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Chapter 3 Economic Order Quantity

Defining the economic order quantity

Background to the model
The approach is to build a model of an idealized inventory system and calculate the fixed order quantity that minimizes total costs. This optimal order size is called the economic order quantity (EOQ).

Assumption for a basic model
• The demand is known exactly, is continuous and is constant over time. • All costs are known exactly and do not vary. • No shortages are allowed. • Lead time is zero – so a delivery is made as soon as the order is placed.

Other assumptions implicitly in the model
• We can consider a single item in isolation, so we cannot save money by substituting other items or grouping several items into a single order. • Purchase price and reorder costs do not vary with the quantity ordered. • A single delivery is made for each order. • Replenishment is instantaneous, so that all of an order arrives in stock at the same time and can be used immediately.

• The most important assumption here is that demand is known exactly, is continuous and constant over time (Fig. 3.2) • The assumptions give an idealized pattern for a stock level. (Fig. 3.3)

Variables used in the analysis
• 1. 2. 3. 4. Four costs of inventory Unit cost (UC) Reorder cost (RC) Holding cost (HC) Shortage cost (SC)

Three other variables:
• Order quantity (Q) • Cycle time (T) • Demand (D)

Derivation of the economic order quantity
• Three steps: 1. Find the total cost of one stock cycle. 2. Divided this total cost by the cycle length to get a cost per unit time. 3. Minimize this cost per unit time.

• Amount entering stock in cycle = amount leaving stock in cycle So Q=DxT Total cost per cycle = unit cost + reorder cost + holding cost (component)

The optimal time between orders is: To = Qo/D =500/6,000 = 0.083 years = 1 month The associate variable cost is: VCo = HC × Qo = 6 × 500 = \$3,000 a year This gives a total cost of: TCo = UC × D + VCo = 30 × 60000 + 3000 = \$183,000 a year

Summary
• We have built a model of an idealized inventory system that relates order size to costs and demand. This shows that large, infrequent orders have a high holding cost component, so the total cost is high: small, frequent orders have a high reorder cost component, so the total cost is also high. A compromise finds the optimal order size – or economic order quantity – that minimizes inventory costs.

• Moving away from the EOQ The EOQ suggests fractional value for things which come in discrete units (e.g. an order for 2.7 lorries) Suppliers are unwilling to split standard package sizes. Deliveries are made by vehicles with fixed capacities. It is simply more convenient to round order sizes to a convenient number.

• • •

How much costs would rise if we do not use the EOQ
Example: D = 6000 units a year Unit cost, UC = £30 a unit Reorder cost, RC = £125 an order Holding cost, HC = £7 a unit a year

Order for discrete items
This suggests a procedure for checking whether it is better to round up or round down discrete order quantities:

1. Calculate the EOQ, Qo. 2. Find the integers Q’ and Q’-1 that surround Qo. 3. If Q’×(Q’-1) is less than or equal to Qo2, order Q’. 4. If Q’×(Q’-1) is greater than Qo2, order Q’-1.

Uncertainty in demand and costs
Error in parameters • Few organizations know exactly what demand they have to meet in the future. • The variable cost is stable around the EOQ and small errors and approximations generally make little difference.

Qo 
or

2  RC  D HC

Qo  HC RC  2 D
2

2  RC  D Q K HC
or

Q

2  RC  D HC  K

• Time for order preparation • Time to get the order to the right place in suppliers • Time at the supplier • Time to get materials delivered from suppliers • Time to process the delivery

Reorder level
The amount of stock needed to cover the lead time is also constant at: Lead time × demand per unit time
Reorder level = lead time demand = lead time × demand per unit time ROL = LT × D

(b) Substituting value LT = 2 and D = 100, gives ROL = LT × D = 2 × 100 = 200 units As soon as the stock level declines to 200 units, Carl should place an order for 250 units.

The cycle length is: T = Q/D = 250/100 = 2.5 weeks What happens when the lead time is increased to 3 weeks ? ROL = LT × D = 3 × 100 = 300

Stock on hand + stock on order = LT × D =300 units
Reorder level = lead time demand – stock on order

n × T < LT < (n+1) × T Reorder level = lead time demand – stock on order ROL = LT × D – n × Qo

Some practical points
• This chapter has shown when to place an order – set by the reorder level. • How much to order – set by the economic order quantity. • A two-bin system gives a simple procedure for controlling stock without computers or continuous monitoring of stock levels.

Three-bin system
• The two-bin system can be extended to a three-bin system which allows for some uncertainty. • The third bin holds a reserve that is only used in an emergency. • The normal stock is used from bin A.

• Our calculations assume that the lead time is known exactly and constant. • In practice, there can be quite wide variation, allowing for availability, supplier reliability, checks on deliveries, transport conditions, customs clearance, delays in administration, and so on.

• Some stock levels are not recorded continuously but are checked periodically, perhaps at the end of the week. • Then an unexpectedly large demand might reduce stocks well below the reorder level before they are checked.

• Another problem appears with large stocks, such as chemical tanks, coal tips or raw materials, where the stock level is only known approximately. Then the reorder level might be passed without anyone noticing.

• We have assumed that the order size is independent of the lead time and the reorder level. • In practice, people often prefer larger orders if there are longer lead times, and they raise the reorder level to add an element of safety. • The reorder level can be also influence the order size, with people typically placing smaller orders with higher reorder levels.

mparison of CBS and Typical Central Bank System Maintains a fixed exchange rate with the Maintains a pegged or floating exchange anchor currency rate Holds foreign reserves of at least 100% of Holds foreign reserves not based on any base money or currency in circulation rules Has full convertibility of its currency Has convertibility or forex control dependent on policy decision Cannot pursue an independent monetary Can pursue discretionary monetary policy policy Cannot freely perform lender of last resort Can fulfil a lender of last resort role for the banking sector or the government

• + monetary autonomy if no exchange rate target (isolation from external influences) • + full capacity as lender of last resort (LLR) • + max. seigniorage • + no international reserve requirement • - overissue/credibility • - exchange rate volatility • - large regulatory expenses • + restoration or establishment of confidence with convertibility assurance • + capturing a certain level of seigniorage • + exchange rate stability if credible • - loss of monetary autonomy and LLR capacity • - exchange rate rigidity • - large reserve requirement

The Case of Patacas
• One currency for many countries Vs many currencies for one country. • Pataca, escudo and renminbi. • Creation of pataca on 27 January, 1906. • Exchange status of pataca: nominally pegged to escudo before 1977; linked to HKD since 1977
– realignments in 1949 and 1967 – attempts to set the pataca at par with the HKD in 1978 and 1983

• The survival of MOP
– realization of the local authority and Macau’s separate entity – “two currencies with different names are essentially unified with a fixed rate of exchange between them” – seigniorage

3.2 Monetary Base and Bank Money
• 3 components of money (M): (i) currency issues, (ii) bank reserves with central bank and, (iii) deposits. • Monetary base (MB)=(i)+(ii). • Bank money (D) = (iii), created by the action of depositing cash into bank and credit expansion under a fractional reserve system • MB↑ multiple expansion of M or D.

3.4 Theory of Money Multiplier
• Simple money multiplier=1/d. • In Macau, d=1-3%. • Does the public hold cash? Do banks hold excess reserve?  money multiplier = (1+c)/(d+e+c). • Δm or/and MBM. • Stable m enable central bank to control M. • Could the central bank control m?

4.1 Definition of Interest Rates
• Interest - amount of money that lenders receive when they extend credit. • Interest rate - ratio of interest to the amount lent. • Measurement - yield to maturity; difference between present and future values. • Functions - allocation of resources; determinant of investment decisions.

4.2 Nominal Vs Real
• Nominal - rate of exchange for monetary unit today and future. • Real - rate of exchange for resource today and future. • Fisher equation: i = r +πe or r = i –πe. •πe a forward looking variable and unlikely to be directly measured. • Fisher effect
– r stable/determined by real factors such as productivity of capital and time preference –πe → i

• Empirical evidence.

4.3 Types of Interest Rates
• Prime rate/best lending rate for most creditworthy customers. • Deposit rate: not necessarily market-driven; MAB indicative rates for 7-day and saving deposits in Macau. • Interbank rate: MAIBOR (1M, 3M, 6M). • Bond rate: benchmark; Pb = R/i. • Policy rate: discount rate, interbank target rate (e.g. Fed funds target rate).

4.4. Determination a. Classical Economists
• i = price paid for the use of capital. • I = demand for capital and S = supply of capital  I(i) = S(i). • Demand for/supply of “waiting” (postponing consumption). • i determined by the market, not the authorities.

(b) Keynes
• i=reward of not-hoarding cash (parting with liquidity), rather than reward of notspending. • People hold cash/money or bonds. • M/P=L(y,i). • If M/P>L  buying bonds  Pb ↑  i↓. • Effect of y changes; effect of M changes and Friedman’s critic. • i ↓ i<mec  I↑ until i=mec.

(c) Loanable Funds Theorists
• A synthetic approach. • Supply - willingness to lend (purchase of financial claims); demand - borrowings (issue of financial claims). • Supply of loanable funds affected by Ms (exogenous), savings (+vely related to i), government budget surplus (exogenous), foreign lending and money hoarding (-vely related to i). • Demand for loanable funds determined by government, business, consumer and foreign borrowings. • Supply and demand  i.

4.5 Term Structure of Interest Rates
• Definition: Relation among interest rates on a particular financial instrument with different terms to maturity. • Question: Why do interest rates of an instrument with different terms to maturity vary?
6.6 6.4 6.2 6 5.8 5.6 5.4 1-M 3-M 6-M

MAIBOR (31/3/00)

(a) Expectations Hypothesis
• S-T interest rates vary over time. • Instruments of different maturities are prefect substitutes. • int = [it + E(it+1) +…..+ E(it+n-1)]/n. • Expecting rising S-T ratesupward sloping yield curve; expecting falling S-T rates inverted yield curve. • Implied future rate.

(b) Segmented Markets Theory
• Instruments of different maturities not substitutable. • Desired holding period  demand for instrument of matching maturity. • Different liability maturities  supply of instrument of matching maturity. • Separate markets, different SS/DD conditions (e.g. investment banks in S-T market, insurance companies in L-T market)  varied rates for different terms of maturity.

(c) Preferred Habitat Theory

• Expectations + premium reflecting supply and demand conditions. • Instruments with different terms of maturity are substitutes, but not prefect substitutes. • int = {[it + E(it+1) +…..+ E(it+n-1)]/n} + knt, where k (term premium) can be +ve or -ve.

• Similar to Preferred Habitat Theory, with k always of +ve sign due to increased market risk for longer term securities. • k a positive function of the term to maturity. • (c) and (d) most popular for interpreting yield curves and future interest rates. • Cases: (i) steeply rising yield curve? (ii) moderately steep yield curve? (iii) flat yield curve? (iv) inverted yield curve?

4.6 Risk Factor of Interest Rates
• Relation among interest rates with same term to maturity. • Default risk (unable to pay interest /face value): yield with default risk = benchmark yield + risk premium; risk premium determined by credit rating/supply of funds. • Liquidity risk (how widely the instrument being traded): risk premium=default+ liquidity. • Tax treatment: exemption  lower i.

Sovereign Ratings by Thomson BankWatch (Ranged from AAA to D), Sept. 2000 China Hong Kong Macau Taiwan Portugal Belgium Finland France Germany Netherlands Colombia India Indonesia Vietnam Pakistan Note: BBB or above=investment grade BBB+ ABBB+ AA AA AA+ AA+ AAA AAA AAA BB+ BB CCC CCC CC

5.1 The Balance Sheet: Liab.
• Demand deposits: non-interest bearing; subject to reserve requirement; M1 component; lowest cost of bank funds. • Non-transaction deposits (savings, notice, time): interest bearing; subject to reserve requirement; M1/M2 components. • Public sector deposits: non-monetary liabilities; a significant value compared with other types of deposits. • Borrowings: from central bank (discount window), large corporation (Repo) and interbank market; focusing on interbank market in Macau (foreign currency transactions > pataca transactions).

• Capital (share capital+retained earnings): minor source of funds in banking; less than 4% of total asset value in Macau.

Assets: Customer & Interbank Loans
• Major use of funds and source of profit. • Over 99% domestic loans to private sector in Macau. • Mortgage, construction and trade finance the largest items of domestic credit to firms & individuals. • Active lending to external customers. • Domestic interbank market relatively inactive with interbank loans accounting for only 6% of claims on monetary institutions; claims on AMCM (MBs) the lion’s share . • Active offshore activity reflects in the large claim on banks abroad which is very much larger than domestic interbank lending. • Other claims on banks include cheques in collection process and deposits with other banks.

Other Assets
• Financial investments: interest earning securities; mainly foreign investments due to strong offshore activity and negligible domestic financial market. • Reserves: deposits with the AMCM and vault cash; excess reserve/required reserve ratio is 20-30%; accounting for less than 2% of total asset (low cost to banks). • Sundry assets such as real estate, furniture and supplies.

5.2 Asset and Liability Management
• John Bond (1998) suggests 5 criteria to evaluate bank performance. • Income growth > cost growth. • Income/cost ≒ 2. • Net income growth > risky asset growth. • Non-interest income/operating profit ≒ 0.5. • Balanced loan portfolio. • Overall, how to max. profit in a prudent manner?

5.2.1 Asset Management
• A balance between interest income and default risk. • A balance between reserve holding and liquidity risk. • In practice – screening of loan cases – specialization – enforcement of restrictive covenants – direct equity holding – collateral – credit rationing

5.2.2 Liability Management
• • • • • • • Stable and low-cost funds. Capital insignificant. Deposits. Interbank loans. Negotiable CDs. Loans from central bank. Macau: domestic liabilities concentrated on deposits and foreign liabilities concentrated on interbank loans.

5.2.3 Interest Rate and Portfolio Adjustment
• Asset/liability types
– rate sensitive/non-sensitive (floating Vs fixed) – maturity (re-pricing time)

• Adjusting the combination according to expectations about the trend of i. • i expected to fall/rise
– rate sensitive asset/liab., more or less? – maturity of asset/liab., lengthen or shorten?

5.3 Risk to Bankers
• • • • • • • • Credit risk Country risk Market risk Interest rate risk Liquidity risk Operational risk Legal risk Reputational risk

Credit Risk
• Default – loans (incl. investment in debt paper) – off-balance sheet exposures • Loan granting (objective & sound principles, written lending policy, loan approval & administration procedures, database of every loan case). • Loan quality incl. provision (periodic review on repayment, strength of guarantees & collateral value). • Concentration alarm (restricting exposures to single borrowers or groups of related borrowers, particular industries, economic sectors or geographical regions). • Prevention of abuse of connected lending (fair terms & conditions, limit, special capital/collateral requirements).

Country, Market, Interest Rate and Liquidity Risks
• Country: cross border exposures incl. transfer risk. • Market: exposures in financial markets (securities, forex, commodities). • Interest rate: adverse movements. • Liquidity: failure to accommodate decreases in liab. or to fund increases in assets. • Clear cut policy and control, appropriate reserves or capital cushion, powerful monitor system, sufficient diversification, contingency plan.

Operational, Legal and Reputational Risks
• Operational: breakdown in internal control and corporate governance system. • Legal: inadequate or incorrect legal advice or documentation. • Reputational: operational failures, failure to comply with laws and regulations. • Effective internal control and auditing procedures, insurance and contingency plans, professional management.

5.4 Clearing and Settlement
• For transactions of cheques, interbank funds, foreign exchange and securities. • Payment and delivery actions. • Centralised clearing house Vs bilateral clearing (Macau 1983, HK 1981). • Significance – large value – chain effect – key infrastructure for financial investments and development • Risks arisen from all kinds of risks discussed in 5.3 and “Herstatt risk”. • RTGS solution proposed by G-10 central banks – continuous, individual without netting debits with credits – intraday finality of settlement across the book of central bank – queued if without sufficient credit balance

5.5 Deposit Insurance
• Run by a government agency, e.g. FDIC in the US. • Premiums calculated as a percentage of the insured deposits paid by banks. • Mostly customer deposits, some also cover interbank and foreign currency deposits. • Focus on small-valued deposits, e.g. up to US\$100,000 in the US. • IMF-suggested benchmark of coverage: twice per capita income.

Types and Objectives
• Fund-based Vs ex post levied. • Voluntary Vs compulsory. • Flat premium Vs riskadjusted premium. • To protect the interest of small depositors (“rumour-sensitive mass”). • To safeguard the stability of the banking system. • Favourable US experience between the 1930s and the early 1980s and banking crisis in HK in the 1960s.

Options for Insurer under Bank Failure

• • • •

Direct payoff Purchase and assumption Indirect payoff (assumption only) Direct assistance (too large to fail)

The Development
• • • • • Explicit DIS for over 60 countries. Compulsory system the majority. US the first country to enact DIS (1934). Becoming popular since the 1960s. Thousands of bank failure in the US in the late 1980s and early 1990s
– a financial burden – an effective tool? – a contributor to the problem?

Problems of Deposit Insurance
• CDs and interbank credits not sufficiently covered. • Adverse selection for voluntary system; cross subsidization for statutory system. • Moral hazard for both banks and depositors. • Agency problems of DIS staff. • Delayed compensation effect.

The Best Practices and Recent Trends
• Incentive compatible
– inducing all economic agents affected by the scheme to keep the financial system sound – inclusion open only to those depository institutions that are well regulated and supervised

• • • • • •

Rise of risk-adjusted premiums. Shifting towards compulsory schemes. Domination of funded DIS. Access to back-up funding from the government. Higher coverage in poor countries. Increasingly limiting the coverage
– coverage per depositor, rather than per account – interbank and foreign exchange deposits excluded

Rebuke to DIS
• Bank runs on insolvent banks Vs systemic crisis • Necessary and sufficient conditions for banking stability
–

lender of last resort to massively withdrawn but solvent banks – effective and credible system of prudential supervision – transparency and information disclosure

Banking Crisis
• Insolvent banks
– asset value < liability value – loan loss > reserves + capital – other risks to bankers

• Systemic crisis and the failure of sound banks. • Costs
– rescue operations – speculative attack against the domestic currency

• More than 30 systemic crises since the 1980s; over 70% in developing countries. • Signals
– weak macroeconomic environment – massive outflows of funds – structural characteristics

Policy Options for Strengthening Banking Systems
• “Banking Crises in Emerging Economies” (Goldstein and Turner 1996). • Reducing volatility. • Defending against lending booms, asset price collapse and surges in private capital flows. • Reducing liquidity/maturity/currency mismatch. • Preparing better for financial liberalization. • Reducing government involvement and connected lending. • Strengthening the accounting, disclosure and legal framework. • Improving incentives for bank owners, managers, creditors, and for bank supervisors. • Preventing the exchange rate regime from compromising crisis prevention/management.

6.1 The Origin of Central Banks
• The first central bank in the world - BOE in 1694 – finance government expenditure in exchange for the right to issue paper money – clearing and settlement for banks • Financial crises in the 1800s – lender of last resort – many western countries have followed the British model since the late 1800s • Post WWI – international financial summit in 1920

6.2 Functions of Central Banks: Conduct of Monetary Policy
• Issue of legal tender, control of money supply and short-term interest rate, regulation of exchange rate. • Objectives: financial stability, price stability, full employment, sustainable economic growth. • “Neither too much nor too little money is created.” • AMCM under Decree Law No. 14/96/M – “to monitor internal monetary stability and the external solvency of the local currency, ensuring its full convertibility.” – “to monitor the stability of the financial system.”

Banker to the Government
• Expenditure payments and revenue receipts through Treasury’s account with central bank. • Financing short-term, seasonal funding needs. • Managing debts and reserves. • Financial adviser. • Representative in international monetary organizations such as IMF/World Bank. • AMCM – “to advise and assist the Chief Executive in formulating and applying monetary, financial, exchange rate and insurance policies.” – “to exercise the functions of a central money depository and mange the territory’s currency reserves and other foreign assets.”

Prudential Supervision of Banks and Financial Market Regulation
• On-site/off-site examination on the quality of deposits and loans, the amount of capital and the quality of management. • Implementation of banking ordinances. • Issue policy directives in relation to bank operations. • Oversee the operation of financial markets to ensure market integrity and protect investors. • Receive complaints from and educate bank customers. • AMCM – “to guide, co-ordinate and oversee the monetary, financial, foreign exchange and insurance markets, ensure their smooth operation and supervise the actions of those operating within them according to the terms established in the regulatory statutes governing each respective area.”

Banker to Banks and Others
• Clearing, settlement and fund transfers. • Lender of last resort. • Development of financial system and infrastructure. • Research. • Macau
– Clearing House managed by MAB, but settlement still made across banks’ accounts with AMCM (Interbank Liquidity Account Service since 2/12/1999)

Do We Need Central Banks?
• Friedman’s critic in Hong Kong (1993). • The conduct of monetary policy aims at establishing a monetary anchor by discretion, but the achievement is far from satisfactory in many instances. • Suggestion: to fix a stable growth of monetary base consistent with economic growth + free banking  central bank replaced by a computer. • Unnecessary lender of last resort – moral hazard – “too big to fail” – “If banks go bad, it is best that they fail earlier and not later.”

6.3 Balance Sheet of Central Banks: Assets
• Securities – largest item of interest-earning assets – primarily domestic Treasury securities – reflecting OMO – missing in Macau, though AMCM extending short-term credits to the public sector • Discount loans – interest earning loans to banks through the discount window – missing in Macau • Foreign assets – gold, silver, forex, financial investment abroad, SDR issued by IMF – BOP adjustments • Cheques in process • Sundry assets

Liabilities
• Currency outstanding – currencies in the hands of the public – CIs in Macau • Bank reserves – deposits with central bank and vault cash – required reserves and excess reserves • Public sector deposits – Treasury payments – deposits drawn out from the banking system • Foreign and other deposits – non-bank and foreign central banks’ deposits – central bank’s borrowing from foreign institutions • Deferred-availability cheque items • Capital accounts and sundry liabilities

6.4 Central Bank Independence
• How free is the central bank from the Administration and Legislation? • Factors – appointment of major executive and board members – source of finance – the power – transparency • The case for independence – politicians “short-sighted” (inflation bias, political business cycle, central bank-financed deficit) – empirical evidences • The case against independence – undemocratic (check and balance, performance) – monetary and fiscal policy coordination

7.1 Classical Model
• • • • • • Dominant school from 1770s-1930s. Oral tradition of Cambridge macro-economics on money. Self-regulating economic system. Flexible wage system ensures full employment. Supply creates its own demand (i as an adjusting variable). Quantity theory of money, MV=PY – Y, V constant  monetary neutrality • Cambridge equation (behavioural version of the quantity theory), Md=kPY
– economic agents hold some fraction of their nominal income as money (transactions motive and precautionary motive)

– If Ms=Mo (fixed), Y interpreted as AD  downward sloping

7.2 Keynesian Model
• 1930s Great Depression brought Keynesian revolution. • “The General Theory of Employment, Interest and Money” – AS always at YF? Demand-determined Y – AS not determined by the quantity theory of money (“supply creates its own demand” not true), but desired expenditures of different sectors of the economy (C, I, G) – i not determined by S and I, but Md and Ms – classical model at best a long run model, but we are all dead in the long run • Money demand (liquidity preference) function – bond and money – speculative demand for money added to transactions and precautionary demand, Md=Md(Y, i) – downward sloping money demand curve

7.3 IS and LM
• AD = C+I+G+NX = [cTr+c(1-t)y]+(IIdi)+G+NX =A’+c(1-t)y-di. • In equilibrium, y = A’+c(1-t)y-di  di=A’+c(1-t)y-y  di=A’-y[1-c(1-t)]  i = (A’/d) - (y/d) [1-c(1-t)]  downward sloping IS curve. • Real money demand, L= ky-hi. • In equilibrium, M/P = ky-hi  hi = ky-M/P  i = [(ky)/h]-(M/hP)  upward sloping LM curve.

General Equilibrium
• Both money market and product market in equilibrium. • Slope of LM curve determined by sensitivity of L to i (h) and sensitivity of L to y (k). • Small h and large k  steep LM curve. • Shift in LM curve: change in M, change in P. • Slope of IS curve determined by sensitivity of I to i (d) and the size of the multiplier (1/(1-c(1-t)). • Small d and small multiplier  steep IS curve. • Shift in IS curve: change in autonomous variables.

Will monetary policy be effective? i.e. the fundamental question: the relationship between M and y. Is the Keynesian monetary policy transmission mechanism effective? How is the effect of changes in the quantity of money transmitted to the real sector of £ £ £ £ the economy? i.e. G M ¡÷ G i ¡÷ G I ¡÷ G y.

Reference for Policy Options Steep LM curve Flat IS curve Flat LM curve Steep IS curve Steep LM curve Steep IS curve Flat LM curve Flat IS curve Flat LM curve Normal IS curve Steep LM curve Normal IS curve Normal LM curve Flat IS curve Normal LM curve Steep IS curve

Monetary policy superior Fiscal policy superior Policies ineffective Policies effective Fiscal policy superior Monetary policy superior Monetary policy superior Fiscal policy superior

Monetarism
• Inflation is always a monetary phenomenon. • Monetary policy very effective in raising Y in the short run (steep LM curve and flat IS curve), but only causes inflation in the long run (quantity theory of money works). • Capacity; relation between expectations of price and money. • Goodhart: to increase M for 2-3 years sufficient to have inflation impacts. • Supply shock such as union-pushed inflation – non-monetary? – reaction of M/P and L – sustainable if no corresponding increase in M?

7.4 Monetary Objectives
• The 1st task to conduct monetary policy: to set a precise objective. • Most popular ultimate objectives – low & stable unemployment (high or stable economic growth) – low & stable inflation (price stability or internal monetary stability) – exchange rate stability (external monetary stability) • Data problem and theoretical compromise  intermediate or proximate objectives. • Criteria of intermediate targets: consistent, measurable, timely and controllable. • Choices of intermediate targets: interest rate, money supply, credit aggregates, commodity prices, gap between short- and long-term interest rates.

Uses of Intermediate targets
• Interest rate – adjust Ms to changes in Md in order to fix i – superior target if volatile & interest elastic Md, unstable money multiplier, stable IS curve • Money supply – offset variations in the value of money multiplier that cause quantity of money to change – superior target if stable & interest inelastic Md, welldefined money supply, volatile IS curve • Commodity prices: leading indicators of inflation. • Credit aggregates: supplement to monetary aggregates. • Spread between short- and long interest rates: stabilising inflation expectations.

7.5 Monetary Instrument: OMO
• Purchase and sale of government securities (monetary bills in Macau). • Impacts on depository institutions’ reserves and short term interest rates. • Announcement effect moves market expectations. • Daily operations. • Outright (changing money supply or interest rates) and Repo (removing fluctuations).

Discount Window, Reserve Requirement and Others
• Discount window – banks discounting securities to the central bank, in exchange for an increase in their reserves (borrowed reserves) – discount rate leading short-term interest rates – discount rate as a price of reserves (monetary base) indirectly influencing money supply – announcement effect Reserve requirement – in proportion to deposits in the form of deposits with central bank or vault cash – little impact on monetary base, but directly affecting the size of money multiplier (hence money supply) – seldom applying the instrument in view of high costs to central bank and commercial banks – acting as a stabiliser of money multiplier and hence enable the central bank to control the money supply with greater accuracy when engaging in OMO Moral suasion, margin requirements, direct credit control.

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