monetary policy - slides

8/10/2019 Monetary Policy - Slides

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MACROECONOMICS

2013 Worth Publishers, all rights reserved

PowerPointSlides by Ron Cronovich

N. Gregory Mankiw

Monetary Policy12-13

MacroeconomicsProf. Rudra Sensarma

Indian Insti tute of Management Kozhikode

www.rudrasensarma.info


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Learning objectives & outcomes

MonetaryPolicy

MoneyDemand,MoneySupply&InterestRate

QuantityTheory

of

Money

MonetaryPolicyTargets

2


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SimplifiedBalanceSheetofRBI

Liabilities Assets

Currencyincirculation(held

bypublic&somebybanks)

Domesticassets(government

bonds,loanstobanks,otherfinancialinstitutions)

Reserves

(depositsby

banks

CRR

&

excessreserves)

Foreignassets

(foreigngovernment

bonds,

gold,forex reserves)

Nonmonetaryliabilities(paid

upcapital,employeesPFetc.)

Otherassets

(physicalassets)


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MoneyDemand,MoneySupply,

andthe

Equilibrium

Interest

Rate

The interest ratemust be such that

the supply of money

be equal to the

demand for money.


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TheEffectsofanIncreasein

NominalIncome

on

the

Interest

Rate

An increase in

nominal income

leads to anincrease in the

interest rate.


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TheEffectsofanIncreaseinthe

MoneySupply

on

the

Interest

Rate

An increase in the

supply of moneyleads to a

decrease in the

interest rate.


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This sets off the spendingmultiplier process, so theaggregate output demandedat price level P increases from

Y to Y

EffectsofanIncreaseintheMoneySupplyon

InterestRates,Investment,andAggregateDemand

An increase in the moneysupply drives the interestrate down to i'.

With the cost of borrowinglower, the amount investedincreases from I to I.

Dm

0 MoneyM M

Sm Sm

b

aInteres

trate

i

i

(a) Supply and demand

for money

DI

0Investment

I I

Interes

trate

i

i

(b) Demand for

investment

AD

0 Real GDPY Y

Price

leve

l

P

(c) Aggregate demand

ADb

a

b

a


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ExpansionaryMonetaryPolicytoCorrecta

Contractionary Gap

At a, the economy is producing

less than its potential in the shortrun, resulting in a contractionarygap of $0.2 trillion.

If the Central Bank increases the

money supply by just the rightamount, the aggregate demandcurve shifts rightward from AD toAD. A short-run and long-runequilibrium is established at b,

with the pride level at 130 andoutput at the potential level of$14.0 trillion

Price

lev

el

125

130

AD

SRAS130

a

Potential outputLRAS

Real GDP

(trillions of dollars)

0 14.013.8

AD

b

Contractionary gap


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IntheLongRun,anIncreaseintheMoneySupply

Resultsin

aHigher

Price

Level,

or

Inflation

The quantity theory of moneypredicts that if velocity is stable,then an increase in money

supply in the long run results ina higher price level, or inflation.

Because the long-runaggregate supply curve is fixed,

increases in the money supplyaffect only the price level, notreal output.

Price

level

130

140

AD

Potential output

LRAS

Real GDP

(trillions of dollars)

0 14.0

AD

b

a


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Howdoes

RBI

change

money

supply?

RBIcanchangethesupplyofmoneythroughOMOs

(OpenMarket

Operations)

IfRBIbuysbondsandpaysforitusingmoney,it

increases

money

supply

(expansionary

monetary

policy).

IfRBIsellsbondsandreceivesmoneyforit,it

reducesmoneysupplyintheeconomy(contractionary monetarypolicy).


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How

does

RBI

change

money

supply?

Threemaininstrumentsofmonetarypolicy:

1. Therepo

rate

2. Cashreserveratio

3. Openmarketoperations


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Reporate

definition:

TheinterestratethattheRBIchargesonshorttermloans(e.g.

overnight)it

makes

to

banks

under

arepurchase

agreement

(8%).

howitworks:

Whenrepo

rate

is

lowered,

banks

borrow

more

from

RBI,

whichallowsthemtomakemoreloansandcreatemore

money.

Howevertheprocessgetsreversedthenextdayasthisisonly

aliquidityadjustmentfacility(LAF).


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RepolendingbyRBItobanks

RBI CommercialBank

(sells

bond)

RBI CommercialBank

(repurchasesbond)

Funds

Govtbond

Govtbond

Nextdaythetransactionisreversed

Funds

RBIchargesbanks8%(reporate)forthisliquidityadjustmentfacility


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Cashreserveratio

definition:

RBIregulationthatrequiresbankstoholdaminimum

cashreserve

deposit

ratio.

howitworks:

IfRBIreducescashreserverequirements,

thenbanks

can

make

more

loans

and

createmoremoneyfromeachdeposit.


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Openmarketoperations

definition:

Theoutrightpurchaseorsaleofgovernmentbondsby

theRBI.

howitworks:

IfRBIpurchasesbondsfrombanks,itreleasesliquidityin

exchangefor

the

bonds,

which

allows

banks

to

make

moreloansandcreatemoremoney.


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Otherinstruments

of

monetary

policy

Interestrateregulation(nolongerinuse)

Selectivecreditcontrols(prioritysector

lending,

margin

requirements

for

lending,

risk

ratingofsectors)

Moralsuasion

(enlisting

the

cooperation

of

bankstopursueRBIsobjectives)


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Monetary

Policy

Targets

PrimaryInstrument:

Reporate

(undertheLAF)

Secondaryinstruments:

CRR

OMOsIndirectInstruments:

Interestrateregulation

SelectiveCreditControl

MoralSuasion

Bankreserves

ShortTerm

InterestRate

(overnightcallrate)

GDP

Growth,

Price

Stability

InstrumentsOperating

Targets

Ultimate

Objectives

Transmission

Channels

ofMonetary

Policy

MoneySupply

LongTerm

InterestRate

(e.g.loanrate)

Intermediate

Targets

Strengthofmoney

multiplier,

Strengthof

Relationship

b/wshort&

longterminterestrates


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Transmissionchannelsofmonetary

policy

Howhighermoneysupplyorlowerinterestrateinfluences

theultimate

objectives

(output,

prices):

Bankchannel(lowerinterestrate,morelending,investment

&GDPbuthigherprices)

Exchange

rate

channel

(lower

interest

rate,

dollar

outflows,

weakerrupee,higherexports&GDPbuthigherprices)

Assetpriceschannel(lowerinterestratewillboostpresent

valueofshares,firmscanraisemorefundsthroughIPOs,

moreinvestment

&

GDP

but

higher

prices)


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Controversy:RBIsmonetarypolicyvsdebt

managementroles

conflict

of

interest?


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Theconflictofinterest

Asdebtmanager(investmentbanker)togovt,RBIhasto

keepinterestratelow

Thisconflict

with

its

monetary

policy

role

which

requires

highinterestratetofightinflation

Govt&severalexpertcommitteesinfavourof

independentdebt

management

office

(DMO)

RBIresisted,nowsaysitwantstoheadDMO!


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Controversy:RBIsrefusaltopayintereston

CRRbalances


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Analytics

of

the

problem

Thebanksargument Notpayinginterestamountstoanimplicittaxonbanks RBIearnsprofitsfrominvestingthefunds,soshouldshare

it

RBIsargument PayinginterestratesimplyreduceseffectiveCRR

Supposedepositsincreaseby1000croresleadingtohigherreservesby40crores(CRR=4%)

IfCRRbalancesarepaid7%interest,effectiveCRR

maintenance=40

7%

of

40

=37.20

cr or

3.72%

RBIcansimplyincreaseCRRto4.3%andnothingwillchange!


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Globaltrendsinmonetarypolicy

AlanGreenspan,ChairmanofUSFed,19872006

Gainedappreciationfortacklingthe1987crash

withinmonthsofjoining

Knownfor

super

low

interest

rates

&

disdain

for

regulation

FeaturedinTimemagazineslistof25peopleto

blameforthecrisis


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Theproblemwithlowinterestrates

Lowinterestratesfuelledaneconomicboomin

1990s early2000s

Lowinterestratesacrossthedevelopedworld

encouragedrecklessborrowing

Superlowinterestratesdidnotleaveroomfor

ratecutswhencrisisstruck


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Monetarypolicyatthecrossroads

Newtoolsofmonetarypolicy:

Quantitativeeasing,Twistoperation

Thenwhataboutinflationtargets?

Inflationtargetabandoned(UK,EU)

IsInflationawayoftacklinggovernment

debt?!Seignorage(not discussed

in

class

butyouareencouragedtoreadup)

NominalGDPtargetingisbeingtalked

aboutas

an

alternative (not

discussed

in

classbutyouareencouragedtoreadup)


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https://www.youtube.com/watch?v=v7LQcJbm3dE

Raghuram RajanonMonetarypolicy


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Next

Macroeconomic Policy Debates

Active Policy Vs Passive Policy

The Role of Expectations

The Phillips Curve

monetary policy - slides

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