Monetary Policy and Economic Outcomes

Monetary Policy and Economic Outcomes Monetary Policy and Economic Outcomes By: OpenStaxCollege A monetary policy that lowers interest rates and stimulates borrowing is known as an expansionary monetary policy or loose monetary policy Conversely, a monetary policy that raises interest rates and reduces borrowing in the economy is a contractionary monetary policy or tight monetary policy This module will discuss how expansionary and contractionary monetary policies affect interest rates and aggregate demand, and how such policies will affect macroeconomic goals like unemployment and inflation We will conclude with a look at the Fed’s monetary policy practice in recent decades The Effect of Monetary Policy on Interest Rates Consider the market for loanable bank funds, shown in [link] The original equilibrium (E0) occurs at an interest rate of 8% and a quantity of funds loaned and borrowed of $10 billion An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to S1, leading to an equilibrium (E1) with a lower interest rate of 6% and a quantity of funds loaned of $14 billion Conversely, a contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to S2, leading to an equilibrium (E2) with a higher interest rate of 10% and a quantity of funds loaned of $8 billion 1/10 Monetary Policy and Economic Outcomes Monetary Policy and Interest Rates The original equilibrium occurs at E0 An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6% A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S 0) to the new supply (S2), and raise the interest rate from 8% to 10% So how does a central bank “raise” interest rates? When describing the monetary policy actions taken by a central bank, it is common to hear that the central bank “raised interest rates” or “lowered interest rates.” We need to be clear about this: more precisely, through open market operations the central bank changes bank reserves in a way which affects the supply curve of loanable funds As a result, interest rates change, as shown in [link] If they not meet the Fed’s target, the Fed can supply more or less reserves until interest rates Recall that the specific interest rate the Fed targets is the federal funds rate The Federal Reserve has, since 1995, established its target federal funds rate in advance of any open market operations Of course, financial markets display a wide range of interest rates, representing borrowers with different risk premiums and loans that are to be repaid over different periods of time In general, when the federal funds rate drops substantially, other interest rates drop, too, and when the federal funds rate rises, other interest rates rise However, a fall or rise of one percentage point in the federal funds rate—which remember is for borrowing overnight—will typically have an effect of less than one percentage point on a 30-year loan to purchase a house or a three-year loan to purchase a car Monetary policy can push the entire spectrum of interest rates higher or lower, but the specific 2/10 Monetary Policy and Economic Outcomes interest rates are set by the forces of supply and demand in those specific markets for lending and borrowing The Effect of Monetary Policy on Aggregate Demand Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP [link] (a) illustrates this situation This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS) The original equilibrium during a recession of E0 occurs at an output level of 600 An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the ... Financial Markets, Monetary Policy and Reference Rates: Assessments in DSGE Framework Nao Sudo * nao.sudou@boj.or.jp No.12-E-12 December 2012 Bank of Japan 2-1-1 Nihonbashi-Hongokucho, Chuo-ku, Tokyo 103-0021, Japan * Financial System and Bank Examination Department Papers in the Bank of Japan Working Paper Series are circulated in order to stimulate discussion and comments. Views expressed are those of authors and do not necessarily reflect those of the Bank. If you have any comment or question on the working paper series, please contact each author. When making a copy or reproduction of the content for commercial purposes, please contact the Public Relations Department (post.prd8@boj.or.jp) at the Bank in advance to request permission. When making a copy or reproduction, the source, Bank of Japan Working Paper Series, should explicitly be credited. Bank of Japan Working Paper Series Financial Markets, Monetary Policy and Reference Rates: Assessments in DSGE Framework  Nao Sudo December 28, 2012 Abstract In this paper, we explore the roles played by reference rates in business cycle ‡uctuations using a medium-scale full-‡edged dynamic stochastic general equilibrium (DSGE) model. Our model is an extended model of chained-credit-contract model develope d by Hirakata, Sudo, and Ueda (2011b) estimated by the Japanese data. In our economy, there are interbank as well as lending markets. Credit spreads determined in the markets are a¤ected by the borrow- ers’creditworthiness and degree of informational friction in the credit markets. Focusing on the role of reference rates that a¤ects economic decisions through the delivery of information about the nature of economy, we evaluate channels through which the reference rates a¤ects credit spreads and macroeconomic activities. We …nd that (i) reference rates may mitigate informational friction in the credit markets, leading to a higher investment, output, and in- ‡ation, (ii) reference rates may contribute to economic stabilization by providing accurate economic forecast, and (iii) reference rates may bring about unintended consequence of mon- etary policy implementation by adding a noise to the credit spreads. Our results indicate the importan ce of reliable reference rates, particularly under the environment where uncertainty prevails, from the perspective of resource allocation, stabilization, and policy implementation. Keywords: Reference Rates; Credit Spreads; Informational Friction, Signal Extraction, Mone- tary Policy  Director, International Division, Financial System and Bank Examination Department, Bank of Japan (E-mail: nao.sudou@boj.or.jp). The author would like to thank Kosuke Aoki, Ichiro Fukunaga, Jacob Gyntelberg, Daisuke Ikeda, Selahattin Imrohoroglu, Sohei Kaihatsu, Koichiro Kamada, Ryo Kato, Tomiyuki Kitamura, Shun Kobayashi, Marco Lombardi, Koji Nakamura, Kenji Nishizaki, Yukisato Ohta, Masashi Saito, Yuki Teranishi, Yuki Uchida, Yoichi Ueno, and Hiromi Yamaoka for their useful c omments. Views expressed in this paper are those of the author and do not necessarily re‡ect the o¢ cial views of the Bank of Japan. 1 1 Introduction Since the …nancial crisis starting in 2007, a growing attention has been paid to the role played by the reference rates in …nancial transactions among both policy makers and scholars. Although there is a strong agreement about the usefulness of the reference rate in guiding pricing of …nancial products, some recent studies emphasize a negative side of a coin. For instance, Abrantez-Mtez et. al (2012), investigatin Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper No. 126 http://www.dallasfed.org/assets/documents/institute/wpapers/2012/0126.pdf Ultra Easy Monetary Policy and the Law of Unintended Consequences * William R. White August 2012 Revised: September 2012 Abstract In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not “a free lunch”, governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level. JEL codes: E52, E58 * William R. White is currently the chairman of the Economic Development and Review Committee at the OECD in Paris. He was previously Economic Advisor and Head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland. +41 (0) 79 834 90 66. white.william@sunrise.ch. This is a slightly revised version of the paper circulated in August 2012. The views in this paper are those of the author and do not necessarily reflect the views of organizations with which the author has been or still is associated, the Federal Reserve Bank of Dallas or the Federal Reserve System. 2  UltraEasyMonetaryPolicyandthe LawofUnintendedConsequences 2  ByWilliamWhite      A. Introduction Thecentralbanksoftheadvancedmarketeconomies(AME’s) 3 haveembarkedupononeofthe greatesteconomicexperimentsofalltime‐ultraeasymonetarypolicy.Intheaftermathofthe economic and financial crisis which began in the summer of 2007, they lowered policy rates effectivelytothezerolowerbound(ZLB).Inaddition, theytookvariousactionswhichnotonly causedtheirbalancesheetstoswellenormously,butalsoincreasedtheriskinessoftheassets theychosetopurchase.Theiractionsalsohadtheeffectofputtingdownwardpressureontheir exchangeratesagainst thecurrenciesofEmergingMarketEconomies(EME’s).Sincevirtually all EME’s tended to resist this pressure 4 , their foreign exchange BANK OF FINLAND DISCUSSION PAPERS 12 • 2004 Nicolas Rautureau Research Department 15.6.2004 Measuring the long-term perception of monetary policy and the term structure Suomen Pankin keskustelualoitteita Finlands Banks diskussionsunderlag Suomen Pankki Bank of Finland P.O.Box 160 FIN-00101 HELSINKI Finland  + 358 9 1831 http://www.bof.fi BANK OF FINLAND DISCUSSION PAPERS 12 • 2004 Nicolas Rautureau* Research Department 15.6.2004 Measuring the long-term perception of monetary policy and the term structure The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. I would like to thank Juha Tarkka, Jouko Vilmunen, Juha Kilponen and seminar participants at the Bank of Finland for their helpful comments. I am also grateful to Heli Tikkunen and Patrice Ollivaud (OECD) for the data. Suomen Pankin keskustelualoitteita Finlands Banks diskussionsunderlag http://www.bof.fi ISBN 952-462-138-X ISSN 0785-3572 (print) ISBN 952-462-139-8 ISSN 1456-6184 (online) Multiprint Oy Helsinki 2004 3 Measuring the long-term perception of monetary policy and the term structure Bank of Finland Discussion Papers 12/2004 Nicolas Rautureau Research Department Abstract This paper has two objectives. The first is to identify the long-term public perception of monetary policy. The second is to identify the relationship between this perception and long-term bond rates. For German data, the use of a two-factor model of the term structure results in the best forecast of long-term interest rates for the period between January 1975 and January 2003. It also allows us to introduce as the second factor the long-term perception of inflation as a characteristic of the behaviour of monetary authorities. Key words: expectations hypothesis, monetary policy, changepoints JEL classification numbers: E43 4 Rahapolitiikkaa koskevien pitkän aikavälin käsitysten mittaaminen ja korkojen aikarakenne Suomen Pankin keskustelualoitteita 12/2004 Nicolas Rautureau Tutkimusosasto Tiivistelmä Tällä tutkimuksella on kaksi tavoitetta. Ensimmäinen on mitata yleisön käsityksiä pitkällä aikavälillä harjoitettavasta rahapolitiikasta. Toinen tavoite on määrittää näiden käsitysten suhde pitkiin bondikorkoihin. Saksalaista aineistolla käytettäes- sä korkojen aikarakenteen mallintaminen kahden faktorin mallilla johtaa parhai- siin pitkien korkojen ennusteisiin tammikuusta 1975 tammikuuhun 2003 ja mah- dollistaa myös pitkän aikavälin inflaatio-odotusten käyttämisen aikarakenteen toi- sena faktorina. Tämä faktori luonnehtii samalla vallitsevia käsityksiä rahaviran- omaisten käyttäytymisestä. Avainsanat: odotushypoteesi, rahapolitiikka, regiiminmuutokset JEL-luokittelu: E43 5 Contents Abstract 3 Tiivistelmä 4 1 Introduction 7 2 Monetary policy, inflation target and long term interest rates 8 3 Theoretical framework 10 3.1 The two-stage approach of Kozicki and Tinsley 11 3.2 Three specifications for the short rate process 12 3.3 The definition of the nominal interest rate endpoint 13 3.4 The transmission to the term structure 14 3.5 The .. .Monetary Policy and Economic Outcomes Monetary Policy and Interest Rates The original equilibrium occurs at E0 An expansionary monetary policy will shift the supply... unemployment rate, and the inflation rate since 1975 Different episodes of monetary policy during this period are indicated in the figure 5/10 Monetary Policy and Economic Outcomes Monetary Policy, Unemployment,... loose and tight monetary policy to changes in output and the price level The Pathways of Monetary Policy (a) In expansionary monetary policy the central bank causes the supply of money and loanable