1. Monetary Policy Strategy

2. Goals Stability in the price level(CPI). Full employment (low unemployment) Unemployment rate 4-6% Greater employment  greater output Greater unemployment  more the employed must share – food stamps, insurance. Economic growth – increase in economy’s output of goods and services. Stabilizing interest rates. Stability in foreign currency exchange rates.

3. Difficulties Measurement difficulties. Policy goals can be competing. It may be difficult to achieve both full employment and low inflation. To keep inflation low  tight monetary policy which pushes up interest rates. Fed will typically adopt a compromise policy. Conflicting goals concerning domestic and international policies.

4. Employment Act of 1946 Congress declared the federal government had responsibility to promote the nation’s economic welfare – “promote maximum employment, production, and purchasing power”. The act contained no specific reference to the related problem of inflation, the promotion of economic growth, or stability in the balance of payments.

5. Humphrey-Hawkins Full Employment and Balanced Growth Act (1978) Corrected the Employment Act of 1946. Set target of 4% unemployment for workers>16 and 3% for >20 by 1983. Set target of 3% inflation by 1983. Problem: the two goals may conflict with one another. To achieve one goal you may have to abandon the other at least in the short run.

6. Evolution of Monetary Policy WWII – 1979: Keynesian Era Fiscal policy – use of the federal budget to achieve economic goals. 60s & 70s revealed serious problems with Keynesian Policy. By 1979 inflation > 13%.

7. Evolution of Monetary Policy 1979-1982: Target Monetary Growth July 1979: Carter appointed Paul Volcker chairman of the Fed. 1981: Reagan administration cut taxes with no corresponding cut in spending Increase in federal deficit Steep rise in interest rates Dollar appreciated 1982: Inflation 4% but unemployment rose to highest level since the Great Depression.

8. Evolution of Monetary Policy 1982-1990:Target Interest Rate Retain Monetarist goal of price stability. Rather than target monetary growth, target the interest rate. Longest peacetime expansion on record.

9. Introduction “Federal Open Market Committee (FOMC) seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output” Examination of the formulation of policy through the Federal Open Market Committee’s directive Review the reasons for the particular course of action that is followed

10. The FOMC Directive The FMOC meets every five or six weeks Review of recent economic and financial developments Prices Unemployment Interest rates Money supply Balance of payments Bank credit Makes projections for the future Based on anticipated economic conditions, proposes appropriate monetary policy

11. The FOMC Directive (Cont.) The FOMC directive In recent years, FOMC directive usually contains a single paragraph that begins with a general qualitative statement of current policy goals Specifies the immediate prescription for implementing longer-term objectives In outlining its operating targets, the Committee refers to conditions in the reserve markets, not in terms of money supply growth

12. The FOMC Directive Although Fed emphasizes monetary and reserve aggregates, in practice it operates on interest rates (Federal Funds Rate) After each meeting, the FOMC releases a statement Summarizes the directive Gives some idea of the Fed’s view of future policy risks Indicates whether policy risks are mainly weighted toward inflationary pressure, economic weakness, or weighted equally between the two

13. The Fed’s Strategy Humphrey-Hawkins Act of 1978 Provides policy guidelines to Federal Reserve Maximum employment Price stability Moderate long-term interest rates Fed has interpreted maximum employment as full employment--economy functions at its potential Meet these three goals by seeking price stability and sustainable growth since long-term interest rates are low when expected inflation is low

14. The Fed’s Game Plan Operating and intermediate targets are more responsive to Fed’s actions These two steps provide timely feedback so Fed can judge if their actions are on the right tract

15. Steps in Development of the Fed’s Plan Decide upon GDP growth rate consistent with inflation and unemployment objectives Set range for monetary growth expected to generate target GDP growth Set a target for growth in reserves Key to the success of Fed’s effectiveness is understanding and predicting the linkages between the different steps

16. Reserves Versus the Federal Funds Rate Different targets selected by Federal Reserve Before October 1979—favored federal funds rate October 1979 to mid-1982—shifted to reserve aggregates to get control over inflation After mid-1982—shifted focus back to federal funds rate It seems that reserves and the federal funds rate are two sides of the same coin

17. Reserves Versus the Federal Funds Rate However, there is often an irreconcilable conflict that prevents the Fed from simultaneously targeting reserves and the fed funds rate Characteristics of the federal funds market Immediately available funds that are lent between banks, usually on an overnight basis Transfer of funds through bookkeeping entry on reserves held by the Fed Interest rate charged is the Federal Funds Rate

18. Reserves Versus the Federal Funds Rate The Federal Funds Rate is established in the competitive market (supply and demand of reserves), but is influenced by the Fed (proactive action) Increase reserves—Lower the rate Decrease reserves—Raise the rate

19. Reserves Versus the Federal Funds Rate In the real world, demand curves for reserves fluctuates with the pace of economic activity These shifts in the demand curve will complicate the actions of the Fed (reactive action) The Fed can target either the level of reserves or the federal funds rate Targeting reserves—the federal funds rate will vary Targeting federal funds rate—the level of reserves will vary

20. Reserves Versus the Federal Funds Rate The Fed cannot set reserve levels and the federal funds rate independently Which target should the Fed choose? Select one that produces less variability in GDP Targeting reserves and letting interest rate change would be best under some conditions Close and predictable relationship between reserves and spending Private spending is subject to destabilizing variations Resulting interest rate changes would stabilize the economy

21. Which Target Should the Fed Choose? Targeting interest rates, with fluctuating reserves Weak linkage between reserves and spending results in variation in demand for reserves not related to changes in spending In this case, automatic changes in interest rates would not allow the Fed to stabilize the economy Under these conditions, the Fed has concluded it is better to target the federal funds rate With significant change in economic activity, it might be necessary to alter targeted federal funds rate

22. Can the Fed Really Control Reserves? Preceding discussion suggests the Fed has complete control over supply of reserves Banking system has ability to affect reserves through borrowing at the discount window New discount window system enhances the Fed’s ability to meet its fed funds rate target Fed funds rate below discount--no borrowing Fed funds rate rising above discount-- Discount borrowing by banks increases reserves thereby lowering fed funds rate

23. The Taylor Rule and Fed’s Track Record During the Greenspan period at the Fed, the focus has clearly been on the use of the federal funds rate to influence interest rates Interest rates then affect the aggregate demand for goods/services, the real GDP and the inflation rate Although it is difficult to forecast the behavior of the Fed, it appears the general direction of interest rate policy can be explained by the Taylor rule

24. Taylor Rule Federal funds rate target is a function of: The difference between actual inflate rate (INFL) and the target inflation (INFL*) The percentage difference between actual and potential real GDP (GAP)

25. The Actual Fed Funds Rate and the Rate Implied by the Taylor Rule The fed funds rate seems to have responded quite well to the concerns of the Fed since it moves in the directions suggested by the Taylor rule However, the actual fed funds rates doesn’t always follow the Taylor rule Impossible to react to certain events such as September 11 until they influence economic activity Suggests an argument for giving the Fed some discretion in responding to special circumstances