Chapter 14: Monetary Policy - PowerPoint PPT Presentation

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Chapter 14: Monetary Policy


Title: Parkin-Bade Chapter 34 Author: Robin Bade and Michael Parkin Last modified by: Administrator Created Date: 4/24/2002 5:17:56 AM Document presentation format – PowerPoint PPT presentation

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Title: Chapter 14: Monetary Policy

Chapter 14 Monetary Policy
  • Objectives of U.S. monetary policy and the
    framework for setting and achieving them
  • Federal Reserve interest rate policy
  • Channels through which the Federal Reserve
    influences the inflation rate
  • Alternative monetary policy strategies

Monetary Policy Objectives and Framework
  • Federal Reserve Act of 1913 states
  • The Fed and the FOMC shall maintain long-term
    growth of the monetary and credit aggregates
    commensurate with the economys long-run
    potential to increase production, so as to
    promote effectively the goals of maximum
    employment, stable prices, and moderate long-term
    interest rates.
  • Equation of exchange

Monetary Policy Objectives and Framework
  • Goals of Monetary Policy
  • Maximum employment, stable prices, and moderate
    long-term interest rates
  • In the long run, these goals are in harmony and
    reinforce each other, but in the short run, they
    might be in conflict.
  • increasing employment in short term may create
    inflation and higher long term interest rates in
    long term.
  • Price stability is essential for maximum
    employment and moderate long-term interest rates.

Monetary Policy Objectives and Framework
  • Stables Prices Goal
  • Fed pays close attention to the CPI excluding
    fuel and foodthe core CPI.
  • The rate of increase in the core CPI is the core
    inflation rate.
  • Core inflation rate provides a better measure of
    the underlying inflation trend and a better
    prediction of future CPI inflation.

Monetary Policy Objectives and Framework
  • Maximum Employment Goal
  • Price stabilization is the primary goal but the
    Fed pays attention to the business cycle.
  • output gapthe percentage deviation of real GDP
    from potential GDP.
  • A positive output gap ? unemplltnatural rate
    inflationary pressures.
  • A negative output gap ? unemployment gt natural
    rate deflationary pressures
  • The Fed tries to minimize the output gap
  • Reduce interest rates if there is a negative
    output gap
  • Raise interest rates if there is a positive
    output gap

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The Conduct of Monetary Policy
  • Choosing a Policy Instrument
  • The monetary policy instrument is a variable that
    the Fed can directly control or closely target.
  • Possible targets
  • monetary growth rate (base, M1, M2)
  • interest rates (federal funds rate, long term
    bonds, etc.)
  • exchange rate
  • inflation rate
  • unemployment rate
  • Difficult to target more than one variable.

The Conduct of Monetary Policy
  • The Federal Funds Rate
  • Currently, the Feds choice of policy instrument
    is a short-term interest rate (federal funds
  • Given this choice, the exchange rate and the
    quantity of money find their own equilibrium

Fed funds rate rises during expansions and is cut
during recessions.
To adjust FFR, Fed tends to increase growth of
monetary base during recessions.
How does Fed Decide on Fed Funds Rate?
  • The Fed could adopt either
  • An instrument rule
  • Set the policy instrument (e.g. FFR) at a level
    based on the current state of the economy.
  • Taylor rule (later) is an instrument rule.
  • A targeting rule
  • set the policy instrument (e.g. fed funds rate)
    at a level that makes the forecast of the
    ultimate policy target equal to the target.
  • e.g. if policy goal is 2 inflation and the
    instrument is the federal funds rate, then
    targeting rule sets FFR so the forecast of the
    inflation rate equals 2.
  • requires large amounts of information to
    forecast inflation and effect of Fed Funds rate
    and other economic variables on inflation.

The Conduct of Monetary Policy
  • Taylor rule (Stanford economist John Taylor)
  • set federal funds rate (FFR) at equilibrium real
    interest rate (which Taylor says is 2 percent a
    year) plus amounts based on the inflation rate
    (INF) and the output gap (GAP) according to the
    following formula (all values are in
  • FFR 2 INF 0.5(INF 2) 0.5GAP
  • FFR will increase if inflation rises or GDP-gap

The Conduct of Monetary Policy
  • FOMC minutes suggest that the Fed follows a
    targeting rule strategy.
  • Some economists think that the interest rate
    settings decided by FOMC are well described by
    the Taylor Rule.
  • The Fed believes that because it uses much more
    information than just the current inflation rate
    and the output gap, it is able to set the
    overnight rate more intelligently than any simple
    rule can set.

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The Conduct of Monetary Policy
  • The Fed hits the Federal Funds Rate Target using
    Open Market Operations
  • When the Fed buys securities, it pays for them
    with newly created reserves held by the banks.
  • When the Fed sells securities, they are paid for
    with reserves held by banks.
  • Open market operations influence banks reserves,
    the supply of loans, and interest rates.

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  • Short term rates track FFR more closely than long
    term rates.
  • Fed has greater control over short term rates
    than long term rates.

Fed control over interest rates
  • Fed has better control over short term than long
    term bonds
  • Inflation expectations and future movements in
    short term rates affect the long term rate
  • Shifts in the yield curve reflect changes in
    expectations about future interest rates
  • steepens when interest rates are expected to rise
    over time
  • flattens when interest rates are expected to fall
    over time.
  • Changes in the risk premium alter spread
    between government bonds and other types of loans
  • risk premium rose in recent financial crisis.

Monetary Policy Transmission
  • When the Fed lowers the federal funds rate
  • Other short-term interest rates and the exchange
    rate fall.
  • The quantity of money and the supply of loanable
    funds increase.
  • The long-term interest rate falls.
  • Consumption expenditure, investment, and net
    exports increase.
  • AD increases.
  • Real GDP growth and the inflation rate increase.
  • When the Fed raises the federal funds rate, the
    ripple effects go in the opposite direction.

Monetary Policy Transmission
  • Exchange Rate Fluctuations
  • The exchange rate responds to changes in the
    interest rate in the United States relative to
    the interest rates in other countriesthe U.S.
    interest rate differential.
  • If U.S. interest rates fall relative to rest of
  • Demand for dollar decreases
  • Supply of dollar increases
  • P of drops (cheaper dollar)
  • exports increase, imports decrease
  • AD rises
  • Other factors are also at work (e.g. inflation
    expectations) which make the exchange rate hard
    to predict.

Monetary Policy Transmission
  • Loose Links and Long and Variable Lags
  • Long-term interest rates that influence spending
    plans are linked loosely to the federal funds
  • The response of the real long-term interest rate
    to a change in the nominal rate depends on how
    inflation expectations change.
  • The response of expenditure plans to changes in
    the real interest rate depends on many factors
    that make the response hard to predict.
  • The monetary policy transmission process is long
    and drawn out and doesnt always respond in the
    same way
  • can be like pushing on a string during
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