The Money Market & Monetary Policy

1. The Money Market &Monetary Policy

2. Transactions demand for money to pay for current transactions. Related mostly to the level of income. Asset demand for money to finance unanticipated transactions (precautionary) and to finance speculative purchases (speculative) Demand for Money

3. Interest rate MD Money Demand for Money Change in r = a movement along the demand curve An inverse relationship between the interest rate and the quantity of money that people are willing to hold at any given interest rate. Fig 16.4

4. As interest rates increase, the opportunity cost of holding money in non or low interest bearing forms increases. The incentive of not holding money increases or the incentive of holding money decreases. Why does the Demand for Money curve Slope Downwards

5. At a point in time, the supply of money is fixed. It is not related to the interest rate. Interest rate Money Supply of Money Ms

6. Interest rate Money Money Market Market equilibrium interest rate (r) occurs where quantity demand for money equals quantity supplied. Ms At interest rate above r, Ms > Md. Market forces drive interest rates lower. At interest rate below r, Ms < Md. Market forces drive interest rates higher. r Md

7. Interest rate Money Demand conditions change Incomes increase. Price level increases Transactions demand for money increases. Ms Interest rates increase. r’ r Md’ Md

8. Money supply is controlled by the RBNZ. Money supply is controlled through changes in the OCR and through OMO and through “Moral Suasion”. Supply conditions change

9. The administration of monetary policy was passed from the Minister of Finance to the Reserve Bank. The objectives of monetary policy were reduced to the single goal of obtaining and maintaining stability in the general level of prices. NZ Monetary PolicyReserve Bank Act 1989

10. Policy Target Agreement (PTA) defines price stability. The % is negotiated between the Government and the RBNZ. PTA defines price stability as annual increases in the CPI of between 1% and 3% on average over the medium term. NZ Monetary Policy

11. The Official Cash Rate (OCR) is an interest rate set by the Reserve Bank to implement monetary policy, so as to maintain price stability. By setting the OCR, the RBNZ is able to influence short term interest rates such as the 90 day bill rate Official Cash Rate

12. When an OCR is announced - it is a percentage number - the Reserve Bank undertakes to pay financial institutions an interest rate 0.25 per cent below the OCR for money deposited in Reserve Bank settlement accounts. The Reserve Bank also undertakes to provide overnight cash to banks, charging interest at 0.25 per cent above the OCR. Official Cash Rate

13. The effect of this is that no commercial bank is likely to offer short-term loans at a rate significantly higher than the Official Cash Rate. That's because other banks would undercut that, using credit from the Reserve Bank. Official Cash Rate

14. The purpose of the Bank's liquidity management operations, which comprises the daily Open Market Operation (OMO), FX swaps and Bond repurchase window, is to offset the big day-to-day fluctuations in government spending and revenue. The Bank currently targets a daily settlement cash level of $20 million through its OMO. Open Market Operations

15. The Bank prepares and maintains forecasts on the influences to settlement cash and uses these to determine how much cash to inject or withdraw on any given day. These forecasts are prepared some months ahead and are then updated on an ongoing basis, as more information comes to hand. Open Market Operations

16. The RBNZ instructs the financial markets what it would like the markets to do. Financial markets usually respond to such ‘suasion’. These instructions can be expressed in periodic press releases or in released MPS (monetary policy statements). Moral Suasion

17. Lowering OCR Raising OCR Interest rate Interest rate MS1 MS1 MS2 MS2 MD MD Money Money RBNZ OCR Changes Fig 16.6 & 16.7

18. Loose Monetary PolicyDecrease in OCR Bank reserves decrease Decrease in OCR Interest rates decrease Supply of money increases I Higher Aggregate Demand Increase in real GDP C ER X M

19. Tight Monetary PolicyIncrease in OCR Increase in OCR Bank reserves increase Interest rates increase Supply of money decreases I Lower Aggregate demand Reduced inflationary pressure Decrease in real GDP C ER X M

20. To increase the money supply, the central bank buys bonds. To decrease the money supply, the central bank sells bonds. Open Market Operations Open Market Operations The buying and selling of bonds by the central bank.

21. Buying back bonds Selling Bonds Interest rate Interest rate MS1 MS1 MS2 MS2 MD MD Money Money RBNZ OMO Changes Fig 16.6 & 16.7

22. The Business Cycle & Monetary Policy In times of economic growth, inflationary pressures are usually high. Capacity is tight, resources are fully employed, the output gap is small and there is pressure for the price level to rise. The RBNZ employs a tight monetary policy increasing the OCR regularly. This tends to reduce inflationary pressures. %GDP change Economic boom Time

23. The Business Cycle & Monetary Policy In times of economic recession, inflationary pressures are usually low. There is excess capacity, resources are unemployed, the output gap is high and real GDP is decreasing. The RBNZ employs a loose monetary policy decreasing the OCR regularly. This tends to boost spending and real GDP. %GDP change Economic Recession Time