX
46
Equilibrium Output
 Find PAE
PAE = C + IP + G + NX
–
–
–
–
––
PAE = C + (mpc) (Y – T) – a r + I – b r + G + NX
–
–
–
–
––
PAE = [C – mpc (T) + I + G + NX] – (a + b) r + mpc Y
 The term [– (a+ b) r] shows that planned spending
goes down when the interest rate goes up

Part of autonomous spending since it does not depend on
Y
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47
Equilibrium Output
 Short-run equilibrium occurs when Y = PAE
–
– – –
––
PAE = [C – mpc (T) + I + G + NX] – (a + b) r + mpc Y
–
– – – ––
Y = [C – mpc (T) + I + G + NX] – (a + b) r + mpc Y
–
– – – ––
(1 – mpc) Y = [C – mpc (T) + I + G + NX] – (a + b) r
–
– – – ––
1
Y=
[C – mpc (T) + I + G + NX] – (a + b)
(1 – mpc)
r
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48
Equilibrium Output
––
–
–
– –
1
Y = (1 – mpc) [C – mpc (T) + I + G + NX] – (a + b) r
Multiplier
Autonomous Spending
The change in Y caused by a change in r depends
on
 The
size of the effect of a change in interest rate on
autonomous spending, (a + b) r, and
 The size of the multiplier
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Equilibrium Output
– –
––
–
–
1
Y=
[C – mpc (T) + I + G + NX] – (a + b) r
(1 – mpc)
 Suppose
C = 640
–I = 250
G = 300
–
––
T = 250
mpc = 0.8
a = 400
b = 600
–
–
NX = 20
Y = [1 / (1 – 0.8)] [640 – 0.8 (250) + 250 + 300 + 20
– (400 + 600) r
 If r = 0.05, Y = 4,800
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