term 2- lecture 1 - monetary policy transmissions Flashcards
what is monetary economics?
monetary economics analyses the relationship between nominal and real variables?
what is monetary policy>?
monetary policy is the study within monetary economics of how central banks should conduct their policy ie what are the goals of central banks and how can central banks achieve said goals. to answer these we need an understanding of the transmission mechanisms of monetary policy
what are the goals of central bank?
central banks seek to stabilise inflaition and the output gap.
the BOE monetary policy objective is to deliver price stability. price stability is defined by the governments inflation target of 2%.
primary objective of the ECB is to maintain price stability . aim for inflation close to 2% over medium term
federal reserve sets nations monetary policy to promote the objectives of maximum employment, stable prices and moderate long term interest rates
what is the money market?
a place for institutions and governments to manage their short term cash need. individual investors can assess the money market through various securities such as T bills, commercial paper and asset backed securities
how can the various transmission channels be summarised?
the standard household based mechanism- intertemporal susbstitution and wealth effects
non household transmission mechanism: investment, exchange rate, and banks/intermediation channels
new household based mechanisms: balance sheet, income risk and indirect income effects
explain the interetemporal susbtitution effect?
as the nominal interest rate decreases, the real interest rate will also decrease. this means consumption today is cheaper relative to tommorow so consumption today increases.
explain the wealth and income effects?
as the nominal interest rate decreases, the real interest rate will also decrease. this means increased future discounted flows. households become wealthier if positive wealth so consumption increases
explain the user cost of capital mechanism?
as the nominal interest rate decreases, so does the real interest rate. this decreases the user cost of capital, therefore investment will increase as a result increasing GDP
why was the user cost of capital mechanism missing during the 2008 recession?
his channel was missing in action during the 2008 recession due to
high uncertainty in the economy. If uncertainty is high, user cost of capital
has a negligible effect on investment for two reasons: firms don’t want to invest (demand), banks don’t want to provide loans (supply).
explain the exchange rate channel
when the nominal interest rate decreases, so does the real interest rate relative to optimal interest rate target. this leads to real depreciation as the real exchange rate increases. this means exports are more competitive so export volumes increase. it also results in prices of imported goods becoming more expensive so prices increase. as a result output increases and CPI profits increas
does the exchange rate channel work?
it doesnt work quite so much as the uncovered interest rate parity does not hold empirically, variation in risk premium, pricing to market, etc)
what are open market operations?
the central banks increases reserves by buying bonds with the central banks money. this money is instantly transferred to the deposit account of the seller and ends up as reserves at the sellers bank. expansive open market operations increase both reserves and deposits
what is quantitiative easing?
an expansion of the central banks balance sheet
what is credit easing?
quantitative easing with a focus on which assets they purchase
explain the banks lending channel mechanism?
as the real interest rate decreases, the cost of financing loans goes down and expansionry open market operations will increase banks reserves and deposits. this in turn increases the level of bank loans a bank can make ( supply effect)
previously constrained firms get loans and GDP increases
explain the banks capital (equity) channel?
expansionary monetary policy results in higher asset prices and/or higher interest margins
this results in gains on bank loan portfolio. this is an expansion in the banks equity/capital
more lending from these banks (supply effect). previously constrained firms get loans and GDP increases
what is the balance sheet channel?
expansionary monetary policy results in higher asset prices and higher net worth of firms
firms can therefore pose more collateral and borrow more
external finance premium decreases
more lending (demand effect) to previously contrained firms therefore GDP increases
what has become increasingly important in modern macroeconomics?
there has been a large increase in incomplete market models
what do incomplete market models incorporate for the household?
incomplete market models incorporate households face:
- uninsurable risks (e.g unemployment, income risk, returns risk)
- and constraints such as liquidity constraints, loan-to-value constraints, loan-to-income constraints
what do incomplete market models imply?
they imply that short run fluctuations affect households. balance sheet effects on households and fiscal policy matters
what the new transmission mechanisms?
households balance sheet channel, income risk effects, indirect income effects (stronger!)
what is the mechanism of the households balance sheet?
the interest rate will decrease, this will lead to the nominal price of housing to increase. borrowing constraint will become slacker. this will lead to an increase in consumption and in the volume of houses
what are the income risk effects?
when households face uninsurable risk, they self insure by accumulating buffer saving. the amount of buffer saving will depend on how effective wealth if at insuring against fluctations in income. when interest rate decreases, they need more buffer to insure against the same level of income risk. therefore when interest rate decreases, precautionary savings increase leading to a fall in consumption
what is the effect of the income risk effects on monetary transmission?
it is the opposite of the standard mechanism with the presence of income risk weakening monetary transmission
what is the complete benchmark for the indirect income effects?
in a complete market, households will react almost nothing to short run changes in wage. main part of monetary transmission is through direct effects
what is the incomplete market outcome for the indirect income effects?
some households are constrained and are very sensistive to short run changes in wages. main monetary transmission is through indirect effects on wages
