Chapter 17- Monetary Policy

Monetary Policy Objectives

Political objectives set out in the mandate of the Board of Governors of the Federal Reserve that are defined by the Federal Reserve Act of 1913 (+ amendments)

Role of the President in Monetary Policy

President is limited to appointing the members and chairman of the Board of Governors; some presidents have tried to influence the Fed's decisions

Prerequisites for Achieving the Goals

1) Financial stability is not an abandonment of the mandated goals of maximum employment and stable prices; it is a prerequisite 2) Financial instability can bring severe recession and deflation (falling prices) and undermine the success of the Fed's mandated goals

Federal Reserve Act

"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" * Clarified in an amendment by Congress in 2000 If the Fed promotes maximum employment, the federal funds rate falls. Aggregate demand increases. The price level rises. Real GDP increases and unemployment falls.

Money and Bank Loans

1) A rise in the federal funds rate decreases the quantity of money and bank loans 2) A fall in the federal funds rate increases the quantity of money and bank loans 3) These changes occur because the quantity of deposits and loans created by the banking system changes and the quantity of money demanded changes 4) A rise in the federal funds rate decreases reserves and decreases the quantity of deposits and bank loans created 5) A fall in the federal funds rate increases reserves and increases the quantity of deposits and bank loans created 6) A fall in the interest rate increases the quantity of money demanded 7) A rise in the interest rate decreases the quantity of money demanded 8) Expenditure and investment increase/decrease with the quantity of money and the supply of loanable funds

Stable Prices Goal

1) Core inflation rate (annual percentage change in the Personal Consumption Expenditure deflator- excluding the prices of food and fuel) provides the best indication of whether price stability is being achieved 2) Price stability is generally regarded as a core inflation rate of between 1 and 2 percent per year *Low enough not to affect the decisions of households and firms

Price Stability

1) Delivers moderate long-term interest rates because the nominal interest rate equals the real interest rate plus the inflation rate

How the Fed Fights Recession

1) FOMC lowers the target federal funds rate 2) Fed buys securities and increases the supply of reserves 3) Banks create deposits by making loans, and the supply of money increases 4) Short-term interest rate falls, and the quantity of money demanded increases 5) Banks create money by making loans, and price level rises 6) Short-run sticky price level: increase in the supply of bank loans increases the supply of (real) loanable funds 7) The real interest rate falls, which lowers the exchange rate, and increases net exports 8) Aggregate planned expenditure increases (shifts the AD curve to the right) 9) Income increases, which creates a multiplier for the increase in aggregate demand 10) The new equilibrium is at full employment but with a higher price level (and faster inflation) *With no action by the Fed, the money wage rate will eventually fall and aggregate supply will increase

How the Fed Fights Inflation

1) FOMC raises the target federal funds rate 2) Fed sells securities and decreases the supply of reserves 3) Banks shrink deposits by decreasing loans and the supply of money decreases 4) Short-term interest rate rises and the quantity of money demanded decreases 5) Banks decrease the supply of loans, and real interest rate rises, which decreases aggregate planned expenditure 6) Aggregate demand decreases (shifts to the left); income decreases, which creates a multiplier process 7) The new equilibrium is at full employment, but the price level falls (and inflation rate slows) *Can also just use opposite of recession card *With no action by the Fed, the money wage rate will eventually rise and aggregate supply will decrease

Choosing a Policy Instrument

1) Fed needs a variable that they can directly control or closely target and that influences the economy in desirable ways 2) The Fed is a monopoly because it is the sole issuer of monetary base, meaning it can fix the quantity and leave the market to determine the price, or fix the price and leave the market to determine the quantity 3) The "price" of monetary base is the federal funds rate (interest rate for banks to borrow/lend federal reserves) *If the Fed wants to decrease the monetary base, the federal funds rate must rise; if the Fed wants to raise the federal funds rate the monetary base must decrease - The Fed can target one or the other

Fed Action Great Depression v. 2008

1) Great Depression: increased risks led banks to increase their holdings of reserves and other to hold more currency The desired reserve ration increase from 8% to 12% and the currency drain ratio increased from 9% to 19%; the money multiplier fell from 6.5 to 3.8 and the quantity of money crashed by 35% (fed did not counteract the contraction of money by injecting reserves into banks) 2) 2008-2009: Fed responded to increased risks by flooding banks with reserves they wanted to hold The money multiplier fell from 9.1 to 2.5 (more than before) but there was no contraction in the quantity of money; quantity of M2 increased by 37.5% (6.6% per year) 3) 2013- Fed faced dilemma because the recovery was slow and unemployment was not falling quickly enough (had to decide when the stop fighting the slow recovery and worry about increasing inflation)

The Taylor Rule

1) If the inflation rate is 2% per year and there is no output gap, the federal funds rate is neutral at 4% per year 2) A 1% deviation of the inflation rate and a 1% deviation of the real GDP moves the federal funds rate 0.5% (Same direction as change in inflation; opposite of change in real GDP) 3) Fed did not follow this rule, which kept the interest rate too low for too long, then raised it too quickly and by too much- caused the financial collapse of 2009 (Aggregate demand was decreasing = inflation was falling)

Fed's Decision-Making Strategy

1) Instrument Rule 2) Targeting Rule

Timeframe of Ripple Effects

1) Interest rate and exchange rate effects are immediate 2) Effects on money and bank loans follow in a few weeks and run for a few months 3) Real long-term interest rate increases quickly; often, short-term rates change in anticipation 4) Spending plans and real GDP growth change after about one year 5) The inflation rate changes between one year and two years *None of these time lags are entirely predictable

Loose Links

1) Long-term real interest rate is linked only loosely to the federal funds rate 2) The response of the long-term real interest rate to a change in the nominal interest rate depends on how inflation expectations change 3) The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict

Time Lags in the Adjustment Process

1) Monetary Policy Transmission is long and drawn out 2) The economy does not always respond in exactly the same way to a given policy change 3) Many factors other than policy are constantly changing and bringing new situations to which policy must respond 4) Turmoil in credit and housing markets (2007)- Fed faced ongoing inflation risks and a fear that spending would bring recession

Means for Achieving the Goals

1) The economy's long-run potential to increase production is the growth rate of potential GDP 2) The 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

Hitting the Federal Funds Rate Target

1) The federal funds rate is also the opportunity cost of holding reserves; holding a larger quantity of reserves is the alternative to lending reserves to another bank 2) The higher the federal funds rate, the smaller is the quantity of reserves that banks plan to hold 3) To decrease the supply of reserves, the Fed conducts an open market sale (left); to increase the supply of reserves, the Fed conducts an open market purchase (right) 4) As the supply of reserves increases, and the quantity of reserves demanded increases, the federal funds rate falls; as the supply of reserves decreases, and the quantity of reserves demanded decreases, the federal funds rate rises

The Federal Funds Rate

1) This is the Fed's choice of monetary policy instrument (Fed permits the monetary base & quantity of money to find their own equilibrium values) 2) Federal funds rate was 5.5% at the beginning of 2000 3) Federal funds rate increased to 6.5% by 2001 4) Federal funds rate was at a historic low between 2002 and 2004 because the inflation was anchored and the Fed was more concerned about avoiding recession 5) Federal funds rate increased 17 times up to 5.25% in 2007 to prevent rising inflation 6) Interest rate decreased to almost 0% by 2008; the Fed cut a quarter of a percentage point (25 basis points), then 50 basis points, then 100 basis points per change *Aggressive cuts were to restore financial stability

Dual Mandate

1) To achieve stable prices (more important) - Keeping the inflation rate low and predictable - Ensuring moderate long-term interest rates 2) To achieve maximum employment - Attaining maximum sustainable growth rate of potential GDP - Keeping real GDP close to potential GDP - Keeping the unemployment rate close to the natural unemployment rate *In the long run, these goals are in harmony and reinforce each other; price stability encourages the maximum sustainable growth rate of potential GDP - In the short run, the Fed faces a tradeoff; taking an action to achieve stable prices raises the unemployment rate and slows real GDP growth; taking an action to lower the unemployment rate and boost real GDP growth brings the risk of rising inflation

Restoring Financial Stability in a Financial Crisis

1) To restore financial stability during a recession, the Fed pumps reserves into banks (via Quantitative Easing) which increases the monetary base 2) When risks increase, banks hold more of their assets in safe, reserve deposits at the Fed; demand for reserves increases which would cause the federal funds rate to rise, lending to shrink, the quantity of money to decrease, and the recession to intensify 3) To avoid these results, the Fed pumps billions of dollars into the bank to increase the supply of reserves, lower the federal funds rate, and prevent the recession from getting worse Fed hits its federal funds rate target by using open market operations and in times of financial crisis by quantitative easing and credit easing

Loose Links and Variable Lags

1) Too large an interest rate cut in an underemployed economy can bring inflation (1970's) 2) Too large an interest rate rise in an inflationary economy can create underemployment (1981 & 1991)

Reality of the Adjustment Process

1) When the Fed raises the federal funds rate, the economy slows down 2) When the Fed lowers the federal funds rate, the economy speeds up 3) On average, real GDP changes 1 year after Fed action, and inflation responds 2 years after Fed action

Interest Rate Changes

1st effect of a monetary policy decision * A powerful substitution effect keeps the interest rate on U.S. government 3-month treasury bills close to the federal funds rate; a loan to another banks is a close substitute for a Treasury bill - If the interest rate on Treasury bills is higher than the federal funds rate, the banks increase the quantity of Treasury bills held and decrease loans to other banks (the price of a Treasury bill rises and interest rates fall) -If the interest rate on Treasury bills is lower than the federal funds rate, the banks decrease the quantity of Treasury bills held and increase loans to other banks (the price of a Treasury bill rises and interest rates rise) Long-term interest rates change by less than short-term interest rates (most significant being the corporate bond rate); interest rate is typically higher because long-term loans are riskier Long-term interest rates fluctuate less than short-term interest rates because they are influenced by expectations about future short-term interest rates as well as current interest rates If the Long-term interest rate exceeds the expected average of future short-term interest rates, people will lend long-term and borrow short-term; long-term interest rate will fall If the Long-term interest rate is below the expected average of future short-term interest rates, people will borrow long-term and lend short-term; the long-term interest rate will rise

Targeting Rule

A decision rule for monetary policy that sets the policy instrument at a level that makes the central bank's forecast of the ultimate policy goals equal to their targets *Fed uses this with inflation and output gap forecasts - Fed does not have formal published targets, it uses implicit targets and weighs decisions for short-term tradeoff

Instrument Rule

A decision rule for monetary policy that sets the policy instrument by a formula based on the current state of the economy (implemented by plugging numbers into a formula)

Inflation Targeting Rule

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 (most likely alternative strategy) *Used by most major industrial countries besides the U.S. and Japan (The U.K., Canada, Australia, New Zealand, Sweden, and the EU) - Ben Bernanke and Frederic S. Mishkin argued that inflationary targeting is the best way to conduct monetary policy; Fed took a step toward transparency by publishing FOMC member's detailed forecasts of inflation, real GDP growth, and unemployment through 2010 (Inflation targets are usually between 1 and 3 percent per year, with an average of 2 percent per year) Main idea is to state clearly and 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 level of employment (may or may not be better than implicit) In 2011, inflation was low but unemployment and the output gap were high Use overnight interest rates as their policy tool (Also needs demand for money to be stable)???

Discretionary Monetary Policy

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

Role of the Fed in Monetary Policy

Board of Governors conducts monetary policy; FOMC makes decisions at 8 schedules meetings per year and publishes its minutes 3 weeks after each meeting

Financial Stability

Enabling financial markets and institutions to resume their normal functions of allocating capital resources and risk

Alternative Monetary Policy Strategies

Fed could pursue a discretionary monetary policy and decide what is best every day, week, and month, but rules are needed to keep inflation expectations anchored close to the target inflation rate (for long-term commitments) 1) Inflation targeting rule 2) Money targeting rule 3) Nominal GDP targeting rule

Role of Congress in Monetary Policy

Fed makes 2 reports to Congress each year, the Fed Chairman makes a testimony before congress, and the Fed sends Congress the minutes of its meetings Limiting the Fed's independence is bad because congress would have a bias toward keeping interest rates low, which would lead to higher inflation in the long run

Exchange Rate Changes

Interest rate differential = the changes in the interest rate of the United States relative to the interest rates in other countries 1) When the Fed raises the federal funds rate, the U.S. interest rate differential rises, and other things remaining the same, the U.S. dollar appreciates 2) When the Fed lowers the federal funds rate, the U.S. interest rate differential falls, and other things remaining the same, the U.S. dollar depreciates *Many other factors also influence the exchange rate

Money Targeting Rule

Milton Friedman proposed the k-percent rule *The quantity of money growth is a rate of k percent per year, where k equals the growth rate of potential GDP - Relies on stable demand for money (a stable velocity of circulation) which can be exploited to deliver a stable price level and small business cycle fluctuations - Worked until the 1970's when U.S. inflation increased over 10% per year Inflation rates fell during the 1980s, but most countries abandoned the k-percent rule (technological changes gets rid of stability and makes the k-percent rule unreliable) Calls for economy to ignore recession/inflation

Expenditure Plans

Ripple Effects change aggregate expenditure: 1) Consumption Expenditure 2) Investment 3) Net Exports 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 Other things remaining the same, the lower the real interest rate, the greater is the amount of investment 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 *A cut in the federal funds rate increases all the components of aggregate expenditure; a rise in the federal funds rate decreases all the components of aggregate expenditure (which will change aggregate demand, real GDP, and the inflation rate)

Global Inflation Targeting

The Eurozone, New Zealand, the U.K., Sweden, Canada, and Australia have achieved inflation targets from 2000-2013; the results encourage public discussion *Eurozone & New Zealand missed their targets

Nominal GDP Targeting Rule

The central bank adjusts the interest rate to achieve a given nominal GDP growth rate target On average, the growth rate of GDP returns to its trend growth rate, which makes this a form of inflation targeting (interest rate responds to deviations in inflation or real GDP) Old idea revitalized by Christina Romer Changes the interest rate only when real GDP, and hence nominal GDP, is off target

Risks of Monetary Policy

Too little action will leave a recessionary or inflationary gap. Too much action will overshoot the objective. * Too much of a slowdown sends the economy from inflation to recession, and too much stimulus launches the economy out of a recession into inflation

Ripple Effects of Monetary Policy

When the Fed lowers the federal funds rate: 1) Other short-term interest rates fall 2) The exchange rate falls 3) The quantity of money increases 4) The supply of loanable funds increases 5) The long-term interest rate falls 6) Consumption expenditure increases 7) Investment increases 8) Exports increase 9) Imports decrease (Net exports increase) 10) Aggregate demand increases 11) Real GDP increases 12) The price level rises 13) Real GDP growth speeds up 14) Inflation speeds up 15) Unemployment decreases When the Fed raises the federal funds rate: 1) Other short-term interest rates rise 2) The exchange rate rises 3) The quantity of money decreases 4) The supply of loanable funds decreases 5) The long-term interest rate rises 6) Consumption expenditure decreases 7) Investment decreases 8) Exports decrease 9) Imports increase (Net exports decrease) 10) Aggregate demand decreases 11) Real GDP decreases 12) The price level falls 13) Real GDP growth slows down 14) Inflation slows down 15) Unemployment increases