Monetary Policy Transmission and Monetary Policy Regulation - Macroeconomics from a Chinese Perspective

Monetary Policy Transmission and Monetary Policy Regulation - Pan Deng's Notes on Macroeconomics

monetary transmission path

Money is a Bank's Liability——The "Physical" Definition of Money

• Fiat Money
  • Legal tender is a currency that does not represent real objects, nor does the issuer have the obligation to convert them into real objects, but only relies on government decrees to become a legal currency
  • Legal tender is actually a symbol of value that can be circulated according to the law
  • Fiat currency itself has no intrinsic value (intrinsic value) and can be created at almost no cost
• The Two Levels of Fiat Currency
  • Base Money: Debt certificates issued by the central bank
    • It is expressed as the "deposit reserve" of the central bank and the "cash" in circulation in commercial banks
    • Changes in the base currency will double the total money supply in the real economy, so it is also called "High-powered Money"
    • It is called "Reserve Money" in the balance sheet of the People's Bank of China.
  • Money Supply: Debt certificates issued by commercial banks
    • Mainly for the "deposits" in commercial banks of enterprises and residents in the real economy
    • Cash is also included in the total money supply
    • In China's monetary statistics, it is called "broad money" M2

Two stages of money creation: the central bank creates base money; commercial banks create broad money

loans create deposits

The central bank creates base currency through asset business. Specifically, there are two

• Disburse cash directly to commercial banks
• Direct changes in the balance sheet of the central bank, expressed as an increase in commercial bank deposit reserves (liabilities) and an increase in commercial bank loans (assets)

money multiplier

• Monetary Multiplier
  • The amount of broad money that can be produced by one unit of base money
  • Money Multiplier = Broad Money / Base Money
• Currency Multiplier Cap = 1/ RRR (Required Reserve Ratio)
• Broad money quantity = base currency quantity * money multiplier (affected by RRR)
  • Changing the quantity of broad money can be achieved by changing the quantity of base currency or changing RRR

Money is memory - the "metaphysical" definition of money

• Under the fiat currency system, money is nothing more than numbers on the bank's books (the creation of money is the bookkeeping)
• From "Say's Law" to the Essence of Money
  • demand precedes supply
  • The part whose own supply is greater than its own demand becomes the demand for currency
  • The demand for money is derived from the demand for the supply that money can be exchanged for
  • Money is nothing more than a memory tool for society as a whole to remember the difference between each individual's own supply and demand
  • Through the memory tool of currency, the division of labor and cooperation in the whole society can be carried out
  • Money is essentially a memory tool (Kocherlakota 1998)

Excess deposit reserve is the prerequisite for the operation of commercial banks

interest rate decision

Important issues

• When the central bank increases money supply, does the nominal interest rate rise or fall?
  • From the Fisher equation, higher money growth leads to higher inflation, which pushes up nominal interest rates.
  • In financial markets, the central bank pumps money but depresses the nominal interest rate on the price of money
• The fact that the central bank lowers the nominal interest rate when it pumps money is at the heart of this section;

Three Theoretical Threads of Interest Rate Determination

• Liquidity effect: the central bank’s money injection lowers the nominal interest rate; the central bank withdraws money to push up the nominal interest rate
  $$△M\uparrow \Rightarrow R\downarrow$$
• Fisher effect: Nominal interest rate = real interest rate + inflation (expected), the injection of money pushes up the nominal interest rate
  $$R=r+{Pi}^e$$
• Manufacturer's optimization condition: real interest rate = marginal rate of return on capital
  $$r=f^{\prime }(k)$$

Two Questions in Three Theoretical Threads

Is the central bank injecting money to drive down the nominal interest rate or push up the nominal interest rate?

• Liquidity Effect: More Money Brings Lower Nominal Interest Rates
• The Fisher Effect: More money leads to higher inflation, which leads to higher nominal interest rates

Are interest rates determined by the central bank or by the real economy?

• Fisher Effect: The central bank can control the nominal interest rate, which in turn affects the real interest rate
• Manufacturer's optimization behavior: the manufacturer's return on capital determines the real interest rate level that the manufacturer can accept

Fisher effect or liquidity effect

• When money transmission is smooth , the Fisher effect plays a leading role, and money supply pushes up the nominal interest rate
  • The central bank's base money injection immediately brings broad money derivatives
  • Derivatives of broad money immediately bring about the expansion of nominal aggregate demand in the real economy, which immediately pushes up inflation (expected)
  • Rising inflation (expected) pushes up nominal interest rates
• When money transmission is not smooth , the liquidity effect plays a leading role, and money supply depresses the nominal interest rate
  • If the central bank's base money injection fails to immediately bring about broad money derivatives, the liquidity effect in the financial market will appear, and the nominal interest rate in the financial market will decrease
  • If the derivation of broad money fails to drive real economic activities and inflation (expected), the liquidity effect in the real economy will appear, and the nominal interest rate in the real economy will decrease
• Monetary transmission takes time, so liquidity effects on the transmission path may be observed in the short term; but eventually, monetary growth will be reflected in higher inflation, pushing up nominal interest rates

real interest rate determination

The real interest rate is ultimately determined by the balance between savings and investment (classical economic theory perspective)

• The real interest rate is the price of saving
• The real interest rate is the cost of investing
• Real interest rate adjustment clears savings-investment market

Monetary aggregates are the financial manifestation of savings in the real economy, the (real) amount of which is determined by the real economy, not the financial system

• If the real economy has less savings and the financial system creates a large amount of money, the real economy will quickly spend the nominal purchasing power brought by the currency, which will quickly push up inflation and depress the real value of the currency
• If there is a lot of savings in the real economy and a small amount of nominal currency created by the financial system, the purchasing power of the currency will settle instead of becoming purchasing power, which will cause inflation to slump and push up the real value of the currency

The central bank's interest rate policy is subject to the real economy—the monetary policy is endogenous to the real economy

• The nominal interest rate is the price of money, and the central bank must stabilize the nominal interest rate at a level consistent with the return on investment in the real economy, otherwise both the money supply and inflation will get out of control
• Simplify the assumption that inflation expectations are 0 at the beginning (the nominal interest rate is equal to the real interest rate), and the central bank will continue to control the nominal interest rate of loans to a level lower than the return on investment in the real economy. The consequences are:
  • Enterprises in the real economy find that loans are profitable, and demand for loans will rise
  • The increase in loan demand will bring about an increase in the demand for base money by commercial banks, thus creating upward pressure on nominal interest rates (interbank market interest rates and loan interest rates)
  • If the central bank wants to maintain low interest rates, it needs to increase the supply of base money and let commercial banks increase the supply of credit
  • The expansion of base money and broad money will lead to upward inflation expectations, triggering an increase in the nominal return on investment in the real economy, resulting in a higher interest rate differential between the real economy and finance, and triggering stronger demand for loans
  • If this cycle continues, the money supply and inflation will get higher and higher, going out of control
• Similarly, if the central bank continues to control the nominal loan interest rate at a level higher than the return on investment in the real economy, the money supply and inflation will become lower and lower, and eventually deflation will become out of control

Analytical Framework for Interest Rates

• Long run: balance between savings and investment (determined by the structure of the economy)
• Mid-term: The financing demand of the real economy is strong or weak (determined by the strength of economic growth)
• Short-term: the central bank's monetary policy (determined by the monetary policy thinking) and the state of the monetary policy transmission path (determined by the state of the financial market)

long

The logic is: China's excavator output reflects China's investment cycle, and the increase in excavator output indicates increased investment, large capital demand, and rising interest rates;

mid term

short term

Monetary Policy: Conventional and Unconventional

Conventional Monetary Policy: Interest Rate Corridors

Since the ultimate goal of the Federal Reserve's monetary policy is to maintain stable inflation and promote full employment, the Federal Reserve responds to changes in inflation and output when regulating the federal funds rate. John Taylor, who proposed the Taylor criterion, after studying the behavior of the Federal Reserve to regulate interest rates, proposed that the behavior of the Federal Reserve to regulate the federal funds rate can be summarized by the following simple equation R t = 0.03 + 1.5 π t + 0.5 ( y ~ t −
$$R_t=0.03+1.5{p.m}_t+0.5({\tilde{y}}_t-{\tilde{y}}_n)$$
${\tilde{y}}_t-{\tilde{y}}_n$Expressed as the output gap, the nominal interest rate must change in the same direction as the inflation rate, and also change in the same direction as the output gap; such a rule is called the Taylor rule ;

Using the data of the United States from 1958 to 2007, it is estimated that the following Taylor rule estimation equation
$$R_t=0.82+1.16\ast CPI+0.53\ast OutputGap$$

Bernanke's Roadmap to Unconventional Monetary Policy

• When traditional monetary policy regulation fails to work (often when the economy falls into sluggish aggregate demand and high deflationary pressure), monetary policy can enter the unconventional field according to the roadmap given by Bernanke
  • In the first step, the central bank's short-term interest rate is reduced to zero
  • In the second step, the central bank buys long-term government bonds and lowers long-term interest rates
  • In the third step, the central bank buys risky assets and compresses the risk premium
  • The fourth supplement, the central bank monetizes the fiscal deficit (Bernanke's "helicopter money")
• The essence of Bernanke's roadmap is that the central bank continues to skip the blocked monetary policy transmission path, and the monetary policy operation will act more directly on the real economy

After the subprime mortgage crisis, the fact that the transmission of monetary policy in the United States was blocked:

Japan's real estate bubble led to a decline in the growth rate of Japan's domestic credit expansion, which hindered the transmission of monetary policy and the unconventional monetary policy of Abenomics

If Japan’s lost 20 years are explained as population aging, then the phenomenon of “Abenomics” stimulating Japan’s economy is hard to explain. Economists who believe in or take advantage of population aging are irresponsible Economists believe in fatalism in a disguised form of population aging, so there is no need to study the economy; in fact, the economic growth brought about by Abenomics obviously cannot be justified by population aging, and it is more reasonable to use unconventional monetary policies Some are more in line with economic logic;