ECON1102:Week8

MonetaryPolicy
ReadChapter8

Unit8:MonetaryPolicy
1.
2.
3.
4.

Moneysupplyandmonetarypolicy
MoneymarketEquilibrium
TransmissionMechanism
PolicyReactionFunction

MoneySupplyvInterestRatetargeting
Therearetwopolarcasesthatwecanconsider;

1. Thesupplycurveformoneyanditspositionis
influencedbytheactionsoftheRBA

2. Thesupplycurveformoneyishorizontalandthe
RBAsuppliesmoneyondemand(atagiveni)

Thedifferentapproachestotheimplementationofmonetarypolicy
RBAtargetsmoneysupply
interestrate(i)

MS

setMSori*

i*

MD
0
money

RBAtriestocontrolthemoneysupply(currencyanddeposits)by
(openmarketoperations)OMO
interestrate(i)

MS

setMSori*

i*

MD
0
money

CanRBAControlMoneySupply?
CaninfluencemoneysupplybyOpenMarket
Operations
Bankscancreatemoneybyissuingloans,and
willdosowhenprofitable.
RBAcaninfluenceBUTNOTcontrolmoney
supply
Mscurveisneververtical

RBAtargetstheinterestrate(on
bonds)
Giventhedemandformoneyfunction,the
RBAwillsupplywhateverquantityofmoney
requiredtoachieveitstargetvalueforthe
interestrate.

Shiftsinmoneydemandareaccommodated
bytheRBAattheinterestratetarget.

RBATargetscashrate
i
i0

Ms
Md
M0

Usingopenmarketoperations(OMO)totargetthe
CASHRATE

BanksholdaccountswithRBA:exchange
settlementaccounts
Thebalanceintheexchangesettlementaccounts
arecalledexchangesettlementfundsorcash
TheCASHRATEistheinterestratewhichbrings
togetherthesupplyanddemandforexchange
settlementfundsintobalance
RBAusesOMOtoinfluencetheCASHRATE
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OpenMarketOperationsinvolve..
TheRBAbuyingandsellingshorttermgovernmentbonds
- Sellinggovernmentbondsmeansbankreservesfall,as
thebuyerspayforthemanddrawontheirbankdeposits
- cashraterises
- Buyinggovernmentsecuritiesmeansbankreservesrise,
astheRBApaysforthemandthesellersdepositthe
proceedsinbanks
- cashratefalls
Moneysupplyiswhateverisrequiredtomaintainthe
cashrate
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RBATargetstheCashRate
AtitsmonthlymeetingtheRBAboarddecideswhat
changes,ifany,shallbemadetothecashrate
http://www.rba.gov.au/monetarypolicy/rbaboard
minutes/2014/01042014.html
RBAthenconductsopenmarketoperationsto
achievethisrate
RBAisalsorequiredtointerveneonanongoingbasis
tokeepthecashrateatitstargetlevel
FlowontootherinterestratesRBAcaninfluence

overalllevelofinterestratesineconomy
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TheFinancialSystem
Awellfunctioningfinancialsystemimproves
theallocationofsavingintwoways:
1. Itprovidesinformationtosaversabout
possibleusesof,andreturnsto,their
funds.
2. Ithelpssaverstosharetherisksof
individualinvestmentprojects.

Bonds
Abondisalegal
promisetorepaya
debt,usuallyincluding
boththeprincipal
amountandregular
interest,orcoupon,
payments.

Bonds
Thecouponratedependson:
Thetermofthebond(thelengthoftimeuntilthe
bondsmaturationdate).
Creditrisk(theriskthattheborrowerwillgo
bankruptandthusnotrepaytheloan).
Taxtreatmentofcouponpayments.
Bondownersarenotrequiredtoholdtheirbonds
untiltheirmaturationdates.
Theyarealwaysfreetoselltheirbondsinthebond
market.

Bondpricesandinterestrates
Themarketvalueofaparticularbondatany
givenpointintimeiscalledthepriceofthe
bond.
Thepriceofabondcanbegreaterthan,less
than,orequaltotheprincipalamountofthe
bond,dependingonhowthecurrentor
prevailinginterestrateinfinancialmarkets
compareswiththeinterestrateatthetime
thebondwasissued.

Interestrates,bondpricesandmoney
marketequilibrium
Whyareinterestratesandbondpricesinversely

related?
Iftheinterestrateisbelowtheequilibriummarketpricefor
money,thedemandformoneyisgreaterthanthesupply.
Toincreasemoneyholdings,thepublicwillstarttosellofftheir
bonds.
Anincreaseinthesupplyofbondsleadstoareductionintheir
price,whichisequivalenttoanincreaseininterestrates.
Athigherinterestrates,thedemandformoneywilldecline,until
equilibriumisreachedwherethemoneydemandisequaltothe
amountofmoneyavailableatthatinterestrate.

Marketfor90DayBills:Demandand
Supply

Borrowfor90days=SupplyofBills
BorrowmorewheninterestrateonBillsislow.
BUT,lowinterestrateimpliesahighpriceforBills
So,SupplycurveforBillsisincreasingintheirprice

Marketfor90DayBills:Demandand
Supply

Lendfor90days=DemandforBills
LendmorewheninterestrateonBillsishigh.
BUT,highinterestrateimpliesalowpriceforBills
So,DemandcurveforBillsisdecreasingintheir
price

Example:Themarketfor90daybills
Figure8.1Themarketfor90daybills

TheEffectofanIncreaseintheCash
Rateonthe90DayBillMarket
InthepreviousfigurePerepresentstheequilibrium
pricefor90daybills.Thiswillalsocorrespondto
anequilibriuminterestratefor90daybills.
NowsupposetheRBAraisesitstargetlevelforthe
cashrate.Howdoesthisaffectthemarketfor90
daybills?
Banksareabletoparticipateinboththeovernight
cashmarketandinthecommercialbillmarket.

TheEffectofanIncreaseintheCash
Rateonthe90DayBillMarket
WhenCashRateIncreases.
Thedemandforcommercialbills(thewillingnessto
lendtofirms)willtendtofall:Demandcurvewillshift
totheleft.
Thisoccursbecausesomebankswillleavethebillmarketin
favourofthehigherreturnsintheovernightcashmarket.

Thesupplyofcommercialbills(thedemandfor90day
loans)willtendtorise:Supplycurvewillshiftoutwards.
Someborrowersintheovernightcashmarketwillnowseek

fundsinthe90daybillmarket,duetothehigher

cashrate

HowdoestheReserveBankaffect
nominalinterestrates?
Figure8.2Theeffectofanincreaseinthecashrateonthe90daybillmarket

Arbitrage
WhileRBAtargetsaveryshortinterestrate,
changesincashrateeventuallyleadtochanges
inlongerterminterestrates.(Aswesawlast
week)

MarketRates=CashRate+Premium

Premiumwilltendtoreflectriskorliquidity
factors.

CantheRBAtargettherealinterestrate?
RBAtargetnominalinterestrate(i)thecashrate
throughOMO

Decisionstosaveandinvestdependontherealinterest
rate(r)

Recall,r=i (wherer=realinterestrate,

i=nominalinterestrate

=inflationrate)

sinceinflationrateadjustsreasonablyslowly,RBAcan
changetherealinterestrate(r)inshortrunbychanging
thenominalinterestrate(i)
Inlongrunrdependsonthesupplyanddemandforsavings

andinterestratedifferential(ascomparedtooverseasinterest

rates)
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7.Howchangingmonetaryconditionsaffecttheeconomy
thetransmissionmechanism
Currentmonetarypolicyworksbychangingthecashrate
TheRBAsells/buysgovernmentsecuritiestoachieve
targetedcashrate
Thebanksbuy/sellgovernmentsecuritiestoaccommodate
theRBAandreserveschange
Asbankreservesfall/rise,banksreduce/increaseloans
Theincrease/reductioninthecashratefeedsthroughto
othershortterminterestrates
Impactsgenerallevelofspendingandthebroadereconomy

27

Monetarypolicyandtheeconomy

cashrate
otherrates

realinterest
rate

spending(I,C)
exchangerate
(NX)

output
employment
inflationary
pressures

28

PAEandtheRealInterestRate
Inourmodelofincomedeterminationwehave
allowedPAEtodependonthelevelofrealoutput.
Wenowwanttoallowarolefortherealinterestrate
toinfluencePAE.

2mainchannels
1. Higherrealinterestrateswillleadhouseholdsto
reducecurrentconsumptioneg.Duetohigher
mortgagepayments
2. Higherrealinterestrateswillraisethecostof
borrowingandreduceinvestmentbyfirms

TheRBAfightsarecession

cashrate
otherrates

realinterest
rate

spending(IC)
depreciation$A
(NX)

output
Employment

inflationary

pressures

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TheRBAfightsarecession

r
SandC
Investment
Depreciationof$Alowerrealexchangerate
increaseininternationalcompetitiveness
demandforXanddemandforM

31

ModelforPAE
Consumption

C d C c(Y T ) ar

Investment

I P I br

Assume (for simplicity) other variables are exogenous

GG

X X

T T

PlannedAggregateExpenditure
Cd C c(Y T) ar

I I br
P

G G

X X
T T
PAE Cd I P G NX

Substitute and collect terms

PAE [C cT I G X (a b)r] cY

Implications

Exogenousexpenditurenowdependsonthereal
interestrate

Foranygivenlevelofoutput,PAEwillfallwitharise
intherealinterestrate.

IfweassumethattheRBAcansettherealinterest
rate,thenwehaveamechanismbywhichmonetary
policycanaffectPAEandequilibriumoutput

Whyloweringinterestratesdoesnot
alwayswork
Accordingtotheprecedingdiscussion,alowerrealinterest
ratewillbeassociatedwithincreasedplannedaggregate
expenditurebyhouseholds.
However,lowrealinterestrateneednotalwaysstimulate
expenditure.
Consumption
Householdsmayraisesavingforprecautionaryreasons.
Thewilltoreducenetdebtandtorebuildwealthpersists
Investment
Especiallyinrecessions,investmentmaybeinterestinelastic

Example:PAEandtherealinterestrate
Inaneconomydescribedby:
Cd=640+0.8(YT)400r
Ip=250600r
G=300
X=20
T=250
BothCdandIpareaffectedbytheinterestrate,r.
PAE=Cd+Ip+G+X
=[640+0.8(Y250)400r]+[250600r]+300+
20
=[10101000r]+0.8Y

PAEandtherealinterestrate
PAE=[10101000r]+0.8Y
Theexogenousexpenditureinthiseconomyis

[10101000r]anddependsontherealinterestrate,r.

Iftherealinterestrateis5%,theequilibriumoutputis
givenby:
PAE=[10101000x(0.05)]+0.8Y
PAE=Ye,so:
Ye=960+0.8Y=4800

TofightarecessionbyhowmuchshouldtheRBA
lowerinterestrates(from5%)?
Weknowatr=5%,Ye=4,800,howeverifY*=5,000
Wehavearecessionarygapof200
Byhowmuchshouldrbereduced?

Recall,Exogenousexpenditure=(1,0101,000r)(Eq1)
Witharecessionaryoutputgapof200,andamultiplierof5,
exogenousexpendituremustriseby40
FromEq1,each1%reductioninrwouldincreaseexogenous
expenditureby10
A4%reductioninrwouldincreaseexogenousexpenditureby
40
rshouldfallfrom5%to1%

38

TheRBAfightsarecession
PAE(plannedaggregateexpenditure)

PAE(r=1%)
PAE(r=5%)

Areductioninrshifts
PAEupward

0
4,800

Y*=5,000

Y(=GDP)
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39

SupposeinsteadY*=4,600wehaveanexpansionarygap
byhowmuchshouldtheRBAraiseinterestrates(from
5%)toclosetheoutputgap?

Weknowatr=5%,Ye=4,800,howeverY*=4,600
Wehaveanexpansionarygapof200,byhowmuchshouldrbe
increased?

Recall,Exogenousexpenditure=(1,0101,000r)(Eq2)
Withanexpansionaryoutputgapof200,andamultiplierof5,
exogenousexpendituremustfallby40
FromEq2,each1%increaseinrwouldreduceexogenous
expenditureby10
A4%increaseinrwouldreduceexogenousexpenditureby40
rshouldincreasefrom5%to9%

40

TheRBAfightsinflation
PAE(plannedaggregateexpenditure)

Anincreaseinrshifts
PAEdown
PAE(r=5%)
PAE(r=9%)

0
Y*=4,600

4,800

Y(=GDP)
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41

8.ModellingthebehaviouroftheRBA

thePolicyReactionFunction

TheRBAattemptstostabilisetheeconomybymanipulating
therealinterestrateinresponsetotheoutputgapandthe
inflationrate
Apolicyreactionfunctiontriestoexplain/predictbyhow
muchtheRBAchangesthecashratewhenthereare
changesinthestateoftheeconomy(egoutputgap,
inflationrate)
THETAYLORRULEhasbeendevelopedtodescribethe
behaviouroftheUSFederalReserve

r=0.010.5[(Y*Y)/Y*]+0.5

=>SuggestsFederalReserverespondstobothoutputgapsand
rateofinflation
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Policyreactionfunction
Example
UsingtheTAYLORRULEr=0.010.5[(Y*Y)/Y*]+0.5a
1%increaseininflation()leadsto
anincreaseinrof0.5x0.1=0.005(or0.5percentagepoints)

ApplicationtobehaviourofRBA
Notdirectlyapplicableduetodifferentweightsontheoutputgap
[(Y*Y)/Y*]andinflation().
Untilrecentlylikelyhigherweightoninflation(duetospecific
inflationtargetof23%),althoughglobalfinancialcrisishas
requiredconsiderationofrecessionaryoutputgap.

43

AhypotheticalRBApolicyreactionfunction
simplifyingassumptionthatRBAreactsonlytoinflation*
realinterestratesetbyRBA(r)

0.06
RBAspolicyreactionfunction

0.05

Movementalongpolicyreactionfunction
Ifchangeinrinresponsetochangein

Shiftofpolicyreactionfunction
Ifchangeinrinabsenceofchangein

0.04
0.03
0.02

0.01

0.02

0.03

0.04

Inflation()

*Capturestendencytoraisecashratewheneconomyisoverheating
(expansionarygap)andreducecashratewheneconomyissluggish
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(recessionarygap)

RBAmonetarypolicyinpractice
RBAreactstochangesinactualinflationrates,inflationary
expectationsandabroadrangeofdomesticandinternational
economicvariables
Decisionsmadeusingbothformalpolicyreactionfunctions
andjudgement
Doesnothaveaprecisemeasureoftheoutputgap
Onlyhasanapproximateideaoftheimpactofinterestrate
changesonplannedspending(orthelagbeforeimpacts
willoccur)

Changesinmonetarypolicysettingscanbetaken
frequently,butRBAhastendedtobecautious

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