Parkin-Bade Chapter 34

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CHAPTER
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• On eight pre-set dates a year, the Federal
  Reserve announces whether the interest rate will
  rise, fall, or remain constant until the next
  decision date.
• How does the Fed make its interest rate decision?
• What does the Fed do to keep interest rates where
  it wants them?
• Does the Feds interest rate changes influence
  the economy in the way the Fed wants?
• Can the Fed speed up economic growth by lowering
  interest rates and keep inflation in check by
  raising them?

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Monetary Policy Objectives and Framework

• A nations 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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Monetary Policy Objectives and Framework

• Monetary Policy Objectives
• The objectives of monetary policy stems 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 economys long-run
  potential to increase production, so as to
  promote effectively the goals of maximum
  employment, stable prices, and moderate long-term
  interest rates.

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Monetary Policy Objectives and Framework

• Goals and Means
• Feds monetary policy objectives has two distinct
  parts
• 1. A statement of the goals or ultimate
  objectives
• 2. A prescription of the means by which the Fed
  should pursue its goals

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Monetary Policy Objectives and Framework

• Goals of Monetary Policy
• 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.
• Key goal is price stability.
• Price stability is the source of maximum
  employment and moderate long-term interest rates.

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Monetary Policy Objectives and Framework

• Means of Achieving the Goals
• 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.
• How does the Fed operate to achieve its goals?

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Monetary Policy Objectives and Framework

• Operational Stables Prices Goal
• The Fed also pays close attention to the CPI
  excluding fuel and foodthe core CPI.
• The rate if increase in the core CPI is the core
  inflation rate.
• The Fed believes that the core inflation rate
  provides a better measure of the underlying
  inflation trend and a better prediction of future
  CPI inflation.

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Monetary Policy Objectives and Framework

• Figure 31.1 shows the core inflation rate and the
  CPI inflation rate.
• You can see that the CPI inflation rate is
  volatile and that the core inflation rate is a
  better indicator of price stability.

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Monetary Policy Objectives and Framework

• Operational Maximum Employment Goal
• Stable price 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 gapthe percentage deviation
  of real GDP from potential GDP.
• A positive output gap indicates an increase in
  inflation.
• A negative output gap indicates unemployment
  above the natural rate.
• The Fed tries to minimize the output gap.

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Monetary Policy Objectives and Framework

• Responsibility for Monetary Policy
• What is the role of the Fed, the Congress, and
  the President?
• The FOMC makes monetary policy decisions.
• The Congress makes no role in making monetary
  policy decisions. The Fed makes two reports a
  year and the Chairman testifies before Congress
  (February and June).
• The formal role of the President is limited to
  appointing the members and Chairman of the Board
  of Governors.

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The Conduct of Monetary Policy

• Choosing a Policy Instrument
• The monetary policy instrument is a variable that
  the Fed can directly control or closely target.
• As the sole issuer of the monetary base, the Fed
  is a monopoly.
• 1. Should the Fed fix the price of U.S. money on
  the foreign exchange market (the exchange rate)?
  
• 2. Should the Fed let the exchange rate be
  flexible and target the short-term interest
  rate?
• The Fed must decide which variable to target.

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The Conduct of Monetary Policy

• The Federal Funds Rate
• The Feds choice of policy instrument (which is
  the same choice as that made by most other major
  central banks) is a short-term interest rate.
• Given this choice, the exchange rate and the
  quantity of money find their own equilibrium
  values.
• The specific interest rate that the Fed targets
  is the federal funds rate, which is the interest
  rate on overnight loans that banks make to each
  other.

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The Conduct of Monetary Policy

• Figure 31.2 shows the federal funds rate.
• When the Fed wants to slow inflation, it raises
  the Federal funds rate.
• When inflation is low and the Fed wants to avoid
  recession, it lowers the Federal funds rate.

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The Conduct of Monetary Policy

• Although the Fed can change the federal funds
  rate by any (reasonable) amount that it chooses,
  it normally changes the rate by only a quarter of
  a percentage point.
• How does the Fed decide the appropriate level for
  the federal funds rate?
• And how, having made that decision, does the Fed
  get the federal funds rate to move to the target
  level?

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The Conduct of Monetary Policy

• The Feds Decision-Making Process
• The Fed could adopt either
• An instrument rule
• A targeting rule

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The Conduct of Monetary Policy

• Instrument Rule
• An instrument rule sets the policy instrument at
  a level based on the current state of the
  economy.
• The best known instrument rule is the Taylor
  rule
• Set the federal funds rate at a level that
  depends on
• The deviation of the inflation rate from target
• The size and direction of the output gap.

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The Conduct of Monetary Policy

• Targeting Rule
• A targeting rule sets the policy instrument at a
  level that makes the forecast of the ultimate
  policy target equal to the target.
• 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.

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The Conduct of Monetary Policy

• To implement such a targeting rule, the FOMC must
  gather and process a large amount of information
  about the economy, the way it responds to shocks,
  and the way it responds to policy.
• The FOMC must then process all this data and come
  to a judgment about the best level for the policy
  instrument.
• The FOMC minutes suggest that the Fed follows a
  targeting rule strategy.
• Some economists think that the interest rate
  settings decided by FOMC are well described by
  the Taylor Rule.

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The Conduct of Monetary Policy

• Hitting the Federal Funds Rate Target Open
  Market Operations
• An open market operation is the purchase or sale
  of government securities by the Fed from or to a
  commercial bank or the public.
• When the Fed buys securities, it pays for them
  with newly created reserves held by the banks.
• When the Fed sells securities, they are paid for
  with reserves held by banks.
• So open market operations influence banks
  reserves.

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The Conduct of Monetary Policy

• Figure 31.3 shows the effects of an open market
  purchase on the balance sheets of the Fed and the
  Bank of America.
• The open market purchase increases bank reserves.

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The Conduct of Monetary Policy

• Figure 31.4 shows the effects of an open market
  sale on the balance sheets of the Fed and Bank of
  America.
• The open market sale decreases bank reserves.

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The Conduct of Monetary Policy

• Equilibrium in the Market for Reserves
• Figure 31.5 illustrates the market for reserves.
• The x-axis measures the quantity of reserves
  held.
• The y-axis measures the federal funds rate.

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The Conduct of Monetary Policy

• The banks demand for reserves is the curve RD.
• The federal funds rate is the opportunity cost of
  holding reserves, so the higher the federal funds
  rate, the fewer are the reserves demanded.
• The demand for reserves slopes downward.

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The Conduct of Monetary Policy

• The red line shows the Feds target for the
  federal funds rate.
• The Feds open market operations determine the
  actual quantity of reserves in banking system.

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The Conduct of Monetary Policy

• Equilibrium in the market for reserves determines
  the federal funds rate.
• So the Fed uses open market operations to keep
  the federal funds rate on target.

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Monetary Policy Transmission

• Quick Overview
• When the Fed lowers the federal funds rate
• 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.

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Monetary Policy Transmission

• 5. Aggregate demand increases.
• 6. Real GDP growth and the inflation rate
  increase.
• When the Fed raises the federal funds rate, the
  ripple effects go in the opposite direction.
• Figure 31.6 provides a schematic summary of these
  ripple effects, which stretch out over a period
  of between one and two years.

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Monetary Policy Transmission
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Monetary Policy Transmission

• Interest Rate Changes
• Figure 31.7 shows the fluctuations in three
  interest rates
• The short-term bill rate
• The long-term bond rate
• The federal funds rate

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Monetary Policy Transmission

• Short-term rates move closely together and 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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Monetary Policy Transmission

• Exchange Rate Fluctuations
• The exchange rate responds to changes in the
  interest rate in the United States relative to
  the interest rates in other countriesthe U.S.
  interest rate differential.
• But other factors are also at work, which make
  the exchange rate hard to predict.

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Monetary Policy Transmission

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

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Monetary Policy Transmission

• 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
• The change in aggregate expenditure plans changes
  aggregate demand, real GDP, and the price level,
  which in turn influence the goal of inflation
  rate and output gap.

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Monetary Policy Transmission

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

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Monetary Policy Transmission

• The increase in the supply of money increases the
  supply of loanable funds in the short-term.

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Monetary Policy Transmission

• 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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Monetary Policy Transmission

• The decrease in the supply of money decreases the
  supply of loanable funds in the short-term.

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Monetary Policy Transmission

• Loose Links and Long and Variable Lags
• 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 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 doesnt always respond in the
  same way.

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Alternative Monetary Policy Strategies

• The Fed might have chosen any of four alternative
  monetary policy strategies One of them is an
  instrument rule and three are alternative
  targeting rules.
• The four alternatives are
• Monetary base instrument rule
• Monetary targeting rule
• Exchange rate targeting rule
• Inflation targeting rule

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Alternative Monetary Policy Strategies

• Monetary Base Instrument Rule
• The McCallum rule makes the growth rate of the
  monetary base respond to the long-term average
  growth rate of real GDP and medium-term changes
  in the velocity of circulation of the monetary
  base.
• The rule is based on the quantity theory of
  money.
• The McCallum rule does not need an estimate of
  either the real interest rate or the output gap.
• The McCallum rule relies on the demand for money
  and the demand for monetary base being reasonably
  stable. The Fed believes that these are too
  unstable to allow a McCallum rule work well.

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Alternative Monetary Policy Strategies

• Money Targeting Rule
• Friedmans k-percent rule makes the quantity of
  money grow at a rate of k percent a year, where k
  equals the growth rate of potential GDP.
• Friedmans idea was tried but abandoned during
  the 1970s and 1980s.
• The Fed believes that the demand for money is too
  unstable to make the use of monetary targeting
  reliable.

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Alternative Monetary Policy Strategies

• Exchange Rate Targeting Rule
• With a fixed exchange rate, a country has no
  control over its inflation rate.
• The Fed could use a crawling peg exchange.
• The disadvantage rate of a crawling peg to target
  the inflation rate is that the real exchange rate
  often changes in unpredictable ways.
• With crawling peg targeting the inflation rate,
  the Fed would need to identify changes in the
  real exchange rate and offset them.

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Alternative Monetary Policy Strategies

• Inflation Targeting Rule
• 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.
• It is not clear whether inflation targeting would
  deliver a better outcome than the Feds current
  implicit targeting.

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Alternative Monetary Policy Strategies

• Why Rules?
• Why do all the monetary policy strategies involve
  rules?
• Why doesnt the Fed use discretion?
• The answer is that monetary policy is about
  managing inflation expectations.
• A well-understood monetary policy rule helps to
  create an environment in which inflation is
  easier to forecast and manage.