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5.2.5 Monetary Policy
a) Objectives
The central bank is a relatively new institution.
For those interested in its hstory, please see
Observation #6: A
Brief History of the Central Bank - UK, USA & Canada. Today the primary objective of every central bank is
preservation of the value of the currency – internally with respect to
domestic inflation and externally with respect to the exchange rate.
Secondary objectives include acting as the government’s banker and debt
manager (particularly internationally), moderating the business cycle as
well as fostering economic growth and full employment.
The primary objective goes to the heart of economic
expectations. The expected price level is the basis of aggregate
expenditure including consumption, investment, government and
export/import decisions. The uncertainty created by inflation
affects the present value of future 'real' earnings, i.e., how
much one is willing to pay today for a future stream of earnings
tomorrow. Change the expectation and a different outcome
will be reached. If prices rise or fall too fast choices must be
hastily re-calculated. Uncertainty increases and uncertainty is the
great and costly enemy of investment.
Rising prices also affect asset values and
hence wealth with a corresponding 'wealth effect'. In a capitalist society or plutocracy wealth is the
measure of one’s worth. Wealth owners – large and small - have a vested
interest in price stability and the value of their assets. The central
bank serves their interests. In a sense, the Central Bank is a
fourth order of government beyond the executive, legislative and
judicial. It represents an institutional marriage of the political
and financial worlds in a capitalist society. The Great Depression
taught that the animal spirits of the investment community could not be
trusted to operate in society's best interest; long history had already
taught that letting the State control the printing press leads to
similarly bad outcomes. A balance was struck: the modern Central
Bank, a post-Great Depression institution.
The logic of control goes like this: by manipulating the
money supply the Central Bank changes interest rates; by changing
interest rates the central bank can control investment; by controlling
investment the central bank can manipulate aggregate demand; and,
thereby, the central bank controls the aggregate price level, i.e.,
inflation. Similarly, control of interest rates allows the Bank to
raise or lower the exchange rate to encourage or discourage foreign
investment. Discretionary change in monetary policy suffers from
policy lag - is there an emerging problem - recession/inflation?
Recognition then requires decision-making - what tools should we use?
Having the tools in hand how long will it take to nudge the system to a
low inflation, full employment AD/AS equilibrium?
Control of interest rates, of course, allows the
Central Bank to achieve both its primary objective of stabilizing the
value of the currency and, in some jurisdictions, secondary objectives including moderating
the business cycle and fostering economic growth and full
employment.
b) Tools
The question arises: How does the central bank manipulate
the money supply and thereby interest rates and thereby investment and
thereby aggregate demand? It uses five principal tools.
i - Required Reserve Ratio (C10/230-33:
215-18; 224-225;
206-207)
First, there are reserve
ratio requirements. By law or moral suasion chartered banks and other
deposit taking institutions may be required to increase or decrease a
percentage of their deposits held in reserve in case of a ‘run’,
i.e., many if not all depositors asking for their money back at the
same time. If the reserve ratio is 10% then 90% of deposits may be
loaned to earn interest and thereby increase the money supply, i.e.,
banks make money by making money. If the ratio is lowered more loans
are made, interest rates fall and investment increases, etc. If
the ratio is raised loans are called in (so-called demand loans first)
and the money supply shrinks, interest rates go up and investment falls,
etc.
This describes the situation at the retail level which
was the subject of post-Great Depression banking reforms. At the
wholesale level, however, the shadow banking system is not currently
subject to reserve requirements as such. Leverage of some investment
banks leading to the Great Recession was in some cases as high as
300:1. In effect reserve requirements act as tax on lending
institutions by imposing an opportunity cost measured by interest income
foregone on reserves. How reserve requirements may be applied to the
wholesale or shadow banking system in the post-Great Recession period
remains to be seen.
ii - Bank Rate and Banker’s Deposit Rate (229;
211)
Second, like all businesses
deposit taking institutions experience short-run cash flow problems.
The central bank acts as “the banker’s bank”. When an institution
borrows from the central bank the rate is the ‘bank rate’. As lender
the central bank can charge more or less than last time indicating the
direction it wishes interest rates to go and thereby add or subtract
from reserves of lending institutions. In Canada, the Bank of
Canada also uses the 'over night' rate to commercial banks for short
term borrowing.
The central bank also holds deposits by chartered banks
and other lending institutions on which it pays interest. Again it can
raise or lower that rate signally its policy. The rate paid is “the
banker’s deposit rate”.
iii - Open Market Operations
(C10/237-38: 222-23;
230-232; 212-214)
Third, there is an array of
government securities that can be bought and sold on financial markets
as income earning assets, e.g., Treasury Bills and Canada Savings
Bonds. By varying their rates, terms and conditions deposit taking
institutions are encouraged to buy or sell them thereby increasing or
decreasing reserves. The money supply increases or decreases, interest
rates move, investment changes, etc.
Treasury Bill auctions are a favoured instrument.
Usually 90 days in duration they are backed by the sovereign power of
the State. Treasury Bills are the safest investment and command no risk
premium. The central bank requests bids for a certain amount usually
offered to meet the government’s short-term cash flow needs. The
central bank then decides which bids to accept. If it wants rates to
rise it accepts higher bids; to fall, lower bids; if stable, the
existing market rate. If rates go up, investment goes down, etc.
and vice versa.
iv - Government Deposit Shifting
Fourth, the government
maintains deposit accounts with the Bank of Canada and other lending
institutions. These accounts are managed by the central bank. By
shuffling government accounts it can increase or decrease deposit taking
institutions’ reserves. The money supply expands or contracts; interest
rates fall or rise; investment grows or declines,
etc.
v - Moral Suasion
Just as animal spirits capture the emotional depths of
investment, moral suasion captures the emotive power of the central
banker. What and the way a chairman of the Federal Reserve, or Governor
of the Banks of Canada or England say or how they raise their eyebrows
in public is intensely studied. This is similar to back in the USSR
when photos of who stood next to whom on Lenin’s tomb during the May Day
parade became an academic career, a.k.a., the dark art of
Kremlinology.
Kenneth Boulding captured the mystery and magic of the
central bank when he wrote in his 1972 article “Towards
a Cultural Economics”:
I have argued for years that bankers were a savage tribe
who should be studied by the anthropologists rather than by the
economists, and I once tried to persuade Margaret Mead to do a book on
“Coming of Age in the Federal Reserve,” with, I regret to say, no
response at all! The culture of bankers, indeed, is more mysterious
than that of the Dobuans or the Chuk-Chuks. The Navaho indeed may have
a Harvard anthropologist in every family, but the Federal Reserve Board
has, to my knowledge, never allowed a single one to attend the
ceremonials in its marble hogan. Nobody really knows what bankers are
like, what kinds of images of the world they have, what they talk about,
what kind of gossip they follow, what taboos they have, and how their
decisions are made. The economics of money and banking is almost
entirely a matter of the analysis of published statistics and the
attempt to find correlations among them. It is pure “black box”
analysis with practically no attempt to pry off the lid to see what are
the actual processes which produce the often very peculiar outputs.
Arguably, moral suasion is the most efficient tool of the
central bank. At the top of the financial food chain, a simple nod or a
wink is usually sufficient to elicit an appropriate response from the
chartered banks and other financial intermediaries.
It is important to note that with deregulation of much of
the US banking system during the 1990s a new 'shadow banking' system
arose outside the direct control of the central bank. For those
interested, please see
Observation #7:
Shadow Banking & the Great Recession of 2008.
c) Interaction with Fiscal Policy
Before considering monetary policy’s application in
lowering unemployment or inflation respectively in a recessionary or
inflationary gap it is important to note that a central bank may pursue
one of two alternative ‘target’ strategies. The first is a
money supply target
that remains fixed while the shifting demand for money curve increases
or decreases interest rates. Monetarist policy publicly promises to
increase the money supply only to match real growth in the
economy and thereby avoid price inflation. What happens to investment
is left to the market.
The second is an
interest rate target
that shifts the vertical inelastic money supply curve to match increases
in the demand for money in order to maintain a targeted interest rate.
This publicly announced strategy increases investment confidence.
While a secondary objective the central bank can use its
powers to increase employment and shift the economy
from a recessionary
gap into full employment. By
increasing the money supply it lowers interest rate. By lowering
interest rates it increases investment. By increasing investment it
shifts the aggregate demand curve up to the right into full employment
equilibrium between aggregate demand, short-run aggregate supply and
potential – the Keynesian Double Cross.
Fighting inflation and maintaining the value of the
currency is the primary objective of the central bank. When the economy
enters an inflationary gap market forces will eventually raise factor
prices and shift the short-run aggregate supply curve up to the left
until equilibrium between aggregate demand, short-run aggregate supply
and potential is achieved. This will, however, include a significant
increase in the aggregate price level, a.k.a., inflation. If,
however, the central bank
tightens the money
supply thereby raising interest rates
and decreasing investment before factor prices can increase then it can
shift the aggregate demand curve down to the left until equilibrium is
achieved at a lower price level.
5.2.6 AD-AS Model
4. Influencing Interest and Exchange Rates
a) Interest Rate (P&B
Fig
28.10; R&L 13th Ed
Fig. 28-3,
Fig. 29-1)
b) Exchange Rate
5. Ripple Effects of Monetary Policy
a) Interest Rate Fluctuations
b) Exchange Rate Fluctuations
6. Money in the AD-AS Model
a) Unemployment (P&B Fig.
28.6)
b) Inflation (P&B
Fig.
28.7)
c) Real GDP
4.2.8 Quantity Theory of Money
- GDP = PY
- V = PY/M
- MV = PY
- P = (V/Y)M
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