Monetary Policy

Inflation Gap

-the difference between current inflation and a target rate -positive gap: inflation exceeds target -negative gap: target exceeds inflation

zero lower bound

-the idea that a nominal interest rate cannot fall below zero -due to transaction costs, they can fall below zero

By controlling the quantity of loans it makes, a central bank can control:

-interest rates -size of reserves -size of monetary base

Discount lending

-lending by the Fed to commercial banks -usually small aside from crisis periods -Fed uses them to have a safe and sound market -the Central Bank is the lender of last resort (make loans to banks when no one else can or will)

Monetary policymakers' goals

-low and stable inflation -high and stable growth -a stable financial system -stable interest and exchange rates

quantitative easing

-making large-scale asset purchases to increase the supply of reserves far beyond the level needed to keep the federal funds rate near zero

Unconventional Policy Tools

-most central banks set a target for the overnight interbank lending rate -however, there are two circumstances when additional policy tools can play a useful stabilization role: 1. When lowering the target interest-rate to zero is not sufficient to stimulate the economy 2. When an impaired financial system prevents conventional interest-rate policy from supporting economic growth

Overnight reverse repo

-serves to keep the market federal funds rate close to the IOER rate -can be used to set a floor under the market federal funds rate

Targeted Asset Purchases

-the central bank's actions can influence both the cost and availability of credit -in the absence of private demand for the risky asset, the central bank's purchase makes credit available where none existed -the impact of TAP is likely to be greater in thin, illiquid markets or to be larger the bigger the difference between the yield on the asset that the central bank buys and the yield on the asset that the central bank sells -harder to sell than short-term treasuries

The federal funds rate

-the rate at which banks lend reserves to each other overnight -it determined in the market and not controlled by the Fed

Taylor Rule requires four inputs

1. the natural rate of interest 2. a measure of inflation 3. a measure of the inflation gap 4. a measure of the output gap

Discount rate

-offered by the market Federal Fund Rate -flattens out with supply at the top

Interest rate

-affects the money exchanging between banks -fed influences it but doesn't control it, it's market driven

secondary credit

-available to institutions that are not sufficiently sound to qualify for primary credit -secondary discount rate: set above the primary discount rate -typically seek this when there is a temporary shortfall of reserves or they cannot borrow from anyone else -borrowing this signals that the bank is in trouble -these banks are experiencing longer-term problems that they need some time to work out -Fed has to make certain they have a good chance of the bank will survive

Quantitative easing

-central bank buys assets, thereby expanding its overall balance sheet -at a market federal funds rate equal to the interest on excess reserves, an addition to aggregate reserves no longer reduces the funds rate -the Fed can add limitlessly to reserves without affecting the market federal funds rate -its difficult to predict the effects of QE -Fed policymakers argue their balance sheet expansion helped to lower long-term interest rates, but there is disagreement on the impacts -the mechanism by which QE affects economic prospects is not clear -an increase in the supply of reserves (QE) may simply lead banks to hold more of them rather than provide additional loans -QE can add credibility to a policymaker's promise to keep interest rates low -announcements of an expansion of aggregate reserves (QE) could lower bond yields by extending the time horizon over which bondholders expect a zero policy rate -a problem with QE is that central banks don't know how much is needed to be effective -it can be a powerful tool for central bankers to prevent a sustained deflation, especially when conventional policy tools have been exhausted -the first and largest application since the Great Depression occurred immediately after the Lehman failure in Sept 2008

European Central bank

-contains overnight interbank rate (equivalent to Fed Funds rate) -a rate at which the central banks lend to commercial banks (equivalent to discount rate) -a reserve deposit rate (equivalent to the IOER) -lend to countries (U.S. lends to counties) -use Repos to buy and sell securities -operate at commercial and investment banks (UBS for example) -US has separated them -have collateral in their marketable assets, including not only government issued bonds but also privately issued bonds and bank loans

Primary Credit

-extended on a very short-term basis, usually overnight, to institutions that the Fed's bank supervisors deem to be sound -typically have to deal with liquidity issues -banks seeking to borrow much post acceptable collateral -the interest rate on primary credit is set at a spread above the IOER called the primary discount rate -primary discount rate: the interest rate on primary credit set at a spread above the IOER rate -adds to the Fed's supply of reserves to the banks

tightening monetary policy through IOER rate

-if there is an increase in the target range for the federal funds rate, the Fed will raise the IOER rate; raising the minimum rate at which banks are willing to lend -the FOMC to raise interest rates, tightening financial conditions, without altering the supply of reserves

Forward Guidance

-to stimulate economic activity, forward guidance aims at lowering the long-term interest rates that affect private spending -to be effective, forward guidance needs to be credible and time consistent -the Fed has used forward guidance with increasing frequency and refinement -it can be effective, but it is difficult to anticipate and reach consensus on the desirable policy path and to communicate these policy intentions simply -there is also potential for disturbing side effects, including asset price bubbles

Taylor Rule

-tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output -natural rate of interest is the real short-term interest rate that prevails when the economy is using resources normally -tracks the actual behavior of the target fed fund rates and relates it to real interest and inflation -the inflation gap is current inflation minus an inflation target (both measured as percentages) -when inflation exceeds the target level, the inflation gap is positive -the output gap is the percentage deviation of current output (real GDP) from potential output (when current output is above potential output, the output gap is positive) -when inflation rises above its target level, the response is to raise interest rates -when output rises above the target level, the response is to raise interest rates -if inflation is currently on target and there is no output gap, the target federal funds rate should be set at the natural rate of interest plus target inflation

seasonal credit

-used primarily by small agricultural banks in the Midwest to help in managing the cyclical nature of farmers' loans and deposits -historically these banks had poor access to national money markets -revolves around agriculture and small banks (in rural communities) -when demand increases the Fed steps in to help with liquidity when ag is in its busy months

Three categories of unconventional policy approaches

1. Forward guidance -this is when the central bank communicates intentions regarding the future path of monetary policy 2. Quantitative easing (QE) -when the central bank supplies aggregate reserves beyond the quantity needed to lower the policy rate to its target (usually zero or lower) 3. Target asset purchases (TAP) -when the central bank alters the mix of assets it holds on its balance sheet in order to change their relative prices in a way that stimulates economic activity *when the fed refers to its unconventional policy of large-scale asset purchases, the purchases are QE, TAP, or both

Desirable Features of a Monetary Policy Instrument

1. It is easily observable by everyone (ensures transparency in policymaking, which enhances accountability) 2. It is controllable and quickly changed (an instrument that can be adjusted quickly in the face of a sudden change in economic conditions is clearly more useful) 3. It is tightly linked to the policymakers' objectives (the more predictable the impact of an instrument, the easier it will be for the policymakers to meet their objectives)

Fed makes three types of loans

1. Primary Credit 2. Secondary Credit 3. Seasonal Credit -fed controls the interest rate on these loans, not the quantity of credit extended -the banks decide how much to borrow

Fed's four conventional policy tools

1. The target range for the federal funds rate 2. The interest rate on excess reserves (IOER) 3. The rate for discount window lending 4 Reserve requirement

Unconventional Policy tools

1. massive purchases of risky assets in fragile market 2. communicating its intent to keep interest rates low over an extended period

effective lower bound

the nominal interest rate level below which intermediaries and their customers will switch from bank deposits to holding cash.

Output gap

the percentage difference between real GDP and potential GDP