Copyright © 2012 Pearson Prentice Hall. All rights reserved. CHAPTER 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview “Monetary policy” refers to the management of the money supply. Although the idea is simple enough, the theories guiding the Federal Reserve are complex and often controversial. But, we are affected by this policy, and a basic understanding of how it works is, therefore, important.

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview We examine how the conduct of monetary policy affects the money supply and interest rates. We focus primarily on the tools and the goals of the U.S. Federal Reserve System, and examine its historical success. Topics include:  The Federal Reserve’s Balance Sheet  The Market for Reserves and the Federal Funds Rate

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview (cont.)  Tools of Monetary Policy  Discount Policy  Reserve Requirements  Monetary Policy Tools of the ECB  The Price Stability Goal and the Nominal Anchor  Other Goals of Monetary Policy

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview (cont.)  Should Price Stability be the Primary Goal of Monetary Policy?  Inflation Targeting  Central Banks’ Responses to Asset-Price Bubbles: Lessons from the 2007–2009 Financial Crisis  Tactics: Choosing the Policy Instrument

© 2012 Pearson Prentice Hall. All rights reserved The Federal Reserve’s Balance Sheet The conduct of monetary policy by the Federal Reserve involves actions that affect its balance sheet. This is a simplified version of its balance sheet, which we will use to illustrate the effects of Fed actions.

© 2012 Pearson Prentice Hall. All rights reserved The Federal Reserve’s Balance Sheet: Liabilities  The monetary liabilities of the Fed include: ─Currency in circulation: the physical currency in the hands of the public, which is accepted as a medium of exchange worldwide. ─Reserves: All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves. The Fed does not pay interest on reserves, but that may change because of legislative changes for 2011.

© 2012 Pearson Prentice Hall. All rights reserved The Federal Reserve’s Balance Sheet: Assets  The monetary assets of the Fed include: ─Government Securities: These are the U.S. Treasury bills and bonds that the Federal Reserve has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply. ─Discount Loans: These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply.

© 2012 Pearson Prentice Hall. All rights reserved Open Market Operations  In the next two slides, we will examine the impact of open market operation on the Fed’s balance sheet and on the money supply. As suggested in the last slide, we will show the following: ─Purchase of bonds increases the money supply ─Making discount loans increases the money supply  Naturally, the Fed can decrease the money supply by reversing these transactions.

© 2012 Pearson Prentice Hall. All rights reserved The Federal Reserve Balance Sheet  Open Market Purchase from Public  Result  R  $100, MB $100

© 2012 Pearson Prentice Hall. All rights reserved The Federal Reserve Balance Sheet  Discount Lending  Result  R  $100, MB $100

© 2012 Pearson Prentice Hall. All rights reserved Supply and Demand in the Market for Reserves we will examine how this change in reserves affects the federal funds rate, the rate banks charge each other for overnight loans.

© 2012 Pearson Prentice Hall. All rights reserved Supply and Demand in the Market for Reserves 1.Demand curve slopes down because i ff , ER  and R d up 2.Supply curve slopes down because i ff , DL , R s  3.Equilibrium i ff where R s = R d

© 2012 Pearson Prentice Hall. All rights reserved Response to Open Market Operations: Case 1—downward sloping demand 1.Open market purchase shifts supply curve to the right (NBR 1 to NBR 2 ). 2.R s shifts down, fed funds rate falls. 3.Reverse for sale.

© 2012 Pearson Prentice Hall. All rights reserved Response to Open Market Operations: Case 2—flat demand 1.Open market purchase shifts supply curve to the right (NBR 1 to NBR 2 ). 2.R s parallel, fed funds rate unchanged. 3.Reverse for sale.

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy Now that we have seen and understand the tools of monetary policy, we will further examine each of the tools in turn to see how the Fed uses them in practice and how useful each tools is.

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy: Open Market Operations  Open Market Operations 1.Dynamic: Meant to change current reserve level 2.Defensive: Meant to offset other factors affecting Reserves, typically uses repos  Advantages of Open Market Operations 1.CB has complete control: OMOs initiated by CB, so the volume is entirely under its control 2.Flexible and precise: Operations are flexible and concise, useful for both small and large changes in the monetary base 3.Easily reversed: Unanticipated effects are easily reversed, if needed 4.Implemented quickly: Once course of action approved, the policy is implements quickly, avoiding administrative delays

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy: Open Market Operations at the Trading Desk  The trading desk typically uses two types of transactions to implement their strategy: ─Repurchase agreements: the Fed purchases securities, but agrees to sell them back within about 15 days. So, the desired effect is reversed when the Fed sells the securities back—good for taking defense strategies that will reverse. ─Matched sale-purchase transaction: essentially a reverse repro, where the Fed sells securities, but agrees to buy them back.

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy: Discount Loans  Discount window ─ CB facility at which discount loans are made ─ Discount rate: interest rate on discount loan  3 types of discount loans: ─ Primary Credit ─ Secondary Credit ─ Seasonal Credit

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy: Discount Loans ─ Primary Credit: Borrowings from Central Bank by healthy banks Also known as the standing lending facility Interest rate on the primary credit is the discount rate and it is set higher than the fed funds rate usually by 100 basis points ─ Secondary Credit: Given to troubled banks experiencing liquidity problems Rate: Set at 50 basis point above the discount rate – a penalty ─ Seasonal Credit: Designed for small, regional banks that have seasonal patterns of deposits such as vacation area Rate: Tied to the average fed funds rate

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy : Discount Loans  Lender of Last Resort Function  Discounting important to prevent banking panics  Reserves are immediately channeled to the banks  Federal Deposit Insurance Corporation (insures depositors up to $100,000 per account)- fund not big enough – FDIC insurance amounts to 1% of the total deposit outstanding – The people need the Fed for additional confidence in the system  To prevent nonbank financial panics Examples: 1987 stock market crash, 2001 World Trade Center destruction, 2007 Sub-prime crisis  Announcement Effect  Problem: moral hazard: Banks and other financial institutions may take on more risk (moral hazard) knowing the Fed will come to the rescue

© 2012 Pearson Prentice Hall. All rights reserved Inside the Fed  The 2007–2009 Financial Crisis tested the Fed’s ability to act as a lender of last resort. Here are some of the details of the Fed’s efforts during this period to provide liquidity to the banking system: ─The Fed lowered the discount rate to 0.5% above the fed funds rate, and then by March 2008, lowered that to just 0.25%. ─Discount loan maturity was extended from overnight loans to loans maturity in 30 days, and then 90 days.

© 2012 Pearson Prentice Hall. All rights reserved Impact of Discount Loans on CB’s Balance Sheet  Discount Lending: Fed giving out loans to the banks Result  R  $100, MB $100

© 2012 Pearson Prentice Hall. All rights reserved Reserve Requirements Reserve Requirements are requirements put on financial institutions to hold liquid (vault) cash again checkable deposits.  Everyone subject to the same rule for checkable deposits: ─3% of first $48.3M, 10% above $48.3M ─Fed can change the 10%  Rarely used as a tool ─Raising causes liquidity problems for banks ─Makes liquidity management unnecessarily difficult FOMC calendar and meeting minutes

© 2012 Pearson Prentice Hall. All rights reserved Tools of Monetary Policy (3): Reserve Requirements  Changing ratio of required reserve, thus changing the demand for reserves  Everyone subject to the same rule for checkable deposits: ─3% of first $48.3M, 10% above $48.3M ─Fed can change the 10%  Advantages 1.Powerful effect – being imposed on all banks  Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks: particularly for banks with low excess reserve 3.Frequent changes cause uncertainty for banks 4.Tax on banks

© 2012 Pearson Prentice Hall. All rights reserved Goals of Monetary Policy Ultimate objective of mp; end results of mp implementation. What mp intends to achieve: 1.High employment 2.Economic growth 3.Price stability: –many social and economic costs of inflation –rising price level creates uncertainty, hampers economic growth; complicates decision making 4.Interest rate stability –Desirable: fluctuations create uncertainties; hard to plan for future 5.Financial market stability –Financial crisis interfere with ability of financial markets to channel funds; lead to economic contraction 6.Foreign exchange market stability

© 2012 Pearson Prentice Hall. All rights reserved Goals of Monetary Policy  Goals often in conflict ─ Economic growth and price stability: When economy expands, inflation rising: achieve growth but instable price ─ Price and interest rate stability: To ensure price stability, interest rate has to increase ─ Unemployment and inflation: Reduce unemployment, inflation starts to rise ─ Decision by central bank Check and balance Depending on priority

© 2012 Pearson Prentice Hall. All rights reserved Central Bank Strategy: Targets  To achieve certain goals, CBs do not directly influence goals, but use the tools at its disposal  All CBs, then, are limited to aiming at variables that lie between their tools and achievement of desired goals  CB identifies intermediate targets which it aims to affect via its operating targets ─ Easier to hit a goal by aiming at targets than aiming at goal directly ─ Allow for mid-course correction  2 types of target variables: ─ interest rates ─ monetary/reserve aggregates

© 2012 Pearson Prentice Hall. All rights reserved Central Bank Strategy: Choosing the Targets  Fed has two options of target variables: interest rates and aggregates. ─ Example: A 5% GDP growth can be achieved through 3% increase in reserves/monetary aggregates or setting interest rate at 2%  But, can CB chooses both targets simultaneously? ─ Unfortunately, the Fed can only choose one of the two variables. ─ The demand and supply analysis that follows will show why this is the case. ─ Any action which affects one of the targets will have some impact on the other target.

© 2012 Pearson Prentice Hall. All rights reserved Criteria for Choosing Policy Instruments  Criteria for Policy Instruments 1.Observable and Measurable Some are observable, but with a lag (eg. reserve aggregates) 2.Controllable Controllability is not clear-cut. Both aggregates and interest rates have uncontrollable components. 3.Predictable effect on goals Generally, short-term rates offer the best links to monetary goals. But reserve aggregates are still used. Interest rates aren't clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates  Criteria for Operating Targets 1.Same criteria as above Reserve aggregates and interest rates about equal on criteria 1 and 2, but for 3 if intermediate target is M s then reserve aggregate is better

© 2012 Pearson Prentice Hall. All rights reserved Fed Policy Procedures: Historical Perspective  Early Years: Discounting as Primary Tool 1.Real bills doctrine 2.Rise in discount rates in 1920: recession 1920–1921  Discovery of Open Market Operations 1.Made discovery when purchased bonds to get income in 1920s  Great Depression 1.Failure to prevent bank failures 2.Result: sharp drop in M s

© 2012 Pearson Prentice Hall. All rights reserved Fed Policy Procedures: Historical Perspective  Targeting Monetary Aggregates: 1970s 1.Federal funds rate as operating target with narrow band 2.Procyclical M s  New Fed Operating Procedures: 1979– De-emphasis on federal funds rate 2.Nonborrowed reserves operating target 3.The Fed still using interest rates to affect economy and inflation  De-emphasis of Monetary Aggregates: 1982–Early 1990s 1.Targeted 3% for the fed funds rate from late 1992–February of Raised the rate to 6% by early Lowered the rate in the face of a slowing economy and LTCM crisis. 4.Continued this trend in 2001, when the economy faced a recession.

© 2012 Pearson Prentice Hall. All rights reserved Monetary Targeting in Other Countries  United Kingdom 1.Targets M3 and later M0 2.Problems of M as monetary indicator  Canada 1.Targets M1 till 1982, then abandons it : declining π targets, M2 as guide  Germany 1.Targets central bank money, then M3 in Allows growth outside target for 2–3 years, but then reverses overshoots s: dilemma of restrain π, but keep exchange rate in EMS

© 2012 Pearson Prentice Hall. All rights reserved Monetary Targeting in Other Countries  Japan 1.Forecasts M2 + CDs 2.Innovation and deregulation makes less useful as monetary indicator 3.High money growth 1987–1989: “bubble economy,” then tight money policy  Lessons from Monetary Targeting 1.Success requires correcting overshoots 2.Operating procedures not critical 3.Breakdown of relationship between M and goals made M- targeting untenable; led to inflation targeting

© 2012 Pearson Prentice Hall. All rights reserved The New International Trend in Monetary Policy Strategy: Inflation Targeting  New Zealand ─ Passed the Reserve Bank of New Zealand act (1990) ─ Policy target agreement set an annual inflation target in the range of 0% to 2% ─ Target has adjusted based on current economic conditions  Canada ─ Established formal inflation targets, starting in 1991 ─ Targets have also been adjusted as needed  United Kingdom ─ Established formal inflation targets, starting in 1992 ─ Targets have also been adjusted as needed

© 2012 Pearson Prentice Hall. All rights reserved The New International Trend in Monetary Policy Strategy: Inflation Targeting  Lessons from Inflation Targeting ─ Decline in inflation still led to output loss ─ Worked to keep inflation low ─ Kept inflation in public eye—reduced political pressures for inflationary policy