Monetary Policy
inflation
process of prices rising more money needed to buy the same basket of goods primary cause: too much money in the market
money supply formula: what is productivity?
real GDP
How can we calculate the optimal interest rate?
recessionary environment = inject money in the market - by how much should they decrease or increase interest rate? --> for that we use the taylor rule
Reserve requirement
Fraction of deposits that banks must keep either on deposit at FED as cash in their vaults control: set by FED board within a legally imposed range impact: stabilizes the demand for reserves (the more system relevant the bank the higher the deposit)
Output Gap
GDP output gap is the difference between actual and potential GDP g = Y-Y*
Measuring Money M2
M1 + M2 broader definition includes assets not used as means of payment (accounts, savings, bonds with maturity up to 12 months ) less liquid savings
Which M do we use do understand inflation
M2 as it represents one half of GDP
Relations between money supply and price level if velocity is not constant (inflation)
price level increases overproportionally
Measuring money
Money aggregate , M1 and M2
Quantity Equation
Money supply is important as it is linked to inflation by the equation of exchange (Irving Fisher, 1911)
Fiat Money
What we have today --> just paper money not backed by anything
open market operations
a monetary policy tool in which central banks buys and sells bonds to regulate money supply in the economy https://www.youtube.com/watch?v=zEP2vkK-LIk
recession
a period of declining real incomes and rising unemployment
Velocity
(no of USD)x(no of times each USD is used) = USD value or transactions/nominal GPD
US Output Gap +g /-g
+g = inflationary gap (until 2001) -g = recessionary gap (2010) below potential
Which impact does a central bank have on GDP
-
economic goals of central bank
- full employment - stable price level - economic growth everything must be achieved sustainable otherwise we have higher inflation
Factors that shift Aggregate Supply Curve
- natural resources - technology - labor - capital stock (manmade and durable) Increases in capacity due to higher productive resources shifts AS to the right. Higher input prices (e.g. oil) causes production to reduce their supply (AS shifts left) Lower labour costs = curve to the right
How CB lowers interest rate by 25 BPS?
- open market operation and printing money --> increases quantity of money supplied
Describe velocity in an inflationary environment
- people don't trust money and would like to get rid of it - money devaluates - velocity is really high
What happens if demand for money increases
- supply of money increases - price of money is down - velocity of money goes up
Why is a low and managed inflation rate actually preferable than no inflation? Two reasons
-->First, a healthy economy actually does better with some expectation of inflation. Why? When shoppers expect prices to rise in the future, they are motivated to buy more now so they can get the lower price. This "buy more now" philosophy stimulates the demand needed to drive economic growth. -->Second, a little inflation is preferable to deflation, which is when prices fall. You'd think that would be a good thing. However, the dangers of deflation are illustrated by the housing market collapse in 2006. As prices fell, homeowners lost equity and even the home itself. New potential buyers rented instead. They were afraid they would lose money on a home purchase. Everyone, including investors, waited for the housing market to recuperate. As this happened, the lack of demand just forced housing prices further into a downward spiral.
FED toolbox
-Target Federal Fund Rate (TDDR) - Discount Rate - Deposit Rate - Reserve Requirement
Functions of central bank
-holds despository institutions reserves - act as the government fiscal agent - supervises member banks - acts as the "lender of the last resort" - regulates the money supply - intervenes in foreign currency markets
AD & AS together
A shift in the AD curve to AD1 as a result of a change in any/all factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation. As economy is operating at less than capacity there would be unemployment and the economy might be growing only slowly.
Shifts in aggregate demand curve
Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift of AD to the right. --> leads to rising GDP and declining unemployment
Problem of gold standard
Central bank not very flexible. you have to find the equilibrium between the money floating and the gold at central bank.
CPI
Consumer Price Index price development over time of service and goods, country specific basket
What happens if money supply grows?
Consumers and businesses have relatively more money in their hands with which to purchase goods and services. Therefore, in theory, faster money supply growth should be associated with faster economic growth after a short lag of perhaps two or three quarters. However, many important changes in how financial assets are held by the public have changed over time and the relationship between money supply growth rates and the economy has deteriorated
Cost-push inflation
Cost push inflation is inflation caused by an increase in prices of inputs like labour, raw material, etc. The increased price of the factors of production leads to a decreased supply of these goods. While the demand remains constant, the prices of commodities increase causing a rise in the overall price level. This is in essence cost push inflation.
GDP
Gross Domestic Product (GDP) Y = C + I + G + (X-M) X-M = NX (net exports)
Menu costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general.
Why managing inflation expectations works (Ben Bernanke)
It lets people know the Fed will continue expansionary monetary policy until inflation reaches that 2% target. As prices rise, people buy more now because they want to avoid higher prices for consumer products. For investments, they buy now because they are confident it will give them a higher return when they sell later. If inflation targeting is done right, prices rise just enough to encourage people to buy sooner rather than later. Inflation targeting works because it stimulates demand just enough.
LRAS
Long-run aggregate supply Economists assume that in the long run (LRAS), there will be no unemployment of resources because markets will clear, thus whatever the rate of inflation, firms will supply the maximum capacity of the economy. --> Thus, the LRAS curve is vertical (perfectly inelastic).
What can a central bank influence
Only intermediate target of growth in money (for example one year later, GDP) two years later you see effect on final objectives (low inflation)
Aggregate Demand Curve
Relates inflation and the level of output, accounting for the fact that monetary policymakers respond to changes in current inflation by changing the interest rate. --> when inflation rises, the quantity of aggregate output demanded falls (curve slopes downward)
Shoe leather cost
Shoe leather cost refers to the cost of time and effort (more specifically the opportunity cost of time and energy) that people spend trying to counter-act the effects of inflation, such as holding less cash and having to make additional trips to the bank.
What is the most important tool for CB?
Target interest rate
Federal fund rate
The interest rate banks charge each other for overnight loans to meet their reserve requirements
M= $500 real output = 2'000 units price per unit = $3
Velocity = 12 what happens if M increased to 750? price level increases from $3->$4.5
Multiplicators Taylor Rule
are only 0,5 and 0,5 if equally weighted otherwise they change. use delta in formula!!! weight depends on CB focus more on GDP or inflation control
How do we measure inflation?
by CPI
How does a central bank stear economy
central bank tries to stear the interest rate in the interbank market
What drives changes in GDP
changes in GDP are only driven by changes in the price level
interbank market
commercial bank A lends money to commercial bank B
Why inflation is bad for an economy
cost of inflation (MCASH): menu cost cost-push- inflation allocative efficiency shoe-leather cost hoarding
aim: stimulate economic growth expansionary monetary policy
decreasing interest rates central bank buys bonds from commercial banks -> commercial bank has more money to give out loans BUT. don't overheat economy!
Conflicting target of CB?
high GDP vs low CPI growths leads to higher prices in long-term ir down leads to growth in GDP & (!) CPI
If Raiffeisenbank gave to much mortgages
higher risk, system relevant bank increase fraction of reserve -> Raiffeisenbank less money they can work with - > give out less loan -> decreases money circulating in the economy
Betafactor
how strong a stock is fluctuating compared to the market 1: fluctuates as the market -1: fluctuates less than the market +1: fluctuates more than the market
Repose (repurchasing agreement)
if a bank needs short term money only in exchange with triple A bonds. (until 14 days) changed in times of crisis as banks didn't have triple A bonds
aim: reduce overheating economy discretionary fiscal policy,
increase interest rates sell bonds to commercial banks remove money from economy -> leads to economic slowdown
Interest rate targeting
increasing interest rate = decreasing qty of reserve --> An approach to monetary policy that requires that the central bank try to keep the inflation rate near a predetermined target rate.
lender of the last resort
interbank market= banks lends each other money on a short term bassi- doesn't work since 2008 not trust leads to central have to jump in and give loans
Discount Rate
interest charged by FED to loans on commercial banks control: set a premium over FED fund rate impact: provide liquidity to the banks in time of crisis FED uses discount rate in order to influence fund rate (being charged by commercial banks to each other)
Target Federal Fund Rate
interest rate charged on overnight loans between banks control: open market operations to target rate impact: changes interest rates throughout the economy is determined in the market and not controlled by FED Rule is = taylor rule! target interest rate: fed funds rate -> overnight rate (interbank lending)
Deposit Rate
interest rate paid by FED on excess reserves held by bank control: set a spread below target fund rate impact: sets a floor under the market FED funds rate interest rate when they park additional money at the central bank (now negative-> forces banks to invest money)
What happens to money growth if Velocity and real output (Y) are constant?
money growth equals inflation
M 0
money in the hand of public and commercial bank reserves (are parked at the central bank)
Measuring Money M1
most liquid assets, traveler checks, deposits currencies in the hand of public
Relationship between money supply and price level if velocity is constant
move at same rate in same direction
Sustained growth (not sustainable growth!!!)
occurs when AS and AD rise at similar rated - GDP can rise without effects on inflation.
When interest rates are changing which curve changes AD and AS curve?
only AD curve would change, as interest rate might have influence on C, I, G.... Supply curve only determined by natural resources, technology...
Federal Fund
reserves of the commercial bank hold at the central bank https://www.youtube.com/watch?v=tOXpijd6t6k
Gold standard
some gold lying at the central bank
Hoarding
start hoarding durable goods as people loose trust in money. Instead of using money they would even go back to exchanging potatoes against carrots
open market operations
target federal fund rate is FOMC'S primary policy instrument (set by the FOMC) market federal fund rate (determined by the market ) the rate at which banks lend money to each other
Relationship between money growth and inflation
the higher the rate of money growth the higher the inflation rate central bank needs to take care about the money growth
monetary aggregates
the quantity of money
commodity money
value on its own, Salt, Whale Teeth...