1. 31 Monetary Policy Notes and teaching tips: 2, 7, 19, 32, 41, and 63.
CHAPTER
Monetary Policy
Notes and teaching tips: 2, 7, 19, 32, 41, and 63.
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2. After studying this chapter you will be able to
Describe the objectives of U.S. monetary policy and the framework for setting and achieving them
Explain how the Federal Reserve makes its interest rate decision and achieves its interest rate target
Explain the transmission channels through which the Federal Reserve influences the inflation rate
Explain and compare alternative monetary policy strategies
If you have been using previous editions of Parkin, you will see that this chapter is a substantially revised on.
I have striven to explain monetary policy as it is conducted by the Fed in language that the student can follow and that will illuminate news reports of Fed policy.
In the final section of the chapter, I place the Fed’s strategy in a broader perspective of alternative possible strategies.

3. What Can Monetary Policy Do?
On eight pre-set dates a year, the Federal Reserve announces whether the interest rate will rise, fall, or remain constant until the next decision date.
How does the Fed make its interest rate decision?
What does the Fed do to keep interest rates where it wants them?
Does the Fed’s interest rate changes influence the economy in the way the Fed wants?
Can the Fed speed up economic growth by lowering interest rates and keep inflation in check by raising them?

4. Monetary Policy Objectives and Framework
A nation’s monetary policy objectives and the framework for setting and achieving that objective stems from the relationship between the central bank and the government.

5. Monetary Policy Objectives and Framework
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 economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

6. Monetary Policy Objectives and Framework
Goals and Means
Fed’s 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

7. Monetary Policy Objectives and Framework
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.
Emphasize the long-run harmony and short-run tension between the goals of monetary policy.
Note that popular discussion focuses on the short run.

8. Monetary Policy Objectives and Framework
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?

9. Monetary Policy Objectives and Framework
Operational “Stables Prices” Goal
The Fed also pays close attention to the CPI excluding fuel and food—the 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.

10. Monetary Policy Objectives and Framework
Figure 31.1 shows the Fed says that 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.

11. Monetary Policy Objectives and Framework
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 gap—the 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.

12. Monetary Policy Objectives and Framework
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.

13. 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.

14. The Conduct of Monetary Policy
The Federal Funds Rate
The Fed’s 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.

15. The Conduct of Monetary Policy
Figure 31.2 shows the federal funds rate.
The federal funds rate was
raised to 8.25 percent a year in 1990 and 6.5 percent a year in when inflation was a concern.
and lowered to about 2 percent a year between and 2004 to avoid recession.

16. The Conduct of Monetary Policy
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?

17. The Conduct of Monetary Policy
The Fed’s Decision-Making Process
The Fed could adopt either
An instrument rule
A targeting rule
The distinction between an instrument rule and a targeting rule is relatively new in the literature and you might not have come across it.
The basic idea is this:
1) Monetary policy is primarily about managing inflation expectations (Woodford)
2) Given 1, monetary policy must be conducted by rule rather than discretion
3) A rule that predictably sets the instrument according to the state of the economy is an instrument rule—examples are the Taylor and McCallum rules.
4) A rule that uses all the available information to make the forecast of the ultimate target equal the target is a targeting rule—examples are inflation targeting and money stock targeting.
The Fed uses an implicit inflation and output/employment targeting rule but sometimes its actions come close to being well described by the Taylor rule.

18. The Conduct of Monetary Policy
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.

19. The Conduct of Monetary Policy
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.

20. The Conduct of Monetary Policy
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.

21. The Conduct of Monetary Policy
Influences on the Federal Funds Rate
The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate (which Taylor says is 2 percent a year) plus amounts based on the inflation rate (INF) and the output gap (GAP) according to the following formula (all values are in percentages):
FFR = 2 + INF + 0.5(INF – 2) + 0.5GAP
If inflation is on target and the output gap is zero (full employment), with a 2 percent inflation target, the federal funds rate will be 4 percent a year.

22. The Conduct of Monetary Policy
The Fed moves the interest rate up and down by less than the Taylor rule moves it.
The Fed believes that because it uses much more information than just the current inflation rate and the output gap, it is able to set the overnight rate more intelligently than any simple rule can set.
Figure 28.3 illustrates.

23. The Conduct of Monetary Policy

24. The Conduct of Monetary Policy

25. The Conduct of Monetary Policy

26. The Conduct of Monetary Policy
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.

27. The Conduct of Monetary Policy
Figure 31.4 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.
You might want to emphasize the link between this material and the explanation of the money multiplier in the earlier money chapter. The text limits this discussion in the interest of flexibility.

28. The Conduct of Monetary Policy
Figure 31.5 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.

29. The Conduct of Monetary Policy
Equilibrium in the Market for Reserves
Figure 31.6 illustrates the market for reserves.
The x-axis measures the quantity of reserves held.
The y-axis measures the federal funds rate.

30. The Conduct of Monetary Policy
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.

31. The Conduct of Monetary Policy
The red line shows the Fed’s target for the federal funds rate.
The Fed’s open market operations determine the actual quantity of reserves in banking system.

32. The Conduct of Monetary Policy
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.

33. 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 interest rate falls.
4. Consumption expenditure, investment, and net exports increase.
The description of the transmission mechanism given here is very eclectic and includes all the possible channels that the literature has suggested. You might want to rebalance the emphasis toward the mechanism that you think most powerful.

34. Monetary Policy Transmission
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 31.7 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.

35. Monetary Policy Transmission

36. Monetary Policy Transmission
Interest Rate Changes
Figure 31.8 shows the fluctuations in three interest rates:
The short-term bill rate
The long-term bond rate
The federal funds rate

37. Monetary Policy Transmission
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.

38. Monetary Policy Transmission
Exchange Rate Fluctuations
The exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential.
But other factors are also at work, which make the exchange rate hard to predict.

39. Monetary Policy Transmission
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.

40. Monetary Policy Transmission
Expenditure Plans
The ripple effects that follow a change in the federal funds rate change three components of aggregate expenditure:
1. Consumption expenditure
2. Investment
3. Net exports
The change in aggregate expenditure plans changes aggregate demand, real GDP, and the price level, which turn influence the goal of inflation rate and output gap.

41. Monetary Policy Transmission
The Fed Fights Recession
If inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target.

42. Monetary Policy Transmission
The Fed Fights Recession
The increase in the supply of money increases the supply of loanable funds in the short-term.

43. Monetary Policy Transmission
The Fed Fights Inflation
If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target.

44. Monetary Policy Transmission
The Fed Fights Inflation
The decrease in the supply of money decreases the supply of loanable funds in the short-term.

45. Monetary Policy Transmission
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 doesn’t always respond in the same way.

46. Monetary Policy Transmission
A Final Reality Check
Figure shows how monetary policy has worked.
The blue line shows the federal funds rate minus the long-term bond rate.
The red line shows real GDP growth one year later.

47. Monetary Policy Transmission
A Final Reality Check
When the Fed pushes the federal funds rate above the long-term bond rate, the real GDP growth rate slows in the following year.
When the Fed lowers the federal funds rate below the long-term bond rate, the real GDP growth rate speeds up in the next year.

48. Alternative Monetary Policy Strategies
The Fed might have chosen any of four alternative monetary policy strategies: One of them are instrument rules and three are alternative targeting rules.
The four alternatives are
Monetary base instrument rule
Monetary targeting rule
Exchange rate targeting rule
Inflation targeting rule
If you are a passionate supporter of one of the alternative monetary policy strategies, don’t be shy about pushing it. Students like to know the passions of their teachers. I’ve tried hard to hide my passion to avoid getting in your way! MP

49. Alternative Monetary Policy Strategies
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.

50. Alternative Monetary Policy Strategies
Money Targeting Rule
Friedman’s 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.
Friedman’s 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.

51. Alternative Monetary Policy Strategies
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.

52. Alternative Monetary Policy Strategies
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 Fed’s current implicit targeting.

53. Alternative Monetary Policy Strategies
Why Rules?
Why do all the monetary policy strategies involve rules?
Why doesn’t 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.

54. China needs to adjust its monetary policy now

55. China’s monetary policy framework
China’s monetary policy framework has gradually moved away from a planned administrative system to a more market-based regime, with money growth as the main intermediate target. As part of this transition, some interest rates have been liberalised, making them more responsive to market signals, and the tools of monetary policy have been modernised. The central bank now has considerable control over short-term interest rates in the interbank market and more influence over longer-term rates through the term structure.

56. China’s monetary policy framework
The central bank’s operational framework needs to place less emphasis on quantity-based liquidity controls and more on interest rate changes. Its benchmark commercial bank lending and deposit rates are losing relevance in the conduct of monetary policy and ought to be progressively phased out. The banking sector has also undergone significant reform and the economy has become far more responsive to market-based policy measures: investment at the firm level is more sensitive to interest rate movements and changes in aggregate demand pressures exert a stronger influence on inflation.

57. China’s monetary policy framework
Hence, the transmission mechanism has become more effective in China and monetary policy can play a greater role in fostering stability. However, the current exchange rate regime limits the effectiveness of this channel by preventing the value of the currency from adjusting to offset macro shocks.

58. China’s monetary policy framework
Allowing greater exchange rate flexibility and putting more weight on an inflation objective – while keeping a vigilant eye on asset prices – would offer the central bank more scope to tailor monetary policy to domestic macroeconomic conditions and reduce the costs and risks of sterilising foreign reserve inflows. Besides, real exchange rate appreciation is to be expected in any event over the medium run in an economy that is catching up rapidly

59. Table 1. Economic projections of Federal Reserve Governors and Reserve Bank presidents, January 2010 Percent Variable Central tendency1 Range Longer run Longer run Change in real GDP 2.8 to to to to to to to to 3.0 November projection 2.5 to to to to to to to to 3.0 Unemployment rate 9.5 to to to to to to to to 6.3 November projection 9.3 to to to to to to to to 6.3 PCE inflation 1.4 to to to to to to to to 2.0 November projection 1.3 to to to to to to to to 2.0 Core PCE inflation3 1.1 to to to to to to 2.0 November projection

60. China Tightening Monetary Policy
China's central bank moved to tighten monetary policy on Tuesday, raising the bank reserve requirement ratio by 0.5 percentage points and slightly increasing the interest rate on its one-year bill by 8 basis points to 1.84 percent. (BEIJING, Jan. 12, 2010 )

61. Part 4: Summary of Economic Projections

65. THE END