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The University of Sydney Page 1 ECON1002 Introductory Macroeconomics Week 6 Lecture School of Economics Semester 1, 2022 The University of Sydney Page 2 Lecture 6 6.1: Money, Prices and the Reserve Bank What is money Money and the banking system Money and inflation Reserve Bank of Australia and the determination of interest rates 6.2: The Reserve Bank and the Economy Bond prices and interest rates How does the RBA affect all interest rates in the economy How does monetary policy affect and respond to the economy Case study: Unconventional monetary policy Readings: Textbook Chs 9 &10. Otto, Glenn 2007, “Central Bank Operating Procedures: How the RBA achieves its Target for the Cash Rate”, Australian Economic Review, 40, 2, pp. 216-224. [on Canvas Reading List or https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1467-8462.2007.00463.x McLeay, Michael and Radia, Amar and Thomas, Ryland, Money Creation in the Modern Economy, Bank of England Quarterly Bulletin 2014 Q1, https://www.bankofengland.co.uk/-/media/boe/files/quarterly- bulletin/2014/money-creation-in-the-modern-economy The University of Sydney Page 3 1. Medium of Exchange Purchase goods & services. 2. Unit of Account Wages and prices expressed in dollars (currency) 3. Store of Value Valued as an asset. Without money, we would have to rely on barter. Money is also a unique asset as it is supplied by a monopoly – the government. Need to satisfy the following Is the cryptocurrency a money What is Money $$$ The University of Sydney Page 4 In the early days, commodity money was standard. Government operated a mint to produce coins from precious metals (gold and silver) to generate seigniorage revenue. What is the problem with this Free banking era (private bank notes): In the US (1837-1863), state chartered (private) banks issued pieces of paper like a currency. What is the problem with this N.B. It was followed by National Banking era in the US (1864-1912). Commodity-backed paper currency: Government issued paper currency backed up by some commodity such as gold, exchanged at specified price, known as the gold standard, (existed in the US before 1933). What is the problem with this Fiat money: Modern money, currency! It has no inherent intrinsic value, but we believe others accept in exchange for goods in the future. What is the problem with this A Brief History of Money The University of Sydney Page 5 A Brief History of Central Banks Amsterdam Wisselbank: A forerunner to modern central banks in 1609. Sveriges Riksbank (est in 1668): World’s oldest central bank but no monopoly over printing money before 1904. Bank of England (est in 1694): takes the form of modern central bank. US Federal Reserve (est 1913): response to frequent banking panics and stock market crashes around 1890 – 1912 in the national banking era. Set up by private banks led by J.P. Morgan. (A conspiracy theory re the RMS Titanic sinking in 1912, https://www.businessinsider.com.au/titanic-sinking-conspiracy-theories-2018- 4 r=US&IR=T) Reserve Bank of Australia (Reserve Bank Act 1959): took over the central banking function from the Commonwealth Bank (est 1911). Australian dollar introduced in 1966 to replace Australian pound. https://www.rmg.co.uk/ The University of Sydney Page 6 Currency = notes + coins M1 = Currency + current deposits M3 = M1 + all bank deposits Broad Money = M3 + borrowings by Non- Bank depository corporations less holdings of currency and deposits of Non-Bank depository corporations Less Liquid Monetary Aggregates: Definitions The University of Sydney Page 7 A Theory of Money and Inflation Intuition: Suppose there are $100 in an economy, and there is one transaction occurred to buy 20 units of a good priced $5. Equation of Exchange: MV = PT, ($100*1 = $5*20). an identity which must be true V = PT/M ; velocity (frequency) of circulation At the aggregate level, Real GDP (Y) is a quantity, proportional to transactions (T). So replace T with Y. Hence, MV = PY (where V = PY/M, PY = Nominal GDP) This is the quantity equation of money. The University of Sydney Page 8 % % % % MV PY M V P Y = + = + % %M P = Assume (1) V is constant (2) Y is constant A Theory of Money and Inflation The University of Sydney Page 9 Money vs Inflation & Output Source: “Some Monetary Facts” (Federal Reserve Bank of Minneapolis Quarterly Review, 1995) Inflation is a monetary phenomenon in the LR! Money is neutral in the LR! The University of Sydney Page 10 Money and Inflation in US Data The University of Sydney Page 11 Reserves to deposits ratio = 100% Fractional Banking System Balance Sheet of Witch Bank: Initial The University of Sydney Page 12 Reserves to deposits ratio = 10% Money and Banks Target Balance Sheet of Witch Bank: after one round of loans The University of Sydney Page 13 Reserves to deposits ratio = 53% Money and Banks Balance Sheet of Witch Bank: after a re-deposit of the loan The University of Sydney Page 14 Reserves to deposits ratio = 10% Money and Banks New loans this time = $81 Balance Sheet of Witch Bank: after a new loan again The University of Sydney Page 15 Reserves to deposits ratio = 36% Money and Banks Balance Sheet of Witch Bank continually changing……… The University of Sydney Page 16 Reserves to deposits ratio = 10% Money and Banks New loans this time = $73 Balance Sheet of Witch Bank continually changing……… The University of Sydney Page 17 Reserves to deposits ratio = 10% Money and Banks Balance Sheet of Witch Bank: Final The initial $100 deposit has created $1000 in deposits! The University of Sydney Page 18 Money and Banks Bank reservesDesired reserves/deposit ratio Bank deposits = Bank reserves 100Bank Deposits = 1000 Desired reserve /deposit ratio 0.10 = = Money = (1/rr) x Reserves M = mm x R This is how money supply can be changed through money multiplier (mm) under a fractional reserve banking system. But, modern monetary policy no longer operates like this! The University of Sydney Page 19 Misconceptions of Monetary Policy McLeay et al (2014) outline some misconceptions. “Deposit creates loans”. Bank lending creates deposits. “Banks act simply as intermediaries” In real world, commercial banks are the creators of deposit money. “Central banks determine the quantity of loans and deposits by controlling the quantity of central bank money (esp. reserves), through the money multiplier process ”. Money and loans are endogenous. Central banks simply set the price of reserves, interest rates. The University of Sydney Page 20 RBA and Interest Rates Dr Phillip Lowe Governor of the RBA (app. Sep 2016) Who sits on the RBA Board https://www.rba.gov.au/about-rba/boards/rba-board.html Reserve Bank of Australia (Reserve Bank Act 1959): took over the central banking function from the Commonwealth Bank (est 1911). Australian dollar introduced in 1966 to replace Australian pound in favour of decimalisation. The University of Sydney Page 21 The principal medium-term objective of monetary policy is to control inflation, ……….. the appropriate target for monetary policy is to achieve an inflation rate of 2–3 per cent, on average, over the cycle, …………… provides discipline for monetary policy decision- making, and serves as an anchor for private sector inflation expectations. The inflation target is defined as a medium-term average rather than as a rate (or band of rates) that must be held at all times. This approach allows a role for monetary policy in dampening the fluctuations in output over the course of the business cycle. When aggregate demand in the economy is weak, for example, inflationary pressures are likely to be diminishing and monetary policy can be eased, which will give a short-term stimulus to economic activity. http://www.rba.gov.au/monetary-policy/about.html Monetary Policy in Australia Objectives and Framework The University of Sydney Page 22 Current target rate = 0.1% (10 basis points) (Since Dec 1, 2020) RBA and Interest Rates “The Reserve Bank sets the target ‘cash rate’, which is the market interest rate on overnight funds. It uses this as the instrument for monetary policy, and influences the cash rate through its financial market operations.” Source: http://www.rba.gov.au/monetary-policy/int-rate-decisions/index.html How does the RBA set the cash rate https://www.rba.gov.au/media- releases/2022/mr-22-05.html The University of Sydney Page 23 Decreasing the cash rate Open Market Operation (OMO) Example: current cash rate = 1.5% target cash rate = 1.25% The University of Sydney Page 24 RBA conducts Open Market Operations (buy financial assets from banks) Banks borrow or lend in the overnight cash market (lend) Changes balances in Exchange Settlement Accounts (credited by the RBA) Affects the overnight cash market (more funds => fall in the cash rate) Open Market Operation The University of Sydney Page 25 Example: current cash rate = 1.5% target cash rate = 1.75% Increasing the cash rate Open Market Operation (OMO) The University of Sydney Page 26 RBA conducts Open Market Operations (sell financial assets from banks) Banks borrow or lend in the overnight cash market (borrow) Changes balances in Exchange Settlement Accounts (debited by the RBA) Affects the overnight cash market (less funds => increase in the cash rate) Open Market Operation The University of Sydney Page 27 How does RBA set Interest Rates Establish a narrow channel (interest rate corridor) around the target level for their policy rates by providing a standing facility for reserves. RBA stands ready to borrow and lend reserves to designated financial institutions at interest rates that are slightly below or above the target rate. Banks hold accounts at the RBA called exchange settlement (ES) accounts To clear payment transactions among banks For the settlement of accounts between the RBA, the federal government and the banking system. Through its OMO, RBA can affect the level of ES funds in the banking systems’ accounts For interbank lending/borrowing, use cash (interbank) market to trade ES funds. Banks need keep a minimum balance in credit. The University of Sydney Page 28 RBA’s MP: Operating Procedures Interest corridor: target – 0.25% ≤ cash rate ≤ target + 0.25% RBA’s Standing Facilities The University of Sydney Page 29 RBA’s MP: Operating Procedures Banking system’s demand for cash The University of Sydney Page 30 RBA’s MP: Operating Procedures RBA’s forecast of cash supply on a given day The University of Sydney Page 31 RBA’s MP: Operating Procedures RBA offers to buy securities (repo) equal to the estimate of excess demand for cash at the target rate The University of Sydney Page 32 RBA’s MP: Operating Procedures After OMO, RBA ensures the excess demand for cash is met at the target rate The University of Sydney Page 33 If i = 5%, $1 in t+1 = If i = 10%, $1 in t+1 = If i increases, the expected present discounted value (i.e., price) falls! The price you would pay for a bond varies inversely with its rate of interest (bond yield): Price (P) = Payoff / (1+i) What if it is a multi-year bond 95. 05.1 1 = + 91. 10.1 1 = + Present Value and Bond Price The University of Sydney Page 34 Bond Prices and Interest Rates Borrowers issue bonds to lenders 2 year bond (principal of $1000) with a “coupon” rate = 5% The University of Sydney Page 35 Bond Prices and Interest Rates The University of Sydney Page 36 P90 day bills S D Q* Q (90 day bills) P* lending borrowing RBA, Bond Prices and Interest Rates The University of Sydney Page 37 P90 day bills S0 D0 Q Q (90 day bills) P Cash rate, bond prices and interest rates: How are they related Consider a monetary tightening (i.e. an increase in cash rate) RBA, Bond Prices and Interest Rates The University of Sydney Page 38 RBA and Other Interest Rates The University of Sydney Page 39 Short-term and Long-term interest rates Long-term interest rates are determined by both short-term interest rates and expectations about future interest rates! The University of Sydney Page 40 RBA, Bond Prices and Interest Rates RBA sets the cash rate (nominal interest rate). Can the RBA affect the real interest rate Assume that π = 0, so that r = i. N.B. Consumption and investment respond to the real interest rate. r i π= The University of Sydney Page 41 PAE Y Ip0 C0 r Monetary Policy and the Economy W hat happens to consum ption and investm ent The University of Sydney Page 42 Y PAE Y 450 PAE1 = C1 + IP1 PAE0 = C0 + IP0 Monetary Policy and the Economy r The University of Sydney Page 43 PAE and the real interest rate: A numerical example – In an economy described by: Cd = 640 + 0.8(Y – T) – 400r Ip = 250 – 600r G = 300 X = 20 T = 250 – Both Cd and Ip are affected by the interest rate, r. PAE = Cd + Ip + G + X = [640 + 0.8(Y – 250) – 400r] + [250 – 600r] + 300 + 20 = [1010 – 1000r] + 0.8Y The University of Sydney Page 44 Monetary Policy and the Economy Let PAE = 1010 – 1000r + 0.8Y Also, assume potential output If r = 0.05, PAE = In equilibrium, Ye(1 – 0.8) = 960 => Ye = 4800 (eq’um output) What’s the output gap Y* = 5000 The University of Sydney Page 45 Monetary Policy and the Economy Recall PAE = 1010 – 1000r + 0.8Y What if r = 0.01 r = 0.01 => Y = 1000 + 0.8Y (in equilibrium) Ye (1 – 0.8) = 1000 => Ye = 5000 Did this eliminate the output gap Y* = 5000 The University of Sydney Page 46 Central bank fights a recession in the Keynesian model The University of Sydney Page 47 Y S Monetary Policy and the Economy Recession90 day bill rate The University of Sydney Page 48 *0.01 0.5 0.5 * π = + + Y Yr Y Policy Reaction Function (PRF) and Taylor Rule r if (i) Y < Y* and/or (ii) inflation (π) decreases r if (i) Y > Y* and/or (ii) inflation (π) increases Example: If inflation is 3% and output gap is zero, the Federal Reserve should set: The real interest rate 0.01 + 0.5 x 0 + 0.5 x 0.03 = 0.025 = 2.5% The nominal rates at 2.5% + 3% = 5.5%. John Taylor proposed a policy rule for the US MP as follows. https://web.stanford.edu/~johntayl/ The University of Sydney Page 49 Y interest rate (r) inflation RBA’s policy reaction function (PRF) Monetary Policy and the Economy The University of Sydney Page 50 Y interest rate (r) inflation RBA’s PRF Monetary Policy and the Economy What happens when the RBA takes a more aggressive (‘hawkish’) stance, e.g. a lower inflation target The University of Sydney Page 51 Case Study: “Unconventional” Monetary Policy Suppose target value for policy rate has been reduced to zero. Central bank has reached the limits of Conventional Monetary Policy. Welcome to the world of “Unconventional” Monetary Policy. Negative Policy Rates Quantitative Easing (QE) Forward Guidance With QE, Central bank buys long-term assets which it pays for by creating new bank reserves. CB actions drive up the price of long-term assets and reduce long-term yields. Recall an inverse relation between the bond price and yields! Directly boosts broad money (with non-banks) without requiring an increase in lending via the banking system. The University of Sydney Page 52 Case Study: “Unconventional” Monetary Policy Source: https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html The University of Sydney Page 53 Case Study: “Unconventional” Monetary Policy Source: https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html