Transcript Slide 1

ECO 120
Macroeconomics
Week 9
Monetary Policy
Lecturer
Dr. Rod Duncan
Topics
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Who controls monetary policy?
How does monetary policy work?
What can monetary policy accomplish?
A simple theory of money- The Quantity
Theory of Money (QTM).
What is monetary policy?
• Typically we consider the problem of how the
government can manipulate monetary policy so
as to control economic variables such as output,
inflation, interest rates, etc.
• Issues: how monetary policy can “stabilize” the
economy? How will monetary policy affect
interest rates or exchange rates?
• We want to use our AD-AS model to discuss
monetary policy and its effects.
Who is this man?
Who is this man?
Who is more important?
• The first man was the first Australian captain to
lose an Ashes contest in 16 years. [Ricky
Ponting]
• The second man sets the interest rates on your
home loans. [Ian Macfarlane]
• Ian Macfarlane is the Governor of the Reserve
Bank of Australia (RBA).
• Ian Macfarlane is the most important Australian
few Australians have ever heard of.
Does the RBA control bank rates?
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RBA Cash Rate
Bank Mortgage Standard
Build. Soc. Mortgage
Standard
Who is more important?
• When the RBA raised cash rates by
+0.25% on 2 March 2005, bank loan rates
went from 7.05% to 7.30%.
• On a $250,000 20 year variable interest
loan, that’s raising weekly repayments
from $487 to $497. Ian Macfarlane cost
every Australian family $10/week.
• So who is this Ian Macfarlane and why
does he hate Australians so much?
Reserve Bank Act, Section 10(2)
It is the duty of the Reserve Bank Board, within the
limits of its powers, to ensure that the monetary
and banking policy of the Bank is directed to the
greatest advantage of the people of Australia
and that the powers of the Bank ... are exercised
in such a manner as, in the opinion of the
Reserve Bank Board, will best contribute to:
(a) the stability of the currency of Australia
(b) the maintenance of full employment in
Australia; and
(c) the economic prosperity and welfare of the
people of Australia.
Who is on the Reserve Bank
Board?
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Ian Macfarlane, Governor
Glenn Stevens, Deputy Governor
Ken Henry, Secretary to the Treasury
Frank Lowy - businessman (Westfield shopping centres)
Hugh Morgan - Business Council of Australia
Jillian Broadbent - Bankers Trust
Donald McGauchie - National Farmers Federation (and
Telstra chairman)
• Warwick McKibbin - economic researcher at ANU
• Robert Gerard – Gerard Corporation and Liberal donor
The last 6 members are all appointed by the Treasury.
Goals of the RBA
• The goals stated in the Act say the Board is to:
– Maintain the value of the Australian dollar;
– Keep unemployment low; and
– Keep GDP growth high.
• How do you do all three?
• What happens if doing one hurts the others?
What if maintaining the A$ requires raising
interest rates which will lower employment and
growth?
Goals of the RBA
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It’s the same as saying: “Design a car which1. Goes as fast as possible.
2. Is as safe as a luxury car.
3. Has high fuel efficiency.
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You could build a light car that satisfied 1 and
3, but would break 2. You could build a
heavier car that satisfied 2 and 3, but would
break 1.
In practice, the RBA aims to keep inflation
low. (Target band: 2-4%) And that’s all.
Tools of the RBA
• For fiscal policy, the government controls taxes
and spending. Fiscal policy can be achieved by
raising or lowering personal income or company
taxes, or by raising or lowering spending across
the economy, or in only one sector.
• Fiscal policy has some fine-tuned tools.
• For monetary policy, the RBA only has control of
the cash rate- the rate on banks’ deposits at the
RBA- called the Exchange Settlement Accounts
(ESAs) is .25% below the cash rate.
Tools of the RBA
• The cash rate is the rate that banks lend to each
other. The cash rate is the cost to banks of
holding reserves.
• The higher the cash rate, the higher will be bank
loan rates to borrowers, and the higher the
interest rate that banks pay to savers.
• By controlling the cash rate, the RBA controls all
interest rates in the economy, which all move in
line with the cash rate.
Open market operations
• The government can control the supply of
ESAs and thus the interest rate. These
actions are called “open market
operations”.
• “Open market operations” are the means
of the government controlling the supply of
ESAs. The RBA buys and sells securities
to control the amount of ESAs, debiting or
crediting the ESA accounts.
Open market operations
• If the RBA sells
securities for ESAs, it
decreases the supply
of ESAs and raises
the cash rate.
• Monetary policy shifts
the ESA supply curve
and so changes the
equilibrium interest
rate.
Cash rate
S1
S0
CR1
CR0
Demand
for ESAs
ESAs
From cash rate to interest rates
• As the cash rate
rises, the supply of
other types of
securities shrinks,
and interest rates for
those funds rises as
well.
• Borrowing becomes
more expensive.
S1
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Funds
Some “must know” definitions
• The RBA implements monetary policy through its
control of the cash rate.
• Cash rate: The cash rate is the rate the RBA
charges bank for loans within the RBA reserves
system. The cash rate is the base interest rate
for the economy, and all other interest rates are
derived from it.
• Easy monetary policy: When the RBA lowers
the cash rate to stimulate aggregate demand.
• Tight monetary policy: When the RBA raises
the cash rate to cut off aggregate demand.
Interest rates and Investment
• As we saw in the Investment section, the
profitability of investment projects depends on
the nominal interest rate.
• The lower are interest rates, the more projects
will be profitable, so the higher will be
investment spending.
• Since the RBA controls the cash rate, and since
all interest rates depend on the cash rate, the
RBA controls I, and so can shift the AD curve.
Interest rates and Investment
• Interest rates are the
cost that companies
pay to make
investments.
• As the cost of
investing rises, fewer
projects will be
profitable, so desired
investment drops.
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i0
i1
I
I0
I1
I
Brief aside: Nominal vs. real
interest rates
• The nominal interest rate is the rate that you
pay on a loan or that you get paid at a bank.
• Problem: You don’t eat money. What you care
about is the buying power of your savings. If
prices double from one year to the next, if
nominal interest rates are less than 100%, you
can buy less with your savings next year.
• The real interest rate is (roughly) the nominal
rate of interest minus the rate of inflation.
How monetary policy works
Chain of causation for monetary policy:
1. Changing ESA supply impacts interest
rates
2. Interest rates affect Investment
3. Investment is a component of AD
4. AD shifts and so equilibrium GDP is
changed.
SF1
SF2
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D1
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Investment
demand
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Amount of investment, i
ASLR
AS
Price level
AD1
P1
Easy Monetary
Policy
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AD2
SF2
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demand
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Amount of investment, i
ASLR
Price level
AS
Tight Monetary
Policy
P1
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Real domestic output, GDP
Monetary policy in operation
• The RBA uses monetary policy to keep inflation
low (or to maintain prices). The RBA uses
monetary policy to “steer against” the rest of the
economy.
• For example, the RBA thinks the AD curve is
shifting right because of increased export
demand. Then the RBA will raise interest rates
to shift AD left (or prevent AD from shifting at all).
• Or if the RBA thinks the AD curve is shifting left,
then the RBA will lower interest rates.
Monetary policy in operation
• The RBA sees an
upcoming shift to the
right of the AD curve,
leading to rising
prices (inflation).
• The RBA counters
this by raising interest
rates and shifting AD
left. If perfectly done,
AD does not move.
P
AS
I
P1
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AD1
AD0
Y0 Y1
Y
But…
• We have the same problems that we saw
with fiscal policy.
– Bad predictions: The RBA has to foresee the
upcoming changes. What if the RBA guesses
wrong?
– Bad data: What is the information about the
present or future is wrong?
– Lags: What if the RBA is late adjusting to
upcoming changes? The economy may
already have moved past.
Monetary policy and the open
economy
• Net Export Effect
– Changes in interest rate affect the value of the
exchange rate under floating exchange rate.
An increase in interest rate appreciates the
currency, resulting in lower net exports
– A decrease in interest rate leads to currency
depreciation and a rise in net exports
• So an easy monetary policy is enhanced
by the net export effect.
How do interest rates affect
exchange rates?
• We will get into this topic in a lot more depth in
Lecture 13.
• An increase in Australian interest rates makes
Australia a better place to invest. But to invest in
Australia you need to have A$.
• So an increase in i increases demand for A$, so
raises the price of A$, which is simply the A$
exchange rate.
• Likewise a decrease in i decreases demand for
A$, so the A$ exchange rate drops.
Economists and models
• A model is just a simplified view of the world. It’s
just a way of thinking.
• Economists only have a few simple models in
their heads. To become an economist, you have
to learn to think within these models.
• Demand-supply, perfectly competitive company
and monopoly would be three models from
micro.
• From macro, AD-AS, Phillips Curve, IS-LM and
Quantity Theory of Money would be some basic
models.
Quantity theory of money
• There is a nice, simple model of money which
explains many features of money supply and
demand. This model is called the quantity
theory of money.
• If we imagine that money is needed for all of the
purchases made each year, then demand for
money is the value of purchases. We only
consider transactions demand for money.
• The nominal value of all purchases is simply the
average level of prices (P) times the real GDP
per year (Y): PY.
Quantity theory of money
• The supply of money for purchases is the
amount of cash in the economy, M.
• But each piece of money in the economy can be
used multiple times during a year in
transactions. We call the number of transactions
that each $1 enters into during a year as the
velocity of money “v”.
• So the total supply of money for transactions in a
year is v times M: vM.
Quantity theory of money
• So demand equals supply requires that:
PY = vM
• When thinking about this model, we
usually imagine that v is fixed by
technology of money and buying habits.
We imagine that Y is determined by the
state of the economy.
• The government controls M, then the only
variable that changing M affects will be P.
• The QTM says that inflation (changing P)
is a result of changing M.
• So if Y goes up, but nothing else does,
then average level of prices must fall.
• The QTM is good to use for thinking about
money and inflation.
• Another view of QTM:
(Growth in P) + (Growth in Y)
= (Growth in v) + (Growth in M)
QTM in an online game
• Example of QTM in a nearly-real world:
• The online role-playing game “Ultima” has
hundreds of thousands of players. It is, in a
sense, bigger than some countries.
• The game has an economy, where people buy
and sell virtual goods for virtual cash “gold
pieces”, M.
• Some players worked out how to “dupe gold” in
Ultima, so they could create a huge amount of
new gold over time.
QTM in an online game
• What happened to prices in this economy when
all this new gold came in?
• Y and v were unaffected, so a big increase in M
led to a big increase in P. There was massive
inflation.
• The designers of the game fixed the dupe bug,
but what to do about all this new gold in the
economy?
• They created a new rare good “red hair dye”, for
which the designers charged the players a lot of
gold. The players handed over the gold, and the
designers deleted it.