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Program Magister Akuntansi Universitas Trisakti. Central Bank’s Monetary Policy. Scope of discussion. How the monetary sector affects the economy? Macroeconomic policy Demand and supply of money Transmission of monetary policy Monetary policy in the long-run Policy conflicts

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Central Bank’s Monetary Policy

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Central bank s monetary policy

Program Magister Akuntansi

UniversitasTrisakti

Central Bank’s Monetary Policy


Scope of discussion

Scope of discussion

  • How the monetary sector affects the economy?

  • Macroeconomic policy

  • Demand and supply of money

  • Transmission of monetary policy

  • Monetary policy in the long-run

  • Policy conflicts

  • Framework of monetary policy


Central bank s monetary policy

REAL SECTOR

GOVERNMENT SECTOR

MONETARY SECTOR

Consumption

Investment

Export

Import

  • Fiscal (APBN)

  • Revenues, incl. grant

  • Expenditures

  • Primary balances

  • Financing

  • Domestic

  • External Luar Negeri

Monetary Authority

Foreign assets net

Domestic assets net

Net Claim on Government

Commercial Banks

Foreign assets net

Domestic assets net

EXTERNAL SECTOR

  • Current Account

  • Export

  • Import

  • Transfer

  • Income

  • Capital & Financial Transaction

  • Direct Investment

  • Financial flows

  • Government

  • Private

  • Official foreign reserves

How the monetary sector affects the economy? (Interrelationship among macroeconomic accounts)

Base money

Aggregate demand:

Y = C + I + G + (X-M)

Money supply


Macroeconomic policy

Macroeconomic policy

  • Monetary policy is an integral part of macroeconomic policy

  • The ultimate target of macroeconomic policy is economic/social welfare


Supply and demand for money

Supply and Demand for Money

  • Supply of money : Ms = mm * Mo

    • determined by the central bank. (Baca AP Lampiran 2.2)

  • Demand for money : Md = f (GDP, CPI)

    • determined by people or money holder

  • Definition of money:

  • Mo = C + Rb where Mo = monetary base (high-powered money) ; C = Currency (bank notes);

  • Rb = Bank reserves (banks’ account at the central bank + cash in vault)

  • M1 = C + DD where DD = Demand deposits (checking accounts, giro accounts)

  • M2 = C + DD + TD where TD = Saving and Time deposits

  • M3 = M2 +


Supply of money money multiplier baca ap box 4 2

Supply of money: Money multiplier (Baca AP Box 4.2)

  • Total reserves (Rb) = Required reserves + Excess reserves

  • Total reserves = Deposits at the Central Bank + Vault cash at commercial banks

  • Money multiplier (mm) = 1/ (RR +ER) where RR is required reserves ratio (reserve requirements) and ER is the proportion of excess reserves in total reserves

  • Ms = mm x Mo --- mm = Ms/Mo

    • mm¹ = M1/Mo (narrow money multiplier)

    • mm² = M2/Mo (broad money multiplier)

  • In practice, the mm can be calculated directly from central bank statistics published by the central bank where Mo, M1 and M2 are regularly (monthly) published. For example, at year-end 2004 the monetary base at BI’s publication is Rp 200 trio and M2 Rp800 trio, then the money multiplier is 800/200 = 4.0.


Reserve requirement

Reserve requirement

  • In the most countries, all depository financial institutions are required to conform to the deposit reserve requirements (giro wajib minimum) set by the central bank.

  • Changes in reserve requirements are a very potent, though little-used tool.

  • Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.

  • An increase in deposit reserve requirements

    • decreases the deposit and money multipliers, slowing the growth of money, deposits and loans

    • reduces the amount of excess legal reserves - institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

    • increases interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies


Effects of changes in reserve requirements on deposits loans and investments

Effects of Changes in Reserve Requirements on Deposits, Loans, and Investments


Supply and demand for money equilibrium

Supply and Demand for Money - Equilibrium

  • Supply of money is determined by the central bank monetary policy, and therefore the supply curve is vertical.

  • Demand for money is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds.

  • Equilibrium: The money interest will gravitate the rate where the quantity of money people want to hold (demand) is just equal to the stock of money the central bank has supplied (supply).

Interest rate

Ms

At i*, people are

willing to hold the

money supply set

by the central bank

Excess

supply

i2

i*

Md

i3

Excess

demand

Quantity

of Money

Qs


Transmission of monetary policy

Transmission of monetary policy

  • The path that monetary policy takes through the macroeconomic system is called the Transmission of Monetary Policy.

  • The impact of a shift in monetary policy is generally transmitted through intrest rates, exchange rates, and assets prices.

  • An expansionary monetary policy will increase supply of loanable funds and put downward pressure on real interes rates. As real interest rates falls, aggregate demand increases (to AD2), leading to a short run increase in output (Y1 to Y2…..and prices (from P1 to P2)… inflation

Real

Interest rate

Price level

S1

S2

AS1

P2

AD2

P1

r2

AD1

D

Quantity of

Loanable funds

Goods/services

(real GDP)

Y1 Y2

Q


Central bank s monetary policy

The Mechanism of monetary transmission

Direct monetary transmission

11

Money Supply-Demand

Money

Credit channels

Bank lending

Loan Supply-Demand

Firms balance sheet

Ext. Financing, Leverage

Interest rate channel

Cost of capital

Final

Objective:

Prices

Output

Monetary

Policy:

Base money

Interest rate

Real interest

Substitution effect

Income effect

Asset price channel

Net exports-cap.flows

Exchange rate

Imported prices

Tobin’s q

Equity-Property prices

Wealth effect

Expectation channel

Real interest rate

Expectation

Moral hazard,

Adverse selection

Uncertainty


Monetary policy in the long run

Monetary policy in the long-run

  • If the impact of an increase in AD accompanying expansionary policy is felt when the economy operating below capacity, the policy will help direct the economy back to a long-run full employment output equilibrium (Yf).

  • In contrast, if the demand-stimulus effects are imposed on an economy already at full employment (Yf), they will lead to excess demand, higher prices,and temporarily higher output (Y2).

  • In the long-run, the strong demand will push up resources prices, shifting back short-run AS.

  • The price level rises to P3 (from P2) and output back to Yf once again.

LRAS

LRAS

Price

level

Price

Level

SRAS2

SRAS1

SRAS1

P3

e3

P2

P2

e2

e2

AD2

AD2

P1

P1

e1

e1

AD1

AD1

Goods/services

(real GDP)

Goods/services

(real GDP)

Yf Y2

Y1

Yf


Monetary policy in the long run1

Monetary policy in the long-run

  • The quantity theory of money

    • M * V = P * Y where M = money; V = velocity of money;

      P = price; Y = income

    • If V and Y are constant, than an increase in M would lead to a proportional increase in P.

  • Implication:

    • In the long run, the primary impact of monetary policy will be on prices rather than on real output

    • When expansionary monetary policy leads to rising prices, monetary authorities eventually anticipate the higher inflation and build it into their choices

    • As it happens, nominal interest rates, wages, and incomes will reflect the expectation of inflation, and so real interest rates, wages, and output will return to their long-run normal levels.


Policy conflicts

Policy conflicts

  • Theoretically, in the short-term there is trade-off between achieving targets of containing inflation and promoting output

    • Phillips Curve:  =  (y – y*)

    • Long-run full employment vs below capacity

  • However, there is growing research evidence that maximum employment, sustainable economic growth, and price stability can be compatible with one another in the longer run.

  • Expantionary monetary policy leads to promote economic activities, but would in turn push inflation upward  A need to strike a balance between monetary and fiscal policy and other macroeconomic policies  policy coordination.


Framework of monetary policy

Framework of monetary policy

Operational

Target

Instruments

Intermediate

Target

Ultimate

Target

  • Open market operation

  • Reserve requirement

  • Discount facility

  • Base money (Mo)

  • Bank reserves

  • Interest rates

  • Monetary aggregates

  • M1, M2, M3

  • Interest rates

  • Price stability

  • Economic growth

  • Employment

  • Not every nation makes it clear to its central bank what its priorities should be among different possible goals (targets).

  • The goals may also conflict with one another.

    • For example, controlling inflation may require the central bank to slow down the domestic economy through restrictions on credit growth and higher market interest rates.

  • However, this policy threatens to generate more unemployment and subdue economic growth.


  • The goal of controlling inflation deflation

    The Goal of Controlling Inflation (& Deflation)

    • Inflation creates undesirable distortions in the allocation of scarce resources.

    • In the 1990s, several central banks (such as New Zealand, Canada, and U.K.) began setting target inflation rates or rate ranges.

    • In 2000s, several Asian central banks (Thailand, Indonesia,etc.) also set inflation targeting.

    • The U.S. has not set an explicit target, though it seeks to drive inflation so low that it does not affect business and consumer decisions.


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