1. Chapter 6 – Monetary Policy BA 543 Financial Markets and Institutions

2. Chapter 6 – Monetary Policy Goals of the Federal Monetary Policy Stability in Price Level Unstable Prices retard economic growth, provoke volatility in interest rates, stimulate consumption, deter savings, and cause capricious redistribution of income and wealth with attendant social disturbances “Controlling Inflation” with a supply shock  Accommodate with increase in money supply – inflation is essentially unchecked  Do not accommodate (Jimmy Carter) – higher initial interest rates and short term decline in economic activity

3. Chapter 6 – Monetary Policy Goals of the Federal Monetary Policy High Employment (Low Unemployment) Frictional Unemployment (Job Changers)  Target 4% to 6% of labor force Increase in Money Supply can bring about:  Economic Expansion  Stimulate Investment  Encourage Consumption  Lead to the Creation of New Jobs  Kindle Inflation  Raise Interest Rates

4. Chapter 6 – Monetary Policy Goals of the Federal Monetary Policy Economic Growth (Increase in Output of Goods and Services) What is the appropriate rate of growth? Sustainable Growth Reasonable Growth Steady Growth Stabilizing Interest Rates Reduce Volatility – But allow changes How do interest rates impact growth?

5. Chapter 6 – Monetary Policy Goals of the Federal Monetary Policy Stability in Foreign Exchange Strong Dollar Means (Indirect Quote goes up)  Exchange Rates are moving so that $1 can buy more foreign currency or U.S. Products are becoming relatively more expensive “overseas”  Trade-Imbalance: Foreign goods purchased more in U.S. and Less U.S. goods purchased abroad Weak Dollar Means (Indirect Quote goes down)  More U.S. goods purchased abroad and fewer Foreign goods purchased in U.S. Who Benefits from Strong Dollar vs. Weak Dollar?

6. Chapter 6 – Monetary Policy Goals are not always Aligned Tradeoffs between Goals Fed “selects” goal most in jeopardy Fed works through Operating Targets – impacts on monetary and financial variables that tend to change Intermediate Targets – that have reasonable linkage to Ultimate Objectives – price level stability, employment, growth and foreign exchange rates

7. Chapter 6 – Monetary Policy Choosing the Operating Targets (Simulation Game at the Federal Reserve in KC) U.S. Targets: Short-Term Interest Rates or Bank Reserves via money supply Can not do both simultaneously, Why? Negative Correlation between reserves and interest rates…as Fed increases reserves it reduces short-term rates and vice versa Variable outside the control of the Fed…demand for money…thus rates and reserves can not be simultaneously determined

8. Chapter 6 – Monetary Policy Choosing the Intermediate Targets Suitable Target must be observable Money Supply  Early standard target…some discussion on which measure and concern that it does not have linkage with the ultimate objectives GNP (GNP growth rate)  Measurability big issues, data is quarterly Inflation  Believed to have better linkage to ultimate goals  Many Europeans using price indexes for sensitive products…Greenspan said to be “gold” follower

9. Chapter 6 – Monetary Policy Historical Trip through Targets 1970s – Feds Fund Rate (Keynesian) 1979 – 1982 Nonborrowed Reserves (Monetarists) let interest rates fluctuate 1983 – 1991 Borrowed Reserves 1991 – 1995 Borrowed Reserves with attention to sensitive commodities (European approach) 1996 – 2000 New Paradigm of Higher Sustainable Growth…Greenspan’s Visible Hand with the Feds Fund Rate