Revision - monetary policies 2

.Overview of Monetary Policy Transmission Mechanism

Course Codes: IF1203 Macroeconomics, BSc Banking and International Finance, BSc Accounting and Finance, BSc IFRM,g BSc Finance

Simplified Asset Choice

Assumes two assets:

• Money: Medium of exchange

• Bonds: Earn higher interest returns, priced on the open market

• Bond prices negatively correlate with interest rates:

Rising interest rates decrease bond prices

Equilibrium in the Money Market

Excess Demand for Money

People sell bonds, lowering bond prices, raising interest rates

Excess Supply of Money: People buy bonds, raising bond prices, lowering interest rates

Monetary Equilibrium: Occurs when money and bond stocks are held at current interest rates

Interest Rate Dynamics

Nominal Rate of Interest:

Influence on equilibrium interest rates across different money quantities

Multiple curves representing the interaction between interest rates and quantity of money

Spending and Interest Rates

Interest rate changes influence spending through various channels:

Investment: Higher rates lower profitable projects

Wealth Impact: Changes in asset valuations affect consumption

Net Trade: Interest rates impact exchange rates affecting international trade

Changes in Investment Expenditure

Rate of Interest Effects:

Illustrates shifts in investment expenditure curves due to interest rate change

Aggregate Demand Effects:

Changes in aggregate expenditure based on interest rates and real GDP shift

Aggregate Demand and Supply Dynamics

Aggregate Demand (AD): Influenced by spending, price shifts, and inflation

Inflationary Gap: Occurs when actual GDP exceeds potential output, causing price level increases

Autonomous increases in aggregate demand leading to further shifts in prices and output

Summary of Policy Channels

Monetary Policy Effects:

Lower rates lead to higher investment, shifting AD and potentially increasing prices

Fiscal Policy Effects: Similar effects initiated by government spending changes

Mechanism of Monetary Policy Effects

Interest rates affect:

Market rates, asset prices, expectations, domestic spending

Investments influenced by borrowing costs, affecting consumption and trade

Time Lags in Policy Impact

Old Monetarist Rule:

One year for output impact, two years for price impacts

Bank of England forecasts:

5 quarters for GDP peak effects

9 quarters for inflation peak effects

Quantitative Easing (QE)

A response to low interest rates to boost AD:

Central banks purchase large asset amounts to increase money supply

Implications of QE:

Lowers long-term interest rates, potentially boosts investment and asset prices

Provides liquidity to banks and encourages lendin

Channels of QE Effect

Macro/Policy News Channel:

Reflects market expectations and future policy signals from QE announcements

Portfolio Rebalancing Channel:

Encourages diversified asset investment due to increased demand for gilts

Liquidity Premium Channel:

Central bank purchases enhance market liquidity, decreasing the liquidity premium

Bank Lending Channel: Critique

Households and firms gain no direct increase in cash from QE

Banks accumulate more reserves but did not increase lending significantly post-GFC

QE Outcomes and Limitations

• Lower gilt yields and asset prices along with increased consumer confidence post-2008/9

• Challenges in business investment recovery

• Minimal exchange rate effects due to global downturn

Quantitative Tightening (QT)

Central banks begin unwinding QE, necessitating careful market handling

Risk of market shocks during asset sell-offs

QT developments linked to market crises and the need for central bank balance sheet management

Final Notes

QE and QT are pivotal strategies in modern monetary policy to influence economic activity and stabilize markets.