FINN2071 Intermediate Financial Economics

Week 8: Monetary Policy II

Dr Haifeng Guo
 Structure

• Monetary policy and exchange rate

• Monetary policy and inflation

• Monetary policy and stock price

 Balance of Payments
The Balance of Payments (BP) is a systematic record of all
economic transactions between residents of a country and the
rest of the world during a specific period, typically a quarter or a
year. It reflects the financial flows and provides a snapshot of a
country's economic relations with other countries.
 FE (BP) Curve
• The FE(BP) 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
 Open Economy IS Curve Derivation
GDP: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
Before, when we assumed NX = 0:
𝑌 = 𝑎 + 𝑏 1 − 𝑡 𝑌 + 𝑒 − 𝑑𝑟 + 𝐺 + 0
Now:
𝑌 = 𝑎 + 𝑏 1 − 𝑡 𝑌 + 𝑒 − 𝑑𝑟 + 𝐺
+𝑥1 𝑌 𝑤 + 𝑥2 𝐸 − (𝑚1 𝑌 − 𝑚2 𝐸)
Rearranging:
𝑎 + 𝑒 + 𝐺 + 𝑥1 𝑌 𝑤 + 𝑥2 + 𝑚2 𝐸
𝑟=
𝑑
1 − 𝑏 1 − 𝑡 + 𝑚1
− 𝑌
𝑑
 IS-LM-FE Curve

• Recall also our definition for the LM curve:

𝑘 1 𝑀𝑠
𝑟= 𝑌−
ℎ ℎ 𝑃
• Finally, we need out definition for the FE curve:
𝑤
𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
𝑟= 𝑟 − 𝑌 − 𝐸 + 𝑌
κ κ κ
 IS-LM-FE Curve Diagram
r 1−𝑏 1−𝑡 +𝑚1
𝑌𝑤
𝑎 + 𝑒 + 𝐺 + 𝑥1 SlopeIS = −
𝑑
+ 𝑥2 + 𝑚2 𝐸 LM
𝑘
𝑑 SlopeLM =
ℎ

FE
𝑚1
SlopeFE =
re κ
𝑥1
𝑟𝑤 − 𝑌𝑤
κ
𝑚2 + 𝑥2
− 𝐸 IS
κ
0 Y
Ye
1 𝑀𝑠
−
ℎ 𝑃
 Fixed Exchange Rates Monetary
Policy Shock IS-LM-FE Curve Diagram
𝑎+𝑒+𝐺+𝑥1 𝑌 𝑤 + 𝑥2 +𝑚2 𝐸 1−𝑏 1−𝑡 +𝑚1
IS: 𝑟 = − 𝑌
r 𝑑 𝑑

LM1 = LM3
𝑘 1 𝑀𝑠
𝐿𝑀: 𝑟 = 𝑌−
LM2 ℎ ℎ 𝑃

FE

r1=rr31 𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
𝐹𝐸: 𝑟 = 𝑟 𝑤 − 𝑌 − 𝐸 + 𝑌
r2 κ κ κ

IS
0 Y
Y1 Y2
=Y3
 Floating Exchange Rates Monetary
Policy Shock IS-LM-FE Curve Diagram
𝑎+𝑒+𝐺+𝑥1 𝑌 𝑤 + 𝑥2 +𝑚2 𝐸 1−𝑏 1−𝑡 +𝑚1
IS: 𝑟 = − 𝑌
r 𝑑 𝑑

LM1
𝑘 1 𝑀𝑠
𝐿𝑀: 𝑟 = 𝑌−
LM2 ℎ ℎ 𝑃

FE1
FE2
r1
𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
r3 𝐹𝐸: 𝑟 = 𝑟𝑤 − 𝑌 − 𝐸 + 𝑌
r2 κ κ κ

IS2
IS1
0 Y
Y1 Y2 Y3
 Fixed Exchange Rates
Fiscal Policy Shock IS-LM-FE Curve Diagram
𝑎+𝑒+𝐺+𝑥1 𝑌 𝑤 + 𝑥2 +𝑚2 𝐸 1−𝑏 1−𝑡 +𝑚1
IS: 𝑟 = − 𝑌
r 𝑑 𝑑

LM1
𝑘 1 𝑀𝑠
LM2 𝐿𝑀: 𝑟 = 𝑌−
ℎ ℎ 𝑃

FE
r2
r3
r1 𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
𝑤
𝐹𝐸: 𝑟 = 𝑟 − 𝑌 − 𝐸 + 𝑌
κ κ κ

IS2
IS1
0 Y
Y1 Y2 Y3
 Floating Exchange Rates
Fiscal Policy Shock IS-LM-FE Curve Diagram
𝑎+𝑒+𝐺+𝑥1 𝑌 𝑤 + 𝑥2 +𝑚2 𝐸 1−𝑏 1−𝑡 +𝑚1
IS: 𝑟 = − 𝑌
r 𝑑 𝑑

LM
𝑘 1 𝑀𝑠
𝐿𝑀: 𝑟 = 𝑌 −
ℎ ℎ 𝑃
FE2
r2
r3 FE1

r1 𝑥1 𝑤 𝑚2 + 𝑥2 𝑚1
𝐹𝐸: 𝑟 = 𝑟 𝑤 − 𝑌 − 𝐸 + 𝑌
κ κ κ

IS2
IS1 IS3
0 Y
Y1 Y3 Y2
 Fixed and Floating Exchange Rates:
Fiscal and Monetary Shock Summary

Fiscal Policy Monetary Policy

r Y r Y
Fixed Exchange
Smaller Impact Larger Impact No Impact No Impact
Rates
Floating Exchange
Smaller Impact Smaller Impact Smaller Impact Larger Impact
Rates
 Inflation
Inflation refers to the rate at which the general level of prices for
goods and services rises over a period of time, leading to a
decrease in the purchasing power of money.

𝑃𝑡 − 𝑃𝑡−1
𝜋𝑡 =
𝑃𝑡−1

𝑒
𝑒
𝑃𝑡 − 𝑃𝑡−1
𝜋𝑡 =
𝑃𝑡−1
 Inflation and the Phillips curve
If inflation varies around a fixed level, it makes sense to set
expectations of inflation equal to this level:

𝜋𝑡𝑒 = 𝜋ത

𝜋𝑡 = 𝜋ത − 𝛼(𝑢𝑡 −𝑢𝑛 )

As unemployment 𝑢𝑡 deviates from its natural rate 𝑢𝑛 , inflation

responds inversely.
Monetary Policy and Inflation: AD-AS-LRAS
Diagram
𝑌
𝑃 AS: 𝑃 = (1 + μ)𝑃𝑒 𝑓 1 − 𝐴𝐿 , 𝑧
𝑀𝑠 𝑑
AD: 𝑃 =
LRAS 𝑌 1−𝑏 1−𝑡 ℎ+𝑘𝑑 − 𝑎+𝑒+𝐺 ℎ
𝑌 1
AS2 LRAS: 𝑓 1 − 𝐴𝐿𝑛 , 𝑧 = (1+μ)

AS1

𝑃𝑒3
𝑃𝑒2

𝑃𝑒1 AD2

AD1

0 𝑌𝑛 = 𝑌𝑒1 𝑌𝑒2 𝑌
= 𝑌𝑒3
Monetary Policy and Inflation: Taylor Rule
▪ Taylor (1993) Suggested an interest rate rule – Taylor rule.

▪ In 1993 “Discretion versus policy rules in practice” paper.

▪ The rule indicates that the federal (fed) funds rate should
be set equal to the inflation rate plus an “equilibrium” real
fed funds rate plus a weighted average of an inflation gap
and an output gap.

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 Taylor Rule

𝑟𝑡 = 𝑟 ∗ + 𝜋𝑡 + 𝜙𝜋 (𝜋𝑡 − 𝜋 𝑇𝑎𝑟𝑔𝑒𝑡 ) + 𝜙𝜋 𝑦𝑡
• where:
• 𝑟𝑡 = Nominal interest rate
• 𝑟 ∗ = Neutral real interest rate
• 𝜋𝑡 = Current inflation rate.
• 𝜋 𝑇𝑎𝑟𝑔𝑒𝑡 = Target inflation rate set by the central bank.
• 𝑦𝑡 = Output gap, calculated as 100*(𝑌𝑡 − 𝑌 ∗ )/ 𝑌 ∗ , where 𝑌𝑡 is actual
output and 𝑌 ∗ is potential output.
 Taylor Rule : Simplified

𝑟𝑡 = 2 + 𝜋𝑡 + 0.5 𝜋𝑡 − 2 + 0.5𝑦𝑡

real Fed funds rate

inflation
(neutral rate of
target
interest)

• where:
• 𝑟𝑡 = Nominal federal funds rate
• 𝜋𝑡 = Inflation rate over the previous four quarters
• 𝑦𝑡 = Output gap

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 Taylor Rule : Simplified
𝑟𝑡 = 2 + 𝜋𝑡 + 0.5 𝜋𝑡 − 2 + 0.5𝑦𝑡

Fed funds rate (𝑟) was expected to be 4% when:

▪ both Inflation and output were on target (2% and 2.2% respectively)

𝑟𝑡 = 2 + 2 + 0.5 2 − 2 + 0.5 0 = 4
 Monetary Policy and Stock Price
Because cov(m,x)=E(mx)-E(m)E(x) and 1 = E(mR) , we can write p=E(mx) as:

p = E(m)E(x) + cov(m, x)

p = E(x) / R f + cov(m, x)
cov u(ct +1 ), xt+1 
p = E(x) / R f +
u(ct )

Alternatively, think about the Dividend Discount Model:

𝐷
𝑃𝑡 =
𝑟−𝑔
 Monetary Policy Transmissions
Interest Rate Channel: Monetary policy primarily influences stock price
through changes in interest rate. When central banks adjust policy rate, it
alters the discount rate used to value future cash flows.

Expansionary (contractionary) monetary policy reduces (increases) interest

rate and then increases (decreases) stock price
 Monetary Policy Transmissions
Bank lending Channel (lender): Monetary policy impacts the supply of loans provided
by banks, influencing borrowers who depend on external financing.

Balance Sheet Channel (borrower): Monetary policy affects firms' net worth and
creditworthiness, thereby influencing the demand for and cost of credit.

Bank lending Channel

Credit Channel ቊ
Balance Sheet Channel
 Monetary Policy Transmissions
Risk Premium Channel: Monetary policy affects investors' risk
appetite and the equity risk premium, which in turn affects stock
prices.

During periods of expansionary monetary policy, reduced

uncertainty and better economic outlook lower the risk
premium, boosting stock price. Conversely, tight monetary policy
increases risk aversion, raising the equity risk premium and
reducing stock prices.
 Information Effect
Central bank actions convey information about the central bank’s assessment of the
economy. This effect can influence expectations and behavior in financial markets and the
real economy.

Suppose the Federal Reserve unexpectedly cuts interest rates. Investors might interpret
this as a sign that the Fed sees significant downside risks to the economy (negative
information effect). In this case, expansionary monetary policy will result in a decrease in
stock price.

Nakamura, E., & Steinsson, J. (2018). High-Frequency Identification of Monetary Non-Neutrality: the information Effect.
The Quarterly Journal of Economics, 133(3), 1283–1330.
 Monetary Policy Shocks
According to the EMH, financial markets are "informationally
efficient." Asset prices reflect all available information.

“Market is unlikely to respond to policy actions that were already

anticipated”(Bernanke and Kutter, 2005).

It is essential to distinguish between expected and unexpected

policy actions when investigating their impacts.
Thank you