Central Banks Macro Adjustments

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Central Banks, macroeconomic adjustments.

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Central Banks Macro Adjustments

  1. 1. Central BanksMacro - Adjustment Strategies
  2. 2. Central Banks & ExchangeRate Regimes Flexible Fixed Managed Floating
  3. 3. Flexible Exchange Rate Exchange rates are freely determined by the demand & supply of currencies.
  4. 4. Increase in Demand for £Under Flexible Exchange Rate e$/£ S£ e’ e D£’ D£ Q£
  5. 5. Fixed Exchange Rate Gold standard (up to 1914)  Peg currency to gold at a mint parity. ($20.67/ounce of gold, £4.25/ounce of gold).
  6. 6. Fixed Exchange Rate Gold standard Pegged rate system  Peg is the central value of exchange rate around which the government maintains narrow limits. (Haitian Gourde = $.20 since 1907 for a long period of time).  Government intervenes in foreign exchange markets to maintain the exchange rate within prescribed limits.
  7. 7. Increase in Demand for £Under Pegged Rate System e$/£ S£ S£’ ē D£’ D£ Q£
  8. 8. Fixed Exchange Rate Devaluation  Peg is increased. • £ was devalued in Nov. 1967 from $2.80/£ to $2.40/£ . Revaluation  Peg is decreased.
  9. 9. Managed Floating Government intervenes in the foreign exchange market to influence the exchange rate, but does not commit itself to maintain a certain fixed rate or some narrow limits around it.
  10. 10. Goods Market Equations Y = C + I + G0 + NX (Equim condition) C = C0 + cYd (Consn function) Yd = Y – T + R0 (Disposable income) T = T0 + tY (Tax function) I = I0 – br (Investment function)
  11. 11. Goods Market Equations Endogenous Variables Parameters Y: National Income  c: MPC C: Consumption  t: Personal Tax Rate Yd: Disposable Income  b: Interest Sensitivity of I T : Personal Tax Revenue  C0 : Exogenous Component of C I : Investment  I0 : Exogenous Component of I  G0 : Government Expenditure  R0 : Transfer Payments  T0 : Fixed personal tax revenue
  12. 12. Goods Market Equilibrium:IS Curve (General form) Goods market equilibrium condition: AS = AD Sn – I = NX - A0 + br + sY = NX0 – mY r = (A0 + NX0)/b – (s + m)/b*Y = (A0 + NX0)/b – 1/αb*Y whereA0 = C0 + c(R0 – T0) + I0 + G0NX0 = X0 – Q0 + (g + j)eP*/Pα = 1/[1 – c(1 – t) + m]
  13. 13. Goods Market Equilibrium:IS Curve (Particular form) r=A0 =Open economy multiplier 1/(s+m) =
  14. 14. IS Curve r[A0 + NX0/b I -1/ b S Y
  15. 15. Assets Markets Markets in which money, bonds, stocks, real estate & other forms of wealth or stores of value are exchanged. We consider two types of assets  domestic bonds  domestic money
  16. 16. Total Real Wealth in the Economy Supply of real wealth  W/P = M/P + VS where W : Nominal wealth P : General price level VS: Stock of bonds Demand for real wealth  W/P = L + V L: Demand for money V: Demand for bonds In equilibrium  L + V = M/P + VS  Or (L - M/P) + (V - VS) = 0
  17. 17. Walras law As long as money market is in equilibrium (i.e. L = M/P), bond market will also be in equilibrium.
  18. 18. Money Market EquationsL = M/P (Money market equim condition) L = L0 + kY – hr (Money demand) M = uH (Money supply) H = IR + CBC0 (High Powered Money) IR = IR-1 + BP-1 (Int. Reserves adjustment)
  19. 19. Money Market Equations Endogenous Variables Exogenous Variables L: Liquidity Demand  k: Income Sensitivity of L r: Real interest Rate  h: Interest Sensitivity of L M: Nominal Money Supply  u: Money Multiplier H: High-Powered Money  L0: Exogenous component of L IR: International Reserves P: General Price Level CBC0: Central Bank Credit
  20. 20. Demand for Money The demand for money can be linearized to: L = L0 + kY – hr
  21. 21. Supply of Money MS = Cp + CD Cp: Currency (coin, dollar notes) in the hand of the public CD: Checkable deposits M = H where  : the money multiplier  H: the high powered money (monetary base)
  22. 22. Central Bank’s Balance Sheet Assets = IR + CBC Liabilities = Cp + RE IR + CBC = Cp + RE = H H is created when the Central Bank acquires assets in the form of international reserves, IR (foreign exchange & gold), & Central Bank credit, CBC (loans, discounts & government bonds).
  23. 23. Simplified Central Bank Balance Sheet Assets ClaimsInternational Reserves $100b Currency $240 bCentral Bank Credit $200b Cash in vaults $20 b Currency in the hand of the public $220b Deposits at the central bank $60 bHigh Powered Money $300b High Powered Money $300 b
  24. 24. Effects of Open Market Purchaseon Central Bank’s Balance Sheet Central bank purchase of securities (increase in CBC). Central bank check is deposited in the commercial bank. If the commercial bank decides to convert the check into cash, the currency in vault (RE) increases. If commercial bank deposit the check at the central bank, commercial bank deposit (RE) increases.
  25. 25. Effects of a Drain of International Reserves on Central Bank’s Balance Sheet IR decreases & Commercial bank deposit decreases. A BP deficit (surplus) decreases (increases) H &, therefore, tends to decrease (increase) MS.
  26. 26. Money Market Equilibrium:The LM Curve MS/P = L0 + kY – hr r = (L0 - MS/P)/h + k/h Y Particular:r=
  27. 27. LM Curve r M L k/h Y[L0-MS/p]/h
  28. 28. Immediate-run Equilibrium Immediate-run equilibrium is obtained when both the product & the money markets are in simultaneous equilibrium.  It occurs for a given level of fixed MS.
  29. 29. Immediate-run Equilibrium r M I rE L S Y YE
  30. 30. Foreign Trade Equations BP = 0 (Foreign sector equim condition) BP = NX + CF (Balance of Payments) NX = X – Q (Net Export function) X = X0 + gePW/P (Export function) Q = Q0 + mY – jePW/P (Import function) e = e-1 – qBP (Exchange Rate adjustment) CF = f(r – rW) (Capital Flow equation)
  31. 31. Foreign Trade Equations Endogenous Variables Exogenous Variables NX : Net Exports (Trade Surplus)  g : Exchange Rate Sensitivity of X X : Value of Exports Q : Value of Imports  m : Marginal Propensity to Imp. BP : Balance of Payments  j : Exch. Rate Sensitivity of Q Surplus  f : Capital Mobility Coefficient CF : Capital Flow (KAB Surplus) e : Exchange Rate  q : Exchange Rate Coefficient (Domestic/Foreign Currency)  rW : World Interest Rate  X0 : Exogenous Component of X  Q0 : Exogenous Component of Q
  32. 32. Foreign Trade Sector Equilibrium:The BP Curve BP = 0 => NX + f (r – rW) = 0 With no capital mobility (f = 0)  NX = NX0 - mY = 0  Y = NX0/m With perfect capital mobility  r = rW With imperfect capital mobility NX0 – mY + f (r – rW) = 0 => r = [rW - NX0/f] + m/f * Y
  33. 33. BP with No Capital Mobility Y = NX0/m In particular form: Y=
  34. 34. BP Curve withNo Capital Mobility r BP Y NX0/m
  35. 35. BP Curve withPerfect Capital Mobility rr = rW BP Y
  36. 36. BP Curve withImperfect Capital Mobility r BP Y
  37. 37. Short-run Equilibrium An immediate-run equilibrium sustaining a BP deficit & losses of international reserves leads to a decline in MS & a leftward shift of the LM curve. A short-run equilibrium exists when all the three markets are in equilibrium.
  38. 38. Short-run Equilibrium withNo Capital Mobility r BP M I rE L S Y YE
  39. 39. Short-run Equilibrium withPerfect Capital Mobility r M I rE BP L S Y YE
  40. 40. Short-run Equilibrium withImperfect Capital Mobility r M I BP rE L S YE Y
  41. 41. Sterilization OperationsOperations carried out by the Central Bank in order to neutralize the effects that its intervention in foreign exchange markets has on H. H = IR + CBC = 0 or CBC = - IR

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