Unlike my previous post, the main concern of this article is to present and explain some theoretical macroeconomics concepts. Today, monetary policy is more than ever under scrutiny. Indeed, most Western societies have relied heavily on conventional and unconventional monetary policies since the 2008 financial crisis to counter economic recession. By unconventional monetary policies, we mean zero interest rate policy (ZIRP) and Quantitative Easing (QE, the central banks’ purchase of government securities or other securities from the market in order to lower interest rates and increase the money supply). These policies that are not used under normal course of economic cycles but rather under extreme case of liquidity crisis, confidence collapse, low growth and/or deflation risks.

In the meantime, fiscal policy promoted by government are as important as monetary policy. Combined together, they become a policy-mix. Macroeconomics understanding is necessary to assess Central banks monetary policy and their impact on growth. Before explaining monetary policy we will introduce some basic macroeconomics concepts in order to understand monetary policy implications.

In an open economy output can be defined as follow:

Y = C + I + G + (X – M)

Where  Y=output (ie: GDP), C = consumption, I = investment, G = government expenditure, X = exportation and M = importation.

Note: In a close economy (X-M) does not exist, as there are no trading partners. 

The IS/LM model

The Saving–Liquidity Preference Money Supply model (IS-LM model) explain the relationship between interest rate and output in the goods market. An advanced version of IS/LM is Aggregate demand–Aggregate supply (AS/AD) model. It represents the aggregate supply and demand of financial, labor and goods markets. Here we will just stick to the commonly known IS/LM model to show the basic mechanism:

  • It shows the relationship between output or economic growth (Y) and interest rate (i)
  • This relationship takes place in the goods and services market, money market & financial market

 

islmgraphNote: In reality, the curves might be flatted or steepened according to the characteristics defining each country.

 How to interpret these two curves?

  •  IS curve (Investment and Saving)

Since interest rate represents the cost of borrowing money, as the cost of money goes down, the output goes up. In other words, households, governments and corporations take advantage of cheaper money to fund expansion. Therefore, IS is a downward sloping curve.

  • LM curve (Liquidity preference Money supply)

As output grows, interest rates rise. Intuitively, when output grows, demand for liquidity increase (e.g loans increases) which raises interest rates. Therefore, LM is an upward sloping curve.

  • The intersection between the two lines thus represents the equilibrium between interest rates and output.

What factors can influence IS-LM curve?

Monetary policy refers to the actions of a central bank that determine the quantity and price (interest rate) of money supply.

Fiscal policy refers to government revenue (Tax) and expenditure (G).

 

recap rmReserve ratio (RR) is a share of depositors’ balance (%) that banks must hold in cash. The central bank determines the RR ratio.

Simplified version

The table below shows that IS-LM can either shift leftward or rightward:

recap

Shifts to the right imply higher output while shifts to the left implies a lower one.

 Monetary policy tools

monetary policy tool

Discount rate: The interest rate charged to commercial banks and other depository institutions for loans received from the central bank.

omos

repo

Generally speaking Open Market Operations (OMOs) are either used to help economy to recover or prevent it from overheating. For example, repurchase agreement is widely used by the People’s Bank of China (PBoC) to sterilize newly issued RMB. Since 1990s, China has had to sterilize new RMB issued in order to avoid inflation.

This is to say that when China receives capital inflows, the PBoC has to create the same amount of value of RMB in order to prevent its currency appreciation. As issuing new RMB could increase inflation, sterilizing (=withdrawing new liquidity issued) enables PBoC to prevent both inflation and RMB appreciation.

Notice that since China has capital controls, Chinese wealth is restricted from going abroad. This implies that if sending money abroad was possible in China, the PBoC would not need to sterilize as much money to contain inflation. In this case, money could freely go abroad releasing pressure on the RMB.

Finally, since the RMB is pegged to USD (fixed exchange rate), when the Fed decides to depreciate the USD in order to help exportation it means that China has also to depreciate the RMB in order to keep the peg. In turn, this would create inflation. The tradeoff is simple: either let the currency to appreciate against the USD or face inflation.

Conclusion

By using different tools the impact of Central Bank monetary policy remains the same: adjust amount (quantity-based tool) and cost (price-based tool) of money supply. Western central banks use price-based tool while the PBoC is progressively converging toward this tool too because it is the more effective way to cope with an economic cycles and economic shocks. Moreover, China’s commitment to liberalize interest rate is consistent with price-based tool.

In the short term, either IS, LM or both will move and therefore change output and interest rate. Also, the nature of exchange rate (fixed or floating or between the two) also significantly influence interest rate level. However, over the long term, adjustments of these curves puts output back to its original level. The bottom line is that monetary policy can influence output or short-run but on the long run, output goes back to its natural level (structural level of GDP and growth potential).

Therefore monetary policy can not replace economic fundamentals over the long term. Moreover, as Japan experienced since the early 1990’s and the Western world since 2008, cheap and available credit for commercial banks does not necessarily translate to more money lent to household and/or corporations. In this configuration, growth cannot really pick up and cannot be sustain by itself. Monetary policy have limits and requirements in order to be fully effective.

Expansionary policy is useful to offset conjectural downturns but not structural ones. If a central bank tries to resolve structural economic downturn by expansionary monetary policy, there exists a high risk of ‘liquidity trap’. According to the Keynesian view, a liquidity trap is characterized by short-term nominal interest rate equal to zero. No one is willing to lend 100 dollars unless he/she gets at least 100 dollars back. Liquidity traps can be managed in theory by affecting of future interest rate or by future price level. According to some empirical studies, the last one seems to be more efficient.

Finally, although monetary policy has to adjust with economic cycles, ultra expansionary monetary policy such as the one conducted since 2008 in the US seems to be very risky, at least if we consider the limited gains associated with growing risks. The way the US Federal Reserves manages its monetary policy is an issue is of major importance for the rest of the world, and is therefore under heavy scrutiny.

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.