14 MONETARY POLICY Part 1

Explain the Fed’s extraordinary policy actions We discuss: Objectives of monetary policy and the framework for setting an achieving them How the Federal Reserve makes its interest rate decision and achieves its interest rate target The transmission channels through which the Federal Reserve influences real GDP, jobs, and inflation Explain the Fed’s extraordinary policy actions

Monetary Policy Objectives and Framework Federal Reserve Act of 1913 and its amendments: The Fed shall ... promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. The goals are maximum employment and stable prices – the dual mandate. Interest rates are a means to achieving the goals.

Monetary Policy Objectives and Framework Means of Achieving the Goals Think of the Quantity Theory of Money - 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. Assume V is constant: If potential GDP growth is 2% and inflation goal is 2%, money growth should be 4%.

Monetary Policy Objectives and Framework Stable Price Goal The Fed looks at two measures of inflation: the CPI and the personal consumption expenditure (PCE) deflator. The Fed’s preferred measure is the PCE deflator excluding fuel and food - the core PCE deflator. The rate of increase in the core PCE deflator is called the core inflation rate. The Fed believes that the core inflation rate is less volatile than the CPI or PCE inflation rate and provides a better measure of the underlying inflation trend.

Why The PCE? Stable Price Goal PCE allows for substitution effects, the CPI does not. PCE hold prices constant and lets quantity change. PCE has broader coverage as it includes items not paid for directly, e.g., employer paid health insurance.

Monetary Policy Objectives and Framework The Fed’s stated objective is 2% inflation. Referred to as the target rate of inflation The Fed looks at the deviation of actual inflation from its 2% target/objective – called the inflation gap. How do you think the Fed reacts if actual inflation is above target?

Monetary Policy Objectives and Framework Maximum Employment Goal Along with price stability 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 actual real GDP from potential real GDP. A positive output gap (actual > potential) indicates increasing inflation – inflationary gap.

Monetary Policy Objectives and Framework Maximum Employment Goal A negative output gap (actual < potential) indicates unemployment above the natural rate – a recessionary gap. Fed policy is formulated to minimize the output gap and the inflation gap.

Monetary Policy Objectives and Framework Who is Responsible 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 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.

The Conduct of Monetary Policy How does the Fed conduct monetary policy? This question has two parts: What is the Fed’s monetary policy instrument? How does the Fed make its policy decision?

The Conduct of Monetary Policy The Monetary Policy Instrument The monetary policy instrument is a variable that the Fed can directly control and closely target. What can the Fed control?

The Conduct of Monetary Policy There are two possible policy instruments: 1. Monetary base (currency + reserves) 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. Most major central banks target an overnight bank lending rate. The Fed sets a target for the federal funds rate and then takes actions needed to keep it close to its target.

The Conduct of Monetary Policy Federal funds rate from 2000 through 2015. 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.

The Conduct of Monetary Policy The Fed can change the federal funds rate by any amount that it chooses… but it normally changes the rate by only a quarter of a percentage point. How ? By using ____________ to adjust the quantity of reserves in the banking system.

The Market for Bank Reserve The x-axis measures the quantity of reserves held. The y-axis measures the federal funds rate. The banks’ demand curve for reserves is RD. .

The Conduct of Monetary Policy The demand for reserves slopes downward because ... the federal funds rate is the opportunity cost of holding reserves and … the higher the federal funds rate, the lower the quantity of reserves demanded.

The Conduct of Monetary Policy The red line shows the Fed’s target for the federal funds rate. The Fed uses open market operations to make the quantity of reserves supplied equal to the quantity demanded at the target rate. The supply curve of reserves is RS. Actual federal funds rate determination: The reason that an increase in the reserves lowers the federal funds rate can be easily developed by focusing on banks. Using an open market operation, the Fed increases the monetary base, which increases the supply of reserves. At the current federal funds rate, there is now an excess supply of reserves. The interest rate at which banks are willing to make overnight loans to other banks decreases. This type of intuitive explanation often can be quite helpful in supplementing the formal analysis

The Conduct of Monetary Policy Equilibrium in the market for reserves determines the actual federal funds rate. By using open market operations, the Fed adjusts the supply of reserves to keep the federal funds rate on target.