Monetary Policy
1
Goals of Monetary Policy
• Price stability (Low and stable inflation)
• High employment
• Economic growth
• Financial market stability
• Interest-rate stability
• Foreign exchange market stability
2
Hierarchical Mandate vs
Dual Mandate
• Hierarchical mandate
Set price stability as a primary goal
May make central bank behave as “inflation nutter”
• Dual mandate
Set two co-equal objectives: price stability and
maximum employment
• Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the
long run but not the short run.
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Goals in the real world?
Central Banks Goals
Bank of Thailand
Federal Reserve
European Central Bank
4
The Bank of Thailand
Source: www.bot.or.th 5
The Bank of Thailand
The Minister of Finance and the MPC
mutually agreed to set the monetary
policy target for price stability such
that the headline inflation is to reside
within the range of 1.0 – 3.0 percent
for the medium-term horizon and for
the year 2021.
Source: www.bot.or.th
https://www.bot.or.th/English/MonetaryPolicy/MonetPolicyKnowledge/AnnounceMPC/AnnouncementMPCTarget_2021.pdf
https://www.bot.or.th/English/MonetaryPolicy/MonetPolicyKnowledge/Pages/Target.aspx
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7
ECB
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Inflation Targeting
• Public announcement of medium-term numerical
target for inflation
• Institutional commitment to price stability as the
primary, long-run goal of monetary policy and a
commitment to achieve the inflation goal
• Information-inclusive approach in which many
variables are used in making decisions
• Increased transparency of the strategy
• Increased accountability of the central bank
Inflation Targeting
• Advantages:
Does not rely on one variable to achieve target
Easily understood
Reduces potential of falling in time-inconsistency trap
Stresses transparency and accountability
• Disadvantages:
Delayed signaling
Too much rigidity
Potential for increased output fluctuations
Low economic growth during disinflation
Linkages Between Central Bank Tools, Policy
Instruments, Intermediate Targets, and Goals of
Monetary Policy
Open Market Operations
Lending Facility
Reserve Requirements
Interest on Reserves
Large-Scale Asset Purchase
Forward Guidance
Choosing the Policy Instrument
• Policy instrument (operating instrument)
Reserve aggregates
Interest rates
Interest-rate and aggregate targets are incompatible (must
chose one or the other)
• Tools
Open market operation
Lending facility
Reserve requirements
Interest on reserves
Large scale asset purchases
Forward guidance
Bank of Thailand Policy Rate
Bank of Thailand Policy Rate
1-day repurchase rate: 0.5%
Source: www.focus-economics.com
US Policy Rate
Federal fund target rate:
0 – 0.25%
ECB policy rate
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Source: www.bot.or.th
Bank of Thailand Tools
https://www.bot.or.th/English/FinancialMarkets/MonetaryOperations/Pages/default.aspx
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Source: www.bot.or.th
Contractionary Accommodative
Monetary Policy (Expansionary)
Monetary Policy
Hawk Dove
Hawkish Dovish
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Transmission mechanism
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Source: www.bot.or.th
Transmission mechanism
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Source: www.bot.or.th
Transmission mechanism
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Source: www.bot.or.th
Transmission mechanism
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Source: www.bot.or.th
Transmission mechanism
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Source: www.bot.or.th
Transmission mechanism
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Source: www.bot.or.th
Market for Reserve and short-term
interest rate
• The market for reserves is where the short-
term interbank interest rates are determined.
• Example of policy rates
Thailand: 1-day Repo rate set by MPC
US: Target Federal Funds rate (Fed Fund rate) set
by FOMC
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Demand for Reserves
Interest rate • Total demanded reserves
= Demanded required reserves
+
Demanded excess reserves
• Excess reserves
Insurance against deposit
outflows
Rd Holding cost: interest rate that
could have earned on lending
these reserves
Quantity of Reserves (R)
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Supply for Reserves
• Total supplied reserves
= Non-borrowed reserves
+
Interest rate Borrowed reserves
• Discount rate is cost of borrowing
Discount from the Fed
rate
• Borrowing from central bank is a
id Rs substitute for borrowing from other
banks
• If iff < id, then banks will not borrow
from the central bank and borrowed
reserves are zero The supply
curve will be vertical
• As iff rises above id, banks will
borrow more and more at id, and re-
NBR Quantity of Reserves (R) lend at iff The supply curve is
horizontal at id
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Interest
rate
Rs = Rd
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Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Forward guidance
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Bank of Thailand Tools
Open market operation
Lending facility
https://www.bot.or.th/English/FinancialMarkets/MonetaryOperations/Pages/default.aspx
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Source: www.bot.or.th
Open Market Operations
• Open market operations are the most
important monetary policy tool.
• Dynamic open market operations
To change the level of reserves and the
monetary base
• Defensive open market operations
To offset movement in other factors that
affect reserves and the monetary base
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Open Market Operations
• Open market purchase
Interest rate
id Rs
iff
Rd
Quantity of Reserves (R)
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Open Market Operations
• Open market sales
Interest rate
id Rs
iff
Rd
Quantity of Reserves (R)
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Advantages of
Open Market Operations
• Central bank has complete control over
the volume
• Flexible and precise
• Easily reversed
• Quickly implemented
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Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Forward guidance
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Lending Facility
• Backup source of liquidity
• Lender of last resort to prevent
financial panics
Creates moral hazard problem
• Put a ceiling on short-term interest rate
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ECB Marginal Lending Facility
Lending Facility
Interest rate
i1 d Rs
iff
Rd
Quantity of Reserves (R)
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Lending Facility
Interest rate
i1ff = i1d Rs
Rd
Quantity of Reserves (R)
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Lending Facility
Interest rate
i1ff = i1d Rs
Rd
Quantity of Reserves (R)
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Lending Facility
Interest rate
i1ff = i1d
Rs
Rd
Quantity of Reserves (R)
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Lending Facility
• A sudden increase in demand for reserves
Interest rate
id Rs
iff
Rd
Quantity of Reserves (R)
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Credit Extended through Federal Reserve Liquidity Facilities
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Source: federalreserve.gov https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
ECB
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Source: Credit Agricole (August 4, 2021)
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ECB - TLTRO III
The rate depends on banks’ lending
performance
• The favourable rate can be can be as low
as:
• -0.5% (Sep 2019 – Jun 2020),
• -1.0% (Jun 2020 – Jun 2022) and
• -0.5% (Jun 2022 – Dec 2024).
• The unfavourable rate can be as high as:
• 0.0% (Sep 2019 – Jun 2020),
• -0.5% (Jun 2020 – Jun 2022) and
• 0.0% (Jun 2022 – Dec 2024).
• This series is by far the most favourable
series, as for the first time ever–banks can
have a rate below the deposit rate, if they
increase their lending to the private
economy enough.
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Advantages and
Disadvantages of Lending Facility
Advantages
• Used to perform role of lender of
last resort
• Used as a backup facility to prevent the federal funds rate from
rising too far above the target
Disadvantage
• Cannot be controlled by central bank; the decision maker is the
bank
• May result in moral hazard
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Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Forward guidance
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Required Reserve Ratio
• Increase required reserves ratio
Interest rate
id Rs
i1ff • Demand for reserves
increases
iff
• Interest rate rises
Rd
Quantity of Reserves (R)
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China Required Reserve Ratio
(%)
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PBOC cut RRR to boost the economy
On 9 th July, China’s central bank, the PBOC, announced a 0.50 percentage point cut on required reserve ratio for
financial institutions (effective on 15th July after this reduction, the weighted RRR of financial institutions is 8.90%).
This 0.50 percentage point RRR cut will release about RMB1 trillion of funds, part of which will be used to replace
maturing MLF this month and make up the liquidity gap due to taxation later this month.
Source: MUFG Global Market Monthly July 2021
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Disadvantages
of Reserve Requirements
• No longer binding for most banks
• Can cause liquidity problems
• Increases uncertainty
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Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Forward guidance
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Interest on Reserve
Interest
rate
Rs = Rd
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ECB Deposit Facility
Selected Liabilities of Federal Reserve
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https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Liquidity provision
• Forward guidance
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Large Scale Asset Purchase or
Quantitative Easing (QE)
https://www.youtube.com/watch?v=APqGR9s2Ywg&index=2&list=PLslyOrpjJ0z2du
ArbcMKan_xjl4lt07WW
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Federal Reserve’s Liabilities
Source: Citi Research, US Economics Weekly (Sep 10, 2021)
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Central Bank Balance Sheet
Change in Central Bank Balance Sheet Size in
Prior 6 Months
Unconventional monetary policy
ECB
Source: BNP Paribas DM week ahead (Sep 10, 2021)
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• At the Monetary Policy Meeting held on September 20 and 21, 2016, the
Bank decided to introduce "Quantitative and Qualitative Monetary
Easing (QQE) with Yield Curve Control.”
• The Bank commits itself to expanding the monetary base until the year-
on-year rate of increase in the observed consumer price index (CPI)
exceeds the price stability target of 2 percent and stays above the target
in a stable manner.
• The guideline for market operations specifies a short-term policy interest
rate and a target level of a long-term interest rate
The short-term policy interest rate: minus 0.1 percent
The long-term interest rate: 10-year Japanese government bon
yields remain more or less at the current level (around zero percent).
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Source: Bank of Japan
Japanese Government Bond Yield
Curve (Oct 13, 2021)
Source: Bloomberg
Tools of Monetary Policy
• Open market operation
• Lending facility
• Reserve requirement
• Interest on reserve
• Large-scale asset purchase
• Forward guidance
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Forward Guidance
• Speech
• Economic forecast
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https://www.bot.or.th/Thai/PressandSpeeches/Speeches/Gov/SpeechGov_29Mar2021.pdf
Press Conference
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Powell’s testimony to the Congress
• WASHINGTON, July 14 (Reuters) -
Federal Reserve Chair Jerome Powell on
Wednesday pledged "powerful support"
to complete the U.S. economic recovery
from the coronavirus pandemic, but faced
sharp questions from Republican
lawmakers concerned about recent
spikes in inflation.
• In testimony to the U.S. House of
Representatives Financial Services
Committee, Powell said he is confident
recent price hikes are associated with the
country's post-pandemic reopening and
will fade, and that the Fed should stay
focused on getting as many people back
to work as possible.
• Any move to reduce support for the
economy, by first slowing the U.S. central
bank's $120 billion in monthly bond
purchases, is "still a ways off," Powell
said, with 7.5 million jobs still missing
from before the pandemic.
Fed's Powell keeps to script on jobs recovery, feels heat on inflation front | Reuters
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Lessons for Monetary Policy Strategy
from the Global Financial Crisis
1. Developments in the financial sector have a far
greater impact on economic activity than was earlier
realized.
2. The zero-lower-bound on interest rates can be a
serious problem.
3. The cost of cleaning up after a financial crisis is very
high.
4. Price and output stability do not ensure financial
stability.
