Chapter 5 – Monetary Policy BA 543 Financial Markets and Institutions

Chapter 5 – Monetary Policy Goals of the Federal Monetary Policy Stability in Price Level (Inflation) Unstable Prices retard economic growth, provoke volatility in interest rates, stimulate consumption, deter savings, and cause capricious redistribution of income and wealth with attendant social disturbances (page 78) Average Inflation 1982 to 2010 is 2.9% “Controlling Inflation” after a supply shock  Refuse to Accommodate with matching increase in money supply – leads to higher interest rates and decline in growth  Accommodate– increase money supply above shock and let inflation be unchecked (find new equilibrium)

Chapter 5 – Monetary Policy Goals of the Federal Monetary Policy High Employment (Low Unemployment) Frictional Unemployment (Job Changers)  Target 4% to 6% of labor force currently at 7.9%  See Table 5-2 Page 79 Increase in Money Supply can bring about:  Economic Expansion  Stimulate Investment  Encourage Consumption  Lead to the Creation of New Jobs  Kindle Inflation – Output near capacity  Raise Interest Rates which reverses the good

Chapter 5 – Monetary Policy Goals of the Federal Monetary Policy Economic Growth (Increase in Output of Goods and Services) What is the appropriate rate of growth? Sustainable Growth Reasonable Growth Steady Growth Via Stabilizing Interest Rates Reduce Volatility – But allow changes How do interest rates impact growth?

Chapter 5 – Monetary Policy Goals of the Federal Monetary Policy Stability in Foreign Exchange Strong Dollar Means (Indirect Quote goes up)  Exchange Rates are moving so that $1 can buy more foreign currency or U.S. Products are becoming relatively more expensive “overseas”  Trade-Imbalance: Foreign goods purchased more in U.S. and less U.S. goods purchased abroad Weak Dollar Means (Indirect Quote goes down)  More U.S. goods purchased abroad and fewer foreign goods purchased in U.S. Who Benefits from Strong Dollar vs. Weak Dollar?

Chapter 5 – Monetary Policy Goals are not always Aligned Tradeoffs between Goals Fed “selects” goal most in jeopardy Fed works through Operating Targets – impacts on monetary and financial variables that tend to change Intermediate Targets – that have reasonable linkage to Ultimate Objectives – price level stability, employment, growth, and foreign exchange rates

Diagram of Fed Tools and Goals Federal Tools – Open Market Operations (Buying and Selling) Operating Targets: Direct Impact from tool (can predict the results of actions) Increase or Decrease in Money Supply Intermediate Targets the Fed indirectly tries to impact Increase in Capital Investing Monetary Goals: Inflation, Economic Growth, Stable Interest Rates and Stable Foreign Exchange Rates – Increase GDP without increasing inflation

Chapter 5 – Monetary Policy Choosing the Operating Targets U.S. Targets: Short-Term Interest Rates (Inflation) or Bank Reserves via money supply Can not do both simultaneously, Why? Negative Correlation between reserves and interest rates…as Fed increases reserves it reduces short-term rates and vice versa Variable outside the control of the Fed…demand for money…thus borrowers and lenders impact the supply of money at banks as well as Fed

Chapter 5 – Monetary Policy Choosing the Intermediate Targets Suitable Target must be observable Money Supply  Early standard target…some discussion on which measure and concern that it does not have linkage with the ultimate objectives GNP (GNP growth rate)  Measurability big issues, data is quarterly Inflation  Believed to have better linkage to ultimate goals  Many Europeans using price indexes for sensitive products…Bernanke has focused on specific inflation rate Responsiveness to stimulation is critical

Chapter 5 – Monetary Policy Historical Trip through Targets 1970s – Feds Fund Rate (Keynesian) 1979 – 1982 Nonborrowed Reserves (Monetarists) let interest rates fluctuate 1983 – 1991 Borrowed Reserves 1991 – 1995 Borrowed Reserves with attention to sensitive commodities (European approach) 1996 – 2000 New Paradigm of Higher Sustainable New century 2001 – today…inflation focus