Slides for lecture week 7

Overview of Monetary Policy Transmission Mechanism

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

• Aggregate Demand Effects:

  • Changes in aggregate expenditure based on interest rates and real GDP shifts

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 lending

Channels of QE Effects

• 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 downturns

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.