class: center, middle, inverse, title-slide # Monetary Policy ## Week 12 ### Krisna Gupta ### 09 May 2021 (updated: 2021-05-10) --- ## Last week-ish - AD-AS see movement of real sector / goods market: - Relationship between real GDP and prices - Unemployment gets affected: - employment follows GDP: moves in short-run, neutral in long-run. - In long-run, wage rate follows prices. - Government can interfere: - prices doesn't change in long-run. --- ## Negative shocks --- ## This week - We have yet the third market: Money market. - Money market completes the macroeconomics relationship: growth, unemployment and inflation. - We will learn supply and demand of money, with interest rate as its price. - We covered how financial system works. - We will then see how central bank fits in. --- class: middle, center # The money market <iframe src="https://giphy.com/embed/kvu3mUFYobXqyYEdMY" width="480" height="395" frameBorder="0" class="giphy-embed" allowFullScreen></iframe><p><a href="https://giphy.com/gifs/agenciamango-money-marketing-digital-dinheiro-kvu3mUFYobXqyYEdMY">via GIPHY</a></p> --- ## Demand for money - We have learned that money is the most liquid form of asset. - Easy to use for transaction - However, there's opportunity cost of holding money - money bears little to no return compared to other asset classes. - While there are many returns to asset, we use interest rate as the main opportunity cost of holding money. - therefore, interest rate is the 'cost' we have to pay to get the convinience of ease of transaction. --- ## Demand for money - We can say that interest rate is the price of money. - As interest rate increase, the opportunity cost of holding money increases. - if interest rate is high, it is better to hold less money and put them in the deposit account. - remember the lesson last week about money creation: - when interest rate is high, borrowing becomes expensive while saving becomes more profitable. - This situation leads to hence less money being created. --- ## Money demand curve .pull-left[ <!-- --> ] .pull-right[ - money demand is downward sloping - changes in interest rate leads to movement along the curve: - r `\(\Uparrow\)`, M `\(\Downarrow\)` - vice versa - Other changes leads to a shift in the money market ] --- ## What shifts the MD curve? 1. **Changes in aggregate price level**. When price is high, you need more cash in hand to purchase them. When I was young, going out with Rp100k in hand is enough to buy dinner and movie tickets. Now? 1. **Changes in real GDP**. As money is used to buy things, when there are more things to buy, there are more money demanded in the economy. 1. **Changes in institution**. Rules such as reserve requirements matter: higher reserve means less flexibility in creating money. --- ## Money supply - We have learned that money is created by the banking system. - However, the main driver of money creation is the central bank. - in Indonesia its Bank Indonesia (BI). - Bank Indonesia controls money supply in three ways: - Open-market operations via buying and selling treasury bills - Discount windows - Change reserve requirements. --- ## Money supply Three main tools for BI to control money supply: 1. **Open-market operations** is buying and selling [treasury bill](https://www.bi.go.id/id/fungsi-utama/moneter/operasi-moneter/Default.aspx) (eg Sertifikat Bank Indonesia, SukBI, etc). BI sells t-bill when they want to reduce money supply, and buys them when otherwise. 1. **Discount windows** is opened when banks needed liquidity and BI provide them with interest rate. The interest rate BI charge to banks is called Repo rate ([BI 7DRR](https://www.bi.go.id/id/fungsi-utama/moneter/Default.aspx)). Low repo rate allows banks to expand money supply. 1. **Reserve requirements**. When liquidity is needed, BI will reduce reserve requirements so banks have more money to lend to people. This is the case during [COVID-19 recession](https://www.thejakartapost.com/news/2020/03/02/bi-cuts-reserve-ratio-frees-up-3-2b-liquidity-in-local-banks-amid-market-sell-off.html). --- ## Money market equilibrium .pull-left[ <!-- --> ] .pull-right[ - This is called **liquidity preference model of interest rate**. - BI sets how much money in the market by setting interest rate. Effectively, BI controls the movement of MS. - When BI wants less money circulated, they crank-up interest rate by using its three tools. ] --- ## Money market equilibrium .pull-left[ <!-- --> ] .pull-right[ - Suppose economy booms and demand for money at `\(L\)`, but BI keeps MS at `\(\overline{M}\)`. - At `\(L\)`, money demand is `\(M_L\)` and interest rate is at `\(r_L\)` - For those who want to sell non-money asset, they has to offer higher interest rate. - Which cranks up general interest rate and reduce money demand back to `\(\overline{M}\)` ] --- ## Changing money supply .pull-left[ <!-- --> ] .pull-right[ - Suppose the cenral bank issue **expansionary monetary policy** either by purchasing t-bill or reducing repo rate. - The policy pushes money to the banking system, which leads banks to reduce their interest rate. - Lower interest rate lower borrowing costs, create more money in circulation. ] --- class: middle, center # Monetary policy and Aggregate Demand --- ## Monetary policy and Aggregate Demand - In the previous week, we touched a bit on what moves AD curves. - When BI increase money supply: - interest rate drops - low interest rate = low borrowing costs: - investment and consumption increases. - leads to AD shifts to the right. -- - When BI decrease money supply: - interest rate increases - high interest rate = high borrowing costs: - people saves; industries halt investment. - leads to AD shifts to the left. --- ## Monetary policy - Central bank should only reduce interest rate when output is below potential output. - The reason is the same as the government: - during normal times, boosting AD will results in inflation. - In fact, inflation is the main mandate of BI, NOT output nor unemployment. -- - The main mandate of BI is to maintain the value of IDR: - controlled inflation - controlled exchange rate --- ## Inflation targeting Framework - Inflation targeting framework (ITF) is a framework where the basis of BI's monetary policy is inflation. - BI announce its inflation target (together with Ministry of Finance), and vows to use monetary policy to get that inflation rate. - as of [today](https://www.bi.go.id/id/statistik/indikator/target-inflasi.aspx), the target is 3$\pm$1% - When inflation is below target, BI will be expansive, whereas high inflation will leads BI to rise interest rate. - Indonesia is an open economy: inflation can happen due to cheap IDR. This is why BI also intervene in the exchange rate market. --- <table class="table" style="font-size: 18px; width: auto !important; margin-left: auto; margin-right: auto;"> <thead> <tr> <th style="text-align:right;"> Year </th> <th style="text-align:right;"> Actual Inflation </th> <th style="text-align:right;"> Target Inflation </th> <th style="text-align:right;"> End of Year BI Rate </th> </tr> </thead> <tbody> <tr> <td style="text-align:right;width: 5cm; "> 2006 </td> <td style="text-align:right;"> 6.60 </td> <td style="text-align:right;"> 8.0 </td> <td style="text-align:right;"> 9.75 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2007 </td> <td style="text-align:right;"> 6.59 </td> <td style="text-align:right;"> 6.0 </td> <td style="text-align:right;"> 8.00 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2008 </td> <td style="text-align:right;"> 11.06 </td> <td style="text-align:right;"> 5.0 </td> <td style="text-align:right;"> 9.25 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2009 </td> <td style="text-align:right;"> 2.78 </td> <td style="text-align:right;"> 4.5 </td> <td style="text-align:right;"> 6.50 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2010 </td> <td style="text-align:right;"> 6.96 </td> <td style="text-align:right;"> 5.0 </td> <td style="text-align:right;"> 6.50 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2011 </td> <td style="text-align:right;"> 3.79 </td> <td style="text-align:right;"> 5.0 </td> <td style="text-align:right;"> 6.00 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2012 </td> <td style="text-align:right;"> 4.30 </td> <td style="text-align:right;"> 4.5 </td> <td style="text-align:right;"> 5.75 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2013 </td> <td style="text-align:right;"> 8.38 </td> <td style="text-align:right;"> 4.5 </td> <td style="text-align:right;"> 7.50 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2014 </td> <td style="text-align:right;"> 8.36 </td> <td style="text-align:right;"> 4.5 </td> <td style="text-align:right;"> 7.75 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2015 </td> <td style="text-align:right;"> 3.35 </td> <td style="text-align:right;"> 4.0 </td> <td style="text-align:right;"> 7.50 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2016 </td> <td style="text-align:right;"> 3.02 </td> <td style="text-align:right;"> 4.0 </td> <td style="text-align:right;"> 4.75 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2017 </td> <td style="text-align:right;"> 3.61 </td> <td style="text-align:right;"> 4.0 </td> <td style="text-align:right;"> 4.25 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2018 </td> <td style="text-align:right;"> 3.13 </td> <td style="text-align:right;"> 3.5 </td> <td style="text-align:right;"> 6.00 </td> </tr> <tr> <td style="text-align:right;width: 5cm; "> 2019 </td> <td style="text-align:right;"> 2.72 </td> <td style="text-align:right;"> 3.5 </td> <td style="text-align:right;"> 5.00 </td> </tr> </tbody> <tfoot> <tr> <td style = 'padding: 0; border:0;' colspan='100%'>^a Source: BI</td> </tr> </tfoot> </table> When inflation was high, BI rate is also high. High BI rate is supposed to have money absorption effect. --- ## Expansionary monetary policy .pull-left[ <!-- --> ] .pull-right[ - When the central bank increase money supply, interest rate goes down, leads to inrease investment and consumption. - AD shifts to the right, output go up to `\(Y_2\)` while aggregate price level increases to `\(P_2\)` ] --- ## Inflation shifts MD... .pull-left[ <!-- --> ] .pull-right[ - The central bank can either pull money supply back, or keep money supply high. - If money supply stay high, because aggregate demand and aggregate price both go up, MD shifts to the right, increasing money demand. - In the long-run, this push interest rate back up to the original position. ] --- ## Long run impact .pull-left[ <!-- --> ] .pull-right[ - Increase of interest rate and wage rate in the long run leads to lower supply (SRAS shifts to the left) - In the end, output level is back to normal, but prices go up (inflation) - The central bank failed to keep GDP and employment high, sacrifices its main target which is inflation. ] --- ## Long-run neutrality of money - Often, many government asks the central bank to finance their expansive program instead of stabilizing prices. - But when the economy is in its normal state, expansionary monetary policy will only leads to higher inflation. - This is called **neutrality of money**, that is, during normal times, you can't boost real GDP because increased prices will neutralize the higher amount of money. --- ## Importance of ITF - The central bank (and the government) have very important job in mitigating recession and stabilizing the economy. - It is not easy, however: - Tightening monetary and fiscal policy too soon risks economy return to recession. - Tightening monetary and fiscal policy too late, and the economy may overheat, inflate, and bursting bubbles. - That is why inflation targeting is important, as inflation is the sign of overheating economy. --- ## In short... **During a recession:** 1. Self-correcting mechanism: - Short-run: AD shifts to left, prices go down, output/GDP go down. - Long-run, self-correcting mechanism: AS shifts to right, prices go even lower but output returns to normal. - In the end, output stays the same, prices level is very low. 1. Government intervention: - Short-run: AD shifts to left, prices go down, output/GDP go down. - Government interventions: AD shifts to the right, prices and output go back to normal. - In the end, output and prices is the same. --- ## Does monetary policy work? - Note that the central bank does not dictate interest rate charged by private banks. - BI set repo rate to increase incentive for banks to expand their lending. - However, there are possibilities that consumer banks do not follow the rate set by BI rate. -- - One reason is **high risk premia**. Some countries has terrible investing condition. In this situation, default rate may be too big for banks to lower their interest rate and forego their reserves. -- - Second reason is **oligopolistic banking market**. Remember that interest rate is basically the price of lending service. Banks can hold high interest rate to maximize profit the same way normal monopoly and oligopoly works. --- ## Does monetary policy work? - Banking sector can become oligopolistic when there are high barriers to entry. - When barriers to entry to banking is high but demand for lending exist, illegal lending pops-up, e.g.: - *lintah darat* - illegal Fin-tech - Third problem is what plague advance countries: **zero-lower bound**. In advance countries, interest rate is so low, it has to go negative to be lowered. - De facto wise, interest rate is already negative in some countries if you consider admin fee. But we still use banks amid convenience. --- ## What to do? - When monetary policy isn't effective, the central bank can turn to the government. - Instead of selling t-bill to banks, BI can sell t-bill straight to the government to finance `\(G\)` - This effectively turns monetary policy to fiscal policy. - However, this method risks hyper-inflation as in 1966. In fact, since it is in the government's interest to grow GDP, it can ask central bank to purchase t-bill even during normal times. --- ## Next-up - Macroeconomics essentially discussing relationship between aggregate demand, aggregate supply, aggregate prices, unemployment, interest rate and money supply. - These understandings are important to make sense of macroeconomic news. - However, we have not discuss one crucial thing: international economics. - Next-week we will learn one more important indicator: balance of trade and balance of payment. - Further, we will see how exchange rate and international credit market plays a role in the economy. --- class: middle, center # The end