Price stability - control inflation
Economic stability - push for sustainable economic growth
Financial stability - efficient payments system
Inflation is bad because:
erode purchasing power
cause uncertainty in economy
reduce country's competitiveness - goods and services become expensive
worse income inequality - the rich can always keep their financial assets in stock market, real estate, foreign assets
other economic costs - rent seeking behavior, inflation make credit cheap
FX intervention is costly
control depreciation - not enough FX reserve
control appreciation - negative carry, FX valuation loss
- negative carry: the difference of interest payment on foreign assets and interest payment on domestic gov bonds
- FX valuation loss: the valuation of FX assets reduce when FX depreciate against domestic currency
FX sterilization: to offset the effect of FX intervention. For example, CB sells domestic currency, and buys foreign currency to support its currency. To mop up excess liquidity in the market , do so by selling gov bonds,
Monetary Policy Tools
Reserve requirement (RR):
for liquidity management and monetary control
increase the cost of operation on banks, distort market system if the reserve does not pay interest (it is a tax on banks)
Open Market Operations (OMO):
- repo, reverse repo
1 day bilateral repo rate: policy rate
7 day, 14 day repo rate, auction
- outright purchase/sale of gov bands
- foreign exchange swap
Discount window and discount rate
- discount window also known as standing facility
lending facility , deposit facility
CB lending rate : policy rate + 0.5%
CB borrowing rate : policy rate - 0.5%
iU - iL : interest rate corridor
important to have corridor, CB wants to influence the market rate around the policy rate
- discount rate is usually set at fed fund rate + 100bp. The purpose is the Fed prefers banks to borrow from each other in the federal funds market, so that they can monitor each other's credit risk.
corridor too wide: more volatility in market rate
corridor too narrow: too little penalty for commercial bank when they come to lend/borrow
standing facility and OMO are market based , RR is not market based. If banks don't transmit well, use RR
Monetary Policy Regime
1. exchange rate targeting:
-CB must have sufficient reserves
-CB and gov must be ready to use capital controls
2. monetary targeting:
-target the supply of money in economy
3. inflation targeting:
-public announcement of medium term inflation target,
-easy to understand
-reduces time inconsistency problem
-stresses transparency and accountability
-take time to have effect ( 6 - 8 quarters)
-too much rigidity, eg. inflation nutter
Monetary Policy and Financial Stability
Time inconsistency problem: CB deviate from a policy after it was announced, destroys CB's creditability
Nominal anchor: money supply or inflation rate
** use nominal anchor because the public can observe nominal variable, such as price increase
** second round effect: if wage goes up, price goes, up, wages goes up, wage-price spiral. If CB can anchor inflation expectations, the second round effect is minimal
**if monetary policy is credible enough to anchor inflation expectation, the inflation overall will be maintained.
Clean vs lean debate:
Lean
besides price stability risk, CB respond to other risk, such as asset bubble risk
because cost of cleaning up is too high
Clean
It is impossible to lean against credit bubbles using monetary policy
difficult to identify asset price bubbles
only clean up after bubble burst
Two types of asset price bubbles:
- credit driven bubble
bank extends BS to investors, debt overhang problem
- "irrational exuberance" bubble
overly optimistic view of the investors
interest rate is a blunt tool, affecting other economic variables
and raising interest rate may not be effective in restraining bubbles
macroprudential policy can be used to reign in asset price bubbles, policy tools such as LTV, leverage ratio, and the below:
countercyclical buffer: good times banks hold more reserves
liquidity ratio: the ratio of liquid assets to total net cash outflows, that banks need to have
It is dangerous to associate easing/tightening of monetary policy with a fall/rise in ST nominal rates. It is important to look at other assets prices as well.
Case study:
In Japan, in the two lost decades, although the nominal rate is low, deflation means real rate remained high. The high real interest rate is reflected in the lower asset prices of real estate and stock valuation.
Monetary Policy and Transmission Channels
Interest rate: real interest rate affects consumers and business, LT interest rate has major impact on spending
Credit supply:
- bank lending channel: policy rate affects banks marginal cost of funds, increase in cost of funds make banks reduce loan
- balance sheets channel: interest rate affects firms balance sheet, firms can borrow more when their balance sheet improves
Asset prices: stock price up, financial wealth up, consumption rises
Exchange rate: FX changes lead to changes in relative prices of domestic and foreign goods and services
Expectations: anchor expectations
Money and Inflation
Nominal Rigidity
- known as price stickiness or wage stickiness
- lags in the adjustment of prices and wages to changes in demand
- so money affects real variables in the short run, and prices in the long run
there are no explicit relationship between money aggregates and inflation but correlation exists
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