The Federal Reserve System Policies & critiques The Gold Standard ECO 473 – Money & Banking – Dr. D. Foster

Goals of Monetary Policy Inflation goals: Low/no inflation with limited year-to-year variability. Output goals: High and stable economic (GDP) growth. Employment goals: Stable employment growth with low unemployment.

Federal Reserve Policy Tools Open Market Operations Buy/sell Treasury bonds to affect bank reserves. The major form of monetary policy. Since 2009, also buying MBS! Discount Window Lend to member banks to affect bank reserves. Purpose is to target the “federal funds rate” – iff This is the rate that banks charge each other for very short term loans. Required Reserve Ratio (rrD) Changing this affects bank excess reserves directly. Was used in 1937 and precipitates more Great Depression. New policy? – Pay banks interest on their Excess Reserves!

Monetary Policy: Goals & Targets Open Market Operations Discount Window Required Reserve Ratio (rrD) Price stability Low unemployment Sustainable growth Interest Rates Monetary Aggregates

Targeting the Federal Funds Rate of Interest Jan. 2018 1.41%

Is Policy the Right Choice? Time lags make effective policy uncertain. Recognition/Response/Transmission lags Discretionary policy promotes uncertainty. It may promote more volatility! Can Rules and credible eliminate bias? Milton Friedman promoted this.

Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag Real GDP Business cycle time

Monetary Policy may be counterproductive % Real GDP time Ideally, policy would dampen the business cycle… But, dampening the business cycle may lower ave. growth! Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Discretion versus Rules (Milton Friedman) Discretionary policy is the source of instability. A policy rule can eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. This is a commitment to a fixed strategy no matter what happens to other economic variables. To be successful, the commitment must be credible. The public believes the Fed will act this way.

Federal Reserve Policies 1970 - 1979 targets the Federal Funds rate. became increasingly inconsistent with money aggregate targets in the late 1970s. 1979 - 1982 targets NBR. led to volatile interest rates and investment uncertainty. 1982 - 1987 targets BR. essentially sets rd to maintain BR, controlling ff*. 1987 - 2005 targets the Federal Funds rate. with “flexible” target ranges . . . meaning???

Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

Has the Fed maintained stable prices?

Has the Fed maintained the value of the $? 4%

Targeting Monetary Aggregates Long Run link between MS growth and Inflation. Milton Friedman & money growth rule. ECB partly uses a money growth rule. Eliminates discretionary policy. Lots of evidence that this is the source of disruption. Eliminates “time consistency” problem. No more uncertainty about policy. Acts as an “automatic stabilizer.” It builds in dampening effects on the business cycle.

fft =  + ff*r + .5( gap) + .5(Y gap) Targeting Monetary Aggregates Set interest rates to achieve goals . . . The Taylor rule: fft =  + ff*r + .5( gap) + .5(Y gap) fft = target federal funds interest rate ff*r = equilibrium ff interest rate (consistent with Y*) Y gap = actual output (Y) minus potential output (Y*), as a % of Y*.  = inflation  gap = inflation minus target inflation coefficients here are assumed to be 0.5 15 15

Using the Taylor Rule ff*r = 2.0% Y gap = -3.0%  = 3.5%  gap = 2.0% fft =  + ff*r + .5( gap) + .5(Y gap) ff*r = 2.0% Y gap = -3.0%  = 3.5%  gap = 2.0% ff*r = 3.5% Y gap = 4.5%  = 4.0%  gap = 2.0% Calculate the target ff rate of interest: fft = 3.5 + 2.0 + .5(2) + .5(-3) = 5.0% Calculate the target ff rate of interest: fft = 4 + 3.5 + .5(2) + .5(4.5) = 10.75% What would the Taylor rule advise for the target federal funds rate if the Fed’s target inflation rate is 2.5%, actual inflation is 2%, output is 3% below its potential and the real federal fund rate at potential output would be 4%? 16 16

Explaining Policy - the Taylor Rule 17 17

Quantitative Easing = Credible? QE 1 QE 2 QE 3

Can the Fed undo the QEs? Inflation is a monetary phenomenon. What happens if the economy starts growing? Banks will want to lend more, raising the MS and causing inflation. The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%? Inflationary expectations grow and become rooted in our economy, ala 1979. Fed starts to pull back by selling UST and MBS. Their prices plummet; so Fed can’t buy back all the excess reserves! Interest rates will soar; investment will falter; a recession ensues. But, a recession accompanied by serious inflation, aka “stagflation.” Is it an “insurance policy” against massive sell-off?

How the Gold Standard works A gold standard implies that we have “fixed” exchange rates between currencies. $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £10.29 mill. American firms export goods to England … tractors. Value = $50 m. British firms export goods to U.S. … fish & chips. Value = £10.29 m. At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms. Suppose that British exports fall by 23% and that only £8 mill. of F&C is exported, selling for $38.88 mill. in the U.S..

How the Gold Standard works $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £8 mill. Now, American exporters can’t exchange all of their £10.29 mill. for $. They can only exchange £8 mill. at the going exchange rate, receiving $38,880,000. But, they aren’t going to lose here… They would cash the rest out in gold: £2.29 mill. = 538,823 oz. They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 Total value received = $50,000,000

How the Gold Standard works $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £8 mill. 538,823 ounces The flow of gold from England to U.S. won’t persist over time. M•V=P•Q  gold =  MS  MS =  P deflation  gold =  MS  MS =  P inflation U.S. exports fall and British exports rise until trade flows balance.

Confounding the Gold Standard In England, the outflow of gold will lead to price deflation and probably a recession (or a depression). So, the Bank of England raises interest rates. This attracts foreign investment (capital inflows) which ends outflow of gold. In the U.S., expanding the money supply means inflation and falling exports. The Fed can buy this gold by selling Treasury securities, so not allowing the money supply to increase. But, this will also raise U.S. interest rates which works against British policy and encourages more gold inflows!

Stress on the Gold Standard WWI - Combatant countries go off gold standard to spending. Gold rushes into the U.S. as countries buy war material. Post-WWI, gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Victors can ease burden by acquiring gold stocks. Burden on losers is unsustainable. Eventually, U.S. lends gold to Germany.

Stress on the Gold Standard The Gold Exchange Standard: U.S. & U.K. hold gold Other countries hold gold, $, £ U.K. recession restores gold value by 1925. France devalues currency; gold inflows. 1927 - France redeems pounds; more gold inflows. Fed lowers i; gold flows from U.S.; burden on U.K. lessened. 1927 - 9% of world’s gold; 1929 - 17%; 1931 - 22% Gold inflows sterilized and MS in France was constant.

Stress on the Gold Standard U.S. monetary policy is erratic: 1927 - lowers i (3.5%) and gold flows out. 1928 - raises i to stop gold outflows. By Sept. 1929, i up to 6%; gold inflows 1929/1930. After crash, i lowered; down to 1.5% in April 1931. Gold outflows 1931; raised i to 3.5%. March 1932 Fed begins OMO which stops deflation. OMO stop in July 1932. Devaluation concerns drive gold outflow Jan-Mar 1933.

The Federal Reserve System Policies & critiques The Gold Standard ECO 473 – Money & Banking – Dr. D. Foster