FINN2071 Intermediate Financial Economics

Week 7: Monetary Policy I

Dr Haifeng Guo
 Monetary policy
The process by which a central bank manages money supply and
interest rates to achieve macroeconomic objectives.

Primary Objectives:
Price stability (inflation control)
Full employment
Economic growth
 Monetary policy
Conventional monetary policy:
Open market operations (OMO)
Policy interest rates
Reserve requirements

Unconventional monetary policy:

Large scale asset purchase (LSAP)/Quantitative easing (QE).
Forward guidance.
 Interest rates
Bank of England (BOE): Monetary Policy Committee (MPC) and
MPC Bank Rate

Federal Reserve (Fed): Federal Open Market Committee (FOMC)

and Federal Funds Target Rate
 Interest rates
MPC Bank Rate London Interbank Offered Rate (LIBOR)
The interest rate set by the BOE’s MPC to influence The average interest rate at which banks
monetary policy and the economy lend to each other in the short-term
interbank market
Policy rate controlled by a central bank Market-determined rate (historically,
based on reported estimates by banks)

Federal Funds Target Rate (FFR target) Federal Funds Rate (FFR)
The interest rate range set by the Fed for banks to target The actual interest rate at which banks
in overnight lending lend reserves to each other overnight
A policy goal set by the Federal Reserve A market-determined rate influenced by
supply and demand for reserves
 Goods Market Recap

• The IS (Investment Saving) Curve shows the relationship

between total output/GDP (Y) and the interest rate (r) for the
goods market.

• All points on the curve simultaneously satisfy the income

identity, consumption, investment, and the net export
functions.
 Goods Market Recap

• As Interest rates rise:

Savings
Consumption
Firm Investment
• Therefore, the quantity of goods demanded also declines
• So higher real interest rates are associated with lower output,
that is, the IS curve slopes downward
 Goods Market Recap

We can calculate the mathematical definition for the IS curve:

• Starting from the definition of GDP

𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)

• We know that 𝐶 = 𝑓(𝑌 − 𝑇) , 𝐼 = 𝑓(𝑌, 𝑟) and 𝑋 − 𝑀 = 𝑁𝑋

(Net Exports)
 Goods Market Recap

• We can rewrite I and assume balanced trade:

𝐼 = 𝑒 − 𝑑𝑟

𝑁𝑋 = 0
Where e is a constant and d is a parameter.
 Goods Market Recap

• We can also rewrite C:

𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇)

Total tax will be equal to tax rate multiplied by income 𝑇 = 𝑌𝑡

𝐶 =𝑎+𝑏 1−𝑡 𝑌
 Goods Market Recap

• Substituting all our definitions into GDP

𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
We arrive at

𝑌 = 𝑎 + 𝑏 1 − 𝑡 𝑌 + 𝑒 − 𝑑𝑟 + 𝐺 + 0

𝑌 − 𝑇 − 𝐶 + (𝑇 − 𝐺) = 𝐼
 Goods Market Recap

• Rearranging, we obtain our mathematical representation of

the IS curve:

𝑎+𝑒+𝐺 1−𝑏 1−𝑡

𝑟= − 𝑌
𝑑 𝑑

If we have data on other variables, we can obtain the interest

rate
 Goods Market Recap

1−𝑏 1−𝑡
−
𝑑
Is the slope of the IS curve.

Note that, the sensitivity of investment to interest rates is

important here. The income elasticity of consumption is also
important.
 IS Curve Diagram
r 𝑎+𝑒+𝐺 1−𝑏 1−𝑡
IS Curve: 𝑟 = − 𝑌
𝑑 𝑑

𝑎+𝑒+𝐺
𝑑

r1 1−𝑏 1−𝑡
Slope = −
𝑑

r2

0 Y1 Y2 Y
 IS Curve Diagram
r 𝑎+𝑒+𝐺 1−𝑏 1−𝑡
𝑎 + 𝑒 + 𝐺′ IS Curve: 𝑟 = − 𝑌
𝑑 𝑑
𝑑
𝑎+𝑒+𝐺
𝑑
r2

r1

0 Y1 Y2 Y
 Financial Market Recap

• The LM (Liquidity Preference Money Supply) Curve shows the

relationship between total output/GDP (Y) and the interest
rate (r) for the financial market.

• All points on the curve ensure that the total of transactions

demand and speculative demand equals the exogenous money
supply.
 Financial Market Recap

• Transactions demand is determined by income

– As incomes rise, we demand more money for everyday transactions

• Speculative demand is determined by the interest rate (cost of

holding cash)
– As interest rates rise, the opportunity cost of holding cash increases
 Financial Market Recap

We can calculate the mathematical definition for the LM curve:

• We first define Money demand

𝑀𝑑 = 𝑘𝑌 − ℎ𝑟 𝑃

• We assume that money supply is exogenously fixed

𝑀𝑠 = 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡
 Financial Market Recap

• Rearranging the equation for Money demand

𝑀𝑑
= 𝑘𝑌 − ℎ𝑟
𝑃

• Rearranging again
𝑘 1 𝑀𝑑
𝑟= 𝑌−
ℎ ℎ 𝑃
 Financial Market Recap

• We know that at every point on the LM curve money demand

is equal to money supply

𝑘 1 𝑀𝑑 𝑘 1 𝑀𝑠
𝑟= 𝑌− = 𝑌−
ℎ ℎ 𝑃 ℎ ℎ 𝑃
 Financial Market Recap

𝑘
ℎ
Is the slope of the LM curve
Note that the slope of the curve is determined by the sensitivity
of transactions demand to output (k) and the sensitivity of
speculative demand to the interest rate (h)
 LM Curve Diagram
r Ms

Md2
Md1
𝑀𝑑 = 𝑘𝑌 − ℎ𝑟 𝑃

r2

r1

0
M
 LM Curve Diagram
r

LM1

𝑘
Slope =
r2 ℎ

r1

0 Y
Y1 Y2
1 𝑀𝑠
−
ℎ 𝑃
 LM Curve Diagram
r Ms1 Ms2

Md1
𝑘 1 𝑀𝑠
𝑟= 𝑌−
ℎ ℎ 𝑃

r1

r2

0
M
 LM Curve Diagram
r

LM1

𝑘
Slope = LM2
ℎ

r1

r2
0 Y
Y1 Y2
1 𝑀𝑠
−
ℎ 𝑃

1 𝑀𝑠 ′
−
ℎ 𝑃
 IS-LM Equilibrium

• Bringing both the IS and LM curves together, we can calculate

the equilibrium interest rates and output levels that
simultaneously balance the goods market and the demand and
supply of money
 IS-LM Equilibrium

Goods Market Equilibrium:

𝑎+𝑒+𝐺 1−𝑏 1−𝑡

𝑟= − 𝑌
𝑑 𝑑

Money Market Equilibrium:

𝑘 1 𝑀𝑠
𝑟= 𝑌−
ℎ ℎ 𝑃
 IS-LM Equilibrium
Setting the two relationships equal to one another:

𝑎+𝑒+𝐺 1−𝑏 1−𝑡 𝑘 1 𝑀𝑠

𝑟= − 𝑌= 𝑌 −
𝑑 𝑑 ℎ ℎ 𝑃
Rearranging, we obtain equilibrium output:

𝑀𝑠
𝑎+𝑒+𝐺 ℎ+ 𝑑
𝑃
𝑌= ℎ𝑑
1 − 𝑏 1 − 𝑡 ℎ + 𝑘𝑑
ℎ𝑑
 IS-LM Equilibrium

Cancelling:
𝑀𝑠
𝑎+𝑒+𝐺 ℎ+ 𝑑
𝑌= 𝑃
1 − 𝑏 1 − 𝑡 ℎ + 𝑘𝑑

Equilibrium Output depends positively on both government

spending (G) and money supply (𝑀𝑠 )
 IS-LM Equilibrium
Through more rearranging and cancelling, we can obtain a similar
equation for equilibrium interest rate:

𝑀𝑠
𝑎+𝑒+𝐺 − 1−𝑏 1−𝑡
𝑟= 𝑘𝑃
ℎ
1−𝑏 1−𝑡 +𝑑
𝑘
Equilibrium Interest rates depend positively on government
spending (G) and negatively on money supply (𝑀𝑠 )
 IS-LM Curve Diagram
r
𝑎+𝑒+𝐺 1−𝑏 1−𝑡
Slope = − LM
𝑑 𝑑
𝑘
Slope =
ℎ

𝑀𝑠
𝑎+𝑒+𝐺 − 1−𝑏 1−𝑡
𝑟𝑒 = 𝑘𝑃
re ℎ
1−𝑏 1−𝑡 +𝑑
𝑘

IS

0 Y
Ye 𝑀
1 𝑀𝑠 𝑎 + 𝑒 + 𝐺 ℎ + 𝑃𝑠 𝑑
− 𝑌𝑒 =
ℎ 𝑃 1 − 𝑏 1 − 𝑡 ℎ + 𝑘𝑑
 Monetary Policy Shock: IS Curve
r
𝑎+𝑒+𝐺
𝑑
𝑎+𝑒+𝐺 1−𝑏 1−𝑡
𝑟= − 𝑌
𝑑 𝑑

r1

IS

0 Y1 Y
 Monetary Policy Shock: LM Curve
LM2
r Ms2 Ms1 r
LM1
Md

r2

r1

0 M 0 Y Y
𝑘 1 𝑀𝑠
𝑟= 𝑌−
ℎ ℎ 𝑃
Monetary Policy Shock IS-LM Curve Diagram
r
1−𝑏 1−𝑡 LM2
𝑎+𝑒+𝐺 Slope = −
𝑑 𝑑
LM1

𝑘
Slope =
ℎ 𝑀
r2 𝑎+𝑒+𝐺 − 𝑠 1−𝑏 1−𝑡
𝑟𝑒 = 𝑘𝑃
ℎ
r1 1−𝑏 1−𝑡 +𝑑
𝑘

IS
0 Y
Y2 Y1
1 𝑀𝑠 ′
− 𝑀
ℎ 𝑃 𝑎 + 𝑒 + 𝐺 ℎ + 𝑃𝑠 𝑑
𝑌𝑒 =
1 𝑀𝑠 1 − 𝑏 1 − 𝑡 ℎ + 𝑘𝑑
−
ℎ 𝑃
 Covid-19 Policy Response IS-LM
r
Curve Diagram
LM1
𝑎 + 𝑒 + 𝐺′
𝑑
LM2
𝑎+𝑒+𝐺 𝑘
Slope =
𝑑 ℎ
Response I

re
1−𝑏 1−𝑡
Slope = −
IS2 𝑑
IS1
0 Y
1 𝑀𝑠 Y1 Y2
−
ℎ 𝑃
1 𝑀𝑠 ′
−
ℎ 𝑃
Coalition Government Era IS-LM Curve
r
Diagram
LM1
𝑎+𝑒+𝐺
𝑑
LM2
𝑎 + 𝑒 + 𝐺′ 𝑘
Slope =
𝑑 ℎ

r1

1−𝑏 1−𝑡
r2 Slope = −
𝑑
IS1
IS2
0 Y
1 𝑀𝑠 Ye
−
ℎ 𝑃
1 𝑀𝑠 ′
−
ℎ 𝑃
 IS-LM Equilibrium

𝑀𝑠
𝑎+𝑒+𝐺 ℎ+ 𝑑
𝑌= 𝑃
1 − 𝑏 1 − 𝑡 ℎ + 𝑘𝑑

𝑀𝑠
𝑎+𝑒+𝐺 − 1−𝑏 1−𝑡
𝑟= 𝑘𝑃
ℎ
1−𝑏 1−𝑡 +𝑑
𝑘
 Exchange Rates and Interest Rates

Uncovered Interest Parity:

𝑒
1+𝑟
𝐸𝑡+1 = 𝐸𝑡
1 + 𝑟𝑤
𝑒
Thus, if no exchange rate changes are expected (𝐸𝑡+1 = 𝐸𝑡 ), we
would expect interest rates to be the same in the domestic
market, as in the rest of the world
 Current Account

• The balance of imports and exports is known as the current

account

• If exports > imports the current account is in surplus

• If imports > exports the current account is in deficit

 Current Account
• We can write the current account algebraically:

𝐶𝐴 = 𝑁𝑋 = 𝐸𝑋 − 𝐼𝑀

𝐶𝐴 = 𝑥1 𝑌 𝑤 + 𝑥2 𝐸 − (𝑚1 𝑌 − 𝑚2 𝐸)
USD/GBP=0.86

If the current account is balanced(𝐶𝐴 = 0):

𝑥1 𝑤 𝑥2 + 𝑚2
𝑌= 𝑌 + 𝐸
𝑚1 𝑚1
Current Account Diagram
r

CA=0 CA=0 CA=0

CA Surplus CA Deficit

As 𝑌 𝑤 ↓ or E↓ As 𝑌 𝑤 ↑ or E↑

0 𝑥1 𝑤 𝑥2 − 𝑚2 Y
𝑌 + 𝐸
𝑚1 𝑚1
 Capital Account

• The balance of inflows and outflows of capital is known as the

capital account

• If inflows > outflows the capital account is in surplus

• If outflows > inflows the capital account is in deficit

 Capital Account
• As a simplifying assumption we assume that capital flows are
solely determined by exchange rates and interest rates
• The capital account equilibrium is then solely determined by
the UIP condition:
𝑒
1+𝑟
𝐸𝑡+1 = 𝐸𝑡
1 + 𝑟𝑤
If we assume no exchange rate changes:
𝐶𝑃 = κ (𝑟 − 𝑟 𝑤 )
 Capital Account Diagram
r

As 𝑟 𝑤 ↑ CP Surplus

𝑟𝑤 CP=0

CP Deficit
As 𝑟𝑤 ↓

0 Y
 FE Curve
• The Foreign Exchange (FE) curve plots equilibrium in the
combined foreign exchange market.

• The curve combines both the capital and current accounts:

Current Account:
𝐶𝐴 = 𝑥1 𝑌 𝑤 + 𝑥2 𝐸 − (𝑚1 𝑌 − 𝑚2 𝐸)
Capital Account:
𝐶𝑃 = κ (𝑟 − 𝑟 𝑤 )
 FE Curve
• The FE curve is in equilibrium when the net of the capital and
current accounts is 0:
𝐶𝐴 + 𝐶𝑃 = 0
Substituting in our definitions:
𝑥1 𝑌 𝑤 + 𝑥2 𝐸 − (𝑚1 𝑌 − 𝑚2 𝐸) + κ (𝑟 − 𝑟 𝑤 ) = 0
Rearranging:
𝑤
𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
𝑟= 𝑟 − 𝑌 − 𝐸 + 𝑌
κ κ κ
 FE Curve
𝑥1 𝑤 𝑚2 + 𝑥2
𝑤
𝑚1
𝑟= 𝑟 − 𝑌 − 𝐸 + 𝑌
κ κ κ
Note:
• Equilibrium interest rates move 1 to 1 with the world interest
rate
𝑚1
• The slope of the FE curve is given by
κ
• As κ → ∞ the FE curve becomes more horizontal
 FE Curve Diagram
r 𝑥1 𝑤 𝑚2 +𝑥2 𝑚1
FE Curve: 𝑟 = 𝑟𝑤 − 𝑌 − 𝐸 + 𝑌
κ κ κ

FE2

𝑚1
FE1 Slope1 =
𝑥1 κ
𝑟 𝑤′ − 𝑌 𝑤
κ
𝑚2 + 𝑥2
− 𝐸
κ

𝑥1 FE3 𝑚1
𝑟𝑤 − 𝑌𝑤 Slope2 =
κ κ′
𝑚2 + 𝑥2
− 𝐸
κ
0 Y
Thank you