L10 Monetary Policy

The world sometimes experiences persistent fluctuations both on an aggregate level (e.g. changes in GDP, income, investment) and on the individual level (higher unemployment, struggle paying mortgages, lose wealth in stock market) however there are two ways to handle these fluctuations:

- Countercyclical monetary policy: Central bank reduces economic fluctuations by controlling bank reserves and interest rates e.g. increasing rates during inflations:

- Countercyclical fiscal policy: Government reduces economic fluctuations by changing government spending and taxes.

Positive and normative way

n a positive way it helps stabilize the economy and reduce fluctuations and in the normative way it is necessary for them to intervene to minimize negative effects on the society.

Central bank = A government organization that:

- Monitors financial organization

- Control key interest rates

- Manage the money supply (monetary policy).

Monetary policy:

The actions central banks take to manage the economy by controlling money supply and interest rates to keep fluctuations and inflation stable > employment > economic growth.

Example of central banks and its goals:

- US Federal reserve (FED): Focus on low and stable inflation + maximum sustainable employment (economic stability)

- Eurozone European central bank and Sveriges riksbank: Focus on controlling inflation.

Why Central bank independence?:

They operate independently to avoid political influence since it can hurt the economy in the long run.

Functions of a Central Bank:

· Regulation: Central banks audit private banks and financial institutions to prevent the collapse of the financial system

· Interbank transfers: Central banks process the transfer of money (bank reserves) between banks.

· Countercyclical monetary policy: Central banks affect the real economy in the short run mainly by influencing interest rates (influence borrowing and spending)

How does central banks affect money inflation and the economy?:

- Money creation: Commercial banks create money by making loans.

- Bank reserves: Commercial banks hold reserves (Vault cash and reserves deposited at the central bank.) to manage daily needs.

- Central bank´s role: By controlling the market for these reserves it impacts those factors especially interest rates.

Bank reserves

Vault cash and reserves deposited at the central bank.

Bank liquidity

How fast banks can access funds to make payments or loans.

Ways bank use reserves:

Banks use reserves to pay out withdrawals, make new loans and repayments to other banks and acquire it from their reserves by borrowing them from other private banks or from central bank.

- The use reserves as safety net to minimize chance of running out of liquidity, since they need money for financial needs and obligations.

Federal funds market

Where banks borrow reserves from one another.

The federal funds rate

The interest rate charged for these overnight loans in the federal funds market.

This is the downward sloping demand curve for reserves:

- As the federal funds rate increases -> Banks demand fewer reserves

The shifts for the downward sloping demand curve for reserves:

o Economic expansions or contraction (recession, uncertainty - right)

o Changing liquidity needs: Increase demand (right) e.g. if higher withdrawal form customers and decrease (left).

o Changing deposit basis (fewer deposits right)

o Changing interest in reserves (IOR)

o When demand decrease it shift left and increase it shift right.

Interest on reserves:

Interest rate on reserves that private banks deposits at central banks. Paid by central banks to private banks.

Central bank supplies federal funds through:

- Open market operations: Where they buy and sell government bonds from private banks in exchange for reserves.

- Central banks target fixed federal funds rate and adjust the supply accordingly to maintain that rate.

- The supply curve is vertical since the central bank only supplies a specific quantity of reserves, means no matter interest rate, the quantity supplied is same.

Equilibrium in the federal funds market:

Interest rate where supply for reserves equals demand for those funds. Here banks are willing to lend and borrow same amount of reserves.

Central banks aim to have a fixed federal funds rate however:

the demand for reserves by banks changes often therefore to maintain a fixed rate central bank adjust the supply reserves as needed. E.g. if demand for reserves increase shifting right the supplies for reserves also increases shifting right to keep the rate from rising.

2 ways for central banks to influence federal funds rate:

- Open market operations: Buying government bonds increases reserves which lowers funds rate.

- Selling government bonds to reduce reserves and to raise federal funds rate.

How central bank controls inflation:

- They affect the federal funds rate which influences the supply of loans from private banks and thus the money supply.

- High federal funds rate -> Reduces loans and money supply -> decreases inflation

- Low federal funds rate -> Increases loans and money supply -> increases inflation

How the Central Bank Affects the Real economy:

- Central bank affects the federal funds rate, which impacts interest rates on private loans

- A lower real interest rate (nominal interest rate minus inflation) stimulates the economy.

- In the long run, central banks aim for low and stable inflation.

- In the short run, some inflation can help alleviate economic recessions

Real interest rate

Nominal interest rate - inflation rate.

Federal reserve, US central bank has a dual mandate

Low inflation and maximum employment.

Federal reserve

Holds the reserves of private banks

Federal reserves 3 things to do:

- Set a key short term interest rate

- Influence the money supply and inflation rate

- Influence long term real interest rates

Money supply (M2)

Total amount of money available in an economy at a given times and includes all money in circulation such as cash, coins and money in bank accounts. Central banks control the money supply to help manage inflation, interest rate and economic growth. Exclude bank reserves.

Expansionary (contractionary) monetary policy

Increases (decreases) the quantity of bank reserves and lowers interest rates.

- To stimulate economic growth during a recession, and encourages borrowing, spending by making money cheaper to borrow,

- Countercyclical policy (expansionary monetary policy) dampens recession.

Simplified mechanism of the monetary policy and the real economy - how a cenral bank´s actions can affect the real economy

1. Central bank lowers nominal interest rate

2. Real interest declines because inflation does not increase immediately (nominal interest lower then lower real interest rate because inflation rate is stable or do not adjust)

3. Households borrow more/save less and consume more - (real interest rate is lower they borrow more) - consumption up

4. Firms borrow more and invest more

5. Both raises the demand for goods and services

6. Labor demand curve shifts to the right

Expansionary monetary policy can either increase the quantity of bank reserves and lower the interest rates or vice versa to help softening the affect from economic shocks and help recovering the economy. An example:

When the economy starts at the peak meaning the phase where economic activities are at their highest, unemployment. However suddenly a shock hits the economy and it turns recession which can be due to financial crises such as a drop in demand, external shocks. This results in slower economic activities leading to less production and increase in unemployment. To minimize this central bank implement an expansionary monetary policy to minimize this.

Ways to minimize recessions is:

- Reduce interest rate so it can push the economic activity

- Increase money supply by buying government bonds to increase money flow in economy.

How does the central bank affect the interest rate?

- It affects the federal funds rate by:

o Changing supply of reserves by buying government bonds

o Changing interest on reserves

- With financial institutions it can impact long term borrowing rates by affecting credit markets to a change in the long-term interest rate.

o Liquidity premium: When interest rate on long term borrowing is higher than short term borrowing, so change to short term it affects the long term to rise or fall as well.

o Banks maturity transformation: Changes in short-term normally translate into changes in long term rates.

Monetary need to do tradeoffs, if they want to use expansionary monetary policy to e.g reduce recession it will lead to consequences: (Philips curve)

- Increase GDP and reduce unemployment and

- Raised inflation.

The challenge is to balance this to get economic stability since it is difficult to get low unemployment and low inflation.

To solve this trade off central banks uses a formula:

- Federal funds rate = Long run federal funds target rate + 1.5 x (inflation rate - inflation rate target) + 0.5 x (output gap in percentage points).

Federal funds target rate:

what banks charge each other

Inflation rate - inflation rate target

- Measures how much actual inflation deviates from the target inflation rate.

Output gap

the gap between real GDP and potential GDP (trend GDP)