1. Policy Tools, Objectives and Targets.
The Federal Reserve
Policy Tools, Objectives and Targets.
ECO 285 – Macroeconomics – Dr. D. Foster

2. Federal Reserve Policy Tools
Open Market Operations
Buy/sell Treasury bonds to affect bank reserves.
The major form of monetary policy.
What will the Fed do if we run out of Treasury bonds?
Discount Window
Lend to member banks to affect bank reserves.
Purpose is to target the “federal funds rate” – iff
This is the rate that banks charge each other for very short term loans.
Required Reserve Ratio (rrD)
Changing this affects bank excess reserves directly.
Used more to reflect structural changes.
Was used in 1937 and precipitates more Great Depression.
Time to let this go?
New policy – Pay banks i for ER (!!)

3. Goals of Monetary Policy
Inflation goals:
Low/no inflation with limited year-to-year variability.
Output goals:
High and stable economic (GDP) growth.
Employment goals:
Stable employment growth with low unemployment.

4. Intermediate Targets of Monetary Policy
The key rationale for intermediate targeting:
The limited long-term information about the economy available to policymakers.

5. Choosing an Intermediate Target Variable
Characteristics:
Frequently observable
Consistency with ultimate goals
Definable and measurable
Controllable
Potential variables:
Monetary aggregates M1, M2, MZM
Interest rates (fed’l funds, prime …)
Others:
Nominal GDP
Credit aggregates
Exchange rates

6. Getting from bond purchases to interest rates$ $ $ $ $ $
$$$
mm/yyyy
Face value (FV)
Maturity date (in n years)
Coupons & value (C)
Usually, we talk of annual coupons
Market price of the bond = present value of income stream discounted at interest rate i:
When the Fed buys bonds, their prices will ___ and interest rates will ___.
sells

7. What is interest?
Payment made to savers to compensate them for foregoing consumption.
“The most powerful force in the universe is compound interest.”
Interest rates embody our expectations of the future.

8. Some simple bond pricing problems
A bond has a face value (FV) of $1000, will mature in 2018 and has an annual coupon of $74 and the market rate of interest is 8.1%.
What is the current market price of this bond?
Suppose that the current market interest rate falls to 6.54%. What will be the new market price for this bond?
Suppose that when the bond was first sold, it’s market price was $ What must have been the market rate of interest then?
Consider a bond with FV=$1000, maturity = 2019, C=$81 and i=7.25%
What is the current price of this bond?
If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it will affect all interest rates to some extent. If they buy lots of bonds and interest rates fall to 6.88%, what will happen to the price of your bond?
The bond in #2 was given to you by your kindly aunt. She told you it matures in 2019, but her eyesight isn’t so good. You take a close look at the bond and see that it matures in Market i=7.25%.
What is the price of this bond? Why is it different than what you calculated in #2a?

9. Is Policy the Right Choice?
Time lags make effective policy uncertain.
Discretionary policy promotes uncertainty.
Rules and credible adherence can eliminate bias.
Independence is a likely key requirement.

10. Time Lags in Monetary (& Fiscal) Policy
Policy time lags
Recognition lag
Response lag
Transmission lag
Real GDP
Business cycle
time

11. Monetary Policy may be counterproductive
Real GDP
time
Ideally, policy would dampen the business cycle…
But, dampening the business cycle may lower ave. growth!
Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

12. Discretion versus Rules (Milton Friedman)
Discretionary policy is the source of instability.
A policy rule can eliminate that instability.
Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion.
This is a commitment to a fixed strategy no matter what happens to other economic variables.
To be successful, the commitment must be credible.
The public believes the Fed will act this way.

13. Has the Fed maintained stable prices?

14. Has the Fed maintained the value of the $?4%

15. Making Monetary Policy Transparent
Yellen’s Press Conference
March 18, 2015
FOMC - PR
April 29, 2015
Find 6/17/15
Watch 6/17/15…

16. Why is Fed pursuing 2% inflation?????
“The Board of Governors … shall maintain long run growth of the monetary and credit aggregates … so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
“The … (FOMC) judges that inflation at the rate of 2 percent … is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment. .”
“Does the Fed really want to increase annual inflation to 2%, such that the price level of the country will increase by more than 700% over the next century? Is that what Congress had in mind when it tasked the Fed with achieving ‘stable prices’?”

17. Making Monetary Policy Rules Credible
Place constitutional limits on monetary policy.
Achieve credibility by establishing a reputation.
Maintain central bank independence.
Establish central banker contracts.
Appoint a “conservative” central banker.

18. Making Monetary Policy Rules Credible
Place constitutional limits on monetary policy.
Achieve credibility by establishing a reputation.
Maintain central bank independence.
Establish central banker contracts.
Appoint a “conservative” central banker.

19. Policy Tools, Objectives and Targets.
The Federal Reserve
Policy Tools, Objectives and Targets.
ECO 285 – Macroeconomics – Dr. D. Foster