THE MACROECONOMICS OF BANKING Kent Matthews Three Topics

THE MACROECONOMICS OF BANKING Kent Matthews

Three Topics to Discuss • examines the role of the central bank in the macroeconomy • examines the implications of financial innovation and the existence of a developed banking system for the efficacy of monetary policy • examines the implications of the banking system for the transmission mechanism

The Role of The Central Bank • Monetary Policy: controls the supply of base money: central banks can alter the required reserve ratio to control bank lending and, thereby, the money supply

WHAT TYPE OF CENTRAL BANK? • Should the goals of the central bank be the stabilization of inflation at a low rate • or should it also try to stabilize the economy by aiming to keep real GDP as close as possible to capacity

Monetary Policy Preferences • Let inflation be denoted as π and the GDP gap as x, where x is defined as the log of real GDP less the log of potential GDP. • Rogof (1985) assumes that there is a wedge between the equilibrium x = 0 and x the target • A loss function of the following type describes the government and society’s preferences

Central Bank Preference π x

Monetary Policy Preferences (Model) • The second term shows that loss (L) increases as the output gap increases over its target; i. e. , b > 0. In a similar way L increases as inflation increases. Note the fact that it is 2 which enters the loss function, thus implying that deflation also imposes a loss in the same way as inflation does.

Loss Function

Government Preference • The government is willing to tolerate more inflation if output increases but, because inflation is ‘bad’, output has to increase at an increasing rate for an indifference to be established.

Philips Curve • Let the actual trade of between inflation and output be described by the following simple, linear, rational expectation ‘Phillips curve’, which specifies inflation as a function of the output gap (excess demand) and expected inflation: What if the model developed from NAIRU perspective?

FINANCIAL INNOVATION AND MONETARY POLICY • How does financial innovation alter the link between money and income and, therefore, weaken the effectiveness of monetary policy • Goodhart (1984) identified one of the major structural changes in the developed economies’ banking system was the switch from asset management to liability management

Demand for Money • Where M is the stock of money, P is the price level, y is real income and Rb is the rate of interest on short-term bonds. With the development of interest-bearing sight deposits, the demand for money function looks like

Demand for Money • The substitution between money and nonmoney liquid assets will depend on the margin between the interest on nonmoney liquid assets and deposits. When interest rates rise, in general, banks will also raise interest rates on deposits; consequently, the rate of interest on liquid assets will have to rise even more to generate a unit substitution from money to nonmoney liquid assets.

Demand for Money • The implication for monetary policy is twofold. First, the slope of the LM schedule is steeper with respect to the rate of interest Rb. Second, the established relationship between income and money is altered. Control of the money supply becomes increasingly difficult for the central bank if banks compete with the government for savings, so that banks will raise interest rates on deposits in response to a general rise in interest rates caused by a rise in the central bank rate of interest.

Response to Shocks

Response to Shocks • The reduction in the response of the demand for money to a change in the rate of interest on nonmoney liquid assets can be thought of as a fall in the interest elasticity of demand for money. We can illustrate the argument that a financial-innovation-induced fall in the interest elasticity of demand for money alters the relationship between money and income by using the results of Poole (1970), who first showed that an economy that is dominated by IS shocks should target the money supply and an economy dominated by monetary shocks should target the rate of interest.