Monetary policy How the Federal Reserve manages the money supply and interest rates to pursue its economic goals. 1 Price stability 2 High employment 3 Economic growth 4 Stability of financial markets and institutions The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy:

How Does the Fed Measure Inflation? Personal Consumption Expenditure Price Index: A Chained Index

The Money Market and the Fed’s Choice of Monetary Policy Targets The Fed tries to keep both the unemployment and inflation rates low, but it can’t affect either of these economic variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly and that, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. Monetary Policy Targets The federal funds rate is the Fed’s most important direct target variable The federal funds rate affects the money supply. Money supply growth affects inflation, unemployment, and growth.

The Money Market and the Fed’s Choice of Monetary Policy Targets The Demand for Money (An increase in the price of bonds) Substitute away from bonds toward money.

Shifts in the Money Demand Curve

Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply People try to buy bonds. Bond prices fall.

The Money Market and the Fed’s Choice of Monetary Policy Targets The Importance of the Federal Funds Rate Federal Funds Rate Targeting, January 1998– July 2009 The Fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the Fed’s target rate. The orange line is the Fed’s target for the federal funds rate, and the jagged green line represents the actual value for the federal funds rate on a weekly basis.

Monetary Policy and Economic Activity Consumption Investment Net exports Changes in interest rates will affect three components of aggregate demand Expansionary monetary policy The Federal Reserve increasing the money supply and decreasing interest rates to increase real GDP. Contractionary monetary policy The Federal Reserve adjusting the money supply to increase interest rates to reduce inflation.

Monetary Policy and Economic Activity The Effects of Monetary Policy on Real GDP and the Price Level: An Initial Look

The Fed Responds to the Terrorist Attacks of September 11, 2001 The Fed in Crisis The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

The Inflation and Deflation of the Housing Market “Bubble”

Too Low for Zero: The Fed Tries "Quantitative Easing” Buy long-term gov’t bonds Buy Mortgage Backed Securities The Fed pushed interest rates to very low levels during 2008 and Banks reduced their lending

Monetary Policy and Economic Activity A Summary of How Monetary Policy Normally Works BEST: Buy Ease Sell Tighten

Some Issues Regarding the Conduct of Monetary Policy Rather than use an interest rate as its monetary policy target, the Fed should target the money supply. Economists who make this argument belong to the Monetarist School. The leader of the monetarist school was Nobel laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule. Steady money growth  steady, predictable inflation Steady money growth  automatic stabilizer. 1. Should the Fed Target the Money Supply? Problem is, it’s hard to get the money supply where you want it. The public’s changing split of its money holdings between currency and demand deposits changes the money multiplier.

2. Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? The Fed Can’t Target Both the Money Supply and the Interest Rate

Monetary Policy and Economic Activity 3. Can the Fed Get Timing Right? The Effect of a Poorly Timed Monetary Policy on the Economy Friedman’s complaint about discretionary monetary policy: “Too much too late”

Taylor rule A rule developed by John Taylor -- a Stanford professor and advisor to Presidents Bush -- that links the Fed’s target for the federal funds rate to economic variables. 4. Should the Fed adhere to a simple rule … or exercise discretion? Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap According to Taylor rule, if inflation rises by one percentage point, the Federal Funds rate should rise by 1 ½ percentage points. The real federal funds rate then rises by ½ %, slowing inflation. 5. Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.

6. Is the Independence of the Federal Reserve a Good Idea? The Case for Fed Independence The More Independent the Central Bank, the Lower the Inflation Rate

Fed Policies During the Recession The Inflation and Deflation of the Housing Market “Bubble” The Housing Bubble Sales of new homes in the United States went on a roller-coaster ride, rising by 60 percent between January 2000 and July 2005, before falling by 76 percent between July 2005 and January 2009.

The Wonderful World of Leverage Making a very small down payment on a home mortgage leaves a buyer vulnerable to falling house prices. RETURN ON YOUR INVESTMENT FROM... DOWN PAYMENT A 10 PERCENT INCREASE IN THE PRICE OF YOUR HOUSE A 10 PERCENT DECREASE IN THE PRICE OF YOUR HOUSE 100% 10% -10% During the housing boom, many people purchased houses with down payments of 5 percent or less. In this sense, borrowers were highly leveraged, which means that their investment in their house was made mostly with borrowed money.

Fed Policies During the Recession The Changing Mortgage Market By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses. Major commercial and investment banks borrowed heavily to buy these mortgages (and other loans), bundled them into Collateralized Debt Obligations (CDOs, one flavor of which is Mortgage Backed Securities, MBSs), and sliced and diced these securities into tranches of varying risk. They sold off these exotic financial products to insurance companies, pension funds, and other investors but held on to a goodly amount of them themselves. By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury. But these large commercial banks and investment banks were TOO BIG TO FAIL The Fed and the U.S. Treasury (taxpayers) acted as lenders of last resort.

The Fed and the Treasury Department Respond Initial Fed and Treasury Actions Fed Policies During the Recession First, although the Fed traditionally made loans only to commercial banks, in March 2008 it announced the Primary Dealer Credit Facility, under which primary dealers— firms that participate in regular open market transactions with the Fed—are eligible for discount loans. Second, also in March, the Fed announced the Term Securities Lending Facility, under which the Fed will loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. Third, once again in March, the Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was on the edge of failing. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac, two government sponsored enterprises (GSEs) that held a lot of mortgages and securities that had fallen in value.

The Fed and Treasury Department Respond Responses to the Failure of Lehmann Brothers Fed Policies During the Recession After the failure of Lehman Brothers, a major investment bank that many thought was Too Big to Fail, panic gripped financial markets. The major players stopped lending to each other... There was a silent run on major financial institutions. In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock. Taking partial ownership positions in private commercial banks was an unprecedented action for the federal government. The recession of 2007–2009, and the accompanying financial crisis, had led the Fed and the Treasury to implement new approaches to policy. Many of these new approaches were controversial because they involved partial government ownership of financial firms, implicit guarantees to large (TBTF) financial firms that they would not be allowed to go bankrupt, and unprecedented intervention in financial markets.

Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule K e y T e r m s