Chapter 10 - Monetary Policy Flashcards
Objectives and Mechanisms
Primary Goals of Monetary Policy
Main Goal is Price Stability.
- Inflation should be low and reasonably stable which is also known as Flexible Inflation Targeting
Other goals include:
- High and stable employment (not LR)
- Sustainable Growth
- Well-functioning financial markets
Why is Inflation the main goal of MP? Should it not be Employment?
Macroeconomic theory suggests that MP cannot affect LR level of production and employment.
This is because it cannot keep employment and production above natural level of production as this would cause a rise in inflation (and could be permanently high)
What happens to to the Phillips curve and IS-LM model when there is a positive demand shock?
(i.e. Consumers become optimistic about the future and expected future incomes increase)
Expected inflation doesn’t change.
AD increases causing the IS curve to shift outwards
- this causes inflation to increase above target level
- Central Bank should increase interest rates
What happens to the Phillips curve and IS-LM model when there is a cost-push shock?
(i.e. in the form of an increase in the price of oil raising cost of firms)
This causes the Phillips curve to shift upwards so inflation will be higher for given output gap.
IS curve shifts but unclear which way.
- If you are the importer of oil it will shift inwards as the cost increases making the country poorer
- If you are exporting oil, this will cause IS curve to shift out as the price will redistribute income
For simplicity it remains unchanged in diagram (IS) but evaluation point
What is the central bank’s communication problem?
in terms of inflation
It may be difficult to communicate to the public that a temporary cost-push shock is only temporary and not expansionary monetary policy which may then increase expected inflation!
- CB will be swayed by how wage setters form expectations about inflation
- If wage setters base inflation expectations on past inflation rates then this may lead to persistent inflation then CB will set IR even higher to counteract rising expectations of inflation
Issues that monetary policy makers face!
They cannot observe certain things which may make decisions difficult, some of which include:
- Exogenous shocks
- natural levels of interest & production
- Wage setters’ expectations about inflation
Time-lag is another issue
- a change in IR affects production with a lag of about 6 quarters and maximum effect on inflation appears after about 2 years
What is the difference between inflation and core inflation?
Core inflation excludes items that face volatile price movements.
- These are taken out of calculations as they impose a temporary shock on the inflation trend and give a false impression on actual changes in price levels
- This includes Energy and other Food stuff and indirect tax (VAT)
What are the 3 reasons why inflation may be above target?
1) Expected inflation is above target
- CB will raise IR to bring inflation down
2) There is a positive output gap
- If demand is expected to remain high then CB will raise the interest rate
3) Cost-push shock
- if shock is temporary CB won’t raise IR
How does the CB control Interest Rates?
Controls short term IR by offering to lend money at an interest rate (decided by decision making board at CB)
Can create new money (monetary base) it can always lend enough money to get the IR where it wants to be!
Interbank market (overnight borrowing)
Banks are not allowed to have a deficit overnight (it can during the day)
If accounts are not balanced by the end of the day then they need to borrow from other banks in the interbank market overnight. (known as federal funds market int he US)
- If bank has a deficit overnight then it automatically converts to overnight borrowing form the CB
- this isn’t ideal for commercial banks as the IR is normally higher with borrowing from CB’s than the interbank market
(this is the celling for the IR in the interbank market) - if CB sees that core inflation doesn’t change but CPI inflation does then the cost-push shock is temporary
Repo Rate (definition)
it is the interest rate implicit in a repurchase agreement.
Another form of a commercial bank taking a loan, they sell securities (gov bonds) to the CB with the agreement of repurchasing the security at a later date at the repo rate.
- repo rate is higher than the initial price of purchase.
advantage:
- buyer holds the seller’s asset as collateral during the duration of the loan
disadvantage:
- repo rate may rise if there is financial uncertainty
Interbank Rate (definition)
interest rate in the interbank market where banks loan to each other!
Overnight interbank rate and repo rate are very close, why?
This is because when a commercial bank is looking to borrow, these are 2 substitutes.
If IR in one market was significantly higher than the other then almost all borrowers would try to borrow in the market with the lower rate, driving up the rates here and resulting in a convergence between repo and interbank rate.
What would cause the interbank rate to differ from repo rate?
difference = repo rate involves collateral
- therefore would expect the change be due to a change in the demand for collateralisation of loans
- if there is financial uncertainty and risk that bank may default then Interbank Rate may > well above Repo Rate
- periods of financial panic often associated with interbank rates well above repo rate
Overnight interbank rate is typically very close to IR on short term government debt! why?
This is because when commercial banks are looking to deposit/lend money these markets are very close substitutes for each other.
- bank can use it to buy a ST gov bond or lend the money onto the interbank market
- if IR was much higher in one, would expect almost all banks to put their money in the market with the higher rate - driving rates down in that market and leading to the rates in the market to converge
