Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 21 Monetary Policy Strategy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Learning Objectives Realize how the Federal Open Market Committee chooses an economic target and a policy lever to reach that target Understand the mechanics of the federal funds market and how the Federal Reserve can interact in that market Define the Taylor rule and explain its significance to monetary policy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Introduction “Federal Open Market Committee (FOMC) seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output” Examination of the formulation of policy through the Federal Open Market Committee’s directive Review the reasons for the particular course of action that is followed

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The FOMC Directive The FMOC meets every five or six weeks –Review of recent economic and financial developments Prices Unemployment Interest rates Money supply Balance of payments Bank credit –Makes projections for the future –Based on anticipated economic conditions, proposes appropriate monetary policy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The FOMC Directive (Cont.) The FOMC directive –In recent years, FOMC directive usually contains a single paragraph that begins with a general qualitative statement of current policy goals –Specifies the immediate prescription for implementing longer-term objectives –In outlining its operating targets, the Committee refers to conditions in the reserve markets, not in terms of money supply growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The FOMC Directive (Cont.) The FOMC directive (Cont.) –Although Fed emphasizes monetary and reserve aggregates, in practice it operates on interest rates (Federal Funds Rate) –After each meeting, the FOMC releases a statement Summarizes the directive Gives some idea of the Fed’s view of future policy risks Indicates whether policy risks are mainly weighted toward inflationary pressure, economic weakness, or weighted equally between the two

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Strategy Humphrey-Hawkins Act of 1978 –Provides policy guidelines to Federal Reserve Maximum employment Price stability Moderate long-term interest rates –Fed has interpreted maximum employment as full employment--economy functions at its potential –Meet these three goals by seeking price stability and sustainable growth since long-term interest rates are low when expected inflation is low

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Strategy (Cont.) Figure 21.1 summarizes some of the choices the Fed must make when deciding upon its strategy Ultimate goals are two steps removed from the Fed’s tools Operating and intermediate targets are more responsive to Fed’s actions These two steps provide timely feedback so Fed can judge if their actions are on the right track

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.1 The Fed’s game plan.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Fed’s Strategy (Cont.) Steps in development of the Fed’s plan –Decide upon GDP growth rate consistent with inflation and unemployment objectives –Set range for monetary growth expected to generate target GDP growth –Set a target for growth in reserves Key to the success of Fed’s effectiveness is understanding and predicting the linkages between the different steps

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate Different targets selected by Federal Reserve –Before October 1979—favored federal funds rate –October 1979 to mid-1982—shifted to reserve aggregates to get control over inflation –After mid-1982—shifted focus back to federal funds rate It seems that reserves and the federal funds rate are two sides of the same coin

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate (Cont.) However, there is often an irreconcilable conflict that prevents the Fed from simultaneously targeting reserves and the fed funds rate Characteristics of the federal funds market –Immediately available funds that are lent between banks, usually on an overnight basis –Transfer of funds through bookkeeping entry on reserves held by the Fed –Interest rate charged is the Federal Funds Rate

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate (Cont.) Figure 21.2 and Figure 21.3 –The Federal Funds Rate is established in the competitive market (supply and demand of reserves), but is influenced by the Fed (proactive action) Increase reserves—Lower the rate Decrease reserves—Raise the rate

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.2 The supply and demand for reserves produces the equilibrium federal fund rate.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.3 An increased supply of reserves lowers the federal funds rate; a lower federal funds rate requires an increased supply of reserves.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate (Cont.) Figure 21.4 –In the real world, demand curves for reserves fluctuates with the pace of economic activity –These shifts in the demand curve will complicate the actions of the Fed (reactive action) –The Fed can target either the level of reserves or the federal funds rate Targeting reserves—the federal funds rate will vary Targeting federal funds rate—the level of reserves will vary

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.4 Controlling reserves (panel (a)) implies volatility in the federal funds rate, while controlling the federal funds rate (panel (b)) implies volatility in reserves supplied.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.4 Controlling reserves (panel (a)) implies volatility in the federal funds rate, while controlling the federal funds rate (panel (b)) implies volatility in reserves supplied. (Cont.)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate (Cont.) The Fed cannot set reserve levels and the federal funds rate independently Which target should the Fed choose? –Select one that produces less variability in GDP –Targeting reserves and letting interest rate change would be best under some conditions Close and predictable relationship between reserves and spending Private spending is subject to destabilizing variations Resulting interest rate changes would stabilize the economy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserves Versus the Federal Funds Rate (Cont.) Which target should the Fed choose? (Cont.) –Targeting interest rates, with fluctuating reserves Weak linkage between reserves and spending results in variation in demand for reserves not related to changes in spending In this case, automatic changes in interest rates would not allow the Fed to stabilize the economy Under these conditions, the Fed has concluded it is better to target the federal funds rate With significant change in economic activity, it might be necessary to alter targeted federal funds rate

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Taylor Rule and Fed’s Track Record During recent years, the Fed’s focus has clearly been on the use of the federal funds rate to influence interest rates Interest rates then affect the aggregate demand for goods/services, the real GDP and the inflation rate Although it is difficult to forecast the behavior of the Fed, it appears the general direction of interest rate policy can be explained by the Taylor rule

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Taylor Rule and Fed’s Track Record (Cont.) Taylor rule –Federal funds rate target is a function of: The difference between actual inflate rate (INFL) and the target inflation (INFL*) The percentage difference between actual and potential real GDP (GAP)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved The Taylor Rule and Fed’s Track Record (Cont.) Figure 21.5 shows the actual fed funds rate and the rate implied by the Taylor rule –The fed funds rate seems to have responded quite well to the concerns of the Fed since it moves in the directions suggested by the Taylor rule –However, the actual fed funds rates doesn’t always follow the Taylor rule Impossible to react to certain events such as September 11 until they influence economic activity Suggests an argument for giving the Fed some discretion in responding to special circumstances

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 21.5 The Actual fed funds rate and the value implied by the Taylor rule.