Lecture 16 1

Macroeconomic Analysis 2003

Monetary Policy: Transmission
Mechanism
http://www.bankofengland.co.uk
http://www.bis.org
Lecture 16 2
Learning Objectives
Objectives, instruments and targets of monetary
policy
Transmission Mechanism of Monetary Policy
Keynesian Model
Impact on output
Impact on interest rate
Money Market
Supply and Demand


Lecture 16 3
Basic Points About Money
Origin of money with Goldsmiths; Bank of England -1994

What is money?

Currency, Demand and time deposits, Financial assets
and other liquid assets

Why do people want money?

Medium of Exchange

Unit of account

Standard for differed payment

Store of Value
Value of Money
P
1

Classical
view Keynesian
and
Monetarist
View
Lecture 16 4
Objective Targets and Instruments of Monetary Policy
Ultimate objective: stability (P, r, E), high growth rate of
output, low unemployment rate

Targets: inflation only; or money supply only; or exchange
rate only; all of them; or two of them; or none of them.

Instruments: Open market operation on treasury bills -
rediscounting
Fixing the interest rate, credit control
Money supply rule, reserve requirement
Deposit insurance
Effectiveness of monetary policy depends upon
Central bank independence and credibility ie, who appoints
the governor?
Moral hazards - bank panics, systematic risk, regulation -
bank supervision

Lecture 16 5
Official
rate
Market
rate
Asset
prices
Exchange
rate
Expectations
and confidence
Domestic
demand
Net external
demand
Domestic
inflationary pressure
Import
prices
Inflation
Total demand
Bank of Englands View on Transmission Mechanisms of Monetary Policy:
How Does Money Supply Affect the Price Level?
Two Conditions to have real effect of Monetary policy
Central bank controls monetary base M1 = R + Cu
Prices do not adjust instantaneously

l l l l l l r i
P
M
P Y G X I C r i M , , , , , t
Y
C+I+G
i,r,er,P
e

P
X,M
MS
Lecture 16 6
Effects of Changes in the Rate of Interest
First round effects
Households: saving, housing, wealth,
foreign asset, portfolio allocations
Firms: cost of capital, debt-equity,
portfolio allocations
Second round effects: consumption
spending, additional demand for goods
Time lags: anticipated and unanticipated
policy changes.
( )
( ) i
P
P P i P
+
= + =
1
1
2
1 1 2
Lecture 16 7
B&W Figure 9.7
Percentage
increase in
prices on a
year earlier
Source: Inflation Report, Bank of England, November 2000
Bank of Englands Fan Chart for Forecast of an
Economic Variable
Lecture 16 8
t + =
n T
r i
n
r i =
0
time
t0
0
r
i
T
An Increase in Money Supply Can Lower Real
and Nominal Interest Rates in the Short but not in the Long Run
l l l l l l r i
P
M
P Y G X I C r i M , , , , , t
Monetary policy can have some real effect in the short run but not in the long run.
Short runs become shorter with more accurate expectations
Fisher Equation
Lecture 16 9
Transmission Mechanisms of Monetary Policy
Interest rate Channel
Lower interest rate
More borrowing and
Spending
More aggregate demand
Open Market Operation
Credit Channel
Lower interest
More reserves
More lending
Higher aggregate demand
Deficit financing
Rediscounting of Treasury Bills
Exchange Rate Channel
Lower interest rate
Depreciation of domestic
currency
More exports and less imports
Higher aggregate demand
Buy back own currencies selling some foreign
assets to avoid depreciation - sterilisation
selling its currency to avoid appreciation



Balance Sheet Channel
Lower interest rate
Increase in prices of stocks,
bonds and other assets
More wealth
More aggregate demand
Moral hazards - bank panics, systematic
risk, regulation - bank supervision

Lecture 16 10
Open Market Operation: Interest Rate Channel
Expansionary Monetary Policy
Short run:
Central bank reduces the repo rate
Commercial banks and financial institutions find
it profitable to sell bonds to the central bank
Central bank raises their reserves
Commercial banks have more money to lend
Firms and households find it cheaper to borrow
They borrow and create more deposits
Demand for goods and services rises
Money supply expands
Long run:
Prices will eventually rise following higher demand
Real money supply (M/P) shrinks
Interest rises back to natural position
Lecture 16 11
Open Market Operation: Interest Rate Channel
Contractionary Monetary Policy
Short run:
Central bank raises the repo rate
Commercial banks and financial institutions
find it profitable to buy bonds from the
central bank
Central bank sell bonds and reduces reserves of the
financial institutions
Commercial banks have less money to lend
Firms and households find it expensive to borrow
They pay back loans and close deposits accounts
Demand for goods and services falls
Money supply contracts
Long run:
Prices will eventually fall
Real money supply increases
Interest rises back to natural position

Lecture 16 12
Central bank
Assets Liabilities
Loans to the government
Loans to the commercial banks
Foreign asset (currency)
Gold and other precious metals
Currencies in circulation
Reserves of the commercial banks
Deposit of the government
Claim by foreigners and Net worth
Commercial banks
Assets Liabilities
Loans to the government
Loans to the private sector
Reserves and deposit at the central bank
Claim on foreign assets
Deposits of private sector
Deposit of the government sector
Obligation to foreigners
Network
Government Sector
Assets Liabilities
Deposit with the commercial banks
Deposit with the central banks
Loans to foreigners
Other assets
Borrowing from the central bank
Borrowing from the private sector
Foreign debt
Network
Private sector
Assets Liabilities
Deposit at commercial banks
Tangible wealth
Currency and precious metal
Loans from the banking system
Payment due to the government
Network

Assets and Liabilities of the Financial System of An Economy
M4
RESERVE
Monetary
Base
Lecture 16 13
Retail Deposits and Cash
Notes & Coins 30 745
NIB Bank Deposits 44 908
Other Bank Deposits 497 768
Building Society Deposits 134 898
Total 708 319
Wholesale Deposits
Bank Deposits 285 386
Building Society Deposits 10 632
Total 296 018

M4 1 004 337
M3 1064 571
Components of M4 in the UK in January 2003 (Million )
Source: Bank of England
Lecture 16 14
Consolidated Balance Sheet of the Banking System
in the UK in January 2003 (Million )
Source: Bank of England
Asset Type Assets Liability Type Liabilities
Public sector loans Sterling 1 186 575 Public sector (CDMMI) Sterling 989 464
Foreing currency 208 764 Foreing currency 166 644
Private sector loans Sterling 35 554 Private sector (CDMMI) Sterling 29 132
Foreing currency 921 Foreing currency 564
Non residents loans Sterling 140 798 Non residents (CDMMI) Sterling 246 211
Foreing currency 1 068 516 Foreing currency 1 377 205
Public sector Securities Sterling 77 668 Financial derivatives Sterling -3 361
Foreing currency 19 954 Foreing currency11 151
Private sector Securities Sterling -2 683 Other Securities Sterling 10 194
Foreing currency 543 Foreing currency28 190
Non residents Securities Sterling 24 817 Other liabilities Sterling 238 642
Foreing currency 332 903 Foreing currency82 454
Other Assets Sterling 58 384
Foreing currency 23 775
Total Sterling 1521 113 Total Sterling 1510 282
Foreing currency 1655 376 Foreing currency 1666 208
Total Assets 3 176 489 Total Liabilities 3 176 490
CDMMI=Currency deposits and money market instruments.
Lecture 16 15
Quantity Theory of Demand for Money: Classical View
Cambridge equation of money demand:
kY
P
M
=
=>

PY
k
M =
|
.
|

\
|
1

If Y and V are constants how does the relation between
prices and money supply look like?

MV=PY
P


M
- Classical dichotomy: Price level is proportional to the
supply of money; no link between monetary and real
sectors.
No link between supply of money and the interest rate and
the real side of the economy; missing link for Keynes.
Lecture 16 16
Money
Supply
Money
Demand
Price Level
Inflation
Nominal
Interest
rate
Link between Money Stock Price Level, Inflation,
Nominal interest Rate in the Classical Model
Missing Link for Keynes
Lecture 16 17
Keynesian View on Monetary Policy : Main Points
Monetary affects real economy through the interest
rate.
Interest rate is determined by the supply and demand
in the money market.
Three kinds of demand
Speculative Demand
Transaction Demand
Precautionary Demand
Demand for money is not stable because of chaning
velocity of money. People do not spend and the
velocity is low in depression and high in the boom.
Lecture 16 18
Keynesian View on Monetary Policy : Main Points
r kY
P
M
= q


Bonds = Financial Wealth (M/P)


Money supply is controlled by the policy maker



Interest Interest rate
Rate









Demand for and Supply of Money Demand for bonds


Increase in MS
Lower interest rate
Reduced cost of Investment
More investment
More Aggregate Demand
But
Keynes Favours Fiscal Policy
Lecture 16 19
Basic Structure of the Keynesian Static Model for Monetary Policy
Consumption:
d
bY a C + =
(1)
Disposable income:
T Y Y
d
=
(2)
Investment:
( ) r q I r I =
0 (3)
Demand for real balances:
r kY
P
M
= q
(4)
National income identity:
G I C Y + + =
(5)
Money Market Equilibrium:
|
.
|

\
|
=
P
M
kY r
q
1
(6)
Aggregate Demand Consistent with Goods and Money
Market Equilibrium:
b
G
P
M
kY q I bT a
Y

+
(

|
.
|

\
|
+
=
1
1
0
q
;
k
q
b
G
P
M q
I bT a
Y
q
q
+
+ + +
=
1
0
(7)
Equilibrium Interest Rate:
(
(
(
(

+
+ + +
=
P
M
k
q
b
G
P
M q
I bT a
k
r
q
q
q
1
0
(8)
Lecture 16 20
Multiplier Effect of Increase in Money Supply on Output and Interest Rate
Shortcoming of the Keynesian Model: Missing Supply Side
( ) P T G M k q b a h Y , , , , , , , , q =
(9)
Impact on Output from Increase in Money Supply :

0
1
>
+
=
c
c
k
q
b
q
M
Y
q
q
(10)
Impact on Output from Increase in Public Spending:

0
1
1
>
+
=
c
c
k
q
b
G
Y
q
(11)
Impact on Interest rate from Increase in Money Supply :
0 1
1
<
(
(
(
(

+
=
|
.
|

\
|
c
c
k
q
b
q
k
P
M
r
q
q
q (12)
Impact on Interest rate from Increase in Public Spending:
0
1
1
>
(
(
(
(

+
=
c
c
k
q
b
k
G
r
q
q (13)
Lecture 16 21
Keynesian Model
Fiscal Policy is
more effective
Monetarist Model:
Monetary policy more
Effective
Small Change in public Spending
has a larger output effect than a
Larger change in money supply
Small Change in money supply
has a larger output effect than a
bigger change in public spending
Controversy Over Macroeconomic Impacts of Fiscal and Monetary Policies
Is0
IS1
LM0
LM1
a
b
c
IS0
IS1
LM0
LM1
b
G qr I bT a
Y

+ +
=
1
0
|
.
|

\
|
=
P
M
kY r
q
1
Y r
D
r
b
r
e
r k
P
M
|
|
.
|

\
|
= , , ,
i
Y
i
Y
Lecture 16 22
Money Supply
Various types of money: M0, M1, M2, M3, M4 ;

Money multiplier:
r
m
1
=
where
D
R
r =


If we considering a leakage in the currency holding:
c r
c
m
+
+
=
1
where
D
R
r =

D
C
c=



C R M + =
0
(a)

D C M + =
4
(b)
then dividing (b) by (a)
r c
c
R C
C D
M
M
+
+
=
+
+
=
1
0
4
.
If people held more currency then multiplier becomes
smaller.
What is the value of the
money multiplier if
r = 10% and c = 20 %?
m = 4.

Lecture 16 23
Money Demand
Quantity theory of Money (QTM): MV = PT

Cambridge equation of money demand:


kY
P
M
=
=>
PY
k
M =
|
|
|
.
|

\
|
1


Keynesian money demand
r kY
P
M
= q


Friedman type money demand

kPY M =
=>
PY r
D
r
b
r
e
r k M
|
|
.
|

\
|
= , , ,

Lecture 16 24
Friedman (1968) on Monetary Policy
Given the natural rates of interest and unemployment,
monetary policy cannot be pegged to lower the interest
rate or the unemployment. Is so it only raises inflationary
expectation and increase in price level. There will be no
impact on real magnitudes.
Monetary authority can control nominal quantities such
as it liabilities, M0, M3 or M4. By controlling them it
can stabilise the price level.
Price mechanism in the market system works better when
prices are stable and relative prices can adjust according
to the dynamics of the economic system.
Lecture 16 25
Contribution of Monetarism in
Macroeconomic Policy
Supply of money is the determinant of the national
income
In the long run, the influence of money is primarily
on the price level and other nominal magnitudes.
Real output and employment are not determined by
monetary factors.
In the short run the supply of money does affect the
output. Money is the dominant factor in causing
cyclical fluctuations in output and employment in
the short run.
Private sector is inherently stable and instability is
primarily the result of the government policy.

Lecture 16 26
Exercises
Transmission mechanism of monetary
policy: impact of of interest decision in the
economy
An Open Economy with the interest rate
and exchange rate
Why low interest keeps house prices rising
despite fall in the stock prices?
Money demand: substitution between
money and bond.
Money multipliers