Lecture 11 Mod 6.1: Monetary Policy

Lecture 11 Mod 6.1: Monetary Policy C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

This week • Mod 6 part 1: Monetary Policy • Textbook, Chapter 16 Macroeconomic Policy 1: Monetary Policy (C) Red Hill Capital Corp., Delaware, USA 2008

Learning objectives On successful completion of this part of the module, you should be able to: • Explain the nature and operation of monetary policy • Discuss differences between ‘classical’ and ‘modern’ monetarist doctrine • Articulate the ‘rules’ versus ‘discretion’ debate over the role of monetary policy • Explain how monetary policy is implemented in Australia (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • The last several modules have been spent looking at macroeconomic variables, and then using them in an aggregate model of supply and demand. • We found that classical economists believed that an economy would always heal itself and forever be able to give everyone a job. That is the classical end of the aggregate supply curve. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • Keynes found another limiting case in which people would be unemployed and remain unemployed unless something was done by the government: a kick start. • In the last lecture, we looked at what makes money money. • Governments print modern money and issue it through their central banks and their banking systems. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • This fiat money is valued against the economy. The amount in circulation will affect its value. • For example, if the supply doubled overnight, no one would be fooled, they would just revalue everything else at prices twice as much as yesterday. Thus, keeping a reign on the supply is important, at least for prices. • Indeed, since there will be both a supply and a demand for money, there will be an intersection of those curves and an equilibrium price. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • We call the price of money the interest rate. • Since the government is the one who makes money, by printing it, minting it, and allowing banks to create it, the government can also have an affect on money supply, which can affect other variables in the economy, like interest rates, investment, output, prices, and employment. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • The economy will have demand for money, and the government can manipulate supply • In this lecture, we take a closer look at money and monetary policy, i.e., how the government views money and uses it to affect interest rates, and the effects that are transmitted through the economy from what the government does about money. • We shall look at money views, theories, transmission mechanisms, and practical applications to try to affect an economy. (C) Red Hill Capital Corp., Delaware, USA 2008

On Monetary policy (C) Red Hill Capital Corp., Delaware, USA 2008

Tools available to a central bank • There are 2 common means by which the central bank can affect money supply and demand. • First, it can affect interest rates. • The central bank can change the rate of interest that it charges to its member banks. • That rate, in turn, will act as a baseline rate for interest rate costs of banks, in the shortest, overnight market for money. • That will be transmitted through others interest rates in the banking system and in the economy for longer maturities and differing risks and costs of lending in its various venues. (C) Red Hill Capital Corp., Delaware, USA 2008

Tools available to a central bank • Alternatively, the bank can make it known what it wants the overnight, inter-bank loan interest rate to be, and let the market work it out. The result, in either case, will be that demand will adjust to supply of money at the new price (interest rate) of money and a new quantity. (C) Red Hill Capital Corp., Delaware, USA 2008

Tools available to a central bank • It can also affect supply of money in the system through open market operations. • In open market operations, the central bank either sells or buys U.S. government securities from its member banks. • The banks, as part of the system, are obliged to enter these transactions. • If banks buy securities from the central bank, they with money, thus, taking money out of the banking system, thus reducing supply of money from banks. (C) Red Hill Capital Corp., Delaware, USA 2008

Tools available to a central bank • Cash is deducted from the bank’s ESA, immediately reducing the money bas, and though the multiplier will reduce the other definitions of money supply. • Dollars are physically removed from the economy. • The opposite occurs when the central bank buys securities from banks. More money is put into circulation. (C) Red Hill Capital Corp., Delaware, USA 2008

Open market operations RBA RBA sells Securities; banks Buy; bank deposits at RBA decline RBA buys Securities; banks Sell; deposits at RBA increase Banks Banks have less money They decrease loans Raise interest rates Banks have more money They increase loans Interest rates decline Public (C) Red Hill Capital Corp., Delaware, USA 2008

The RBA’s goals of monetary policy • As we learned in the last lecture, the RBA was originally given a mandate of keeping a stable currency, maintaining full employment, and ensuring economic prosperity and welfare of the Australian people. • Then, that goal seemed to be limited to keeping inflation between 2 and 3 percent on the CPI in the last decade, but does that mean that it has abandoned the other 2 goals? (C) Red Hill Capital Corp., Delaware, USA 2008

The RBA’s goals of monetary policy • In fact, the RBA believes that by pursing that one goal, it will, in addition, take care of the other 2 in the medium to long term. • The logic is that: It would take away its focus, if it went chasing after different problems in the short run. • Inflation can have other affects on an economy, like causing bad expectations and increasing interest rates. (C) Red Hill Capital Corp., Delaware, USA 2008

The RBA’s goals of monetary policy • If it keeps its eye on inflation and keeps it low, through ups and downs, then, economic growth will come. Moreover, with growth, there will be employment. • We can look at the record of monetary policy versus history. • We can discuss some theories and some prescriptions for what monetary policy can and should do. (C) Red Hill Capital Corp., Delaware, USA 2008

Policy Transmission (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • The central bank can affect the supply of money, thus, tinkering with the equilibrium point between supply and demand for money. • The equilibrium will be a quantity of money and a price of money, the interest rate. • The bank can change the supply of money or it might also set the interest rate directly. • By setting supply at a certain vertical quantity, the bank might be trying to pick a spot on the money demand schedule, which will be at a certain interest rate. (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • If it sets the rate, it is trying to bring the demand curve to a certain point of implied supply. • After it becomes clear where the central bank wants interest rates be, both HH and businesses will make savings, borrowing, and investing decisions. • Those decisions will, in turn, affect other variables in the economy. • For example, when rates are high, both business and HH will be more unlikely to borrow. (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • Consumers buy large durable goods for large dollar amounts, like appliances, cars, land, and houses with borrowed money, while business borrow money to invest in capital. • People will tend to save money and try to take advantage of the interest rate. • That will take money out of the system. • It will take money out of DI and put it into S, so C will decrease. (C) Red Hill Capital Corp., Delaware, USA 2008

Intro • Business will also borrow less and invest less, causing I to decline • Thus, interest rates will ultimately affect AD. • If the affect is a decrease in AD, then, there may also be a decrease in employed people. • If AD increases, it may lead to more employment in the economy. • It may also lead to increased prices and inflation. • We shall examine some ways that monetary policy can be transmitted through the economy, so we can understand the consequences of tinkering with the supply of paper money. (C) Red Hill Capital Corp., Delaware, USA 2008

The Keynesian mechanism • Suppose an economy is operating near its capacity and increased inflation has begun to appear above the previously lower more stable rate. • The central bank would then tighten money, reduce supply, and the interest rate would rise. • That would cut private-sector demand in I and C (for durable goods, at least), which would have a multiplier effect through the economy, and AD would decrease. (C) Red Hill Capital Corp., Delaware, USA 2008

The Keynesian mechanism • The fall in AD would slow down economic activity and reduce the rate of inflation. • Thus, in the Keynes view, interest rate changes are the key to the transmission process. • We show the causal chain of events, in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008

The Keynes Causal Chain Change in Money Policy Change in Money Supply Change in Interest Rates Change in Price, GDP, Employment Change in Aggregate Demand Change in Investment (C) Red Hill Capital Corp., Delaware, USA 2008

Monetarism (C) Red Hill Capital Corp., Delaware, USA 2008

Monetarist school • The monetarist school of thought is that changes in the money variable have far more direct and vast effects on economic variables. • In the Keynes transmission, money policy affects interest rates. Then, investment and AD. Then, prices, output, and employment. It is a cascade effect: a chain of events. (C) Red Hill Capital Corp., Delaware, USA 2008

Monetarist school • The monetarist view is that changes in money supply directly affect prices, output and employment, in addition to interest rates. • We show the causal chain for monetarism in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008

The Causal Chain: monetarism Monetarist Chain Shortcut Keynes Route Change in Money Policy Change in Money Supply Change in Interest Rates Change in Price, GDP, Employment Change in Aggregate Demand Change in Investment (C) Red Hill Capital Corp., Delaware, USA 2008

The monetarists’ logic • Modern monetarism has its roots in classical economics. • It puts the spotlight on the money supply as a large determinant in the economic outlook. • Simplistically, if the supply expands too rapidly (whatever that means), prices will rise and there will be inflation. (C) Red Hill Capital Corp., Delaware, USA 2008

The monetarists’ logic • An extreme example is, if the supply doubles, overnight, prices will double because no one is fooled...the money is worth half as much as it was worth, yesterday. • If the supply expands too slowly to meet the economy’s transaction needs, prices might fall or people might lose jobs. (C) Red Hill Capital Corp., Delaware, USA 2008

The equation of exchange • We begin with the classical economics equation of exchange, a classical notion from the 19th century. • It is simply an accounting identity relating the supply of money, M, to the times it is spent, turned over, in a year (period). • The annual (period) turnover is referred to as money velocity, V. • Then, the equation relates money spent to nominal GDP (=PQ) as: MV= PQ. (C) Red Hill Capital Corp., Delaware, USA 2008

A simple economy • Assume an economy with only one $20 bill in circulation. • Linlin has the $20 and wants to eat fish, so she pays $20 to Tintin for fish. • Now, Tintin has the money, and she decides to go to go to Shadow’s wang bar and spend her money on internet, tea and crumpets. • Now, Shadow decides to go to Violet’s nail salon to have a facial and her nails done. • Thus, in our quick little jaunt, the single $20 has paid for $60 in G&S. Money gets around. (C) Red Hill Capital Corp., Delaware, USA 2008

A simple economy: abstracted • Thus, you can visualize how the equation is simply a statement of reality. • Money gets around an economy, and the number of transactions that it is involved in, during some period of time, determines the total value of the transactions that are done, which is the economy’s nominal value of GDP, during that time. • The question becomes: how are Q and P, in GDP, separately affected. That would be more useful information. (C) Red Hill Capital Corp., Delaware, USA 2008

A larger example • Consider an economy with a GDP of $500 billion and M1 of $100 billion. • Then, solving the exchange equation we find that the velocity was V = GDP/M1 = $500 billion/$100 billion = 5. • Thus, M1 was turned over 5 times during the year, going through an average of 5 transactions for final goods and services, to pay for total output of the economy in current dollars. (C) Red Hill Capital Corp., Delaware, USA 2008

Quantity theory of money • In classical economics, V and Q are regarded as constants. • It assumes that people have stable spending habits, and it is also under the broader assumption that prices are flexible and everyone is employed. • The resulting quantity theory of money, then, says that the change in money supply determines inflation, as MV0 = PQ0, where V0 and Q0 are now constants. (C) Red Hill Capital Corp., Delaware, USA 2008

Quantity theory of money • It may have been an ok assumption in the 19th century, and the argument has some appeal, in a certain sense. • However, it misses supply shock, cost push inflation, like happened in the 1970’s with oil prices. • It also loses predictive power, if V is not actually constant but varies, for one reason or another. (C) Red Hill Capital Corp., Delaware, USA 2008

Quantity theory of money • For example, financial innovation, like occurred in the 1980’s & 90’s with EFTPOS on the rise, the need for pocket money changed substantially. • If an economy does not have full employment, changes in money might translate into increased output, not prices. (C) Red Hill Capital Corp., Delaware, USA 2008

Modern monetarist thinking • The historical record shows that velocity is not unwavering. • Monetarists acknowledge that reality but argue that V is fairly predictable. • Then, if predicted V for next year is 6, GDP will be $600 billion. (C) Red Hill Capital Corp., Delaware, USA 2008

Modern monetarist thinking • Then, predictions of changes in prices versus output are tempered by where the economy is in the range between Keynes and classical on the AS curve. • The monetarist prescription is, then, do not let the money supply grow too fast or too slowly, and you will be able to keep inflation and unemployment under control. (C) Red Hill Capital Corp., Delaware, USA 2008

Keynes vs. monetary transmission • The monetarists deemphasize the transmission of money changes through the interest rate as an intermediary. • In that regard, when people find themselves with extra money in their hands, they will not just go out and buy bonds, they will also spend money on more G&S. • Thus, instead of just bidding up bond prices and changing interest rates, prices of G&S will be bid up and demand will increase. (C) Red Hill Capital Corp., Delaware, USA 2008

Keynes vs. monetary transmission • Instead of working through interest rates to investment to AD, the change in money directly determines economic activity. • A famous “thought experiment” imagines that a community wakes up to find $50 bills littered everywhere. • Some people will invest it, others will rush out to buy CD players, flat screen TV’s, computers, cars and new clothing and food. • The result will an increase in bond prices and nominal GDP, albeit mostly an increase in prices. (C) Red Hill Capital Corp., Delaware, USA 2008

The Role of Monetary Policy (C) Red Hill Capital Corp., Delaware, USA 2008

Rules vs. Discretion Debate • Both schools of thought on money agree that monetary policy will affect the economy. • They would further agree that the short-term affects, about the first 9 months, will be responses in output and employment, with inflation following at about 18 months out. • However, they differ in their views of the role of monetary policy. • Keynesians believe that the central bank should have discretion to change its policy to meet changing perceived problems in the economy. (C) Red Hill Capital Corp., Delaware, USA 2008

Rules vs. Discretion Debate • Monetarists, on the other hand, believe that the banks should adhere to widely-published rules of engagement. The most common of which is a target range for money supply growth. • Monetarists would, for example, argue that countercyclical monetary policy will suffer from information lags, decision and implementation lags, and effectiveness lags, and such policy pursuit might actually exaggerate swings in the cycle instead of damping them. (C) Red Hill Capital Corp., Delaware, USA 2008

Lags & Nags • First, since information is imperfect and partially visible, there will be an information lag about the actual state of the economy. • As the outlook on the economy crystallizes, policy finally takes shape, but again at a lag, and implementation thereafter occurs. • Then, there will be the final lags between implementation of policy and affects in the economy. • By the time that all follows, it might be the wrong affect at the wrong time. (C) Red Hill Capital Corp., Delaware, USA 2008

Lags & Nags • The monetarist would prescribe that the central banks should announce targets of monetary growth for a year. Then, use the tools available to it to keep the growth of supply in line with the target, and review the target annually. • For example, if we want GDP growth to be in the range 5-6%, with real growth and inflation in the 2-3% range, then, money supply should be grown at that rate. (C) Red Hill Capital Corp., Delaware, USA 2008

Lags & Nags • Indeed, even if velocity varies to result in temporary inflation or slower growth in output, policy should remain steadfast. • The Keynesian would say: ok, don’t just do something, stand there! • The monetarist believes the head of the central banks should be a horse. Each year the horse would be debuted to the public. He would tap his foot 4 times for 4% growth in M, then, not be seen again for another year. (C) Red Hill Capital Corp., Delaware, USA 2008

Velocity instability • The predictability of velocity is a central issue in the debate of targeted money growth or a discretionary approach. • Most economists would agree that velocity is not stable in the short run. They disagree on its behavior over the longer run. • Keynesians do not accept the monetarist view that velocity evolves in a fairly stable and predictable manner over the longer run. (C) Red Hill Capital Corp., Delaware, USA 2008

Velocity instability • Keynesians believe that velocity is determined by the community’s demand for holding money balances, and that demand for money is not stable in the short or long run. • If velocity is not stable or predictable, then, a change in supply could result in a change in nominal GDP that is either larger or smaller than monetarists would predict. (C) Red Hill Capital Corp., Delaware, USA 2008

Lecture 11 Mod 6.1: Monetary Policy