Monetary Policy

Goals Intermediate Instruments Targets Discretion Monetary policy can be categorized by four characteristics Goals Intermediate Targets Monetary Policy Instruments Discretion

Instruments refer to the policy options the Fed has to control the supply of money… Discount Window Loans The Fed can also influence reserves by altering the interest rate charged on loans to commercial banks. (MB) Open Market Operations By purchasing or selling US Treasuries, the Fed can alter the supply of bank reserves (MB) Reserve Requirements Reserve Requirements influence the ability of banks to create new loans which affects the broader aggregates (M1,M2,M3) This is the most often used instrument!

Monetary Policy goals address the central bank’s agenda in general terms The Bank of England Follows an explicit Inflation Target. Specifically, the goal is to maintain 2% annual inflation. The Bank of China appears to have export driven growth as their primary objective The ECB (European Central Bank) and the Federal Reserve follow policies of stable prices and maintenance of full employment

Intermediate Targets address the question: “How will I meet my goals?”. Targets are variables that the central bank can more directly control. Goals vs. Targets The target is to score 18 under par (the number he thinks he needs to win) For Tiger Woods, the goal is to win the golf tournament The Bank of China is currently targeting the exchange rate at 8.28 Yuan per dollar The Federal Reserve is currently targeting the Federal Funds Rate at 2.75% The Bank of England is currently targeting the repo rate at 4.75%

Targets can be broadly classified into either “Price Targets” or “Quantity Targets” Suppose that the Federal Government could influence the supply of oranges and wanted to regulate the orange market Price Supply Lowering the price to $4 (price target) and Raising the quantity to 1,500 (quantity target) are both describing the same policy (expanding the orange market) $5/Lb $4/Lb Demand Quantity of Oranges 1,000 1,500

However, your response to demand changes will differ across policies Targets can be broadly classified into either “Price Targets” or “Quantity Targets” However, your response to demand changes will differ across policies Price Supply If demand for oranges increases and the Fed is following a price target, they must respond by increasing supply Target Range $5/Lb Demand Quantity of Oranges

However, your response to demand changes will differ across policies Targets can be broadly classified into either “Price Targets” or “Quantity Targets” However, your response to demand changes will differ across policies Target Range Price Supply If demand for oranges increases and the Fed is following a quantity target, they must respond by decreasing supply Demand Quantity of Oranges 1000Lbs

Suppose that the Fed wants to lower its target to 4% (expansionary monetary policy) M2 Multiplier = 8 Interest Rate (i) M2 = mm(MB) A $250 purchase of Treasuries would be required 2,000 = $250 5% 8 4% Md(y,t) M P Change in M2 = $2,000

Suppose that the Fed is Targeting the Interest Rate at 5% M2 Multiplier = 8 Interest Rate (i) Suppose an increase in GDP raises Money Demand M2 = mm(MB) The Fed needs to increase the monetary base by 5% 1,000 = $125 8 Md(y,t) (An Open Market Purchase of Treasuries) M P Change in M2 = $1,000

During the late 70’s, the federal reserve changed its policy from an interest rate target to a money target. The money target was abandoned in the mid eighties.

Rules vs. Discretion Should the Federal Reserve “pre-commit” to a particular course of action? The Chinese have pre-committed to maintaining a fixed exchange rate while the British have pre-committed to a fixed inflation rate. The ECB (European Central Bank) and the Federal Reserve both follow discretionary policies (i.e. policy is decided at the FOMC meeting)

Rules vs. Discretion Should the Federal Reserve “pre-commit” to a particular course of action? Benefits of Rules A states monetary policy rule is easy top forecast (i.e. it has less uncertainty) Costs of Rules A fixed policy rule allows the possibility of speculative attacks (i.e. exploiting the monetary policy rule for profit)

For most of its history, the US has followed a gold standard US Treasury A Gold Standard has two rules: The government sets an official price of gold ($35/oz) The government guarantees convertibility of currency into gold at a fixed price Assets Liabilities 200 oz. Gold @ $35/oz $7,000 (Gold) $10,000 (Currency) $3,000 (T-Bills) Reserve Ratio = 70% Value of Gold Reserves $7,000 = Reserve Ratio = Currency Outstanding $10,000 During most of the gold standard era, the Government had a reserve ratio of around 12%

By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply US Treasury (P = $35%) Price Assets Liabilities Supply 200 oz. Gold @ $35/oz $7,000 (Gold) $10,000 (Currency) $35 $3,000 (T-Bills) 100 oz. Gold @ $35/oz $3,500 (Currency) Demand Q Reserve Ratio = 70% Suppose that the Treasury purchased gold to increase the supply of currency outstanding (i.e. increase the money supply)

By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply US Treasury (P = $35%) Price Assets Liabilities Supply 200 oz. Gold @ $35/oz $7,000 (Gold) $10,000 (Currency) $35 $3,000 (T-Bills) Demand Q Reserve Ratio = 70% As the market price rises above $35 (due to increased demand), households start buying gold from the Treasure @ $35.oz and sell it in the open market. This reverses the original transaction

The gold standard and prices: Recall that in the long run, the price level is directly proportional to the ratio of money to output: $35(Gold Reserves) M = Reserve Ratio With a (relatively) fixed supply of money, prices remained stable in the long run

The gold standard and the supply of gold: US Treasury (P = $35%) Price Assets Liabilities Supply 200 oz. Gold @ $35/oz $7,000 (Gold) $10,000 (Currency) $35 $3,000 (T-Bills) 100 oz. Gold @ $35/oz $3,500 (Currency) Demand Q Reserve Ratio = 70% From time to time, new gold deposits were discovered. This increased supply would push down the market price. In response, households would buy the cheap gold and sell it to the Treasury for $35. This would increase the money supply.

The gold standard and the business cycle: US Treasury (P = $35%) Price Assets Liabilities Supply 200 oz. Gold @ $35/oz $7,000 (Gold) $10,000 (Currency) $35 $3,000 (T-Bills) (-) Gold (-) Currency Demand Q Reserve Ratio = 70% Typically, during recessions, the price of gold would rise (flight to quality). High gold prices would cause households to buy gold from the Treasury to sell in the market. This would force the treasury to lose reserves and contract the money supply.

Gold Standard: Long Run vs. Short Run Long Run: By restricting the long run supply of money, the gold standard produced constant, low average rates of inflation (bankers are happy) Short Run: By forcing monetary policy to be subject to fluctuating gold prices, the gold standard exacerbated the business cycle (farmers are unhappy)

Currently, the Fed follows an interest rate target Currently, the Fed follows an interest rate target. The target interest rate (Fed Funds Rate) is adjusted according to a ‘Taylor Rule” FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation – 2%) 1% Cyclical Unemployment = 2.5% Output Gap FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)

Currently, the Fed follows an interest rate target Currently, the Fed follows an interest rate target. The target interest rate (Fed Funds Rate) is adjusted according to a ‘Taylor Rule” FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%) Long Run: When the economy is at full employment ( Unemployment = 5%) and inflation is at its long run target (2%), the Fed targets the Fed Funds Rate (Nominal) at FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4% Short Run: During recessions (when inflation is low and unemployment is high), the Fed lowers its target. During expansions, when inflation is high and unemployment is low), the Fed raises its target.

Case study: Productivity Growth during the late 90’s Ms 4% 4% I + (G-T) Md Loanable Funds M P During the late 90’s, rapid income growth and productivity raised consumer spending (savings falls) and raised investment spending. Higher spending raised the demand for money. As unemployment dropped to 4.5% (above capacity), prices began to rise.

Case study: Productivity Growth during the late 90’s Ms 4% 4% I + (G-T) Md Loanable Funds M P The Fed responded by raising interest rates (contracting the money supply). The Fed was able to “slow down” the economy before inflation became a problem.

End of 1992 Recession Asian Financial Crisis Late 90’s Expansion Stock Market Bubble

Case study: Stock Market Crash and Liquidity Shocks Ms 4% 4% I + (G-T) Md Loanable Funds M P After the market crash, demand (primarily investment) slowed down and interest rates started falling. Further, the economy was operating well below capacity (Unemployment hit 6%) and inflation was hovering around zero.

Case study: Stock Market Crash and Liquidity Shocks Ms 4% 4% I + (G-T) Md Loanable Funds M P Lowering the Fed funds target allowed the fed to increase the money supply and stimulate spending.

Stock Market Crash Beginning of Recovery? Recession of 2001