Macro 14

Goals of Monetary Policy

Goals are 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. The key goal is price stability. Price stability is the source of maximum employment and moderate long-term interest rates.

The Monetary Policy Instrument

is a variable that the Fed can directly control or closely target.

Operational "Stables Prices" Goal

The Fed also pays close attention to the CPI excluding fuel and food—the core CPI. The rate of increase in the core CPI is the core inflation rate. The Fed believes that the core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation.

Monetary Policy Objectives

Monetary policy objectives stem from the mandate of the Board of Governors of the Federal Reserve System as set out in the Federal Reserve Act of 1913 and its amendments. The law states: The Fed and the FOMC shall maintain long-term growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, ... so as to promote effectively the goals of maximum employment, stable

Operational "Maximum Employment" Goal

Stable prices is the primary goal but the Fed pays attention to the business cycle. To gauge the overall state of the economy, the Fed uses the output gap—the percentage deviation of real GDP from potential GDP. A positive output gap indicates an increase in inflation. A negative output gap indicates unemployment above the natural rate. The Fed tries to minimize the output gap.

Inflation Rate

If it is above the comfort zone or expected to move above it, the Fed considers raising the federal funds rate target. If it is below the comfort zone or expected to move below it, the Fed considers lowering the federal funds rate target.

Output Gap

If the output gap is positive, an inflationary gap, the inflation rate will most likely accelerate. The Fed might consider raising the federal funds rate. If the output gap is negative, a recessionary gap, inflation might ease. The Fed might consider lowering the federal funds rate.

Means of Achieving the Goals

By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable.

Unemployment Rate

If the unemployment rate is below the natural unemployment rate, a labor shortage might put pressure on wage rates to rise, which might feed into inflation. The Fed might consider raising the federal funds rate. If the unemployment rate is above the natural unemployment rate, a lower inflation rate is expected. The Fed might consider lowering the federal funds rate.

two possible instruments

The Fed has two possible instruments: 1. Monetary base 2. Federal funds rate

Goals and Means

The Fed's monetary policy objective has two distinct parts: 1. A statement of the goals or ultimate objectives 2. A prescription of the means by which the Fed should pursue its goals

Taylor Rule

The Taylor rule is a formula for setting the interest rate. By using a rule to set the interest rate, monetary policy contributes towards lessening uncertainty. With less uncertainty, financial markets, labor markets, and goods markets work better as traders are more willing to make long-term commitments.

Federal funds rate

—the interest rate at which banks borrow monetary base overnight from other banks. The Fed's choice of policy instrument (which is the same choice as that made by most other major central banks) is the federal funds rate. The Fed sets a target for the federal funds rate and then takes actions to keep it close to its target.