Macro: Chapter 14: MONETARY POLICY

Monetary Policy Objectives

Monetary policy objectives stem from the mandate of the Board of Governors of the Federal Reserve System as set out in the Federal Reserve Act of 1913 and its amendments. The law states: The Fed and the FOMC shall maintain long-term 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.

Operational "Maximum Employment" Goal

Stable prices is the primary goal, but the Fed pays attention to the business cycle. To gauge the overall state of the economy, the Fed uses the output gap—the percentage deviation of real GDP from potential GDP. A positive output gap indicates increasing inflation. A negative output gap indicates unemployment above the natural rate. The Fed tries to minimize the output gap.

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Table

Means of Achieving the Goals

The 200 law instructs the Fed to pursue its goals by maintaining long-run growth of the quantity of money in line with the economy's long-run potential to increase production. That is, the Fed is expected to be able to maintain full employment and keep the price level stable. How does the Fed operate to achieve its goals?

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The Fed Fights Inflation If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target.

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The Fed Fights RecessionIf inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target.

Operational "Stables Prices" Goal

The Fed pays attention to two measures of inflation: the CPI and the personal consumption expenditure (PCE) deflator. The Fed's operational guide is PCE deflator excluding fuel and food—the core PCE deflator. The rate of increase in the core PCE deflator is the core inflation rate. The Fed believes that the core inflation rate is less volatile than the CPI inflation rate and provides a better measure of the underlying inflation trend.

Two Other Interest Rates: The Fed stands ready to make overnight loans to banks at an interest rate called the ___________ ________ A bank will not borrow from another bank unless the interest rate is lower than or equal to the discount rate. So, the discount rate caps the federal funds rate. The Fed pays __________ __ _________ held at the Fed. A bank will not lend reserves unless the interest rate is ________ _______ or _________ to the interest rate on reserves. So, the interest rate on reserves sets a floor on the federal funds rate.

The Fed stands ready to make overnight loans to banks at an interest rate called the discount rate. A bank will not borrow from another bank unless the interest rate is lower than or equal to the discount rate. So, the discount rate caps the federal funds rate. The Fed pays interest on reserves held at the Fed. A bank will not lend reserves unless the interest rate is higher than or equal to the interest rate on reserves. So, the interest rate on reserves sets a floor on the federal funds rate.

The Fed's Policy Actions in Crisis

The Fed's policy actions dribbled out for more than a year. The Fed conducted massive open market operations to keep the banks supplied with reserves.

During the financial crisis and recession of 2008-2009, the Fed lowered the federal funds rate to the floor. What can the Fed do to stimulate the economy when it cannot lower the federal funds rate? The three main events that put banks under stress were:

The Key Elements of the Crisis: The three main events that put banks under stress were: 1. Widespread fall in asset prices 2. A significant currency drain 3. A run on the bank

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The Taylor Rule says ...The Fed kept interest rates too low from 2001 to 2005, which fuelled the 2007-2008 financial crisis. Then the Fed raised interest rates too fast and too high. In 2009, the federal funds rate should have been negative. Since 2011, the Fed has been too slow to raise interest rates

The Taylor rule

The Taylor rule is a formula for setting the interest rate. Calling the federal funds rate FFR, the inflation rate INF, and output gap GAP (all percentages),

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The decrease in investment decreases aggregate planned expenditure.Real GDP decreases and closes the inflationary gap.

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The decrease in the supply of money decreases the supply of loanable funds.The real interest rate rises and investment decreases.

The discount rate and the interest rate paid on bank reserves held at the Fed create a corridor that ________ the movement of the federal funds rate. The corridor is 0.5 percentage points. When the interest rate on reserves is 2.0 percent, the discount rate is 1.5 percent. In normal times, the Fed sets the federal funds rate at the center of the corridor.

The discount rate and the interest rate paid on bank reserves held at the Fed create a corridor that limits the movement of the federal funds rate. The corridor is 0.5 percentage points. When the interest rate on reserves is 2.0 percent, the discount rate is 1.5 percent. In normal times, the Fed sets the federal funds rate at the center of the corridor.

Exchange Rate Fluctuations: 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. _________ ________ ________________ But other factors are also at work, which make the exchange rate hard to predict.

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. interest rate differential. But other factors are also at work, which make the exchange rate hard to predict.

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The increase in investment increases aggregate planned expenditure.Real GDP increases to potential GDP.

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The increase in the supply of money increases the supply of loanable funds.The real interest rate falls and investment increases.

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The interest rate that the Fed pays on reserves is 1.5 percent.The discount rate is 2.0 percent—0.5 percentage points above the interest rate on reserves.The blue band is the corridor.

The Tools: The main macroprudential regulation tools are rules about the ____________ _______ of banks and other financial institutions. They are rules about ______ __ ______ to net worth or _______ ___ _______ and other liquid asset reserves that vary with respect to the macroeconomic environment. For example, a microprudential regulation requires banks to increase their minimum ratio of net worth to loans, ... while a macroprudential regulation might make that minimum ratio increase during a recession and decrease in an expansion.

The main macroprudential regulation tools are rules about the Balance Sheets of banks and other financial institutions. They are rules about ratios of loans to net worth or loans to cash and other liquid asset reserves that vary with respect to the macroeconomic environment. For example, a microprudential regulation requires banks to increase their minimum ratio of net worth to loans, ... while a macroprudential regulation might make that minimum ratio increase during a recession and decrease in an expansion.

The main macroprudential regulation tools are rules about the __________ ______ of banks and other financial institutions. They are rules about ratios of loans to ______ ______ or _____ to ______ and other liquid asset reserves that vary with respect to the macroeconomic environment. For example, a microprudential regulation requires banks to increase their minimum ratio of net worth to loans, ... while a macroprudential regulation might make that minimum ratio increase during a recession and decrease in an expansion.

The main macroprudential regulation tools are rules about the balance sheets of banks and other financial institutions. They are rules about ratios of loans to net worth or loans to cash and other liquid asset reserves that vary with respect to the macroeconomic environment. For example, a microprudential regulation requires banks to increase their minimum ratio of net worth to loans, ... while a macroprudential regulation might make that minimum ratio increase during a recession and decrease in an expansion.

The Monetary Policy Instrument The Fed has two possible instruments:

The monetary policy instrument is a variable that the Fed can directly control or closely target. The Fed has two possible instruments: 1. Monetary base 2. Federal funds rate—the interest rate at which banks borrow and lend overnight from other banks. The Fed's policy instrument is the federal funds rate. The Fed sets a target for the federal funds rate and then takes actions to keep it close to its target.

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The short-term bill rate and other short-term rates follow the federal funds rate.Long-term rates move in the same direction as the federal funds rate but are only loosely connected to the federal funds rate.

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To hit the federal funds target of 1.75 percent, the Fed uses open market operations to make the supply of reserves RS0.In recent years, the federal funds target has been at the bottom of the corridor. To hits this target, the Fed has made the supply of reserves RS1.

Macroprudential Regulation Today

U.S. regulation is centralized in the Financial Stability Oversight Council (FSOC) established in 2010. The job of FOSC is to identify threats to U.S. financial stability and to respond to emerging risks to the U.S. financial system. The Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 created the FOSC and made wide-ranging changes to financial regulation. In 2017, Congress was seeking to roll back many of the provisions of Dodd-Frank.

Responsibility for Monetary Policy

What is the role of the Fed, the Congress, and the President? The Fed's FOMC makes monetary policy decisions. The Congress plays no role in making monetary policy decisions. The Fed makes two reports a year and the Chair testifies before Congress (February and June). The formal role of the President is limited to appointing the members and Chair of the Board of Governors.

Money and Bank Loans

When the Fed lowers the federal funds rate, the quantity of money and the quantity of bank loans increase. Consumption and investment plans change

Expenditure Plans The ripple effects that follow a change in the federal funds rate change three components of aggregate expenditure:

- Consumption expenditure - Investment - Net exports A change in the federal funds rate changes aggregate expenditure plans, which in turn change aggregate demand, real GDP, and the price level.

Congress's Policy Actions in Crisis

- Extended deposit insurance - Authorized the Treasury to buy "troubled" assets from banks. These actions provided banks with more reserves, more secure depositors, and safe liquid assets in place of troubled assets.

The Fed's Decision-Making Strategy The Fed's decision begins with an intensive assessment of the current state of the economy. Then the Fed forecasts three variables

- Inflation rate - Unemployment rate - Output gap

Policy Strategies and Clarity Two other approaches to monetary policy that other countries have used are

- Inflation rate targeting - Taylor rule

During the financial crisis of 2007-2008 and the recession that followed, the Fed took extraordinary actions to limit the damage and restore stability while Congress took actions aimed at making the financial system more robust. The Anatomy of the Financial Crisis A financial crisis arises when many financial firms fail to pay their debts. Three events can put a bank under stress:

- Widespread fall in asset prices - Large currency drain - Run on the bank

Means and Goals The Fed's monetary policy objective has two distinct parts:

1. A prescription of the means by which the Fed should pursue its goals 2. A statement of the goals

Quick Overview When the Fed lowers the federal funds rate, it buys securities in an open market: 1. Other short-term interest rates and the exchange rate fall. 2. The quantity of money and the supply of loanable funds increase. 3. The long-term real interest rate falls. 4. Consumption expenditure, investment, and net exports increase.

1. Other short-term interest rates and the exchange rate _____. 2. The quantity of money and the supply of loanable funds __________. 3. The long-term real interest rate _______. 4. Consumption expenditure, investment, and net exports ____________.

5. Aggregate demand ____________. 6. Real GDP growth and the inflation rate _____________. When the Fed raises the federal funds rate, it sells securities in an open market and the ripple effects go in the ______________ direction. Figure 14.4 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.

5. Aggregate demand increases. 6. Real GDP growth and the inflation rate increase. When the Fed raises the federal funds rate, it sells securities in an open market and the ripple effects go in the opposite direction. Figure 14.4 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.

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A decrease in the monetary base decreases the supply of money.The short-term interest rate rises.

Monetary Policy Objectives and Framework

A nation's monetary policy objectives and the framework for setting and achieving that objective stems from the relationship between the central bank and the government.

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An increase in the monetary base increases the supply of money.The short-term interest rate falls.

Banks hold reserves to meet required reserve ratio and excess reserves to make ______________. Because reserves can be loaned in the federal funds market at the federal funds rate, reserves are _________ to hold. The higher the federal funds rate, the _________ is the quantity of reserves demanded.

Banks hold reserves to meet required reserve ratio and excess reserves to make payments. Because reserves can be loaned in the federal funds market at the federal funds rate, reserves are costly to hold. The higher the federal funds rate, the smaller is the quantity of reserves demanded.

The Long-Term Real Interest Rate

Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate. The long-term real interest rate influences expenditure plans.

the Taylor rule formula is

FFR = 2 + INF + 0.5(INF - 2) + 0.5GAP Figure 14.8 show the federal funds rate and what it would have been if the Taylor rule has been used.

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Figure 14.1 shows the core inflation rate since 2000 along with the Fed's comfort zone.Most of the time, the Fed has kept its core inflation rate inside its comfort zone of 1 to 2 percent per year.

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Figure 14.2 shows the federal funds rate.When the Fed wants to avoid recession, it lowers the Federal funds rate.When the Fed wants to check rising inflation, it raises the Federal funds rate.

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Figure 14.3 illustrates the market for bank reserves.The x-axis measures the quantity of reserves held on deposit at the Fed.The y-axis measures the federal funds rate.The banks' demand curve for reserves is RD.

Interest Rate Changes

Figure 14.5 shows the fluctuations in three interest rates: - The federal funds rate - The 3-month Treasury bill rate - The long-term bond rate

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Figure 14.8 show the federal funds rate and ...what it would have been if the Fed had used the Taylor rule.

Fed's Monetary Policy Goals: A Dual Mandate

Goals are maximum employment, stable prices, and moderate long-term interest rates. In the long run, these goals are in harmony and reinforce each other. But in the short run, they might be in conflict. The key goal is price stability. Price stability is the source of maximum employment and moderate long-term interest rates.

Implementing the Policy Decision Having decided the appropriate level for the federal funds rate, how does the Fed get the federal funds rate to move to the target level? The answer is: To see how an open market operation changes the federal funds rate, we look at two markets:

Having decided the appropriate level for the federal funds rate, how does the Fed get the federal funds rate to move to the target level? The answer is by using open market operations to adjust the quantity of bank reserves. To see how an open market operation changes the federal funds rate, we look at two markets: - The federal funds market - The market for bank reserves

Output Gap If the output gap is positive, it is an inflationary gap and the inflation rate will most likely _______________. The Fed might consider raising the federal funds rate. If the output gap is negative, it is a ________________ gap and inflation might _______. The Fed might consider lowering the federal funds rate.

If the output gap is positive, it is an inflationary gap and the inflation rate will most likely accelerate. The Fed might consider raising the federal funds rate. If the output gap is negative, it is a recessionary gap and inflation might ease. The Fed might consider lowering the federal funds rate.

Unemployment Rate If the unemployment rate is below the natural unemployment rate, a labor shortage might put pressure on wage rates to ________ , which might feed into _______________. The Fed might consider raising the federal funds rate. If the unemployment rate is above the natural unemployment rate, a __________ inflation rate is expected. The Fed might consider ______________ the federal funds rate.

If the unemployment rate is below the natural unemployment rate, a labor shortage might put pressure on wage rates to rise, which might feed into inflation. The Fed might consider raising the federal funds rate. If the unemployment rate is above the natural unemployment rate, a lower inflation rate is expected. The Fed might consider lowering the federal funds rate.

The Federal Funds Market

In the federal funds market, the higher the federal funds rate, the greater is the quantity of overnight loans supplied and the smaller is the quantity demanded. The equilibrium federal funds rate balances the quantities supplied and demanded.

What is Inflation Rate Targeting What are the commitments (2)

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment 1. To achieve an explicit inflation target 2. To explain how its policy actions will achieve that target Several central banks practice inflation targeting and have done so since the mid-1990s. Inflation targeting is a strategy that avoids serious inflation and persistent deflation.

Inflation Rate

Is the inflation rate inside the Fed's comfort zone? If the inflation rate is above the comfort zone or expected to move above it, the Fed considers raising the federal funds rate target. If the inflation rate is below the comfort zone or expected to move below it, the Fed considers lowering the federal funds rate target.

The Market for Bank Reserves

Lending in the federal funds market is an alternative to holding larger reserves while borrowing is an alternative to holding smaller reserves.

Loose Links and Long and Variable Lags: Long-term interest rates that influence spending plans are linked loosely to the _______ _____ rate. The response of the real long-term interest rate to a change in the nominal interest rate depends on how ______________ expectations change. The response of expenditure plans to changes in the _______ ___________ rate depends on many factors that make the response hard to predict. The monetary policy transmission process is _______ and drawn out and doesn't always respond in the same way.

Long-term interest rates that influence spending plans are linked loosely to the federal funds rate. The response of the real long-term interest rate to a change in the nominal interest 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. The monetary policy transmission process is long and drawn out and doesn't always respond in the same way.

Macroprudential Regulation

Macroprudential regulation is financial regulation to lower the risk that the financial system will crash. The global financial crisis of 2007-2008 brought this type of regulation to center stage.

Macro Versus Micro

Microprudential regulation seeks to lower the risk of failure of individual financial institutions. Macroprudential regulation focuses on the interconnections among individual financial institutions and markets and their shared exposure to common shocks.