layout: true background-image: url(figs/tcb-logo.png) background-position: bottom right background-attachment: fixed; background-origin: content-box; background-size: 10% --- class: title-slide .row[ .col-7[ .title[ # Principles of Macroeconomics ] .subtitle[The Central Bank and Monetary Policy] .author[ ### Dennis A.V. Dittrich ] .affiliation[ ] ] .col-5[ ] ] --- class: practice-slide # 1. .col-8[ A con man has a great idea: he’ll open a bank without any capital and lend all the deposits at high interest rates to property developers. If the property market booms, the loans will be repaid, and he’ll make high profits. If the property market goes bust, the loans won’t be repaid and the bank will fail - but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme? ] ??? Capital requirements Reserve requirements The bank needs more assets (loans plus reserves) than deposits --- # Monetary Policy .col-7[ **Monetary policy** is a policy of influencing the economy through changes in the banking system's reserves that influence the money supply and credit availability in the economy * Fiscal policy is controlled by the government directly * Monetary policy is controlled by the central bank * Monetary policy works through its influence on credit conditions and the interest rate in the economy **Expansionary monetary policy** is a policy that increases the money supply and decreases the interest rate and it tends to increase both investment and output ![](img10/cut3102.jpg) **Contractionary monetary policy** is a policy that decreases the money supply and increases the interest rate, and it tends to decrease both investment and output ![](img10/cut3101.jpg) ] --- ## Monetary Policy and the Central Bank .col-7[ A **central bank** is a type of banker's bank whose financial obligations underlie an economy's money supply * If commercial banks need to borrow money, they go to the central bank * If there's a financial panic and a run on banks, the central bank is there to make loans It... * conducts monetary policy (influencing the supply of money and credit in the economy) * (often) supervises and regulates financial institutions * is lender of last resort to financial institutions * provides banking services to the government * issues coin and currency * provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions The ability to create money gives the central bank the power to control monetary policy ] --- class: practice-slide # 2. .col-8[ Explain how each of the following would affect the real and nominal quantity of money demanded 1. Short-term interest rates rise from 5% to 30%. 2. All prices fall by 10%. 3. New wireless technology automatically charges supermarket purchases to credit cards, eliminating the need to stop at the checkout. 4. For some reasons, firm return to the old practice of paying employees in cash rather than with cheques / bank transfers. ] ??? Real money: M/P Increase in the opportunity cost of holding cash, reduces the demand for nominal and real quantity of money. A movement along the money demand curve. Reduces the nominal quantity of money by exactly 10%. Real demand is not affected. Makes cash currency unnecessary, reduces both nominal and real demand for money. Shift of the curves to the left. Cash payments require holding more money, increasing the nominal and real demand at all interest rates. Shift to the right. --- # The Conduct of Monetary Policy .col-7[ The Central Bank influences the amount of money in the economy by controlling the monetary base * Monetary base is vault cash, deposits of the Central Bank, and currency in circulation Monetary policy affects the amount of reserves in the banking system * Reserves are vault cash or deposits at the Central Bank * Reserves and interest rates are inversely related ] --- class: practice-slide # 3 .col-8[ a. Assume that there is an increase in the demand for money at every interest rate. Using a diagram, show the effect this will have on the equilibrium interest rate for a given money supply. b. Now assume that the central bank is following a policy of holding interest rates constant. What will the central bank do to keep the interest rate unchanged, assuming it uses open market operations to achieve its policy goal? ] ??? --- # Open Market Operations .col-7[ **Open market operations** are the primary way in which the Central Bank changes the amount of reserves in the system * Open market operations are the Central Bank's buying and selling of government securities * To expand the money supply, the Central Bank buys bonds * To decrease the money supply, the Central Bank sells bonds When banks are eager to lend, they keep reserves low, and the Money Multiplier will be high. * Changes in MB will have a larger effect on the money supply. When banks are reluctant to lend, they hold reserves high, and Money Multiplier will be low. * Changes in MB will have a smaller effect. ] --- class: practice-slide # 4. .col-8[ If the Federal Reserve wants to lower interest rates via open market operations, should it buy bonds or should it sell bonds? ] ??? The Fed should buy bonds to raise the reserve supply and push rates down. Buying bonds raises the demand for bonds, which raises the price of bonds, thus lowering the interest rate on bonds. --- # Open Market Operations .row[ .col-6[ An open market **purchase** is expansionary monetary policy that tends to reduce interest rates and increase income * When the Central Bank buys bonds, it deposits money in banks' account with the Central Bank * Bank reserves are increased, and when banks loan out the excess reserves, the money supply increases * Increased supply of money leads to increase in supply of loans * Decreased interest rate leads to increase in demand for loans An open market **sale** is a contractionary monetary policy that tends to raise interest rates and lower income * When the Central Bank sells bonds, it receives checks drawn against banks * The bank's reserves are reduced and the money supply decreases ] .col-6[ ![](img10/c32-001.png) ]] --- class: practice-slide # 5. .col-8[ Could the central bank affect the money supply by buying and selling goods or services other than bonds? For example, suppose the central bank decided to implement an expansionary policy that involved buying pizzas or haircuts instead of bonds. Would this work? ] ??? Theoretically, if the Fed is buying pizzas or haircuts and paying for them with IOUs, then the Fed is increasing the monetary base and, thus, the money supply that can be supported. However, there are some drawbacks to using pizzas or haircuts for this purpose. First, when the Fed buys bonds, it does not necessarily impact the consumption of households, but if the Fed were to buy up pizzas and haircuts, it would. Real available resources would be directly affected. This does not happen when the Fed buys bonds. Secondly, the Fed buys bonds in such large volumes that an equivalent dollar-amount of pizzas or haircuts would mean purchasing an impossible number of pizzas or haircuts. --- class: practice-slide # 6. .col-8[ What is quantitative easing? How is it different from open market operations? In what way may it help to counter slow economic growth in an economy? ] ??? --- # Offensive and Defensive Actions .col-7[ **Defensive** actions are designed to **maintain** the current monetary policy * The Central Bank buys bonds during emergencies * Reserves would otherwise decrease because individuals and businesses don't get to the bank with their cash **Offensive** actions are designed to have expansionary or contractionary effects on the economy ] --- class: practice-slide # 7. .col-8[ a. In the short run, if the Fed wants to cut short-term, nominal interest rates, what does it do: Does it increase the growth rate of money or decrease the growth rate of money? Why? Will this tend to lower the real rate or will it tend to lower inflation? b. In the long run, if the Fed wants to cut short-term, nominal interest rates, what does it do: Does it increase the growth rate of money or decrease the growth rate of money? Why? Will this tend to lower the real rate or will it tend to lower inflation? ] ??? a. The Fed will increase the growth rate of money to push down interest rates. This increases the supply of loans, which pushes down the interest rate on loans. This will tend to lower the real rate. b. In the long run, the Fed can’t control the real interest rate, but it can control the inflation rate. It will do this by slowing the growth rate of money. The lower inflation rate will decrease the nominal interest rate in the long run. --- # Overnight lending rate .col-7[ The Central Bank controls a real rate of interest only in the **short-run.** * Lending and borrowing decisions depend on the real interest rate. The Central Bank has greatest influence over the overnight lending rate that banks charge each other. Monetary policy is usually conducted around the the overnight lending rate. * It is a convenient signal of monetary policy. * It responds quickly to actions by the Central Bank. * It can be monitored on a day-to-day basis. * M1 and M2 are more difficult to measure and monitor. ] --- # Reserves .row[ .col-6[ **Reserves** are currency and deposits a bank keeps on hand or at the central bank, to manage the normal cash inflows and outflows The **reserve ratio** is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals The **reserve requirement** is the percentage the Central Bank sets as the minimum amount of reserves a bank must have Banks can keep more reserves: **excess reserve ratio** Reserve ratio = required reserve ratio + excess reserve ratio ] .col-6[ Banks with surplus reserves loan these reserves to bankswith a shortage in reserves * **Central Bank funds** are loans of excess reserves banks make to each other * **Central Bank funds rate** is the interest rate banks charge each other for Central Bank funds By **selling bonds**, the Central Bank decreases reserves, causing the **Central Bank funds rate** to **increase** By **buying bonds**, the Central Bank increases reserves, causing the **Central Bank funds rate** to **decrease** ] ] --- class: practice-slide # 8. .col-8[ Where you get your loans is a signal about what kind of bank (or person) you are. Which of the following would seem like bad signs? If you think one or more of the cases are ambiguous, explain. 1. Your friend borrows money from a federal student loan program. 2. Your friend borrows money from a payday loan store. 3. Your friend pays for ordinary living expenses by borrowing with her credit card. 4. Your friend borrows money from her parents. 5. Your friend borrows money from an illegal loan shark. ] ??? Borrowing from b, c, and e seem the most troubling: All charge high interest rates, so you wouldn’t go to them unless you were really in dire need of cash. If you see someone doing these things, it probably wouldn’t be safe to help this person out. Borrowing student loan money or borrowing from one’s parents seems like a relatively good signal, though it’s possible that borrowing from parents is a bad sign, depending on the family situation. --- # Borrowing from the Central Bank .row[ .col-7[ In case of a shortage of reserves, a bank can borrow reserves directly from the Central Bank * Because the Central Bank can create money at will, it is lender of last resort. These loans increase the Monetary Base, when the banks repay the loans the monetary base shrinks back. Banks in good health usually borrow from other banks. * There is a stigma to borrowing from the Central Bank. ] .col-5[ The **discount rate** is the interest rate the Central Bank charges for those loans it makes to banks * An increase in the discount rate makes it more expensive to borrow from the Central Bank and may decrease the money supply * A decrease in the discount rate makes it less expensive to borrow from the Central Bank and may increase the money supply ] ] ??? --- ## Suppose that entrepreneurs are suddenly more pessimistic .col-7[ * This results in less borrowing and lending and the growth rates of M1 and M2 fall. * AD falls and the rate of growth of real GDP falls. * Eventually the economy will recover at the original growth rate of real GDP and a lower rate of inflation. * If wages are sticky, this process takes longer and higher unemployment will last longer. What would be the Central Banks best response to the result of the entrepreneurs pessimism? ] --- ## Monetary Policy and the Money Market .row[ .col-6[ ![](img10/3102.jpg) ] .col-6[ If the Central Bank increases (the growth rate of) the money supply the interest rate will fall. The decline in interest rates increases investment spending, which shifts the AD curve to the right ]] .row[ .col-6[ .col-9[ ![](img10/f3501.jpg) ]] .col-6[ If the Central Bank increases the growth rate of the money supply, and the AD curve shifts back by just the right amount, the length and severity of the recession can be reduced. ]] --- class: practice-slide # 9. .col-[ Suppose the economy is suffering from a recessionary gap and the central uses expansionary monetary policy to close the gap. Describe the short-term effects on the following 1. The money supply curve 2. The equilibrium interest rate 3. Investment spending 4. Consumer spending 5. Aggregate output 6. Aggregate price level 7. Savings 8. The supply curve of loanable funds in the loanable funds market ] ??? The money supply curve shifts to the right The equilibrium interest rate falls Investment spending rises, due to the fall in the interest rate Consumer spending rises, due to the multiplier process Aggregate output rises because of the rightward shift in the aggregate demand curve The aggregate price level rises because the economy moves up the short run aggregate supply curve Savings rise because disposable income rises; part of the increase in disposable income is saved The supply curve of loanable funds shifts rightward because savings rise. --- # Monetary policy looks easy, but... .row[ .col-6[ ![](img10/f3502.jpg) ] .col-6[ The Central Bank must operate in real time -- when much of the data about the state of the economy are unknown. * Data... Are often released on a quarterly or monthly basis * Are often amended after the fact * Take time to analyze and interpret. The Central Bank's control of the money supply is incomplete and subject to uncertain lags. * An increase in the money supply typically affects the economy with a lag of 6 to 18 months. * If banks aren't willing to lend -- AD will be affected very little ...the Central Bank will undershoot. * If the economy recovers before the monetary policy has an effect -- the Central Bank can easily produce a higher than desired rate of inflation ...overshoot. ] ] --- class: practice-slide # 10. .col-8[ Monetary policy is difficult when the interest rates are low. For example, in the early 2000s the Bank of Japan lowered the interest rate to 0.01% with little effect on investment. Why is it difficult for monetary policy to be effective when interest rates are very low? ] ??? Zero Lower bound for nominal interest rates. --- class: practice-slide # 11. .col-8[ Given zero nominal interest rates, if people are expecting deflation, what is the effect on the labor demand curve? ] ??? If inflation keeps falling below zero. The real interest rate will rise, reducing investment, reducing aggregate demand, and reducing the labor demand: The labor demand curve shifts to the left. --- # Rules vs. Discretion .row[ .col-7[ The Central Bank should not try to respond to every shock. Some suggestions... * Set target ranges for M1 and M2. * Set target ranges for inflation. * Milton Friedman: Strict rule in which money supply would grow by 3% a year. Allow some adjustments, stated in advance. The Central Bank should have the discretion (and flexibility) to do what it thinks best. **Discretionary policy** has resulted in less volatility. ] .col-5[ When the Central Bank chooses a monetary rule that targets the interest rate, it creates an effective monetary supply curve that is horizontal ![](img10/3106.jpg) ]] --- ## Central Banks in different countries may have different objectives .col-7[ While the **Fed** focuses on the Central Bank funds rate as its operating target, it also has its eye on its ultimate targets: * stable prices, * acceptable employment, * sustainable growth, and * moderate long-term interest rates * preventing the spread of systemic risk The **European Central Bank's** sole objective is price stability. Central Banks may be more or less independent of the government. ] --- ## 12. .row[ .col-6[ Suppose that inflation is running at 10%. Velocity shocks are 0 and that the Solow growth rate is 3%. 1. The central banker would like to lower inflation to 2% without reducing real growth. * What should the central banker tell the public? * And at what level should the central banker set money growth? 2. Suppose that the public does believe the central banker. What temptation might the central banker face? 3. If the central banker is not believed, what will happen? Use your answer to parts b and c to discuss the importance of independent central banks. ] .col-6[ <img src="img10/c33-1.png" width="100%" /> ] ] ??? b. If the public believes that the central banker will reduce inflation but instead of reducing AD, the central banker keeps AD constant, then the economy will move to point c in the above figure, thus, creating a temporary economic boom. c. If the central banker is not believed but the central banker does reduce AD, the economy will move to point d, creating a temporary economic bust. An independent central bank may be able to more credibly promise not to try to create temporary booms and therefore is less likely to create temporary busts. --- ## **Credibility**: When people expect the central bank to stick with its policy .row[ .col-7[ Policy makers are very concerned about establishing policy credibility because they believe that it is necessary to prevent inflationary expectations from becoming built into the system If expansionary policy leads to expectations of increased inflation, nominal rates will increase and leave real rates unchanged Most economists believe that a monetary regime, not a monetary policy, is the best approach to policy Monetary regimes are now favored because rules can help generate market expectations An explicit monetary policy regime has problems because special circumstances arise where it makes sense to deviate from the regime ] .col-5[ A **monetary regime** is a predetermined statement of the policy that will be followed in various situations A **monetary policy** is a response to events chosen without a predetermined framework ]] --- # Market Confidence .col-7[ One of the Monetary Policy Maker's / Central bank's most powerful tools is **Market Confidence** **Expectations** (perhaps more important than money supply and interest rates!) **Uncertainty** -- the opposite of confidence... * Drives people to hold more cash * Lending falls * Example: 9/11 -- uncertainty goes up after the terrorist attacks. * A bandwagon effect could have caused a severe recession. * US Fed sent a strong signal by increasing lending to banks by over $45 billion. * A severe recession did not develop. ] --- class: practice-slide # 13. .col-8[ We often want higher real growth and lower inflation. What kind of shock makes that happen? ] ??? A positive Solow growth shock, which is somewhat similar to an increase in supply. --- # The Negative Real Shock Dilemma .col-7[ Monetary policy is less effective at dealing with a real shock than an AD shock. Example The shock: a sudden and large increase in the price of oil. * This negative shock shifts the Solow growth curve to the left. * Sticky wages and prices amplify the shock by shifting SRAS even more to the left. * Lower growth and higher inflation. ] --- ## Contracting the money supply to deal with the higher inflation rate .row[ .col-7[ The Negative Real Shock Dilemma ![](img10/f3503.jpg) ] .col-5[ Real growth will slow even more, and unemployment will rise. ]] --- ## Expanding the money supply to deal with the decrease in the real growth rate .row[ .col-7[ The Negative Real Shock Dilemma ![](img10/f3504.jpg) ] .col-5[ Inflation will rise even higher. ]] --- class: practice-slide # 14. .col-8[ Demonstrate the effect of expansionary monetary policy in the AS/AD model when the economy is a) below potential output, b) significantly above potential output. ] ??? --- # ...Monetary Policy is difficult .row[ .col-7[ Central Bank actions to increase the monetary base are not guaranteed to work. * We don't know exactly how much M1 and M2 will change. * We don't know exactly by how much lower interest rates will stimulate investment spending. The Central Bank has most influence over short-term rates while investment is most affected by long-term rates. Monetary policy takes time to work and the response lags vary. Analysis of the economy is difficult. ] .col-5[ ![](img10/cut3105.jpg) ] ]