1. The Federal Reserve II. Fed Policy: tools & critique ECO 473 – Money & Banking – Dr. D. Foster

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

3. Federal Reserve Policy Tools Open Market OperationsOpen 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 WindowDiscount Window –Lend to member banks to affect bank reserves. –Purpose is to target the “federal funds rate” – i ff This is the rate that banks charge each other for very short term loans.This is the rate that banks charge each other for very short term loans. Required Reserve Ratio (rr D )Required Reserve Ratio (rr D ) –Changing this affects bank excess reserves directly. –Used more to reflect structural changes.structural changes –Was used in 1937 and precipitates more Great Depression. –Time to let this go?let this go New policy? – Pay banks i for ER (!!)

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

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

6. Targeting the Federal Funds Rate of Interest

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

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

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

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

11. Making Monetary Policy Rules Credible constitutional limitsPlace constitutional limits on monetary policy. reputationAchieve credibility by establishing a reputation. independenceMaintain central bank independence. contractsEstablish central banker contracts. conservativeAppoint a “conservative” central banker.

12. Has the Fed maintained stable prices?

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

14. Making Monetary Policy Transparent FOMC - PR Dec. 16, 2015 Yellen’s Press Conference Dec. 16, 2015

15. Quantitative Easing = Credible? QE 1 QE 2 QE 3

16. Can the Fed undo the QEs? Inflation is a monetary phenomenon. –Austrians: the only meaningful definition of inflation is w.r.t. the money supply. What happens if the economy starts growing? –Banks will want to lend more, raising the MS and causing inflation. –The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%? –Inflationary expectations grow and become rooted in our economy, ala 1979. –Fed starts to pull back by selling UST and MBS. Their prices plummet; so Fed can’t buy back all the excess reserves! –Interest rates will soar; investment will falter; a recession ensues. –But, a recession accompanied by serious inflation, aka “stagflation.” Is it an “insurance policy” against massive sell-off?

18. The Federal Reserve II. Fed Policy: tools & critique ECO 473 – Money & Banking – Dr. D. Foster