MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1. MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Monetary Policy

2. Key Concepts • Central Banks • Monetary Policy Targets and Goals • Transmission Mechanism

3. Central Banks • Central Banks • Monetary authority: conduct monetary policy and act as a lender of last resort • Sometimes a bank regulator • Ideal is an independent central bank • Independent from Finance ministry and political pressures • For most countries, central banks are a 20th century phenomenon • Prior gold standard = little need for central banks • Similar to dollarization today • Steep learning curve for central banks in 20th century • Fiat money and the “Great Inflation” of the the 1970s • Examples of independent central banks: • U.S. Federal Reserve, EU Central Bank, Bank of England, Bank of Mexico, Bank of Japan, Bank of Canada, Bank of New Zealand

4. Central Banks • Three tools to implement monetary policy • Open market operations • Reserve requirements • Direct lending facility • Closer look at open market operations • Buy treasury bonds from public =>supply reserves to banking system => increase money supply • Sell treasury bonds to public => remove reserves from banking system => decrease money supply

5. Federal Reserve System“High employment consistent with stable prices” • Organization • Board of Governors – 7 Members • 12 Federal Reserve District Banks • Federal Open Market Committee (FOMC) • Instrument • Short term market interest rates (Discount rate) • Reserve Requirements • Open Market Operations • Federal Funds rate • Rate charged on interbank loans

6. Federal Reserve System

7. Elements of Monetary Policy • Operational Instruments • Short-term interest rates, reserve requirements, monetary base • Intermediate Targets • Money supply, exchange rates, inflation targeting • Policy Goals (book calls them “ultimate targets”) • Price stability • Output and employment stability

8. Operational Instruments • Short term interest rate • Base money • Cash plus reserves of banks • Also called monetary base, high-powered money, reserve money • Central bank can supply reserves to or drain reserves from the financial system

10. Intermediate Targets • Variable which • Tracks policy goal (e.g., inflation) • Over which central bank has reasonable control • Three main targets • Money supply • Exchange rate • Inflation forecast

11. Intermediate Target I: Money Supply Targeting • Quantity Theory implies direct relationship between money supply growth and inflation MV=PY • Assume velocity is relatively stable • Assume real output controlled by real factors • US: money targeting used in early 1980s • Difficulties with money supply targeting • Which aggregate to use? • Is velocity stable or at least predictable? • Can central banks control the money supply? • What about supply shocks?

12. Money Growth, US M3 M2 M1

13. Growth rate, monetary aggregates M1 M2 M3 Source: Federal Reserve Board, Current release. http://www.federalreserve.gov/releases/ Monthly growth rate converted to annual rate and smoothed with moving average filter.

14. Intermediate Target II: Exchange Rate Targets • Fix exchange rate against another currency • Will tie domestic inflation to foreign inflation • Cost is lack of flexibility in influence on domestic economy • The Exchange Rate as a Tool of Monetary Policy • When the exchange rate is flexible: • Tighter monetary policy reduces net exports. • How? • higher interest rates => increased capital inflows => dollar appreciate => U.S. exports more expensive to foreigners (higher real exchange rate) • Easier monetary policy stimulates net exports. • Monetary policy affects consumption, investment, and net exports in open economy

15. Intermediate Target III: Inflation Targeting • Specified a target range for realized inflation • Common measure of 2% annual inflation • Specific targets for Bank of Canada, Bank of Canada, Bank of New Zealand • Some allow band around target • Allows for discretion in implementation • Use inflation forecast which may incorporate many variables • Discretion comes at a price

16. Recall Equation of Exchange MV = PY Md/P = (1/V)Y Real Money Demand Velocity, depends on interest rate

17. Money Market Money Supply Nominal Interest Rate R R0 Money Demand M0 Quantity of Money

18. Money MarketIncrease in Income Money Supply R1 Nominal Interest Rate R0 Money Demand M0 Quantity of Money

19. Money MarketIncrease in Money Supply Money Supply Nominal Interest Rate R R0 R1 Money Demand M0 M1 Quantity of Money

20. Money supply or interest rates? Money Supply Interest rate

21. Money MarketMoney targeting Money Supply Interest Rate R1 R R0 Money Demand M0 Increase in Money Demand produces rise in interest rate if Money Supply is fixed Quantity of Money

22. Money MarketMoney targeting Money Supply Interest Rate R1 R R0 Money Demand M0 Increase in Money Demand produces no rise in interest rate if Money Supply is allowed to increase Quantity of Money

23. Monetary Policy Goals • GDP growth • Unemployment • Price Stability • New Zealand • England • European Central Bank • Why not target zero inflation? • Mismeasurement • Lubricate the labor market • Zero nominal interest rate lower bound • Nominal rate = real rate + expected inflation

24. Transmission Mechanism Market Rates Domestic Demand Asset Prices Domestic Inflationary Pressure Net External Demand Official Rate Inflation Import Prices Expectations and Confidence Exchange Rate