Monetary Policy &

Interest Rates
Central Banks
 What is a central bank?
Central banks began as banks to the government.
Today controls the level of liquidity by operating
the payment system.
Control the printing of notes/currency
Control the accounts used for interbank payments.

Monetary
Base Liquidity
Aggregates
Cash
Cash
+ Used by banks to +
Reserve Back up deposits Deposit
Accounts
Accounts
 Money Supply The stock of the medium of exchange.

Types of Financial Assets

M1 Currency in Hands of the Public [C] + Demand

Deposits [D]

M2 M1 + Savings Deposits + Small Time Deposits +

[Liquid Money Market Instruments inc/ Small NCDs]

M3 M2 + LTD [Large Time Deposits and NCDs]

 Money & Inflation: 1975-1994

Inflation & Money OECD Countries

0.2
0.18

0.16
Average Inflation Rate

0.14
0.12

0.1

0.08
0.06

0.04

0.02

0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18
Average Money Growth
 Policy Framework
Japan Objective: Bank of Japan Act Article 2
Currency and monetary control by the Bank of Japan
shall be aimed at achieving price stability, thereby
contributing to the sound development of the national
economy
ECB Objective The primary objective of the ECBs
monetary policy is to maintain price stability. The
ECB aims at inflation rates of below, but close to, 2%
over the medium term.

Look forward to Inflation Targeting

 HKMA Link
KEY GOAL OF CENTRAL BANKS:
PRICE STABILITY
Great Inflation of the 70s & 80s
C PI Inflation,% A nnual R ate

35

30
25
20
15
10
5

0
-5
61

65

69

73

77

81

85

89

93

97

01

05

09
19

19

19

19

19

19

19

19

19

19

20

20

20
O EC D East A sia Subsaharan A frica Latin A m erica
 Troubles with Inflation
1. Unpredictable inflation generates risk for:
- borrowers and lenders
- workers and employers

2. High inflation generates losses of purchasing

power for people who hold money.
Money is a tool of liquidity, becomes less useful when
subject to a high inflation tax.
 Hyperinflation: Inflation reaching growth of 50% per
month.

C PI Inflation,A nnual%

8000
7000
6000
5000
4000
3000
2000
1000
0
1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992
A rgentina B razil Peru
 Hyperinflation in China
Shanghai
Price Index
Sep-45 100
M ay-49 105000000000
Dynamics of Hyperinflation in China 1945-1949 TW Hu, 1970

1945 1947 1949

 Monetary Policy Framework
Goals Overall objectives
Anchors Benchmarks of Performance
Policy Instruments Day-to-day operations
Transmission Mechanism How central bank
activities affect the economy
 Nominal Anchors
Nominal Anchors act as the measure of currency value
maintenance which orient the activities of the central
bank.
Exchange Rate Targets: Maintain value
relative to another currency or basket of
currencies.
Inflation Targets: Maintain value relative
to a basket of goods.
 Importance of Nominal Anchors
Commitment to nominal anchor can stabilize
the value of money and implement low and
stable inflation.
Visible, credible commitment to nominal
anchor implements low inflation expectations
in financial markets and private sector.
 Adjusting Interest Rates for Inflation
Payoff on 1 year, 1 period loan is $1+i, but
what is the purchasing power of the payoff?
Convert the payoff into the prices prevailing in
initial loan year by dividing the pay-off by the
trajectory of prices.
Inflation adjusted interest rate is sometime
referred to as real interest rate.
1 it
1 rt rt it gt 1
P
Pt 1
Pt
Monetary Policy and the Fisher Effect
In the long-run, real interest rate unaffected by
monetary policy.
High long term inflation path translates into
high inflationary expectations.
High inflationary expectations lead to high
interest rates.
it rt E[ g ]
P
t 1
Fisher Effect: OECD Economies Great
Inflation of 1970s
20

18

16

14
Interest Rates-1984

12

10

0
0 2 4 6 8 10 12 14 16 18
Average Inflation 1970-1984
Inflation Targeting
 What is IT?
Using price of goods as a nominal anchor.
Set specific numerical targets for future
inflation
Report regular forecasts of expected inflation
under current economic conditions.
Set interest rate policy to push future inflation
back into bounds.
 Target the Forecasts
Monetary policy decisions must be made on
the basis of expected inflation because policy
does not have immediate impact on inflation.
Variety of approaches toward forecasting
inflation including statistical and theoretical
modeling.
Stabilizing expected inflation stabilizes interest
rates by limiting Fisher effect.
List of
Inflation
Targeting
Countries
Rose
A Stable International Monetary
System Emerges: Inflation
Targeting is
Bretton Woods, Reversed
 Operating Instruments
On a day to day basis, most central banks will
choose to set either interbank interest rates or
exchange rates.
Central bank provides liquidity for interbank
payments and can determine interest rates in the
interbank market.
Central bank can also govern the degree of
liquidity in forex market (which is mostly made up
of banks).
RBI Report of the Working Group on Monetary Policy...
 Money Market Rates Capital Market Rates

Maturity Above 1 Year

Interbank Rates Government Bond Rates

Maturity 1 Day to 1 Year

Policy Treasury Bill Rates Corporate Bond Rates
Rates

Commercial Paper Rates Lending Rates

Negotiable CD Rates

Usually,
price of
liquidity
issued at
regular
intervals
by central
bank
 Transmission Mechanism
Long-term
Rates
Policy Short-term Domestic
Rates Rates Demand
Asset
Prices
(Stocks/RE) Inflation
&
GDP
Exchange External
Rates Demand
 Transmission Lags
Monetary policy works by changing decision
making of private individuals.
Individual decision making is characterized by
inertia.
Effects of monetary policy not fully felt until a
year.
Bank of England Estimates of Effect of
Interest Rate
 Raising policy interest rates reduces liquidity in
money markets and raises short-term rates.
Less liquidity for inventory or credit purchases.
Raising money market rates attracts liquidity from
stock, RE and bond markets reducing stock and RE
prices and raising LT bond rates.
Higher LT rates reduces corporate investment and
reduced wealth hurts
Raising money market rates attracts cash from other
economies, leading to appreciation of domestic
currency.
Expensive domestic currency makes net exports less
competitive.
 Short-term Stabilization
Japan

3
When short-term
output is below trend,
2
inflation tends to be
1
decelerating.
Stablilizing inflation
Inflation A cceleration

-8 -6 -4 -2
0
0 2 4 6 can also stabilze the
-1
business cycle
-2
Inflation Acceleration =
-3 InflationToday InflationLastYear
O utputG ap
 Watching Central Banks
Monetary policy and market expectations of
monetary policy have strong impact on stock
and bond markets.

Link

Link
 Exchange Rate Anchors
Monetary Authorities
Fixed Exchange constantly maintain the external value
Rates of the currency.

Crawling Peg adjusts currency periodically in small

amounts at a fixed rate or in response to
changes in selective indicators.

Managed Floating attempt to influence the exchange rate

without having a specific exchange rate
path or target. Indicators for managing
the rate are broadly judgmental.
De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks

Exchange rate Monetary Policy Framework

arrangement Exchange rate anchor Inflation Other
(Number of targeting
countries) framework
U.S. dollar (66) Composite Other _ _
(15) (7) (44) (33)
Currency board Hong Kong SAR Brunei
arrangement (13)

Other conventional Bangladesh

fixed peg Mongolia
arrangement (68) Sri Lanka
Vietnam
Crawling peg (8) China

Managed floating Cambodia Singapore Indonesia Malaysia

with no pre- Lao P.D.R. Vanuatu Thailand Pakistan
determined path for Myanmar India
the exchange
rate (44)
Independently Korea Japan
floating (40) Philippines
 Why Exchange Rate Stability?
Why Exchange Rate Anchor?
Easily measurable & visible benchmark for
maintaining value of the currency.
Stabilizes international trade and finance.
Why Exchange Rate Instrument?
Forex markets most liquid market in frontier
markets.
Link
 Fixed exchange rates stabilize both the value
of the domestic currency relative to the
anchor currency but also stabilizes the
domestic interest relative to the interest rate
of the anchor currency.
M oney M arketR ates

8
7
6
5
4
%

3
2
1
0
20 3

20 3

20 3

20 3

20 3

20 3

20 3

20 3

20 3

20 3

20 3

00

01

02

03

04

05

06

07

08

09

10

11
20

H ong K ong U SA
 Exchange Rate Misalignment
Over-valuation/Undervaluation
of Currency
Exchange rate
misalignment: when price Overvalued/ S< Pj
of currency differs from PANC
Uncompetitive
relative prices of goods Undervalued/ S> Pj
making domestic goods PANC
Competitive
relatively
cheap/competitive or Exchange rate misalignment tends to be
relatively resolved through either 1) exchange rate
adjustment; or 2) inflation/deflation in
expensive/uncompetitive domestic prices.
 Currency Wars
Developed economies believe that some
Asian central banks are acting in FX
markets to keep S high and undervalue
currencies.
Measuring proper valuation is difficult
because it is hard to determine the proper
price level.
 Short-term measures of competitiveness

Unit labor costs Total Labor Costs/Constant

Dollar GDP
Labor Costst Wage Ratet Labor Hourst Wage Ratet
ULCt = = = GDPtConstant$
GDPt Constant$ GDPt Constant$ Labor Hourst

ULC is cost of wages relative to real

productivity.
Unit of measure: Domestic Currency
 Overvaluation in Japan
120

115

110
ULC in US $ (2005 = 100)

105

100 Japan
Korea

95

90

85

80
2004 2005 2006 2007 2008 2009 2010