Australia: Overnight cash rate, 1976 – 2017
Lecture 3.2 The behaviour of interest rates, part 2
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The determination of interest rates is central to monetary polices conducted by central banks
We are studying two approaches to this issue
The previous lecture looked at the traditional or quantity-based approach
This lecture looks at the modern central banking approach, and considers how it differs from the quantity-based analysis
Source: Macfarlane (2001)
Learning objectives
Understand the difference between the quantity-setting and rate-setting views of monetary policy
Understand the reasons why the rate-setting view has prevailed in modern central banking
Review the historical development of this approach
Note that the zero lower bound problem (ZLB) has become relevant
Figure 1. Equilibrium in the Market for Money: fixed money supply
With excess supply, the interest rate falls to i *.
With excess demand,
the interest rate rises
Interest Rate, i (%)
Quantity of Money, M
($ billions)
Figure 2. Effect of an increase in money demand when money supply is fixed
Figure 3. Accommodating an increase in money demand
Figure 4. Equilibrium with elastic supply of money
Two views of monetary policy
Traditional view (as presented in Mishkin, Ch5): quantity-setting
Modern central banking view: rate-setting
All major central banks shifted to a rate-setting view during the early-to-mid 1990s
This has meant central bank policy announcements are now routinely expressed in terms of the policy rate, not the money supply
Most central banks now give little emphasis to analysing the monetary aggregates
In recent years, things have become more complicated because of the ZLB
What does a rate-setting policy look like?
Not a permanently fixed level of interest rates
The central bank uses R rather than M as the instrument of control and management
R has to be varied systematically in response to economic conditions (this is the subject of a future lecture) in order to have a stabilising influence on the economy
Australia: Overnight cash rate
Interest rate setting by major central banks
The monetary policy transmission process
Central bank sets the overnight interbank rate
The mechanism for this arises from the CB’s role as monopoly supplier of settlement funds to the banking system
The overnight rate, in turn, influences the rest of the interest rate structure
This in turn influences spending decisions across the economy and hence aggregate macroeconomic conditions
Why has the rate-setting view prevailed?
Unstable demand for money
Any attempt at precise control of any monetary aggregate would result in unacceptable volatility of interest rates
The monetary aggregates also have been found to have little information value about economic trends
Changes in money supply growth found to bear little relation to the objectives of monetary policy, which are output and inflation
Why study the quantity-based view?
Still relevant for understanding simpler monetary systems, for monetary history, and for the analysis of hyperinflations
Provides principles that may be useful in understanding extreme situations, such as the ZLB* problem
*ZLB = zero lower bound for nominal interest rates
Background to the Macfarlane speech (2001)
Rate setting approach was still relatively new
Classical monetary theory emphasised quantity setting
Historically, efforts to control interest rates had been associated with undesirable outcomes:
over-regulation of banks
or, inflationary policies
RBA was criticised for unpopular interest rate rises
Macfarlane set out to explain the reasoning behind the new approach
Macfarlane (2001): Three questions on the movement of interest rates
If central banks can set the interest rate, why do they have to keep changing it?
2. Alternatively, why can’t central banks just leave it to the market?
3. Why do we have to have our own interest rate instead of just adopting the rate from another country like the US?
Question 1: Why is it not feasible to set the interest rate at a fixed level?
Dynamically unstable
Suppose R is set at a rate lower than consistent with general equilibrium: result is an inflationary spiral
Similarly if R is set too high, the result is a deflationary spiral
Even if R is initially exactly right, any random disturbance would be destabilising
Question 2: Why not leave it to the market?
Preliminary point: the central bank cannot feasibly cease market operations
need to offset accommodate predictable changes in money supply caused by government fiscal flows
need to accommodate predictable changes in demand for currency
Fundamental point: demand for money is unstable
a quantity setting policy would generate unacceptable volatility of interest rates
policy actions to reduce interest rate volatility involve the central bank in rate-setting
Question 3: why not adopt another country’s interest rate?
Two ways to achieve this
Interest rate focused policy:
This would be unstable for the same reason as in Q1
No stabilising force for the nominal economy
Fixed exchange rate
Interest rate convergence to US would be a consequence of this policy
With a fixed exchange rate, the system would be dynamically stable, but sub-optimal: monetary conditions would be driven by conditions in another country
Some further questions on interest rates
What objectives guide these monetary policy decisions?
How does the policy rate affect other important rates such as
deposit and lending rates
long-term rates?
How do central banks think about the strategy of rate-setting?
These will be discussed in later lectures
Some history: extracts from selected RBA policy announcements
23 January 1990 (first announcement of an interest rate decision)
The Governor of the Reserve Bank (Mr Bernie Fraser) confirmed that the Bank had operated in the domestic money market this morning to bring about a modest reduction in interest rates.
15 February 1990
The Reserve Bank acted in the domestic money market this morning to bring about a further modest reduction in interest rates. Specifically, the Bank is seeking a reduction in cash rates of up to 0.5 percentage points from their recent levels.
4 April 1990
The Reserve Bank proposes to operate in the domestic money market this morning with a view to reducing cash rates to within the range of 15 to 15½ per cent. In recent weeks cash rates have averaged a little under 16½ per cent. This action follows yesterday’s Board meeting and consultations with the Treasurer.
2 August 1990
The Reserve Bank will be operating in the domestic money market this morning with a view to reducing cash rates by about one percentage point. This action is being taken following the regular late July meeting of the Board and after consultations with the Treasurer.
18 December 1990
Given current and prospective developments in the Australian economy, including the improved outlook for inflation, the Reserve Bank and the Government believe that a further easing in monetary policy is appropriate. To this end, the Bank will be operating in the domestic money market this morning to reduce cash rates by a further 1 percentage point, to around 12 per cent. It is expected that this reduction in cash rates will flow promptly and fully into banks’ indicator lending rates.
7 November 2007 (during 2007 election campaign)
At its meeting yesterday, the Board decided to increase the cash rate by 25 basis points to 6.75 per cent.
1 March 2022
At its meeting today, the Board decided to maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances at zero per cent.
How interest rates affect the economy (1)
How interest rates affect the economy (2)
Cash flow channel: net borrowers face higher costs
Cost of borrowing: housing
Cost of borrowing: business investment
Exchange rate channel: effect on both output and prices
Indirect effect of spending on output, employment, wages and prices
Summary: other things equal, a higher nominal interest rate reduces expected GDP growth and inflation
201720122007200219972022 0 1 2 3 4 5 6 7 % 0 1 2 3 4 5 6 7 % AustralianCashRateTarget Source:RBA
20182014201020062022 -1 0 1 2 3 4 5 % -1 0 1 2 3 4 5 % PolicyInterestRates US Japan Euroarea* * Mainrefinancingrateuntiltheintroductionof3-yearLTROsin December2011;depositfacilityratethereafter. Source:Centralbanks
20182014201020062022 -2 0 2 4 6 8 % -2 0 2 4 6 8 % PolicyInterestRates–Selected AdvancedEconomies UK Canada Sweden NZ Switzerland Source:Centralbanks
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