Macroeconomics for Finance

Transcription

1 Macroeconomics for Finance Joanna Mackiewicz-Łyziak Lecture 3

2 From tools to goals Tools of the Central Bank Open market operations Discount policy Reserve requirements Interest on reserves Large-scale asset purchases Forward guidance Policy Instruments Reserve aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base) Short-term interest rate Intermediate Targets Monetary aggregates (M1, M2) Interest rates (shortand long-term) Inflation expectations Goals Price stability High employment Financial market stability Interest rate stability Foreign exchange market stability

3 From tools to goals Literature: Mishkin F., Economics of Money, Banking and Financial Markets, 11/e, chapters 15, 16, 17 Example: suppose that the central bank s ultimate goal of price stability is consistent with 2% increase of the price level. The central bank estimates that the goal will be achieved by a 3% growth rate for M2 (intermediate target), which will in turn be achieved by a growth rate of 2.5% for the monetary base (policy instrument). The central bank will carry out open market operations (policy tool) to achieve the 2.5% growth in the monetary base. After implementing this policy the central bank may find that the monetary base is growing too slowly. It can correct this too slow growth by increasing the amount of its open market purchases. Later, the central bank will see how its policy is affecting the growth rate of the money supply. If M2 is growing too fast, the central bank may decide to reduce its open market purchases or make open market sales to reduce the M2 growth rate.

4 Monetary base Define monetary base as the central bank liabilities Monetary Base (MB) = Currency (C) + Reserves (R) Total reserves can be divided into two categories: reserves that the central bank requires banks to hold (required reserves) and any additional reserves the banks choose to hold (excess reserves). The central bank exercises control over the monetary base through: Open market operations Discount loans Changes in international reserves

5 Channels for changing the monetary base open market operations Open market purchase from a bank suppose that the CB purchases $100 of bonds. Banking system Assets Securities -$100 Reserves +$100 Liabilities Assets Central bank Liabilities Securities +$100 Reserves +$100 Result: reserves have increased by $100, the amount of the open market purchase. Because there has been no change of currency in circulation, the monetary base has also risen by $100.

6 Channels for changing the monetary base open market operations Open market purchase from the nonbank public let s assume that the person or corporation that sells the $100 to the central bank and deposits the central bank s check in the local bank. Nonbank public Assets Securities -$100 Checkable deposits +$100 Liabilities Banking system Asstes Liabilities Reserves +$100 Checkable deposits +$100 Central bank Assets Liabilities Securities +$100 Reserves +$100

7 Channels for changing the monetary base open market operations Open market purchase from the nonbank public let s assume that the person or corporation that sells the $100 to the central bank cashes the check at a local bank or at the central bank for currency. Nonbank public Assets Securities -$100 Currency +$100 Liabilities Assets Central bank Liabilities Securities +$100 Currency in circulation +$100 Result: reserves remain unchanged, while currency in circulation increases by the $100, thus monetary base increases by $100.

8 Channels for changing the monetary base open market operations Monetary expansion open market purchases expands the central bank s balance sheet Monetary contraction open market sales contracts the central bank s balance sheet Open market operations are run by central banks on a daily basis, not just for changing monetary policy conditions

9 Channels for changing the monetary base discount loans The central bank affects monetary base making discount loans to commercial banks. Let s assume that the central bank makes a $100 discount loan to a commercial bank. Assets Banking system Liabilities Reserves +$100 Discount loans +$100 Assets Central bank Liabilities Discount loans +$100 Reserves +$100 Result: monetary liabilities of the central bank have increased by $100 and the monetary base has increased by this amount. The central bank is committed to provide loans upon request at the discount rate, so it is in fact the private sector that decides whether the monetary base will be expanded (differently than OMO) The reserves provided to the system by the means of discount loans are called borrowed reserves. The remainder is called non-borrowed reserves. Hence, monetary base may be divided into non-borrowed monetary base (under the central bank s control) and borrowed monetary base (less tightly controlled).

10 Channels for changing the monetary base changes in international reserves Under fixed exchange rate central banks buy/sell foreign currency in order to stabilize the exchange rate If the central bank buys foreign currency, it pays in domestic currency and vice versa if sells foreign currency it gets paid in domestic currency. These transactions affect the monetary base. Foreign currency purchases increase monetary base (increase in international reserves in the central bank s balance sheet), foreign currency sales decrease the monetary base (decrease in international reserves). Accounting mechanism is the same as in the former cases.

11 Market for reserves Conventional monetary policy tools: OMOs, Discount lending, Reserve requirements, Interest on reserves Now we will see how the use of these tools affects interest rates. But to fully understand this mechanism we have to learn how the market for reserves works. Commercial banks have to hold required amount of reserves, proportionally to their deposits. They also may hold excess reserves or can lend it to other banks. The market for reserves is the interbank market on which banks trade the reserves and where the interbank interest rate is determined.

12 Market for reserves The interbank interest rate is very important interest rate in the economy. If the central bank could influence the interbank interest rate, it could influence the entire yield curve and thus the economy. Since the interbank interest rate is market interest rate, it is not directly determined by the central bank. However the central bank can manipulate the conditions on the market to affect the interbank rate. The central bank can create corridor for fluctuations of the interbank interest rate. It determines the discount rate (i d ), at which it makes loans to the commercial banks. It means that the interbank rate will never go above i d, because nobody would borrow at a higher rate. The interbank interest rate would also never fall below the interest rate paid by the central bank on excess reserves (i or ).

13 Market for reserves - equilibrium Source: Mishkin, p.412

14 Impact of monetary policy tools on the interbank interest rate - OMO Open market purchase leads to greater quantity of reserves supplied (higher nonborrowed reserves) Open market purchase shifts the supply curve to the right The effect on the equilibrium interest rate depends on the initial conditions An open market purchase causes the interbank rate to fall (unless it has already hit the lower band of the corridor i or in this case the interbank interest rate remains unchanged) An open market sale causes the interbank rate to rise (unless it has already hit the upper band of the corridor i d in this case the interbank interest rate remains unchanged)

15 Impact of monetary policy tools on the interbank interest rate - OMO Source: Mishkin, p.414

16 Impact of monetary policy tools on the interbank interest rate discount lending If the central bank decreases the discount rate (expansionary monetary policy), the supply curve shifts down. The effect of a discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section. A decrease/increase in the discount rate has no effect on the interbank interest rate, unless it is already equal to the discount rate. If the demand curve intersects the supply curve on its flat section (there is some discount lending), changes in the discount rate do affect the interbank rate (decrease/increase in the discount rate causes decrease/increase in the interbank rate).

17 Impact of monetary policy tools on the interbank interest rate discount lending Source: Mishkin, p.415

18 Impact of monetary policy tools on the interbank interest rate reserve requirement When the required reserve ratio increases, required reserves increase and hence the quantity of reserves demanded increases for any given interest rate. A rise in the required reserve ratio shifts the demand curve to the right. The effect on the equilibrium interest rate depends on the initial conditions. When the central bank raises reserve requirements, the interbank interest rate rises, unless it has already been equal to the discount rate i d. When the central bank lowers reserve requirements, the interbank interest rate decreases, unless it has already been equal to the rate i or.

19 Impact of monetary policy tools on the interbank interest rate reserve requirement Source: Mishkin, p.416

20 Impact of monetary policy tools on the interbank interest rate interest on reserves The effect of a change in the interest rate paid by the Fed on reserves depends on whether the supply curve intersects the demand curve in its downward-sloping section or its flat section. If the intersection occurs on the demand curve s downward-sloping section, a rise in the interest rate on reserves does not change the Interbank interest rate. If the intersection occurs on the demand curve s flat section, a rise in the interest rate on reserves raises the interbank interest rate.

21 Impact of monetary policy tools on the interbank interest rate interest on reserves Source: Mishkin, p.416

22 Impact of monetary policy tools on the interbank interest rate In practice, most effective and commonly used by central banks conventional instrument are OMOs Advantages of open market operations as monetary policy tools: The central bank has complete control over their volume Open market operations are flexible and precise OMOs are easily reversed OMOs can be implemented quickly; they involve no administrative delays

23 Can the central banks target monetary base and interbank rate at the same time? Targeting the nonborrowed reserves

24 Can the central banks target monetary base and interbank rate at the same time? Targeting the interbank rate

25 Criteria for choosing the policy instrument Observability and measurability Policy instrument is useful only if it signals the policy stance rapidly. Reserve aggregates are easily measured but with some lag. Short-term interest rates are easy to measure and immediately observable (however, nominal vs. real interest rates). Controllability Reserve aggregates are not completely controllable. Short-term interest rates are controlled very tightly (but, again, nominal vs. real interest rates!) Predictable effect on goals In recent years the dominant view is that the link between interest rates and goals (such as stable inflation) is stronger than between aggregates and inflation.

26 Taylor rule How the central banks choose the target interest rate? A simple answer to this question provided John Taylor (John Taylor, Discretion versus Policy Rules in Practice. Carnegie Rochester Conference Series on Public Policy 9(4), ). He proposed a simple rule for monetary policy, stating that monetary policy should respond to the deviations of inflation from the inflation target (inflation gap) and to the percentage deviation of real GDP from an estimate of its potential full employment level. According to the Taylor rule the central banks care not only about inflation but also stabilize output.

27 Taylor rule The original Taylor rule can be written as follows (for the Fed): Federal funds rate target= inflation rate + equilibrium real fed funds rate + ½(inflation gap) + ½(output gap) Taylor has assumed that the equilibrium real fed funds rate is 2% and that an appropriate target for inflation would also be 2%, with equal weights of ½ on the inflation and output gaps. i t = π t + 2% (π t 2%) y t

28 Taylor rule For the USA Taylor showed that the rule is a good empirical description for the Fed s monetary policy.

29 Taylor rule The Taylor rule works well for many central banks. It s specification evolved over time: Some authors suggested that it should include forecasted rather than current values of macroeconomic variables (Clarida et al. 1998, 2000; Batini, Haldane, 1999) i t = i + α(e[π t,k Ω t ] π ) + βe[y t,l Ω t ] Common assumption made in estimating Taylor rules is that the central banks smooth the interest rate path (Judd and Rudebusch, 1998) i t = ρi t 1 + (1 ρ)i t i t = ρi t ρ γ + απ t+k + βy t+l + ε t

30 Taylor rule It is argued that for open economies the Taylor rule should include additional variables, such as the exchange rate and the foreign interest rate (Ball, 1999; Svensson, 2000; and Taylor, 1999) i t = ρi t ρ γ + απ t+k + βy t+l + δx t Current approach in empirical studies on the Taylor rules assumes that the weights on the inflation and output gaps, the equilibrium real interest rate and the smoothing parameter are not constant but may change over time. Advantages of the Taylor rule: very simple and transparent, empirically robust, compatible with different economic views of monetary policy, combines inflation targeting with stabilizing policy Disadvantages: measurement problems

31 Taylor rule a global Great Deviation? Source: Hofmann B., Bogdanova B., 2012, Taylor rules and monetary policy: a global Great Deviation?, BIS Quarterly Review, September 2012.