1. What can Government do to foster Economic Growth and Equity? The Role of Monetary Policy Cathy Minehan Economic Growth with Equity Open Classroom PPS 225 February 18, 2009

2. Monetary Policy  What is it?  Why is it necessary?  How does it work?  Goals:  Price stability  Financial stability  Current challenges  Was monetary policy part of the problem?  What’s happening now 2

3.  Money: Anything that acts as a medium of exchange  Monetary Policy: Controls the supply of money  Economic growth requires money; money demand fluctuates with pace of growth  Monetary policy seeks to get money supply right as a condition to solid growth  Too much supply: prices rise (inflation)  Too little: prices fall (disinflation/deflation)  Monetary policy seeks to reduce supply by raising interest rates: increase supply by reducing interest rates What is Monetary Policy? 3

4.  Price Stability - adjust growth of money to desired short- term pace of economic growth  Avoid inflation/deflation  More importantly – help to achieve higher standards of living  Financial Stability – the central bank is the key responder to financial crises  Historical reason for central banks  Bank of England “lend freely at high rates”  1907 Crisis Federal Reserve formation  1934 Creation of FOMC  1951 Treasury/Fed Accord (“independent” central bank)  Typically Fiscal Policy too slow; Monetary Policy lowers interest rates, increases liquidity and bolsters confidence  Fiscal Stimulus in 2002 and current stimulus packages are exceptions Why is Monetary Policy Necessary? 4

5.  Banks hold money (reserves) at central bank  U.S. Central Bank – Federal Reserve System  Central banks control supply of money and its price  How?  Buying and selling securities in the Open Market (Open Market operations)  Lending to banks and others against collateral (Discount Window Lending)  Reserve Requirements How Does Monetary Policy Work? 5

6.  Governed by Federal Open Market Committee (FOMC); Implemented by Open Market Desk at Federal Reserve Bank of New York  Buy a security in the secondary market  Adds reserves/money to system  Fed creates money  Sell a security  Takes reserves/money out of system  Fed destroys money  Add money – interest rates go down  Subtract money – interest rates go up  The trick – match interest rates to the pace of growth so price stability is maintained (relative vs. absolute?) Open Market Operations 6

7. Federal Funds Target Rate 7

8.  Discount Window Lending  Traditionally to commercial banks, secured by collateral, and made at the “Discount Rate”  Issue of collateral type and value  Reserve Requirements  A portion of commercial bank deposits with the Federal Reserve are “required reserves”  Amount is based on the nature of deposit liabilities  Reserves are “high powered”  Traditionally Open Market Operations is key tool of Monetary Policy, but new uses of all three tools Discount Window and Reserve Requirements 8

9.  Lending  Short-term credit to both commercial banks and primary dealers  Loans to Bear Stearns and AIG  “SWAP” lines to foreign central banks  Reserves  Paying interest facilitates rate setting  Market-Based Programs  Asset Backed Commercial Paper Funding  Money Market Investor Lending  GSE Debt & Mortgage Backed Securities  Term Asset Backed Securities Loan Facility (TALF)  Student Loans  Auto Loans  Credit Card Loans  SBA Loans  *Commercial Real Estate Loans (New)  In partnership with private sector and Treasury New Federal Reserve Programs 9

10. Federal Reserve Bank Credit 10

11.  Yes:  Interest rates too low for too long  Reaching for yield leads to under pricing of risk Was Monetary Policy Part of the Current Problem? 11

12. Rapid Growth in Wealth with Low Inflation 12

13.  Yes:  Interest rates too low for too long  Reaching for yield leads to under pricing of risk  No:  Inflation low and economic growth slow after recession of 2001  Housing boom fueled by demographics, financial innovation  Inflows from abroad keep interest rates low, demand for securities high Was Monetary Policy Part of the Current Problem? 13

14. Rapid Growth in Wealth with Low Inflation 14

15.  Yes:  Interest rates too low for too long  Reaching for yield leads to under pricing of risk  No:  Inflation low and economic growth slow after recession of 2001  Housing boom fueled by demographics, financial innovation  Inflows from abroad keep interest rates low, demand for securities high  Maybe:  Stronger regulation could have helped  Issue of asset price vs. consumer price escalation Was Monetary Policy Part of the Current Problem? 15

16. Rapid Growth in Wealth with Low Inflation 16

17.  Financial markets remain in disarray though interbank leading, residential mortgage rates and commercial paper markets have stabilized  Economic growth stalled  Deflation a concern  Target Fed Funds Rate range of 0-25  Good news: Monetary Policy has been unusually innovative and various programs seem to be working  Not so good news: Process is slow, complicated and uncertain  Need to start worrying about how to get out What is Happening Now? 17