14 MONETARY POLICY Part 2.

14 MONETARY POLICY Part 2

The Conduct of Monetary Policy
The Fed’s Decision-Making Strategy The decision to change the target Federal Funds rate begins with an assessment of the current state of the economy. Three key variables Inflation rate compared to 2% target – inflation gap Unemployment rate Output gap 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. Classroom activity Check out Economics in Action: FOMC Decision Making

Inflation Gap If the inflation rate rises above the 2% target or expected to move above it, the Fed considers raising the federal funds rate target. If the inflation rate is below the target or expected to move below it, the Fed considers lowering the federal funds rate target.

Unemployment Rate If the unemployment rate is below the natural unemployment rate, a labor shortage might put pressure on wage rates to rise, which might feed into inflation. The Fed will consider raising the federal funds rate. If the unemployment rate is above the natural unemployment rate, lower inflation is expected. The Fed will consider lowering the federal funds rate.

Unemployment and Inflation –the Dual Mandate
Fed Monetary Policy and The Phillips Curve Inflation Rate Unemployment Rate SRPCbuilt-in expected inflation = 2% LRPC Fed wants to be at point F F 2% Un

Output Gap If the output gap is positive, have an inflationary gap and the inflation rate will most likely accelerate. The Fed will consider raising the federal funds rate. If the output gap is negative, it is a recessionary gap and inflation might ease. The Fed will consider lowering the federal funds rate.

Monetary Policy Transmission
The Fed lowers the federal funds rate when it _______(buys;sells) securities in the open market - 1. The Federal Funds rate falls and other short-term interest rates fall because they are near substitutes. 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 (next chapter) 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.

5. Aggregate demand increases. 6. Real GDP growth and the inflation rate increase. When the Fed raises the federal funds rate, it sells securities in an open market and the “ripple” effects go in the opposite direction. Classroom activity Check out Economics in the News: Monetary Stimulus Not Stimulating

Monetary Policy Transmission Expansionary Policy
Steps 2 and 3 Money supply increases and interest rates fall (short-term and long-term) Step 1 Fed buys bonds Steps 4 and 5 C, I , (X – IM) and AD increase Step 6 Real GDP and P increase Steps 1 through 6 can stretch out over a period of between 12 and 24 months.

Monetary Policy Transmission Contractionary Policy
Steps 2 and 3 Money supply decreases and interest rates rise (short tern and long term) Step 1 Fed sells bonds Steps 4 and 5 C, I ,(X – IM) and AD decrease Step 6 Real GDP and P decrease Steps 1 through 6 can stretch out over a period of between 12 and 24 months.

Interest Rate Changes Figure 14.5 shows the fluctuations in three interest rates: The federal funds rate The short-term Treasury bill rate The long-term bond rate

Short-term rates move closely together and follow the federal funds rate. Why? Banks have a choice - lend excess reserves in Federal Funds market or buy short- term Treasury bills. Essentially perfect substitutes. Long-term rates move in the same direction as the federal funds rate but are only loosely connected to the federal funds rate.

Long-term Bond Interest rates Two features to consider about long-term bond interest rates: Higher than short-term interest rates Fluctuate less Higher because long-term bonds are riskier. Investors require higher compensation.

Long-term Bond Interest rates Fluctuate less because long-term bond interest rates are an average of current and expected short-term bond interest rates. An alternative to borrowing long-term is to borrow using a sequence of short-term bonds. Suppose current 1-year interest rate is 3% and the 1-year interest rate next year is expected to be 4%. The average cost to borrow for 2 years is : 3%+4% 2 = 3.5% . The alternative is to borrow using a 2-year bond. The interest rate for the 2-year bond will be 3.5%. If the interest rate on the 2-year bond was 4%, people would borrow short-term at 3.5% and lend long-term at 4% . The long-term interest rate will fall.

Long-term Bond Interest rates Suppose current 1-year interest rate is 3% and the 1-year interest rate next year is expected to be 4%. The average cost to borrow for 2 years is : 3%+4% 2 = 3.5%. The alternative is to borrow using a 2-year bond. The interest rate for the 2-year bond will be 3.5%. If the interest rate on the 2-year bond was 4%, people would borrow short-term at 3.5% and lend long-term at 4%. The long-term interest rate will fall.

Long-term Bond Interest rates Suppose current 1-year interest rate is 3% and the 1-year interest rate next year is expected to be 4%. The average cost to borrow for 2 years is : 3%+4% 2 = 3.5%. If the interest rate on the 2-year bond was 3%, people would borrow using a long-term bond at 3% and lend short- term at 3.5%. The long-term interest rate will rise. The difference is called “arbitrage” and will be eliminated by market forces.

Long-term Bond Interest rates Suppose current 1-year interest rate is 3% and the 1- year interest rate next year is expected to be 5%. The average cost to borrow for 2 years is : 3%+5% 2 = 4%. The short-term rate changes by 1 percentage point and the long-term rate changes by ½ percentage point. The long-term interest rate fluctuates less because the long-term bond interest rate is an average of the current and expected short-term bond interest rates.

Money and Bank Loans When the Fed lowers the federal funds rate, the quantity of reserves in the banking system increases and the quantity of bank loans increase. Long-term real interest rates fall. Consumption and investment plans change.

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

An increase in the monetary base increases the supply of money (chapter 8). The short-term interest rate falls.

The increase in reserves and the supply of money increases the supply of loanable funds. The real interest rate falls and investment increases.

The increase in investment increases aggregate planned expenditure. Real GDP increases to potential GDP.

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

A decrease in the monetary base decreases the supply of money (chapter 8). The short-term interest rate rises.

The decrease in reserves and the supply of money decreases the supply of loanable funds. The real interest rate rises and investment decreases.

The decrease in investment decreases aggregate planned expenditure. Real GDP decreases and closes the inflationary gap.

Loose Links and Long and Variable Lags The link between the federal funds rate and the Fed’s policy goals is very loose and the time lags are “long and variable”. This is why monetarist say stay out of the policy business and just have the money supply grow at a fixed rate of growth. The Fed can control short-term interest rates, but not long-term rates. The long-term interest rate is market determined and at best loosely linked to the federal funds rate. Classroom activity Check out Economics in Action: A View of the Long and Variable Lag

Loose Links and Long and Variable Lags The response of real long-term interest rates is what counts. That response depends on inflationary expectation. real rate = nominal rate - inflation expectations. If prices do not change much in the SR and inflation is relatively fixed, changes in the nominal rate translate into changes in the real rate. Classroom activity Check out Economics in Action: A View of the Long and Variable Lag

Loose Links and Long and Variable Lags The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict. Need to know if spending plans are sensitive to changes in real interest rates. If not, monetary policy is not effective. The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way. Classroom activity Check out Economics in Action: A View of the Long and Variable Lag

Loose Links and Long and Variable Lags Most studies show it takes about 1 year for real GDP to respond to changes in the Federal Funds. It takes an additional year for prices(inflation) to respond. Classroom activity Check out Economics in Action: A View of the Long and Variable Lag

Monetary Policy Transmission Expansionary Policy
Steps 2 and 3 Money supply increases and interest rates fall (short-term and long-term) Step 1 Fed Reserve buys bonds Steps 4 and 5 C, I and (X – IM) increase Step 6 Real GDP and P increase Need to know how sensitive spending is to changes in long-term real interest rates. Policy makers need to know how sensitive long-term real interest rates are to changes in short-term interest rates. Need to know multiplier.

Monetary Policy Transmission Contractionary Policy
Steps 2 and 3 Money supply decreases and interest rates rise Step 1 Fed Reserve sells bonds Steps 4 and 5 C, I and (X – IM) decrease Step 6 Real GDP and P decrease Policy makers need to know the same stuff

Money, GDP and the Price Level
What happens to real GDP and the price level depends on the slope of the aggregate supply curve

Output and Inflationary Effects of Expansionary Monetary Policy
SRAS 113 If AS is flat , lot of impact on real GDP with little impact on P. If AS is steep, lot of impact on P with little impact on real GDP. Price Level AD1 AD0 B 103 E 6,400 100 AD3 6,000 AD2 Real GDP

Extraordinary Monetary Policy
During the financial crisis and recession of , the Fed lowered the federal funds rate to the floor – the zero lower bound. What can the Fed do to stimulate the economy when it cannot lower the federal funds rate? The Key Elements of the Crisis The three main events that put banks under stress were: Widespread fall in asset prices A significant currency drain A run on the bank

Extraordinary Monetary Stimulus
The Policy Actions Massive open market operations were used to increase bank reserves. Deposit insurance was expanded from $100,000 to $250,00. The Fed bought mortgages assets from banks. The Fed increased loans to banks and also investment banks. These actions provided banks with more reserves, more secure depositors, and safe liquid assets in place of troubled assets. Classroom activity Check out At Issue: Support for and Opposition to Keeping Interest Rates Low for a “Considerable Time” Check out Economics in the News: The Fed Keeps Stimulating

Policy Rules and Clarity
Two other approaches to monetary policy that other countries have used are Inflation rate targeting Taylor rule

Inflation Rate Targeting
Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment 1. To achieve an explicit inflation target – usually 2%. 2. To explain how its policy actions will achieve that target Approximately 23 central banks practice inflation targeting and have done so since the mid-1990s. The central bank’s primary focus is inflation. This policy framework is very different from the Fed’s dual mandate of low stable price and maximum growth.

Taylor Rule John Taylor at Stanford The Taylor rule is a formula for setting the interest rate. FFR = 2% + INF + 0.5(INF – 2%) + 0.5(output gap) (inflation gap) By using a rule to set the interest rate, monetary policy reduces uncertainty. With less uncertainty, financial markets, labor markets, and goods markets work better as traders are more willing to make long-term commitments.

Taylor Rule How it works (keep in mind the current FFR is 1.0%)
Suppose INF = 2% and the output gap = 0 FFR = 2% + INF + 0.5(INF – 2%) + 0.5(output gap) FFR = 2% + 2% +0.5(0) (0) FFR = 4% INF is currently 1.6% and the output cap is about -2% FFR = 2% + 1.6% +0.5(-0.4) (-2) FFR = 2.4% In 2008: INF = 0 and the output gap was about -6% FFR = 2% + 0% +0.5(-2%) (-6) FFR = -2%

14 MONETARY POLICY Part 2.

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