Presentation on theme: "Monetary policy How the Federal Reserve manages the money supply and interest rates to pursue its economic goals. 1 Price stability 2 High employment 3."— Presentation transcript:
Monetary policy How the Federal Reserve manages the money supply and interest rates to pursue its economic goals. 1 Price stability 2 High employment 3 Economic growth 4Stability of financial markets and institutions Stable interest rates Stable exchange rates Healthy banks The Goals of Monetary Policy
How Does the Fed Measure Inflation? Personal Consumption Expenditure Price Index: A Chained Index
The Money Market and the Fed’s Choice of Monetary Policy Targets The Fed wants to keep both the unemployment and inflation rates low It can’t affect either of these variables directly. The Fed uses variables, called monetary policy targets, that it can affect directly These, in turn, affect variables that are closely related to the Fed’s policy goals, such as real GDP, employment, and the price level. The federal funds rate is the most important direct target variable Changes in the Fed’s federal funds rate target changes the money supply. Money supply growth affects inflation, unemployment, and growth.
The Money Market and the Fed’s Choice of Monetary Policy Targets Money or Interest Rate? Federal Funds Rate Targeting, January 1998–July 2009 To keep the federal funds rate on target, the Fed Buys or Sells bonds: This affects the quantity of reserves in the banking system Which affects the money supply Which affects other interest rates Which affect economic activity
Federal Funds Rate Targeting, January 1998–September 2011 The Fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the Fed’s target rate. The orange line is the Fed’s target for the federal funds rate, and the jagged green line represents the actual value for the federal funds rate on a weekly basis. Note: The federal funds target for the period after December 2008 was 0 to 0.25 percent. To keep the federal funds rate on target, the Fed Buys or Sells bonds: This affects the quantity of reserves in the banking system Which affects the money supply Which affects other interest rates Which affect economic activity
The Money Market and the Fed’s Choice of Monetary Policy Targets The Demand for Money (An increase in the price of bonds) Substitute away from bonds toward money.
Shifts in the Money Demand Curve
Equilibrium in the Money Market The Impact on the Interest Rate When the Fed Increases the Money Supply People try to buy bonds. Bond prices fall.
Contractionary monetary policy The Federal Reserve adjusting the money supply to increase interest rates to reduce inflation.
Rather than use an interest rate as its monetary policy target, the Fed should target the money supply. Economists who make this argument belong to the Monetarist School. The leader of the monetarist school was Nobel laureate Milton Friedman. Friedman and his followers favored replacing monetary policy with a monetary growth rule. Steady money growth steady, predictable inflation Steady money growth automatic stabilizer. Should the Fed Target the Money Supply? Problem is, it’s hard to get the money supply where you want it. The public’s changing how it splits money holdings between currency and demand deposits changes the money multiplier.
Why Doesn’t the Fed Target Both the Money Supply and the Interest Rate? The Fed Can’t Target Both the Money Supply and the Interest Rate
Monetary Policy and Economic Activity 3. Can the Fed Get Timing Right? The Effect of a Poorly Timed Monetary Policy on the Economy Friedman’s complaint about discretionary monetary policy: “Too much too late”
Taylor rule A rule developed by John Taylor -- a Stanford professor and advisor to Presidents Bush -- that links the Fed’s target for the federal funds rate to economic variables. Should the Fed adhere to a simple rule … or exercise discretion? Federal funds target rate = Current inflation rate + Real equilibrium federal funds rate + (1/2) x Inflation gap + (1/2) x Output gap According to Taylor rule, if inflation rises by one percentage point, the Federal Funds rate should rise by 1 ½ percentage points. The real federal funds rate then rises by ½ %, slowing inflation. 5. Should the Fed Target Inflation? Inflation targeting Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation.
The Money Market and the Fed’s Choice of Monetary Policy Targets The Importance of the Federal Funds Rate Federal Funds Rate Targeting, January 1998– July 2009 The Fed does not set the federal funds rate, but its ability to increase or decrease bank reserves quickly through open market operations keeps the actual federal funds rate close to the Fed’s target rate. The orange line is the Fed’s target for the federal funds rate, and the jagged green line represents the actual value for the federal funds rate on a weekly basis.
Fed Policies During the Recession The Inflation and Deflation of the Housing Market “Bubble” The Housing Bubble Sales of new homes in the United States went on a roller-coaster ride, rising by 60 percent between January 2000 and July 2005, before falling by 76 percent between July 2005 and January 2009.
Fed Policies During the Recession The Changing Mortgage Market: Securitization Slicing and dicing. By the 1990s, a large secondary market existed in mortgages, with funds flowing from investors through Fannie Mae and Freddie Mac to banks and, ultimately, to individuals and families borrowing money to buy houses. Major commercial and investment banks borrowed heavily to buy these mortgages (and other loans), bundled them into Collateralized Debt Obligations (CDOs, one flavor of which is Mortgage Backed Securities, MBSs), and sliced and diced these securities into tranches of varying risk. They sold off these exotic financial products to insurance companies, pension funds, and other investors in the US and around the world but held on to a goodly amount of them themselves. As seen in the Frontline video: Meltdown By mid-2007, the decline in the value of mortgage-backed securities and the large losses suffered by commercial and investment banks began to cause turmoil in the financial system. Many investors refused to buy mortgage-backed securities, and some investors would only buy bonds issued by the U.S. Treasury. But these large commercial banks and investment banks were TOO BIG TO FAIL The Fed and the U.S. Treasury (taxpayers) acted as lenders of last resort.
The Fed and the Treasury Department Respond Initial Fed and Treasury Actions Fed Policies During the Recession First, although the Fed traditionally made loans only to commercial banks, in March 2008 it announced the Primary Dealer Credit Facility, under which primary dealers— firms that participate in regular open market transactions with the Fed—are eligible for discount loans. Second, also in March, the Fed announced the Term Securities Lending Facility, under which the Fed will loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. Third, once again in March, the Fed and the Treasury helped JPMorgan Chase acquire the investment bank Bear Stearns, which was on the edge of failing. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac, two government sponsored enterprises (GSEs) that held a lot of mortgages and securities that had fallen in value.
The Fed and Treasury Department Respond Responses to the Failure of Lehmann Brothers Fed Policies During the Recession After the failure of Lehman Brothers, a major investment bank that many thought was Too Big to Fail, panic gripped financial markets. The major players stopped lending to each other... There was a silent run on major financial institutions. In October 2008, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock. Taking partial ownership positions in private commercial banks was an unprecedented action for the federal government. The recession of 2007–2009, and the accompanying financial crisis, had led the Fed and the Treasury to implement new approaches to policy. Many of these new approaches were controversial because they involved partial government ownership of financial firms, implicit guarantees to large (TBTF) financial firms that they would not be allowed to go bankrupt, and unprecedented intervention in financial markets.
Contractionary monetary policy Expansionary monetary policy Federal funds rate Inflation targeting Monetary policy Taylor rule K e y T e r m s