the central bank & the economy. monetary transmission mechanism interbank interest rate money...
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Monetary Transmission Mechanism
Interbank Interest Rate
Money Market Rates
Forex
Rate
s
Economy
Stock P
ricesLT
Inter
est R
ates
Inventories
Trade Balance
Investment
Consumption
Policy Feedback• How does the central bank gauge whether the current
monetary policy is effective in guiding the economy toward its goals?
• If it is not, how do they choose the level of the operating target in order to guide the economy toward its goals?
Real Interest Rates and Demand• Components of aggregate demand are sensitive to the
real interest rate in a negative way. • Consumer Durables• Residential Housing• Corporate Investment
• High interest rates means an exchange rate appreciation which hurts the trade balance.
Shifts in Aggregate Expenditure
r
Y
AE
AE’
AE’’
•But other factors like consumer or
business confidence, fiscal policy, or foreign
demand factors will shift spending at any
given interest rate.
Monetary PolicyThe central bank stabilizes inflation using the interest rate target.
• If inflation is above target, πTGT, central bank will raise interest rate• If inflation is below target, πTGT, central bank will cut interest rate
Under Taylor Principle, inflation above target is associated with rising real rates.
Monetary Policy Reaction Curve
* TGTt tr r b
r* - Neutral real interest target b – inflation sensitivity
Monetary Policy Reaction Curve
r
π
r*
πTGT
MPR
• Real interest rate is an increasing function of the interest rate
Aggregate Demand Curve
Y
π
AD
• The reaction of monetary policy to inflation exacerbates the effect of inflation on AD.
Increasing π→Increasing r → Decreasing AD
• The more sharply that monetary policy responds to inflation, the more sharply demand responds to inflation.
Relationship between inflation and aggregate
demand depends on how sensitive MPC is to inflation
r
π
π
Insensitive
SensitiveInsensitive
Sensitive
MPR
AD
AD
MPR
Y
Short Run Aggregate Supply Curve• Some wages and prices will be pre-set based on price-
setters inflation expectations. When inflation is accelerating ahead of expectations, firms will respond with extra production (ex. McDonalds).
• Potential output is an efficient level of production when inflation expectations match actual inflation. Associated with an economy with flexible prices.
• The output gap is the percentage deviation between potential real GDP and real GDP.
• P
t tt P
t
Y YOutput Gap
Y
Rise in Household-Business Confidence\Stock-Real Estate Market Booms\
Expansionary Fiscal policy The AD Curve
Shifts Out
Y
π
AD
AD'• Various events may shift demand out for goods at any given interest rate• Household
consumption may increase because of optimism or wealth effect
• Corporate investment may increase because of optimism
• Government Deficit Spending
Adaptive Expectations• Adaptive Expectations: Inflation expectations adjust to
actual inflation
• Et-E
t-1= [t-Et-1]
• The SRAS adjusts to self-correct the output gap.• Eventually, inflation expectations catch up with inflation.
π
Y
YP
SRAS
AD Insensitive
AD Sensitive
1
2a2b
• The more sensitive is monetary policy, the flatter is the AD curve.
• The flatter the AD curve, the less that inflation will need to decline to return the economy to potential output.
Inflation Targeting:Inflation Sensitive Interest Rate Rule
• Under inflation targeting, central bank is sensitive to the inflation rate in setting the interest rate, raising interest rates in response to increasing inflation, cutting interest rates
• A benefit of this approach is not only stable inflation and inflation expectations, but also more stability of output and shorter duration business cycles in the face of demand shocks.
21
Short-term Stabilization
• When output gap is negative, inflation tends to be decelerating. Stabilizing inflation can also stabilize the business cycle
Japan
-3
-2
-1
0
1
2
3
-8 -6 -4 -2 0 2 4 6
Output Gap
Infla
tion
Acc
eler
atio
n
Inflation Acceleration =
Today LastYearInflation Inflation
Supply Shocks• Inflation itself may be subject to cost-push shocks such as
energy prices etc.• A monetary policy committee which strives to maintain a
fixed inflation target with a very sensitive MPR will face a relatively large decline in output to maintain the target.
• Central bank often adjusts the inflation target to supply side conditions
An MPR for HK
,
1 , 1E HK HK Et t t t HK t
HK US USA HKt t t t
r i
r r
• Remember in HK, the nominal interest rate is equal to the US$ interest rate.
• Again, assume that inflation expectations respond to actual inflation
• In HK, as inflation rises, real interest rate falls!