© 2010 Pearson Addison-Wesley

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.

© 2010 Pearson Addison-Wesley 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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 Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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? Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley Figure 14.1 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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. Monetary Policy Objectives and Framework

© 2010 Pearson Addison-Wesley 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.

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley Figure 14.2 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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? The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley The Feds Decision-Making Process The Fed could adopt either An instrument rule A targeting rule The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley Figure 14.3 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley Figure 14.4 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley Equilibrium in the Market for Reserves Figure 14.5 illustrates the market for reserves. The x-axis measures the quantity of reserves held. The y-axis measures the federal funds rate. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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. The Conduct of Monetary Policy

© 2010 Pearson Addison-Wesley 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.

© 2010 Pearson Addison-Wesley 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 14.6 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley Monetary Policy Transmission

© 2010 Pearson Addison-Wesley Interest Rate Changes Figure 14.7 shows the fluctuations in three interest rates: The short-term bill rate The long-term bond rate The federal funds rate Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley The Fed Fights Recession If inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley The increase in the supply of money increases the supply of loanable funds in the short-term. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley The Fed Fights Inflation If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley The decrease in the supply of money decreases the supply of loanable funds in the short-term. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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. Monetary Policy Transmission

© 2010 Pearson Addison-Wesley 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

© 2010 Pearson Addison-Wesley 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. Alternative Monetary Policy Strategies

© 2010 Pearson Addison-Wesley 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. Alternative Monetary Policy Strategies

© 2010 Pearson Addison-Wesley 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. Alternative Monetary Policy Strategies

© 2010 Pearson Addison-Wesley 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. Alternative Monetary Policy Strategies

© 2010 Pearson Addison-Wesley 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. Alternative Monetary Policy Strategies