Macroeconomics for Finance Joanna Mackiewicz-Łyziak Lecture 1
Contact E-mail: jmackiewicz@wne.uw.edu.pl Office hours: Wednesdays, 5:00-6:00 p.m., room 409. Webpage: http://coin.wne.uw.edu.pl/jmackiewicz/
Introduction topics that we will discuss Monetary policy Instruments and goals, monetary policy rules; Zero lower bound and non-conventional monetary policy; Monetary transmission mechanism; Fiscal policy Determinants of sovereign bonds yields; Public debt dynamics, fiscal sustainability; Sovereign debt crises;
Topics cont. Exchange rates Determinants of exchange rates; Exchange rate regimes; Currency crises; Financial crises in advanced and emerging economies Business cycles and financial cycles
Exam Multiple choice test 30 questions (1 correct answer 1 p.) 2 open questions analytical problems concerning theory and empirical examples discussed during the course (5 p. for each question). Max 40 points, passed from 20 points.
Today s lecture outline Monetary policy Monetary policy goals Money supply proces Conventional monetary policy tools Mishkin F., Economics of Money, Banking and Financial Markets, 11/e, chapters 15, 16,17
Why do we start with central banks? Central banks are the government authorities in charge of monetary policy and therefore are among most important players in financial markets. Central banks affect interest rates, the amount of credit and the money supply all of which have direct impacts on financial markets, but also on output and inflation. We will see that central banks in fact operate through financial markets. What are the central banks goals?
Goals The primary goal of most central banks is to maintain price stability Price stability is desirable because inflation creates uncertainty in the economy and that uncertainty might hamper economic growth. Why most central banks are primarily focused on the price stability goal? Rational expectations and time-inconsistency problem (Barro and Gordon, 1983). Tinbergen rule: if there exist conflicting goals of economic policy, you need as many (independent) policy tools as you have goals. Monetary policy is more efficient in achieving the inflation goal, while fiscal policy in achieving the output goal. Inflation is monetary phenomenon in the long-run and monetary policy is assumed to be neutral in the long-run (does not affect real activity).
Goals Central banks may also have goals other than price stability, e.g.: Economic growth High employment Financial stability External balance Exchange rate stability The central bank s goals may be different in different countries Hierarchical vs. dual mandate Hierarchical mandate price stability is primary goal and other policy goals may be pursued so long as they don t conflict price stability. Dual mandate the central bank may pursue simultaneously price stability and other goals, even potentially conflicting with price stability.
Goals The European Central Bank (ECB) has a hierarchical mandate: The primary objective of the European System of Central Banks shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community.
Goals The Federal Reserve Bank (Fed) has a dual mandate: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate longterm interest rates.
Goals The Bank of Japan (BoJ): Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy. The National Bank of Poland: The basic objective of the activity of NBP shall be to maintain price stability, while supporting the economic policy of the Government, insofar as this does not constrain the pursuit of the basic objective of NBP. The Peoples Bank of China: The objective of the monetary policy is to maintain the stability of the value of the currency and thereby promote economic growth.
From tools to goals The central bank cannot directly control such variables as inflation or economic growth (final goals) The central bank has a set of tools open market operations, changes in the discount rate, and changes in reserve requirements. They are directly controlled but they affect the goals indirectly after a period of time. The central banks use intermediate targets variables that have direct impact on the price level and employment, such as the monetary aggregates (M1, M2 or M3) or interest rates (short- or long-term). However, even the intermediate targets are not directly affected by the central bank s policy tools. Therefore, central banks use another set of variables to aim for policy instruments or alternatively operating instruments, such as reserve aggregates (reserves, nonborrowed reserves, monetary base, or non-borrowed base) or interest rates. They are more responsive to policy tools and indicate the stance (easy or tight) of monetary policy.
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
From tools to goals 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.
Money supply Before we will discuss tools and intermediate targets of monetary policy, let s recall what money supply is. Money Supply (MS) = Currency (C) + Deposits (D) Money supply is not directly controlled by the central bank. Much tighter control the central bank has over monetary base. To understand monetary base and hence the money supply process, let s start from considering the central bank s balance sheet. Assets Government securities Discount loans The central bank Liabilities Currency in circulation Reserves
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: Buying treasury bonds on primary markets Open market operations Discount loans Changes in international reserves
Channels for changing the monetary base buying government bonds on the primary market The central bank can increase monetary base by buying newly issued treasury bonds. This is the direct way of financing the budget deficit by the central bank with the government issuing new debt (selling bonds) and the central bank buying them. Financing debt by the central bank (monetizing debt) can create inflationary pressures. Governments have strong incentive for monetizing debt. In most countries buying bonds by the central banks on primary markets is prohibited to guarantee the central banks independence.
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.
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
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.
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
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).
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.
Back to the money supply So far we understand how the central bank affects the monetary base. But what we really want to know is how the money supply is determined. Let s repeat: Monetary Base = Currency + Reserves Money Supply = Currency +Deposits To understand the link between the money supply and the monetary base one has to analyze the relationship between reserves and deposits. Since the money supply is broader than the monetary base it means that increase of reserves by $1 causes increase in deposits by more than $1. That conclusion leads us to deposit creation and the money multiplier.
Deposit creation Let s assume that the reserve requirement rr=10% (the share of deposits the commercial banks must deposit as reserve at the central bank). The central bank increases monetary base through OMOs by $100. The commercial bank A that sells securities to the CB finds that it has an increase in reserves of $100. Assuming that the bank A does not want to hold excess reserves and because its deposits have not increased, it can make a loan equal in amount to $100. Let s assume that the borrower deposits the $100 deposit created by the loan at bank B. It means that the bank B has available $90 for new loan ($100 = $10 required reserves + $90 excess reserves). The next bank that receives new $90 deposit, must keep 10% of $90 as required reserves and has $81 available for a new loan, and so on It means that the initial increase of the monetary base increases the deposits by: 100+(1-rr)100+(1-rr) 2 100 +(1-rr) 3 100+ =(1/rr)100 ΔD=(1/rr)ΔR Deposits increase by a multiple of the initial amount of OMO done by the central bank.
Factors that determine the money supply Player Variable Change in variable Money supply response Reason Central bank Banks Nonborrowed monetary base, MB n Required reserve ratio, rr Borrowed reserves, BR Excess reserves More MB for deposit creation Less multiple deposit expansion More MB for deposit creation Less loans and deposit creation Depositors Currency holdings Less multiple deposit expansion Source: Mishkin (2015), p.401
Money multiplier So far we assumed that there are no excess reserves and that people keep no money as cash. Let s note: rr required reserves ratio, the ratio of deposits that banks must keep as required reserves, e excess reserves ratio, the ratio of deposits that banks want to keep as excess reserves, c currency ratio, the ratio of deposits that people want to keep as cash. rr = RR D e = ER D c = C D
Money multiplier MB = R + C = RR + ER + C = rd + ed + cd = rr + e + c D MS = C + D = cd + D = c + 1 D MS = c + 1 rr + e + c MB = m MB We derived the money multiplier: m = c+1 r+e+c It tells how much the money supply changes in response to a given change in the monetary base.
Money multiplier How changes in the parameters affect the money multiplier: rr the money multiplier and the money supply are negatively related to the required reserve ratio. Increase in reserves means that banks can provide fewer loans. Required reserve ratio is set by the central bank. e - the money multiplier and the money supply are negatively related to the excess reserves ratio, for the same reasoning as above. Excess reserves ratio is determined by banks. c the money multiplier and the money supply are negatively related to the currency ratio c. Currency does not undergo multiple expansion, so more money kept as cash must negatively affect money multiplier. This amount is determined by depositors. Conclusion: the central bank does not have full control over money supply. It controls the monetary base (but full control only over non-borrowed monetary base) and the required reserve ratio. Excess reserves and currency ratio are not controlled by the central bank.
Quantitative easing and the money supply in the US, 2007-2014 Large-scale asset-purchase programs by June 2014 377% increase in the monetary base (quatitative easing) M1 money supply rose by less than 110%. Source: Mishkin (2015), p. 406
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. We know that 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.
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 ).
Market for reserves - equilibrium Source: Mishkin, p.412
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)
Impact of monetary policy tools on the interbank interest rate - OMO Source: Mishkin, p.414
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).
Impact of monetary policy tools on the interbank interest rate discount lending Source: Mishkin, p.415
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.
Impact of monetary policy tools on the interbank interest rate reserve requirement Source: Mishkin, p.416
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.
Impact of monetary policy tools on the interbank interest rate interest on reserves Source: Mishkin, p.416
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