© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 18 Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy

18-2 Monetary Policy & Interest Rates: The Big Questions 1.What are the tools used by central bankers to meet their stabilization objectives? 2.How are the tools linked to the central bank’s balance sheet? 3.How is the interest rate target chosen?

18-3 Monetary Policy & Interest Rates: Roadmap Federal Reserve’s Toolbox Operational Policy at the ECB Linking Tools to Objectives A Guide to Setting Interest Rates

18-4 Federal Reserve’s Monetary Policy Toolbox Federal Funds Rate Discount Rate Reserve Requirement

18-5 The Target Federal Funds Rate and Open Market Operations Interest rate on overnight interbank loans It is a market rate, the Fed doesn’t control it precisely. Since they are the monopoly supplier of reserves, they influence the market by controlling supply.

18-6 The Target Federal Funds Rate and Open Market Operations Could simply participate in the market as a borrower and a lender Don’t lend because the market is unsecured Fed won’t accept credit risk They don’t borrow, because that would mean paying interest on reserves

18-7 The Target Federal Funds Rate: and the Market for Bank Reserves Use Open Market Operations Estimate the demand for reserves each morning, and then supply the amount they expect to meet the demand at the target interest rate.

18-8 The Target Federal Funds Rate: and the Market for Bank Reserves Reserve Demand Slopes Down For levels of reserves less than the discount rate, supply is vertical For levels of reserves more than the discount rate, supply is horizontal

18-9 The Target Federal Funds Rate: and the Market for Bank Reserves An increase in reserve demand is met by an open market purchase The vertical portion of reserve supply shifts to the left to keep the federal funds rate at the target level

18-10 Target and Effective Federal Funds Rate

18-11 Federal Funds Rate is overnight lending rate Long-term interest rates = average of expected short-term interest rates plus risk premium When expected future path of the federal funds rate changes, long-term interest rates we all care about change.

18-12 Work is done by the Markets Group at the Federal Reserve Bank of New York Job is to stabilize the fed funds rate Use both temporary and permanent open market operations –Permanent are about once a week –Temporary are every day

18-13 Temporary Open Market Operations use repurchase agreements

18-14

18-15 Deciding the level of reserves is complicated and uses information from –Treasury about their balance –Reserve managers at commercial banks –Fed funds dealers

18-16 Discount Lending Not an important part of day-to-day monetary policy. Primarily to avert crises: Central bank is the lender of last resort

18-17 Discount Lending The Details Primary credit –Fed funds target basis Points –Banks qualify by having good supervisory ratings and by having posted acceptable collateral –Hope is that it will cap the funds rate Secondary credit –Fed funds target basis points –Banks who don’t qualify for primary credit and can’t get the funds more cheaply in the market Seasonal credit –Purpose is to address seasonal liquidity needs.

18-18 Reserve Requirements Not really a policy tool any more. Details –Banks must hold a minimum level of reserves based on two-week average of balances in certain accounts. –Reserve computation period ends every 2 nd Mon –Reserve maintenance period: 2 weeks ending the 3 rd Thurs following the end of the computation period. –Rules make reserve demand predictable.

18-19 The Fed’s Monetary Policy Toolbox

18-20 Operational Policy at the European Central Bank Targets the main refinancing rate: Rate on a weekly auction of 2-week maturity loans from the central banks to the commercial banks. Marginal Lending Facility ECB makes loans at target +100 bps Deposit Facility ECB pays interest at target –100 bps on excess reserves

18-21 Operational Policy at the European Central Bank

18-22 Central banks set a target overnight rate plus –A lending rate –A deposit rate The purpose is to keep the market overnight rate inside the channel

18-23 Linking Tools to Objectives: Desirable Features of Instrument Easily observable by everyone Controllable and quickly changed Tightly linked to the policymakers’ objectives

18-24 What if the Fed Targeted the Quantity of Reserves? A shift in reserve demand would move the market federal funds rate Reserve targets make interest rates volatile The federal funds rate is the link from the financial sector to the real economy Targeting reserves could destabilize the real economy

18-25 Linking Tools to Objectives: Targets and Instruments Operating Instruments Interest rates or Monetary base Intermediate targets Monetary Aggregates (M1, M2) Objectives Low Inflation, Growth, stable interest rates

18-26 Linking Tools to Objectives: Targets and Instruments

18-27 Bypasses intermediate targets and focuses on final objective Components: –Public announcement of numerical target –Commitment to price stability as primary objective –Frequent public communication

18-28 Setting the Interest Rate Target: The Taylor Rule The Taylor Rule tracks the actual behavior of the target federal funds rate and relates it to the real interest rate, inflation, and output. Target Fed Funds rate = 2½ + Current Inflation + ½ (Inflation gap) + ½ (Output gap)

18-29 Setting the Interest Rate Target: The Taylor Rule When inflation rises above target: respond by raising the interest rate When output falls below target: respond by lowering the interest rate

18-30 Setting the Interest Rate Target: The Taylor Rule If inflation = target and output = potential output, then target federal funds rate = 2½ + inflation target

18-31 Setting the Interest Rate Target: The Taylor Rule

18-32 Economic data is revised relatively often and the revisions can be large Real GDP data is –Initially released at the end of a quarter –Revised 6 times over the next 3 years –Continues to be revised after that

18-33

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 18 End of Chapter