CS代考 FINC5090 Finance in The Global Economy

Transmission Mechanisms of Monetary Policy

Transmission Mechanisms of Monetary Policy
Lecture 10

FINC5090 Finance in The Global Economy

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Lecture 10 Transmission mechanisms of monetary policy
Monetary policy goals
Monetary policy instruments
Implementing monetary policy
Transmission mechanisms
Interest rate channels
Asset price channels
Credit channels

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Central banks aim for price stability, economic growth, low unemployment, etc. which they do not directly control.
As a result, central banks rely on a variety of instruments to achieve these objectives.
These instruments will not directly affect the goals but affect the target variables such as money supply and interest rates which then affect goal variables with lag.
In fact, even target variables are not sufficiently responsive to the operation of the central bank instruments. For example, you learned in the last week that the magnitude of deposit creation is not fully under the control of the central bank.
These instruments affect target variables through another set of indicators such as monetary base and short-run interest rates.
In this week, we will look at how the central banks utilize the instruments to affect the indicators and how the influences are passed onto the target variables.

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1. Monetary policy goals
Central banks normally pursue the following goals (explicitly/implicitly):
High employment
Economic growth
Price stability
Interest rate stability
Stability of domestic financial markets and foreign exchange markets

Different goals may get different emphasis in different countries and times.

For example, the RBA has three objectives when setting monetary policy
The stability of the currency of Australia
The maintenance of full employment in Australia
The economic prosperity and welfare of the people of Australia
(What is the primary goal of the RBA in 2020 and 2021?)

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2. Monetary policy instruments: open market operations
Open market operations refer to central bank purchases or sales of government securities in order to expand or contract money in the banking system and influence interest rates. Open market operations (OMOs) are the most important conventional monetary policy tool.
Central banks normally target the overnight rate of the interbank lending market when conducting OMOs.
In Australia, the overnight rate is the cash rate for borrowing and lending Exchange Settlement (ES) balances (similar to the US reserves).
In the US, the overnight rate is the federal fund rate for borrowing and lending excess reserves.

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2. Monetary policy instruments: open market operations
There are two types OMO transactions the central banks typically conduct:
Outright transactions which involves a purchase/sale of securities in exchange for excess reserves (examples were introduced in Topic 9).
Repurchase agreement (repo) and matched sale-purchase agreement (reverse repo)
Repo: the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time (e.g. 1 to 15 days).
Reverse repo: Fed sells securities and the buyers agrees to sell them back to the Fed in the near future.
The OMO transactions will permanently/temporarily change the supply/demand of excess reserves so as to keep the federal fund rate in the target range.

Read the following article on how OMOs are conducted by the trading desk.
https://www.newyorkfed.org/aboutthefed/fedpoint/fed32.html

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2. Monetary policy instruments: other conventional instruments
Discount window: the facility at which banks can borrow reserves directly from the Fed to meet temporary shortages of liquidity.
The discount rate is normally higher (e.g. 1%) than the target federal fund rate (why?)*.

Lender of last resort: the Fed was to provide reserves to banks when no one else would, thereby preventing bank and financial panics.
E.g. Bear Stearns and American International Group, Inc., were bailed out in the midst of the 2008 financial crisis.
Opponents of the function allege that commercial banks and other financial institutions are likely to make risky investments knowing that they will be bailed out if they experience financial difficulties (moral hazard).
Reserve requirements: changes in the required reserve ratio affect the money supply by causing the money supply multiplier to change.
Interest on excess reserve: the Fed sets the interest rate on reserves below the federal funds target (why?)**

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* and **: because the central bank prefers that banks borrow from each other so that they continually monitor each other for credit risk and liquidity. The discount rate and the interest on excess reserve serve as the cap and floor for the target federal fund rate. This helps to control the volatility of the federal fund rate.

2. Monetary policy instruments: nonconventional tools
When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job, for two reasons.
First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse.
Second, the negative shock to the economy can lead to the zero-lower-bound problem, in which the central bank is unable to lower its policy interest rate further (e.g. end of 2008).

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2. Monetary policy instruments: nonconventional tools
Central banks need non-interest-rate tools, known as non-conventional monetary policy tools to stimulate the economy.

Liquidity provision: The Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets

Asset purchases: During the crisis, the Fed started three new asset purchase programs to lower interest rates for particular types of credit (e.g. QEs).
providing liquidity to a particular segment of the credit market that has seized up;
increasing the demand for the securities that the Fed purchases in the QEs and lower the interest rate for the borrowers in particular credit markets (e.g. lower MBS rates have led to a decrease in residential mortgage rates)
Purchase long-term T-bonds helped to lower the long-term interest rates which are more relevant to investment decisions.

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The Expansion of the Federal Balance Sheet, 2007–2020
The size of the Fed’s balance sheet more than quadrupled during and after the GFC.

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2. Monetary policy instruments: nonconventional tools
Forward guidance:

refers to the communication from a central bank about the state of the economy and likely future course of monetary policy.
By committing to the future policy action of keeping the federal funds rate at zero for an extended period, the Fed could lower the market’s expectations of future short-term interest rates, thereby causing the long-term interest rate to fall.

Negative interest rates on bank deposits at the central bank

Setting negative interest rates on banks’ deposits is supposed to work to stimulate the economy by encouraging banks to lend out the deposits they were keeping at the central bank, thereby encouraging households and businesses to spend more.

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3. Implementing monetary policy
The Federal Reserve in the US explicitly targets the federal funds rate.
This is the rate you hear about when you hear an announcement on the news
In the past, open markets operations were the main tool. But now reserves are ample: so large that market operations could be ineffective
A new corridor system has been implemented from 2008:
The interest rate on reserve balances (IORB) is the ceiling. This is the rate banks get by simply keeping reserves at the FED. This is the main tool to target the Fed funds rate
The overnight reverse repurchase facility (ON RRP) rate is the floor. This is a way to “lend” to the central bank that is also open to institutions that cannot deposit reserves. The rate is slightly lower than the IORB since the institution get a security like a government bond and can thus earn interest from it.
The opportunity for arbitrage keeps the target rate within the set corridor
For example, if the fed funds rate is too high, a bank withdraws reserves from the Fed to lend them to other banks. This new supply of funds decreases the federal funds rate.

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3. Implementing monetary policy

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3. Implementing monetary policy: inflation targeting
Price stability, which central banks define as low and stable inflation, is increasingly viewed as the most important goal of monetary policy.
Nominal anchor: a nominal variable such as the inflation rate or the money supply that ties down the price level to achieve price stability.
A central bank will have better inflation performance in the long run if it doesn’t try to surprise people with an unexpectedly expansionary policy, but instead keeps inflation under control.
For example, the RBA uses an inflation targeting framework to guide its monetary policy decisions and attempts to keep the medium-term inflation rate between 2 and 3 percent on average.
This medium-term inflation target provides the flexibility for the Reserve Bank Board to set monetary policy so as best to achieve its broad objectives, including maintenance of full employment and financial stability, consistent with its legislative mandate.

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In addition to Australia, , Canada, the UK, among other countries, have adopted a form of inflation targeting.
3. Implementing monetary policy: inflation targeting

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3. Implementing monetary policy: Australia practice
The Reserve Bank Board meets eleven times each year, on the first Tuesday of each month except in January.
The Reserve Bank Board’s explanations of its monetary policy decisions are announced in a media release, which is distributed through electronic news services and published on the Reserve Bank’s website at 2.30 pm on the day of each Board meeting.
The Reserve Bank responds to changes in the demand and supply of ES balances to maintain the cash rate target. This is mainly achieved with open market operations.
For more information on the daily OMO transactions, please visit https://www.rba.gov.au/mkt-operations/resources/tech-notes/open-market-operations.html

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4. Transmission mechanisms
The transmission of monetary policy describes how changes made by the central bank to the ‘instrument’ of monetary policy – flow through to economic activity and inflation.

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4. Transmission mechanisms: interest rate channels
This is the traditional view of the monetary transmission mechanism.
An easing of monetary policy (e.g. increasing money supply) leads to a fall in real interest rates which in turn lowers the real cost of borrowing, causing a rise in investment spending, there by leading to an increase in aggregate demand.

Note represents both business investment spending and consumers’ housing and durable expenditure.
If prices are sticky, expansionary monetary policy, which lowers the short-term nominal interest rate also lower the short-term real interest rate. If the change in the short-term real interest rate is persisting, then the market expectation on the future short term interest rate will also decline, resulting in the decline of the long-term interest rate (a downward shift of the yield curve).

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4. Transmission mechanisms: interest rate channels
With nominal interest rates at a floor of zero, a commitment to future expansionary monetary policy can raise expected inflation (), thereby lowering the real interest rate ( ) and stimulating spending through the interest-rate channel:

Thus monetary policy can still be effective even when nominal interest rates have already been driven down to zero.

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4. Transmission mechanisms: other asset price channels
Changes in monetary policy not only influences interest rates (i.e. cost of debt) but also exchange rates and stock prices.

Exchange rate effects on net exports

When domestic real interest rates fall, domestic dollar assets become less attractive relative to assets dominated in foreign currencies. As a result, the dollar depreciates ( ), reducing the relative expensiveness of the domestic goods, thereby causing a rise in net exports (NX).

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4. Transmission mechanisms: other asset price channels
Changes in monetary policy not only influences interest rates (i.e. cost of debt) but also exchange rates and stock prices.

Stock market and investment
Lower real interest rate mean that the expected return on stock falls. This makes stocks more attractive relative to debts, and so demand for them increases, which raises their prices. Companies will issue more shares to finance their investing activities which will finally lead to an increase in the aggregated demand.

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4. Transmission mechanisms: other asset price channels

Stock market and Tobin’s q channel

Tobin’s q is measured as:
When Tobin’s q is high, it’s relative cheaper to purchase new plant and equipment (the replacement value) relative to the funds that can be raised in the stock market (the market value).
Lower real interest rate mean that the expected return on stock falls. This makes stocks more attractive relative to debts, and so demand for them increases, which raises their prices and increase Tobin‘s q. Companies will issue more shares to finance their investing activities which will finally lead to an increase in the aggregated demand.

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4. Transmission mechanisms: other asset price channels

Stock market and wealth effect
According to Modigliani’s life cycle hypothesis of consumption, consumption spending is determined by not only today’s income but also the life resources of consumers (e.g. financial wealth). When stock prices rise, consumers’ lifetime resources increase, which means that consumption should rise.

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