MACRO ch 17

Inflation targeting

-- is 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. Of the alternatives to the Fed's current strategy, inflation targeting is the most likely to be considered. In fact, some economists see it as a small step from what the Fed currently does.

Federal Reserve Act

-- passed by Congress in 2000 states that: 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.

monetary policy instrument

Choosing a Policy Instrument To conduct its monetary policy, the Fed must select a monetary policy instrument. A --is a variable that the Fed can directly control or closely target and that influences the economy in desirable ways. As the sole issuer of monetary base, the Fed has a monopoly and can fix either the quantity or the price of monetary base.

dual mandate..stable prices...maximum employment

Goals: The Dual Mandate The Fed's goals, often called the "--," are to achieve stable prices and full employment. The goal of "---" means keeping the inflation rate low. The goal of "---" means attaining the maximum sustainable growth rate of potential GDP, keeping real GDP close to potential GDP and the unemployment rate close to the natural unemployment rate.

Core..excluding

Operational "Stable Prices" Goal The Fed believes that core inflation provides the best indication of whether price stability has been achieved. -- inflation is the annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator)--the prices of food and fuel. The Fed has not defined price stability, but many economists regard it as a core inflation rate of between 1 and 2 percent a year.

financial stability

Prerequisites for Achieving the Goals The financial crisis brought the problem of financial instability to the top of the Fed's agenda. The focus of policy became the single-minded pursuit of ---—a situation in which financial markets and institutions function normally to allocate capital resources and risk. - is a prerequisite for attaining the goals. Financial instability has the potential to undermine the attainment of the mandated goals.

Federal Reserve Act..Congress

Responsibility for Monetary Policy The -- makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy. - makes a monetary policy decision at eight scheduled meetings a year and publishes the minutes three weeks after each meeting. -- plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress. The Fed makes two reports to Congress each year. The formal role of the President of the United States is limited to appointing the members and the Chairman of the Board of Governors.

Nominal GDP targeting.. nominal

-- is 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 government or adopted by the central bank. The growth rate of nominal GDP equals the growth rate of real GDP plus the inflation rate, as measured by the GDP price index. The growth rate of real GDP, on average, keeps returning to the trend growth rate, so-- 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 an old idea that many economists have recommended, but it gained momentum during 2011.

interest rate differential.

Exchange Rate Changes The exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. i--- 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. And 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.

federal funds rate..smaller

Hitting the Federal Funds Rate Target The -- is the interest rate that banks earn (or pay) when they lend (or borrow) reserves. -is also the opportunity cost of holding reserves. Holding a larger quantity of reserves is the alternative to lending reserves to another bank. Holding a smaller quantity of reserves is the alternative to borrowing reserves from another bank. So the quantity of reserves that banks are willing to hold varies with the federal funds rate: The higher the federal funds rate, the -- is the quantity of reserves that the banks plan to hold. The Fed controls the quantity of reserves supplied. The Fed can change this quantity of reserves supplied by conducting an open market operation. To hit the federal funds rate target, the Fed conducts open market operations until the supply of reserves is at just the right quantity to hit the target federal funds rate.

Inflation

How Inflation Targeting Is Conducted -- targets are specified in terms of a range for the CPI inflation rate. This range is typically between 1 percent and 3 percent a year, with an aim to achieve an average inflation rate of 2 percent a year. Because the 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 two years

dual mandate

In 2013, the "---" put the Fed in a dilemma. The recovery was slow and unemployment was not falling quickly enough. The Fed's dilemma was when to stop fighting the slow recovery and start worrying about unleashing inflation.

instrument rule...Taylor

Instrument Rule An --- is a decision rule for monetary policy that 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. The -- rule sets the federal funds rate by a formula that links it to the current inflation rate and current estimate of the output gap.

credit

Means for Achieving the Goals The 2000 law instructs the Fed to pursue its goals. The "economy's long-run potential to increase production" is the growth rate of potential GDP. The "monetary and --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.

Federal Reserve System.

Monetary Policy Objectives The objectives of monetary policy are ultimately political. The objectives are set out in the mandate of the Board of Governors of the ------- The mandate is defined by the Federal Reserve Act of 1913 and its subsequent amendments. The objectives have two distinct parts: a statement of goals and a prescription of the means by which to pursue them.

k-percent rule

Money Targeting Rule An example is Friedman's k-percent rule. The---is a monetary policy rule that makes the quantity of money grow at k percent per year, where k equals the growth rate of potential GDP. 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.

minimize

Operational "Maximum Employment" Goal The Fed pays close attention to the business cycle and tries to steer a steady course between recession and inflation. The Fed tries to -- the output gap—the percentage deviation of real GDP from potential GDP.

targeting rule

Targeting Rule A --is 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. If the ultimate 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.

Federal funds rate

The price of monetary base is the federal funds rate. -- is the interest rate at which banks can borrow and lend reserves in the federal funds market. The Fed can target the quantity of monetary base or the federal funds rate, but not both. 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.

Inflation

What Does-- 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.

Discretionary monetary policy

Why Rules? The alternative to a monetary policy rule is discretionary monetary policy. --- is a monetary policy that is based on an expert assessment of the current economic situation. A well-understood monetary policy rule helps to keep inflation expectations anchored close to the inflation target and creates an environment in which inflation is easier to forecast and manage. Although rules beat discretion, there are three alternative rules that the Fed might have chosen. They are An inflation targeting rule A money targeting rule Nominal GDP targeting rule