1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 29 Monetary Policy

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-2 In this chapter you will learn to 1. Describe the long-term objectives of the Federal Reserve. 3. Describe the market for commercial bank reserves. 2. Explain why the Fed has chosen to express its short-term monetary policy targets in terms of an interest rate rather than the money supply. 4. Explain how the Fed uses open market operations to achieve its short-term objectives in the federal funds market. 5. Describe the recent track record of monetary policy and some likely future challenges.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-3 Long-Run Objectives of Monetary Policy Like most central banks, the Fed pursues: 1.maximum employment 2.price stability 3.moderate long-term interest rates Objectives of Monetary Policy

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-4 Short-Term Targets of Monetary Policy The Fed has targeted the money supply and the federal funds rate: Money supply during the late 1970s and early 1980s Federal funds rate — the price of borrowing reserves — for most of the period since 1970 Regardless of whether the Fed chooses either short-term targets, both potential target variables will react to any change in reserves. The question for the Fed is not which variable to influence but rather which variable to watch

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-5 Linking the Short-Run and Long-Run Goals: The Transmission Process Monetary policy affects the economy through the monetary transmission mechanism: The Fed sets a target for the federal funds rate which influences other market interest rates which change desired aggregate expenditure which changes aggregate demand which affects the price level and the level of real GDP

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-6 Figure 29.1 The Monetary Transmission Mechanism

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-7 Policy Procedure The Fed’s policy procedure is to link short-term targets for monetary conditions and its long-term objectives. To close an inflationary gap: - raise the target federal funds rate To close a recessionary gap: - lower the target federal funds rate Linking the Short-Run and Long-Run Goals

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-8 Figure 29.2 The Output Gap, Inflation, and Monetary Policy

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-9 Long-Run Objectives of Monetary Policy Money Supply Targets versus Interest Rate Targets Monetary policy can be implemented either by pursuing a target for the money supply or for the interest rate, but not both. Why? - For a given money demand curve, both cannot be set independently.

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-10 Figure 29.3 Two Approaches to the Implementation of Monetary Policy

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-11 Why the Fed does not use the money supply as a target? The Fed is unable to predict accurately the position of the M D curve at any given time. - largely due to innovations in the financial sector Like the Fed, most central banks choose to influence the interest rate directly. Monetary Policy Target

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-12 Reserve Markets and the Federal Funds Rate How the Fed Implements Monetary Policy APPLYING ECONOMIC CONCEPTS 29.1 The Federal Funds Rate and the Treasury Bill Rate The Fed has the ability to shift the demand and supply curves. The market for reserves is similar to those for money supply and money demand.

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-13 Figure 29.4 The Federal Funds Market The Fed uses its influence over the supply of reserves to keep the equilibrium federal funds rate close to its target level.

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-14 The Fed’s Monetary Policy Tools and the Market for Reserves The three policy tools that the Fed uses to affect conditions in the market for reserves: 1. open market operations 2. the discount rate 3. reserve requirements

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-15 Table 29.1 Initial Balance Sheet Changes Caused by an Open Market Purchase from a Commercial Bank The Fed can increase the reserves available to the banking system by purchasing bonds on the open market.

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-16 The Discount Window The intention of the discount window was initially that the Fed would help banks survive a panic by serving as a “bank for bankers.” The difference the amount lent and the amount repaid by the bank is called a “discount.”

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-17 Reserve Requirements The Fed has the authority to set the required levels of reserves for banks and other depository institutions If the Fed raises the required reserve ratio, banks would lend a smaller fraction of their deposits, which would decrease the money supply and increase the federal funds rate. If the Fed lowers the required reserve ratio, banks would lend a larger fraction of their deposits, which would increase the money supply and decrease the federal funds rate.”

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-18 Figure 29.5 The Fed’s Response to a Shift in the Demand for Reserves The Fed responds to the shift in the demand curve by rising the supply of reserves through open market purchase of bonds.

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-19 APPLYING ECONOMIC CONCEPTS 29.2 A Look at a Federal Open Market Committee Meeting Achieving the Federal Funds Rate Target

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-20 Monetary Policy in Action: Challenges and Issues The stagflation of the 1970s revealed the cost of allowing elevated inflation expectations to emerge. Since the early 1990s, inflation has been relatively low and stable. In 2006, Ben Bernanke replaced Alan Greenspan as chairperson of the Federal Reserve. Bernanke inherited an economy with a low inflation rate and a level of real GDP close to its potential level.

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-21 Figure 29.6 The Output Gap and the Inflation Rate

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-22 Uncertainty about the Monetary Policy Transmission Process The Fed faces uncertainty regarding: 1.the magnitude of the policy response −our analysis does not tell us how much the target for the federal funds rate needs to change to close an output gap 2.the timing of the policy response −the federal funds rate only affects inflation through a series of chain reactions, each of which can take months to be complete

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-23 The Stock Market Stock market performance does not equate the health of the overall economy. However, because developments in the stock market can affect the rest of the economy, the Fed pays attention to the stock market.

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-24 Deflation, Low Interest Rates, and the Money Supply Deflation: when the average price level is falling over time. Because money wages fall much more slowly than they rise, a recessionary gap that leads to deflation might last for a long period of time.  a prompt monetary policy response is needed

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 29-25 Inflation Targeting Prior to joining the Fed, Ben Bernanke (the current Fed Chairman) argued that central banks should announce explicit targets for the inflation rate.  speculation that the Fed will eventually adopt an inflation rate target Since price stability is achieved only when real GDP is close to potential, the Fed’s current goals of price stability and maximum employment is still compatible with an inflation rate target. A number of countries have adopted formal targets for inflation.