Macroeconomics - Ch. 17

Monetary Policy During Inflation

*During inflationary periods, the appropriate monetary policy is to decrease money supply, increase the federal funds rate, increase the market interest rates, decrease investment spending, decrease aggregate demand, and decrease GDP. *During inflationary periods, the NY Fed sells securities on the open market and decreases bank reserves to hit the federal funds rate target.

Monetary Policy During Recession

*During recession, the appropriate monetary policy is to increase money supply, decrease the federal funds rate, decrease the market interest rates, increase investment spending, increase aggregate demand, and increase real GDP. *The Fed can increase the money supply by conducting open market purchase of govt. securities/bonds. *The Federal Reserve Bank that conducts open market operation is the NY Federal Reserve Bank.

Impact of Federal Funds Rate on Exchange Rate

*Exchange rate is the price of one country's currency in terms of another country's currency. *The exchange rate responds to changes in the interest rate in the US relative to the interest rates in other countries - the US interest rate differential. *When the Fed raises the federal funds rate, the US interest rate differential rises and, other things remaining the same, the US dollar appreciates (increases in value in terms of other currencies). *When the Fed lowers the federal funds rate, the US interest rate differential falls and, other things remaining the same, the US dollar depreciates.

Means for Achieving the Goals (Max. Employ. & Stable Prices)

*The Fed pays close attention to the business cycle and tries to steer a steady course b/w recession and inflation. *The Fed tries to minimize the output gap; the percentage deviation of real GDP from potential GDP. *The Fed believes that the core inflation provides the best indication of whether price stability has been achieved.

Nominal GDP Targeting (2)

*The growth rate of real GDP, on average, keeps returning to the trend growth rate, so nominal GDP targeting is a version of inflation targeting. *Under this policy, the Fed would adjust the interest rate when either inflation departs from its target or real GDP growth departs from its long-term growth rate. *Nominal GDP targeting is old idea that many economists have recommended, but it gained momentum during 2011.

What Does Inflation Targeting Achieve?

*The idea of inflation targeting is to state publicly the goals of monetary policy, to establish a framework of accountability, and to keep the inflation rate low and stable while maintaining a high and stable employment. *There is wide agreement that inflation targeting achieves its first two goals. *It is less clear whether inflation targeting does better than the Fed's implicit targeting in achieving low and stable inflation.

Time Lags in Adjustment Process

*The monetary policy transmission process is long and drawn out. *The economy does not always respond in exactly the same way to a given policy change b/c many factors other than the policy are constantly changing and bringing new situations to which policy must respond. *The time lags in the adjustment process are not predictable, but the average time lags are known. *After the Fed takes action, real GDP begins to change about one year later and the inflation rate responds w/ a lag that averages around two years. *This long time lag b/w the Fed's action and a change in the inflation rate, the ultimate policy goal, makes monetary policy very difficult to implement.

Monetary Policy Objectives

*The objectives of monetary policy are carried out by the Federal Reserve. *The objectives include: 1. statements of goals 2. prescriptions on how to achieve the stated goals *The stated goals are to: 1. promote maximum employment 2. achieve stable prices 3. moderate long-term interest rates *The goal of "maximum employment" means attaining the maximum sustainable growth rate of potential GDP, and "stable prices" means keeping the inflation low.

Loose Links and Long Variable Lags

*The ripple effects of a change in monetary policy are often hard to predict in reality. *The long-term real interest rate that influences spending plans is linked only loosely to the federal funds rate. *Also, the response of the long-term real 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.

Monetary Policy Rule

*When well understood, they help to keep inflation expectations anchored close to the inflation target and creates an environment in which inflation is easier to forecast and manage. *3 alternative rules the Fed might have chosen: 1. inflation targeting rule 2. money targeting rule 3. nominal GDP targeting rule **Allows the quantity of money to grow at a percentage rate equal to the growth rate of potential GDP per year.

Nominal GDP Targeting

A monetary policy rule that adjusts the interest rate to achieve a target growth rate for nominal GDP. *The target might be set by the govt. or adopted by the central bank. *the growth rate of nominal GDP = the growth rate of real GDP + the inflation rate (as measured by the GDP price index)

Inflation Targeting

A monetary policy strategy in which the central bank makes a public commitment to achieving an explicit inflation target and to explaining how its policy actions will achieve that target. *Inflation targets are specified in terms of a range for the CPI inflation rate. *This range is typically b/w 1-3% a year, with an aim to achieve an inflation rate of 2% a year. *B/c lags in the operation of monetary policy are long, if the inflation rate falls outside the target range, the expectation is that the central bank will move the inflation rate back on target over the next 2 years.

Discretionary Monetary Policy

A monetary policy that is based on an expert assessment of the current economic situation.

Monetary Policy Instrument

A variable that the Fed can directly control or closely target to influence the economy in a desirable direction. *The Fed can target the quantity of monetary base or the federal funds rate, but not both.

Targeting Rule

Sets the policy instrument at a level that makes the forecast of the policy goal equal to the target. *If the policy goal is a 2 percent inflation rate and the instrument is the federal funds rate, then the targeting rule sets the federal funds rate at a level that makes the forecast of the inflation rate equal to 2 percent a year.

Instrument Rule

Sets the policy instrument by a formula based on the current state of the economy. *The best known instrument rule for the federal funds rate is the Taylor Rule, which links the current inflation rate to the current estimate of the output gap.

Core Inflation

The annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) EXCLUDING the prices of food and fuel. *The Fed believes it has achieved the price stability goal when the ________ _________________ rate is betweeen 1 and 2 percent a year.

Federal Funds Rate

The interest rate at which banks can borrow and lend reserves in the federal funds market. *If the Fed wants to decrease the money supply, it raises the ______ ______ ___________. (and vice versa) *When the Fed wants to slow inflation, it raises the _______ ________ _________. *When the inflation rate is below target and the Fed wants to avoid recession, it lowers the ________ ____________ ____________.

Money Targeting

Works when the demand for money is stable and predictable. *But technological change in the banking system leads to unpredictable changes in the demand for money, which makes money targeting unreliable.