Summary of Courses in Finance MACROFINANCE MONETARY POLICY

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Summary of Courses in FinanceMACRO-FINANCEMONE
TARY POLICY

• Dr. Tarafás Imre
• 2007

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MACRO-FINANCE

• I. MONETARY POLICY IN A CLOSED ECONOMY
• I.1. MONEY CREATION AND THE INSTRUMENTS OF
  MONETARY POLICY
• I.1.A. THE CREATION OF MONEY
• I.1.B. THE DESTRUCTION OF MONEY
• I.1.C. UNCERTANTIES
• I.1.D. THE INSTRUMENTS OF MONETARY POLICY
• I.2. EXO- OR ENDOGENEITY OF MONEY
• I.2.A. THE MONEYMARKET, THE BANKS ASSET AND
  LIABILITY MANAGEMENT
• I.2.B. ENDOGENEITY STRUCTURAL AND ACCOMODATING
• I.3. THE OBJECTIVES OF MONETARY POLICY
• I.3.A. THE PHILLIPS-CURVE AND ITS CRITICS
• I.3.B. A CONSENSUS APPROACH

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MACRO-FINANCE

• II. MONETARY POLICY IN AN OPEN ECONOMY
• II.1. THE BALANCE OF PAYMENTS
• II.1.A. DEVALUATION AND ELASTICITY
• II.1.B. THE ABSORPTION APPROACH
• II.2. EXCHANGE-RATE REGIMES
• II.2.A. CRITIQUE OF THE FIXED RATE REGIME
• II.2.B. FLEXIBLE EXCHANGE RATES AS PROPOSED
• II.2.C. FLEXIBLE EXCHANGE RATES IN REALITY
• II.2.D. LIBERALISATION, DEREGULATION
• III. TOWARDS STABILITY IN EUROPE
• III.1. THE ECONOMIC AND MONETARY UNION
• III.2. JOINING THE EUROZONE

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MONETARY POLICYIN A CLOSED ECONOMY
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I.1. THE CREATION OF MONEY AND THE INSTRUMENTS OF
MONETARY POLICY

• I.1.A. THE CREATION OF MONEY
• Payment
• with cash
• transfer within the bank
• transfer via Central Bank
• Two-tier banking system CB and commercial banks
• Bank of banks
• Issuer of legal tender
• Bank of the state

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• An example of money creation
• Banknotes issued in the amount B
• Bx kept in notes
• B(1-x) deposited
• B(1-x)y bank reserves
• purposes of reserves

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1.
credits granted by the banks
2.
credits granted by the banks
3.
n.
n8
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• Starting from the commercial banks
• Credit extended in the amount M
• Cash required
• Mx for the public
• M(1-x)y for reserves in banks
• Altogether
• Endogenous or exogenous money

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I.1.B. THE DESTRUCTION OF MONEY

• Creation through credit extension
• 2. Credit ? deposit ? banknote (cash)
• 1. Banknotes ?deposit ?credit ?banknote ?
  deposit
• Creation of money by the CB credit to
  government
• Repayment of credit
• debt end deposit disappear
• Foreign exchange purchase by bank
• forex deposit
• Foreign exchange sale by the bank
• deposit ? foreign exchange
• Credit risk bank failure

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I.1.C. UNCERTAINITES

• Ability to extend credit demand for credit
• the business cycle
• credit crunch the prudent bank
• Stability of x and y
• long-term trend
• y influenced by x and the money market
• seasonal fluctuations
• geographical
• extraordinary events (banking panic)

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I.1.D. THE INSTRUMENTS OF MONETARY POLICY

• INDIRECT INSTRUMENTS
• Rediscounting
• eligibility reserves in interest-bearing form
• efficacity as a monetary instrument
• passing on changes in i rate
• banking systems dependence on CB
• i elasticity of D for credit

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• Open market operations
• P market price
• N nominal value
• r0 nominal i
• r1 market rate of i
• buy dear and sell cheap
• repo active, passive

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• Simplified formula in reality, if maturity
  closer, more stabile
• The structure of i
• risk-free i risk premium
• perception
• (credit D, S)
• If open market operation ? all i move

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• Efficacity of indirect instruments
• In both cases
• i elasticity of D for credit
• cost
• expectations
• the prudent bank
• inflation expectations

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DIRECT INSTRUMENTS

• Reserve requirements
• prudential requirement monetary instrument
• efficace when increased
• too much so?
• Downward efficacity?
• Rediscounting quotas or ceilings
• Directed lending, interest ceilings, etc.

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PRESENT TRENDS

• Profit-based incentives rather than regulations
• circumventing regulations
• indirect tax global competition
• strengthening dependence on CB
• Indirect instrument
• open market operations
• Lender of Last Resort

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I.2. EXO- OR ENDOGENEITY OF MONEY

• The creation of money
• Creation by CB ? deposits in commercial banks ?
  drive to lend ? endogenous creation of money
• Economic decisions ? D for credit, creation of
  money ? funding ? endogenous

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I.2.A. THE MONEY MARKET, BANKS ASSET AND
LIABILITY MANAGEMENT

• y bank by bank
• too much or insufficient
• 1-14 days, maybe several months
• positions quickly changing or durable
• re-allocation of quotes, etc.
• CD (Certificate of Deposit) impact on reserves
• Off-balance-sheet liabilities relying on the
  market
• Liability management starting from D for credit

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• CB eligibility and liquid papers
• selling buying of loans
• Maturity, liquidity structure of A and L
• m m limits everyday presence in both sides
• borrowing, repo, selling, buying
• structure of A and L
• i and Xr expectations
• Reserves ? 0
• Technical conditions
• data processing, decision-making, communication

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I.2.B. STRUCTURAL AND ACCOMODATING ENDOGENEITY

• Structural endogeneity
• The international markets
• Accommodating endogeneity
• Consensus
• When monetary policy ineffective no exogeneity
• deep degression
• Credit crunch
• CB credibility no endogeneity

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I.3. THE OBJECTIVES OF MONETARY POLICY

• Under the gold standard
• Achieving full employment
• Budget deficits monetary consequences

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I.3.A. A PHILLIPS-CURVE AND ITS CRITICISM

• The price of full employment inflation
• Phillips-curve
• Excess S of labour - wages ?
• Excess D for labour - wages ?
• Any point on the curve

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nominal wages, inflation annual
Unemployment,
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• Criticism by the monetarists
• Inflation expectations
• Accelerating inflation
• The natural rate of unemployment
• NAIRU

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• The efficiency of economic policies
• Data availability
• Understanding what the data say
• Lags in response
• Lags and excesses
• Conclusion constant rate of growth of money
  supply
• Orienting expectations
• 3-5, some of it inflation
• Technically 100 res. req.
• Who lends?
• Exogeneous money
• Built-in stabilizers

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I.3.B. A CONSENSUS APPROACH

• No money illusion and no fast adapting
  expectations
• Monetary policy unable to ensure full employment
• But constant rate expansion of money S
  unacceptable
• The threat of deflation
• Downward rigidity of wages and prices
• Debt-deflation spiral
• Credible policy aiming at price stability
• Dynamic inconsistency
• Margins of error

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II. MONETARY POLICY IN AN OPEN ECONOMY
II.1. THE BALANCE OF PAYMENTS

• Closed or open economy
• The current account (of bop)
• current payments definitive
• Foreign trade
• i, investment income
• Unrequited transfers

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• The capital (financial) accounts
• The counterpart of current account imbalance
• Long-term K
• Foreign direct investment
• Portfolio investment
• Borrowings
• Short-term K
• Changes in foreign exchange reserves

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• Any combination possible F-, F, T, T-
• Statistical errors, omissions
• Motives of K movements
• Economic FDI
• Financial lending
• In-between portfolio
• Financing the deficit
• FDI long term impact in M
• Borrowing
• Long term but
• Short term

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• Sustainability
• Stock of foreign debt
• Debt service
• Forex reserves
• Pressure to correct before unsustainability
• Threat of liquidity solvency crisis
• Protecting home business
• Protecting home employment

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II.1.A. DEVALUATION THE ELASTICITY APPROACH

• The price elasticity of the supply of exports
• Unutilized capacities
• Domestic demand
• The price elasticity of the D for exports
• The price elasticity of the supply of imports
• Sacrifice for the market
• The price elasticity of the D for import
• Competing domestic industries, substitution
• Domestic demand

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• Devaluation helps, if
• ex price elasticity of the supply of exports
• Domestic currency
• nx price elasticity of the D for exports
• Foreign currency
• em price elasticity of the supply of imports
• Foreign currency
• nm price elasticity of the D for imports
• Domestic currency

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• If ex0 (no increase in X)
• no changes in forex revenues
• And em0 (foreign exporters cut prices)
• forex expenditures decrease
• Formula

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• If ex infinite
• X can increase by any amount that D will take
• And em infinite
• Forex price of imports unchanged
• Then devaluation helps, if

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• Devaluation perverse effects, if ex és em
  infinite nx and nm0
• X price down, volume flat
• M price and volume unchanged
• May be initial effect the J-curve

Balance of trade
Date of devaluation
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II.1.B. THE ABSORPTION APPROACH

• Current account deficit excess of absorption
  over income
• If elasticities favourable
• X and Y up
• M down and Y up
• If price level rises
• M prices up
• sales diverted to X
• Inflation real income - absorption

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• Current account deficit excess of absorption
  over income
• YCIGX-M
• YCST
• X-M(S-I)(T-G)
• X-MF
• ACIG
• Y-AF

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• To adjust absorption (to income)
• devaluation maybe sufficient
• restriction maybe needed
• Low elasticities devaluation ? high
  inflationary, low income impact
• Monetary restriction and devaluation
• supplements or alternatives to each other
• inflationary or deflationary context

domestic price level with devaluation
international price level domestic price
level with restriction
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• When prices are rigid downward
• and foreign prices are stable
• Restriction q instead of p
• Marginal propensity to import gt 0
• ?M / ?Y gt 0
• Y ? ? M? ? F-
• X?
• A??Y? ?M? ?F
• X?
• either X ? Y? M? ? F
• or X Ø Y? M? ? F
• Combined policies
• Inconsistent policies

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II.2. XR REGIMES
II.2.A. CRITICISM OF THE FIXED XR REGIMES
upper
intervention points
lower

• Reserves, restriction, conflicting objectives
• Convertibility on current transactions or full

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II.2.B. FLEXIBLE XR AS PROPOSED

• The role of prices in a market economy
• Automatic correction of bop imbalance
• The stabilizing force speculation
• R 0, or dirty
• Restriction no more needed

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II.2.C. FLEXIBLE X R REALITY

• Since 1973, often dirty
• The role of the oil price shock
• the inflationary impact of huge changes in
  relative prices
• Long experience with a shifting Phillips-curve

new energy prices
new average prices
average price level
non-energy prices, the favourable case
non-energy prices, the unfavourable case
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• The anchor disappears
• Large numbers of possible paths
• Different currencies in different phases
• i and Xr volatility hugely increased
• Speculation lost orientation and adds to
  instability

price level, high energy prices, unchanged
policy price level, actual policies price level
originally
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II.2.D. LIBERALISATION, DEREGULATION

• Removing barriers to international K movements
• earlier restrictions, licencing systems
• flexible Xr favourable to liberalization
• lost efficacity of remaining restrictions
• K movements disguised
• transfer pricing
• intracompany cash-flows
• Fx turnover gt 50 times trade daily1900md USD

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• Real economy subordinated to K flows
• early 80s high i in US
• late 90s expected profits, stock market folly
• K? ? Xr ? ? X?, M?
• current account deficit
• AgtY
• C I G
• Positive role of speculation
• imposing sustainable policies on governments
• Negative role of speculation destabilization
• 1992 sterling, 1993 franc

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III.2. JOINING TO THE EUROZONE

• Preventing XR fluctuations, related uncertainty
• If possibility is there in todays
  international monetary system
• The Maastricht criteria
• inflation the best 3 1,5 max
• Xr stay within 15 band
• i best 3 in inflation 2 max
• budget max. 3, unless
• Public debt max. 60, unless

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• Price level and relative prices
• Services and the industrial price level
• Balassa Samuelson effect
• productivity? industry gt services
• wages ? approx. the same
• prices? servicesgt industry
• the industrial price level and the Xr
• Destabilizing Xr
• Relative Unit Labour Cost 2001-5 ?25
• F 8, budget deficit
• i
• risk appetite
• Instability, sacrifice in growth, impact on
  budget and current account