Title: Chapter 14: Monetary Policy
1Chapter 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
2Monetary 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
3Monetary 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.
4Monetary 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.
5Monetary 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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7The 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.
8The Conduct of Monetary Policy
- The Federal Funds Rate
- Currently, the Feds choice of policy instrument
is a short-term interest rate (federal funds
rate). - Given this choice, the exchange rate and the
quantity of money find their own equilibrium
values.
9Fed funds rate rises during expansions and is cut
during recessions.
10To adjust FFR, Fed tends to increase growth of
monetary base during recessions.
11How 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.
12The 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
percentages) - FFR 2 INF 0.5(INF 2) 0.5GAP
- FFR will increase if inflation rises or GDP-gap
rises
13The 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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15The 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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17- Short term rates track FFR more closely than long
term rates. - Fed has greater control over short term rates
than long term rates.
18Fed 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.
19Monetary 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.
20Monetary 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
world, - 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.
21Monetary Policy Transmission
- Loose Links and Long and Variable Lags
- Long-term interest rates that influence spending
plans are linked loosely to the federal funds
rate. - 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
recessions.