2.4 Dii Details on how Monetary Policy Works

1. 2.4 Dii Details on how Monetary Policy Works Very helpful information to evaluate monetary policy

2. The money supply is the amount of money that banks make available by providing loans. As they loan out more, they increase the quantity of money in the economy. Central banks attempt to control this by encouraging or discouraging loans. They have three tools in their “monetary toolbox” • Open-market operations • Changing the reserve requirement • Changing the Bank Rate (Official Cash Rate in NZ) How might the central bank control the money supply?

3. Open-Market Operations: government bonds – long-term promissory notes issued by the central bank, bearing a rate of interest &maturity date (5–30 years) Treasury Bills (T-Bills) – short-term (3 month) promissory notes with no published rate of interest – they are sold “at a discount” • First, the RB sells bonds (or treasury bills) as a way of borrowing money from the public. • This _____________________ the money supply. • Later, the RB buys back the bonds by repaying the money to the public. • This _____________________ the money supply.

4. M1 When The central bank buys back (or doesn’t sell more) bonds and bills to the public, money flows into the economy Thus the Money supply increases!

5. From Wikipedia: Quantitative easing (QE) An unconventional monetary policy used by some central banks to stimulate their economy when conventional monetary policy has become ineffective. The central bank buys government bonds and other financial assets, with new money that the bank creates electronically, in order to increase money supply and the excess reserves of the banking system. Quantitative easing shifts monetary policy instruments away from interest rates, towards targeting the quantity of money. However the goals of monetary policy (including inflation targets) remain unchanged.

6. 2. Changing the Reserve Ratio • The reserve ratio is the amount (%) of a bank’s total reserves that may not be loaned out (i.e. kept in the bank). If the reserves increase, loans decrease – and spending decreases. Thus, Increasing the reserve requirement decreases the money supply. If the reserves decrease, loans increase – and spending increases. Thus, Decreasing the reserve requirement increases the money supply. Reserve ratios are no longer controlled by the RB; banks are free to establish their own reserves. For more information about how this works, see the PPT on Fractional Banking

7. 3. Changing the Bank Rate In New Zealand the (OCR)official cash rateis the interest rate the RBNZ charges COMMERCIAL banks for loans (or pays for deposits). Shortages must be borrowed (at 0.25% above OCR); surpluses are deposited (at 0.25% below OCR). Increasing the OCR decreases the money supply Decreasing the OCR increases the money supply This is the preferred instrument these days!

8. How the OCR powerfully influences the market interest rates: • A commercial bank will not make short term loans at an interest rate significantly higher than the OCR. • Why? because its competitors would be able to take out loans from the RB and then loan this short term money at a cheaper rate. • A commercial bank will also not make loans at a rate below the OCR because it can make the very same loans to the RB and receive the risk free OCR.

9. Real-World Examples that complicates successful operation of monetary policy

10. The Popularity Problem: Who likes contraction? Certainly not the export sector! see http://tvnz.co.nz/business-news/concern-over-predicted-house-prices-spike-2958620/videoon how rising house prices in NZ has stimulated household borrowing/spending, causing an inflationary gap, which then has to be reduced by contractionary monetary policy, which then raises the interest rates, thus increasing exchange rates and then hurting the export sector!

11. Other Government Policies:they don’t work well • Income Policies • Trying to persuade unions, employers to not increase wages, known as jawboning Q: "The Central Bank raised interest rates today in response to a fiscal stimulus package presented by the government BUDGET." What's wrong with this picture? Look carefully. • Price Controls • In the mid 80’s wage and price freezes were introduced to directly influence inflation, which consequently dropped 20%. • However when the conditions where lifted prices rose even higher than before.

12. The limitations of macroeconomic policy • Supply side: takes too long because… • Expansionary fiscal policies • Not enough tax revenue because… • Too much debt becomes too great a burden to bear because… • Expansionary monetary policy won’t work when there’s a liquidity trap. • Liquidity preference is the desire to hold money rather than other forms of wealth. I.e. to not invest. This must be overcome during times of recession and deflation.

13. How low can interest rates go? The liquidity trap occurs when the real interest rate cannot be lowered any further to stimulate aggregate demand.

14. Who wags the Tail? • The two biggest influences on wholesale rates of interest, be it short-term or long-term, are the inflation rate, and hence monetary policy, and the changes in similar offshore rates. • Hence, when inflationary pressures are on the rise then short-term interest rates will typically also rise, either because of Reserve Bank action or more usually because of anticipation of Reserve Bank action. Hence, it is no coincidence that the graph of inflation rates is similar to the graph of the 90-day bank bill yield.

15. CPI Driven Interest Rates

16. Reserve Bank raises cash rate by quarter pointNZ HERALD 15.05.2002 The Reserve Bank today increased the Official Cash Rate from 5.25 per cent to 5.5 per cent. "Demand conditions no longer warrant the degree of interest rate stimulus that seemed necessary late last year," said Reserve Bank Acting Governor Rod Carr. "The economy's ability to meet increasing demand without pressure on costs, margins and therefore prices appears limited. "Core inflation is still at the upper end of the 0 to 3 per cent target band, leaving little headroom for price pressures to accelerate from here on." He said pressures on resources looked likely to be maintained in the foreseeable future.