Topic 13 Monetary Policy: Goals Tools and Target

What is the FOMC?

(federal open markets committee) meets every 6 weeks to discuss the federal funds rate

What is the main goals of the Fed?

1. Inflation/price stability Since rising prices erode the value of money as a medium of exchange and a store of value, policymakers in most countries pursue price stability as a primary goal. 2. high employment price and high employment are often referred to as the dual mandate of the Fed. Stability of Financial Markets and Institutions The Fed makes funds available to banks in times of crisis, ensuring confidence in those banks. • In 2008, the Fed temporarily made these discount loans available to investment banks also, in order to ease their liquidity problems. 4. Economic Growth Encourages long-run investment, which is itself necessary for growth Congress and the president may be in a better position to address this goal (property rights, etc for growth)

The fed pursues what four main monetary policy goals

1. Price stability High employment Stability of financial markets and institutions Economic growth *Also pays attention to Interest rate stability and foreign-exchange market stability

Instead, the Fed began paying banks interest on their reserve holdings. The interest rate it pays sets a floor on the federal funds rate. • Why?

? If the federal funds rate were much lower than the interest rate on reserve balances, banks could borrow funds in the federal funds market, deposit them at the Fed, and earn risk-free profit. Such actions are not actually costless, though, so the effective floor is below the interest rate on reserves. interest on reserve (set by fed reserve -FLOOR) federal fund rate (banks lend eachother over night - demand + supply of reserves) discount (fed through discount windows lends to lender banks - above fed fund rate and set by fed)

What is a bubble?

A bubble in a market refers to a situation in which prices are too high relative to the underlying value of the asset

According to the Taylor rule, the Fed should set its ________rate target equal to the ___________ rate, the __________rate, and two additional terms (inflation and output gap)

According to the Taylor rule, the Fed should set its current federal funds rate target equal to the current inflation rate, the equilibrium real federal funds rate, and two additional terms [1/2 inflation (current inflation - target rate) and 1/2 output gap]

Arguments against Inflation Targeting

Against: • Reduces the Fed's flexibility to address, and accountability for, other policy goals. • Assumes the Fed can correctly forecast inflation rates, which may not be true. • Increased focus on inflation rate may result in Fed being less likely to address other beneficial goals.

The Fed pushes the federal funds rate down during recessions to _____ and up during expansions to ______

Although it does not directly set the federal funds rate, through open market operations the Fed can control it quite well. The Fed pushes the federal funds rate down during recessions to encourage high employment, and up during expansions to encourage price stability.

What is the liquidity trap?

Banks did not believe there were good loans to be made, so they refused to lend out reserves, despite the federal funds rate being maintained at zero. This is known as a liquidity trap: the Fed was unable to push rates any lower to encourage investment.

But the Fed was certain the economy was below potential GDP, so it wanted to stimulate _______. It performed __________ several times: buying securities beyond the normal short-term Treasury securities, including 10-year Treasury notes and mortgage-backed securities.This dramatically changed the Fed's balance sheet.

But the Fed was certain the economy was below potential GDP, so it wanted to stimulate demand. It performed quantitative easing several times: buying securities beyond the normal short-term Treasury securities, including 10-year Treasury notes and mortgage-backed securities.This dramatically changed the Fed's balance sheet.

By keeping interest rates low for too long, the Fed encourages

By keeping interest rates low for too long, the Fed encourages real GDP to go far beyond potential GDP. The result: • High inflation • The next recession will be more severe.

Can the Fed Eliminate Recessions?

Completely offsetting a recession is not realistic; the best the Fed can hope for is to make recessions milder and shorter. Another complicating factor is that current economic variables are rarely known; we usually can only know them for the past—i.e. with a lag.

How Interest Rates Affect Aggregate Demand (Consumption, Investment, Net Exports)

Consumption • Lower interest rates encourage buying on credit, which typically affects the sale of durables. Lower rates also discourage saving. Investment • Lower interest rates encourage capital investment by firms: - By making it cheaper to borrow (sell corporate bonds). - By making stocks more attractive for households to purchase, allowing firms to raise funds by selling additional stock. • Lower rates also encourage new residential investment. Net exports • High U.S. interest rates attract foreign funds, raising the $US exchange rate, causing net exports to fall.

What are components of AD?

Consumption, Investment and net exports

The Effect on the Interest Rate When the Fed Increases the Money Supply

Equilibrium occurs in the money market where the two curves cross. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money

Arguments for Inflation Targeting

For: • Makes it clear that the Fed cannot affect real GDP in the long run. • Easier for firms and households to form expectations about future inflation, improving their planning. • Promotes Fed account-ability— provides a yardstick against which performance can be measured.

Bubbles can form due to:

Herding behavior: failing to correctly evaluate the value of the asset and instead relying on other people's apparent evaluations; and/or • Speculation: believing that prices will rise even higher and buying the asset intending to sell it before prices fall.

What does the fed do when the economy may be producing above potential GDP.

In that case, the Fed may perform contractionary monetary policy: increasing interest rates to reduce inflation.

What is Inflation targeting:

Inflation targeting: A framework for conducting monetary policy that involves the central bank announcing its target level of inflation. This policy has been adopted by central banks in some other countries, including the Bank of England and the European Central Bank. • The typical outcome of adopting inflation targeting appears to be that inflation is lower, but unemployment is (temporarily) higher.

Describe the lags in the effects of monetary policy - interest rates, output, and prices. Be sure to note how long it takes each variable to respond to policy changes.

Interest rates respond quickly to changes in monetary policy, reacting within the first month. But the effect is transitory, and after 6 to 12 months, the interest rate has returned most of the way to its original value. Output and prices barely respond to a change in monetary policy at first. Output begins to change after about 4 months, with the full effect being felt about 16 to 20 months after the initial policy change. The price level doesn't change much until about a year after the change in policy.

Should the Fed Target the Money Supply? *use monetarism

Monetarists, led by Nobel Laureate Milton Friedman, said "yes". • Friedman advocated a monetary growth rule, increasing the money supply at about the long-run rate of real GDP growth. • He argued that an active countercyclical monetary policy would serve to destabilize the economy; the monetary growth rule would provide stability instead. Monetarism was popular in the 1970s, but since the 1980s, the link between the money supply and real GDP seems to have broken down: M1 seems to change "wildly," but real GDP and inflation do not react in the same way. • Now, targeting the money supply is not seriously considered.

What happens when interest rates rise?

Money earns little or no interest, so an increase in the interest rate induces people to reduce their holdings of money and switch into interest-bearing financial assets

The Effect on the Interest Rate When the Fed decreases the Money Supply by selling treasury securities

Now firms and households (who bought the securities with money) hold less money than they want, relative to other financial assets . • In order to retain depositors, banks are forced to offer a higher interest rate on interest-bearing accounts.

What is the Taylor Rule?**

Taylor rule is a monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate. • The Taylor rule is an estimate of the value of the federal funds rate (after adjustment for inflation) to be consistent with real GDP being equal to potential real GDP in the long ru

The Fed can make both large and small open market operations. Often, ______ require large purchases or sales whereas ________ call for small.

The Fed can make both large and small open market operations. Often, dynamic operations require large purchases or sales whereas defensive operations call for small.

Who elected the Fed?

The Fed chair is appointed, not elected. Under current law the president can remove Fed Chair only "for cause"; but the Supreme Court has never ruled what that means.

Reserve requirements by Fed? How can Fed change money supply by changing reserve reqs?

The Fed forces banks to hold reserves of about 10% of the value of their transactions deposits (less for small banks) -The Fed could change the money supply by changing reserve requirements but seldom does so because reserve requirements have a large impact on both the money supply and bank profits

Why would the Fed intentionally reduce real GDP?

The Fed is mostly concerned with long-run growth. If it determines that inflation is a danger to long-run growth, it can contract the money supply in order to discourage inflation, i.e. encouraging price stability.

The Fed often faces ____ in attempting to reach its goals, particularly the goals of _______ and _____

The Fed often faces tradeoffs in attempting to reach its goals, particularly the goals of high economic growth and low inflation

How does the fed use intermediate targets?

The Fed uses intermediate targets ( M1, M2, and interest rates) to guide policy as a step between its tools (such as open-market purchases) and its goals or ultimate targets of price stability and stable economic growth

What is the equation for the taylor rule and use it to explain how a decline in real gdp below potential gdp will affect the fed reserve target for the federal funds rate

The Taylor rule states that the Fed should set the federal funds target so that it is equal to: the real equilibrium federal funds rate + the current inflation rate + (w1) × inflation gap + (w2) × output gap. The inflation gap is the difference between the current inflation rate and the target rate. The output gap is the percentage difference between real GDP and potential GDP. The values w1 and w2 are weights determined by the Fed. If the growth rate in real GDP is below potential GDP, then the output gap will be negative. This will lower the federal funds target

The ability of the Fed to affect economic variables such as real GDP depends on

The ability of the Fed to affect economic variables such as real GDP depends on its ability to affect long-term real interest rates. • It uses the federal funds rate (a short-term nominal interest rate) for this—an imperfect tool.

What is Monetary Policy?

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals.

Describe the benefits of open market operations and discount loans

The benefits of open market operations include control, flexibility, and ease of implementation. • Discount loans depend in part on the willingness of banks to request the loans and so are not as completely under the Fed's control.

The forecasts of most economists in 2006/2007 did not anticipate the severity of the coming recession. So the Fed missed the ___________.

The forecasts of most economists in 2006/2007 did not anticipate the severity of the coming recession. So the Fed missed the opportunity to dampen the effects of the recession.

Would the fed reserve respond more aggressively with interest rates in a recession caused by a decrease in spending or by oil spills?

The inflation rate responds differently in the two recessions. A large increase in oil prices decreases real GDP, but increases inflation. The large decrease in spending decreases real GDP and decreases inflation. The Fed wants to increase real GDP, but they also want to prevent an increase in inflation. Cutting interest rates increases aggregate demand which increases real GDP and increases inflation. With a recession caused by a drop in spending, the rate of inflation declines, which allows the Fed to more aggressively cut interest rates.

was the money multiplier stable during the great recession? What is the effect of unstable money multipliers?

The money multiplier was not stable during the Great Recession. The money multiplier declined sharply, because the currency-deposit ratio and especially the reserve-deposit ratio both rose dramatically, as people increased their demand for currency, and banks increased their demand for excess reserves. Instability in the money multiplier creates instability in the money supply for a given monetary base.

The tools of monetary policy don't allow the Fed to have direct control over __________

The tools of monetary policy don't allow the Fed to have direct control over real output or the price level.

There are many different interest rates in the economy; the Fed targets the federal funds rate: _____ • The Fed does not set the federal funds rate, but rather affects the supply of ___________ through ____________.

There are many different interest rates in the economy; the Fed targets the federal funds rate: the interest rate banks charge each other for overnight loans. fed rate can influence but influencing supply and demand of bank reserves

How does the fed lower federal fund rates?

They lower federal fund rates by buying treasury bills with open market operations - which would inject the banking system with reserves. The increased supply of reserves would lower the overnight loan rate on these reserves, which is called the federal funds rate. Changes in the federal funds rate will usually result in changes in the interest rates on other short-term financial assets such as Treasury bills, and eventually affect longer-term rates such as the rate of corporate bonds and mortgages. However, the effect on these longer-term rates is usually smaller than the impact on short-term rates and occurs with a lag.

The Fed conducts expansionary monetary policy when it takes actions to decrease interest rates to increase real GDP. Why does this work

This works because decreases in interest rates raise consumption, investment, and net exports. • The increase in aggregate demand encourages increased employment, one of the Fed's primary goals.

To fight bubbles, the Fed would first need to

To fight bubbles, the Fed would first need to identify them, which are only clear in hindsight, but not as the bubbles develop. Another question is what actions can the Fed take to deflate an identified bubble without harming the financial system or the economy. Traditionally, Fed policymakers have been reluctant to raise interest rates to head off potential asset bubbles. Former Fed Chairman Ben Bernanke argued that regulation and supervision of financial firms can do a better job

How Does the Fed Manage the Money Supply? What is open market operations? What happens when we decrease money supply?

To increase the money supply, the Fed buys those securities (from banks + other institutions); the sellers deposit the sale proceeds in a checking account, and the money gets loaned out—increasing the money supply. • Decreasing the money supply would require selling securities

What are treasury securities?

Treasury securities are divided into three categories according to their lengths of maturities. These three types of bonds share many common characteristics, but also have some key differences.

Describe the strategy of inflation targeting - why many countries have begun to use this strategy instead of targeting money growth? what are the advantages and disadvantages?

Under inflation targeting, the central bank announces the inflation rate that it will try to achieve over the next 1 to 4 years. Countries have moved to inflation targeting because money-growth targeting had problems in the 1980s as money demand became unstable. Inflation targeting has the advantage of sidestepping the problem of instability in money demand, of being easier to explain to the public, and of increasing the central bank's accountability to the public. But the major disadvantage of inflation targeting is that the long lags through which inflation responds to monetary policy make it difficult for the central bank to judge what policy actions are needed.

What are intermediate targets? What are the most frequent?

are variables the Fed cannot directly control but can influence predictably, and they are related to the Fed's goals Most frequently used are monetary aggregates such as M1 and M2, and short-term interest rates, such as the fed funds rate

Why is the money demand curve negative?

as interest rates increase, the quantity of moneydemand lowers.

What is quantitative easing?

buying longer term Treasury securities that are not usually involved in open market operations.

What are reserves?

deposits that banks have received but have not loaned out

In 2008, the Fed temporarily made these discount loans available to investment banks also, in order to

ease their liquidity problem

What problems can high inflation cause for the economy

loss of purchasing power of money, menu costs, and unintended redistribution

What is an example of monetary policy target and why does the fed use policy targets?

money supply and interest rates are policy targets- the fed uses policy targets because it cannot y manipulate and change monetary policy goals such as high employment, economic growth, and price stability. The Fed can affect the targets directly and they in turn affect the variables such as real GDP and the price level, which are closely related to the Fed's policy goals

Fed has three monetary tools at its disposal

open market operations discount policy reserve requirements Directly influences its monetary policy targets. The money supply • The interest rate (primary monetary policy target of the Fed)

Why should the fed adopt inflation targeting as a framework for monetary policy?

t. First, an explicit inflation target will draw the public's attention to the fact that the Fed can only have an impact on inflation and not real GDP in the long run. Second, the public announcement of the target makes it easier for households and firms to form accurate expectations about future inflation. This will increase efficiency in the economy. Third,,an inflation target would promote accountability by the Fed. The target would offer a yardstick to measure the performance of the Fed.

What is the federal funds rate?

the overnight loan rate on reserves.

What is the Role of the Federal Reserve?

to prevent bank runs. After the

The Fed also faces timing difficulties:

• The information lag refers to the Fed's inability to observe instantaneously changes in economic variables. • The impact lag is the time that is required for monetary policy changes to affect output, employment, or inflation. One possible solution to those timing problems is for the Fed to use targets to meet its goals.

To spur economic growth, the Fed could lower the target for the federal funds rate which ____ the money supply, potentially increasing the ___

• To spur economic growth, the Fed could lower the target for the federal funds rate, which increase the money supply, potentially increasing the inflation rate in the longer run.