Chap 14 - Monetary Policy

Means for Achieving the Goals

"Economy's long run potential to increase production" is the growth rate of potential GDP. " Monetary and credit aggregates" are the quantities of money and loans. 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.

Fighting a Recession

1. Market for Bank Reserves - FOMC lowers the target federal funds rate. 2. Money Market - With increases reserves, the banks create deposits by making loans and the supply of money increases. Short term interest rate falls and the money demand increases. 3. Loanable Funds Market - Banks create money by making loans. Long run, an increase in the supply of bank loans is matched by a rise in the price level and the quantity of real loans is unchanged.

Goals of Monetary Policy

1. Maximum Employment 2. Stable Prices 3. Moderate Long Term Interest Rates *Long Run - These goals are in harmony and reinforce each other *Short Run - These goals might come into conflict Price Stability is the key goal

2 Fed Instruments

1. Monetary Base OR 2. Interest rate at which banks borrow and lend monetary base overnight

Policy Actions in a Financial & Banking Crisis

1. Open Market Operation 2. Extension of Deposit Insurance 3. Term Auction Credit 4. Primary Dealer and Other Broker Credit 5. Asset-Bancked Commercial Paper Money Market Mutual Fund Liquidity Facility 6. Troubled Asset Relief Program (TARP1) 7. Troubled Asset Relief Program (TARP2) 8. Fair Value Accounting

What 3 main events can put a bank under stress?

1. Widespread fall in asset prices (capital loss) 2. A significant currency drain 3. A run on the bank

Monetary Policy Transmission Process

1. Change in the Federal Funds Rate (Interest Rates will Change) *Federal Funds Rate *Short Term Bill Rate *Long Term Bond Rate 2. Exchange Rate Fluctuations 3. Money & Bank Loans 4. Long Term Real Interest Rate 5. Expenditure Plans 6. The Change in AD and Real GDP and the Price Level

Expenditure Plans

1. Consumption Expenditure 2. Investment 3. Net Exports *Cut in the federal funds rate increases AE and a rise in the federal funds curtails AE. These changes in AE plans change AD, real GDP and price level.

What are 2 alternative approaches to monetary policy?

1. Inflation Rate Targeting 2. Taylor Rule

Indicators that the Fed's look at to gauge the state of output and employment relative to full employment are?

1. Labor Force Participation Rate 2. Unemployment Rate 3. Measures of Capacity Utilization 4. Activity in the Housing Market 5. Stock Market 6. Regional Info Gathered by the Regional Federal Reserve.

Fight Inflation

1. Market Bank Reserves - FOMC raises the target federal funds rate. 2. Money Market - With decreased reserves, the banks shrink deposits by decreasing loans and the supply of money decreases. 3. Loanable Funds Market - Decrease in reserves banks must decrease the supply of loans. The supply of (real)loanable funds decreases and the supply of loanable funds curve shifts leftward.

Operational "Maximun Employment" Goal

The Fed regards stable prices (a core inflation rate of 1 to 2 percent a year) as the primary goal of monetary policy and as a means to achieving the other two goals.

Net Exports

Other things remaining the same, the lower the interest rate, the lower is the exchange rate and the greater are exports and the smaller are imports.

Consumption Expenditure

Other things remaining the same, the lower the real interest rate, the greater is the amount of consumption expenditure and the smaller is the amount of saving.

Investment

Other things remaining the same, the lower the real interest rate, the greater is the amount of investment.

Output Gap

Percentage deviation of real GDP from potential GDP *Output gap is positive, it is an inflationary gap that brings an increase in the inflation rate. *Output gap is negative, it is a recessionary gap that results in the lost output and in employment being below its full employment equilibrium level. *The Fed tries to minimize the output gap.

What is the Fed's choice of monetary policy instrument?

Interest rate at which banks borrow and lend monetary base overnight

What are the roles of the Fed, Congress and the President?

*Fed - Responsible for the conduct of monetary policy *Congress - Has NO role in making monetary policy decision but the FRAct requires the Board of Governors to report on monetary policy to Congress *President - Role is limited - Appoints the members and chairman of the Board of Governors.

2 Parts of the Monetary Policy Objective

1. A statement of goals / ultimate objectives 2. Prescription of the means by which the Fed should pursue its goals.

What are the 2 measures of inflation?

1. CPI 2. Personal Consumption Expenditure (PCE) Deflator

Core Inflation Rate

A measure of the inflation rate that excludes volatile prices in an attempt to reveal the underlying inflation trend. The Fed's operational guide is the rate of increase in the core PCE deflator, which is the PCE deflator excluding food and fuel prices.

Inflation Rate Targeting

A monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and explains how its policy actions will achieve it.

Monetary Policy Instrument

A variable that the Fed can directly control or at least very closely target.

Maximum Employment

Attaining the maximum sustainable growth rate of Potential GDP and Keeping real GDP close to potential GDP. Also means keeping the unemployment rate close to the natural unemployment rate.

Inflation Rate

Above the top of the comfort zone, the Fed's consider raising the federal funds rate target. Below or expected to move below the bottom of the comfort zone, it considers lowering the interest rate.

Fed's Decision-Making Strategy

Begins with the Beige Book Forecasting 3 variables 1. Inflation Rate 2. Unemployment Rate 3. Output Gap

Who is responsible for monetary policy in the United States?

Board of Governors of the Federal Reserve System and the Federal Open Market Committee FOMC makes a monetary policy decision at eight scheduled meetings each year and communicates its decision with a brief explanation.

Change AD, Real GDP and Price Level

By changing real GDP and the price level relative to what they would have been without a change in the federal funds rate, the Fed influences its ultimate goal: inflation rate and output gap.

Long Term Real Interest Rate

Demand and supply in the market for loanable funds determine the long term real interest rate, which equals the long term nominal interest rate minus the expected inflation rate. The long term real interest rate influences expenditure decisions.

Federal Reserve Act (FRA) of 1913

Is an Act of Congress that created and set up the Federal Reserve System, central banking system of the United States and granted it the legal authority to use Federal Reserve Notes and Federal Reserve Bank Notes as legal tender.

Long Term Bond Rate

Is the interest rate paid on bonds issued by large corporations. *Higher than the short term rates and it fluctuates less than the short term rates.

Moderate Long Term Interest Rates

Keeping long term nominal interest rates close to (or even equal to) long term real interest rates.

Stable Prices

Keeping the inflation rate low (and perhaps close to zero).

Amendment of the FRA 2000

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run 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 prices and moderate long term interest rates.

Beige Book

The Fed's publication that summarizes all the data that it gathers and that describes the current state of the economy.

Exchange Rate Fluctuation

The exchange rate responds to changes in the interest rate. Raises the federal funds rate, the U.S. interest rate differential rises and, other things remaining the same, the U.S. dollar appreciates. Lowers the federal funds rate, the U.S. interest rate differential falls, and other things remaining the same, the U.S. dollars depreciates. Monetary policy influences the exchange rate, many other factors also make the exchange rate change.

Supply and Demand Federal Funds E.g.

The higher the federal funds rate, the greater is the quantity of overnight loans supplied and the smaller is the quantity of overnight loans demanded

Short Term Bill Rate

The interest rate paid by the U.S. government on 3 month Treasury bills. *Short term bill rate and federal funds rate are almost identical

Federal Funds Rate

The interest rate that the banks charge each other on overnight loans.

Money & Bank Loans

The quantity of money and bank loans change when the Fed changes the federal funds rate target. Rise in the federal funds rate decreases the quantity of money and bank loans. Fall in the federal funds rate increases the quantity of money and bank loans. 2 Reasons for Change 1. Quantity of deposits and loans created by the banking system change 2. Quantity of money demanded changes

Taylor Rule

To set the policy interest rate by using a rule or formula. FFR = Federal Funds Rate INF = Inflation Rate GAP = Output Gap FFR = 2 + INF + 0.5(INF-2) + 0.5GAP

Unemployment Rate

Unemployment rate is below the natural rate, a lob or shortage might put upward pressure on wage rates, which might feed through to increase the inflation rate. Unemployment rate is above the natural rate, a lower inflation rate is expected, which indicates the need for a lower interest rate.