Chapter 12 Monetary Policy

CONTENS 12.1 The Federal Reserve’s Monetary Policy Toolbox 12.2 Linking Tools to Objectives: ----- Making Choices 12.3 A guide to Central Bank Interest Rates: Taylor Rule

CONTENS 12.4 Interest Rate Target, Inflation Target and 12.5 Monetary Policy Transmission Mechanism 12.6 Challenges for Modern Monetary Policymakers

The Fed’s Monetary Policy Toolbox The Federal Reserve has three monetary policy tools, also known as monetary policy instruments The target federal funds rate, or the interest rate at which banks make overnight loans to each other The discount rate, or the interest rate the Fed charges on the loans it makes to banks The reserve requirement, or the level of balances a bank is required to hold either as vault cash on deposit or at a Federal Reserve Bank

12.1 The Fed’s Monetary Policy Toolbox 1. The federal funds rate is the rate at which banks lend reserves to each other overnight, it is determined in the market, rather than being controlled by the Fed Target Fed Funds Rate Web Link Market (Effective) Fed Funds Rate Web Link

The Fed’s Monetary Policy Toolbox

The Fed’s Monetary Policy Toolbox

The Fed’s Monetary Policy Toolbox 2. Discount Lending – Lender of Last Resort （1）Types of Loans – Web Link Primary Credit Short-term 100 basis points above target Fed Funds Rate Secondary Credit For banks that qualify for primary credit 150 basis points above target Fed Funds Rate. Seasonal Credit Small banks with cyclical farm loans

The Fed’s Monetary Policy Toolbox 3. Reserve Requirements The Monetary Control Act changed the rules slightly, so that the Fed can now set the reserve requirement ratio between 8 percent and 14 percent of so-called transactions deposits.

The Fed’s Monetary Policy Toolbox

The Fed’s Monetary Policy Toolbox 4. Operational Policy at the European Central Bank Minimum Bid Rate (Target Refinancing rate) Marginal Lending Facility 100 basis points above target refinancing rate Reserve Requirements 2% applied to checking accounts Overnight Cash Rate (like market Fed Funds Rate)

The Fed’s Monetary Policy Toolbox

12.2 Linking Tools to Objectives 1. Desirable Features of a Policy Instrument （1）Easily observable by everyone （2）Controllable and quickly changed （3）Tightly linked to the policymakers’ objectives

Linking Tools to Objectives Reserve targets make interest rates volatile.

Linking Tools to Objectives 2. Targets and Instruments Operating Instruments Interest rates or Monetary base Intermediate targets Monetary Aggregates (M1 , M2) Objectives Low Inflation, Growth, stable interest rates

Linking Tools to Objectives

Linking Tools to Objectives 3. Use of (Operating and Intermediate) Targets Suppose that the Bank wants to achieve a 5% rate of growth for nominal GDP and is targeting an aggregate (say M1+). If the Bank feels that the 5% nominal GDP growth rate will be achieved by a 4% growth rate for M1+ (its intermediate target), which will in turn be achieved by a 3% MB growth rate (its operating target), it will use its tools to achieve the 3% MB growth rate.

Use of (Operating and Intermediate) Targets After implementing this policy, if the Bank finds that MB is growing too slowly, it can use open market purchases to increase it. Somewhat later the Bank will begin to see how its policy affects the growth rate of M1+. If M1+ is growing too fast (say at 7%), the Bank will reduce its open market purchases or make open market sales to reduce the M1+ growth rate.

Desirable Features of a Policy Instrument These requirements leave policymakers with few choices, and over the years central banks have switched between controlling the quantity and controlling the prices.

Applying the Concept: Choosing an Operating Instrument (page 685) While the Fed has chosen the federal funds rate as its operating instrument, that rate was not the only possible choice. Other possibilities include the level of reserves or the monetary base. But if the Fed chooses to target the quantity of reserves it gives up control of the federal funds rate. Targeting interest rates keeps them from being too volatile and stabilizes growth.

Linking Tools to Objectives Reserve targets make interest rates volatile.

The conclusion from Figures 18 The conclusion from Figures 18.4 is that interest rate and monetary aggregate targets are incompatible: a central bank can hit one or the other but not both.

Operating Instruments and Intermediate Targets Over the last two centuries, central bankers largely abandoned intermediate targets, having realized that they didn’t make much sense. Instead, policymakers focus on how their actions directly affect their target objectives.

10.3 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)

The Taylor Rule When inflation rises above its target level, the response is to raise interest rates; when output falls below the target level, the response is to lower interest rates.

The Taylor Rule If inflation is currently on target and there is no output gap so that the current GDP equals potential GDP, then the target federal funds rate should be set at its neutral rate of the target inflation rate plus 2½.

The Taylor Rule

12.4 Interest Rate Targeting or Inflation Targeting 1. History of Bank of U.S Policy Procedures （1） Early Years: Interest Rate Targeting 1962-1971, Fixed exchange rate (Bretton Woods System) 1971-1975, Flexible exchange rate Result: During the early years, i or (i - i*) were the intermediate target of U.S monetary policy and the Bank’s objective was to keep the FX market and domestic bond markets functioning smoothly. The Bank paid no attention to the growth rate of M. As a result, monetary policy was expansionary and by 1974   to double digits (to 11%) compared to only 3% in 1971.

Inflation Rates Interest Rates During the early years, i or (i - i*) were the intermediate target of U.S monetary policy. As a result, i and  followed generally similar patterns in U.S and the U.S. Interest Rates

（2） Targeting Monetary Aggregates: 1975-81 By the end of 1975 there was a consensus among central banks that fluctuations in M contained useful information about P and Y. This evidence contributed to the rise of monetarism (a theory that emphasized a steady, predictable ). In response to this and the rising  in the early 1970’s,

the Bank introduced a program of “monetary gradualism,” under which M1 growth would be controlled within a gradually falling target range (see Table 18-1). The Bank, however, continued to use an interest rate as its operating target Result: Bank was successful at keeping actual M1 growth within the target range (see Table 18-1), but   because of a series of financial innovations that  the demand for M1 and  the demand for M2. Monetary targeting was abandoned in November 1982.

Interest Rate Targeting or Inflation Targeting （3） The Checklist Approach: 1982-88 With the abandonment of M1 targets, the Bank focused on a list of factors, including i, E, and broad monetary aggregates (like M2 and M2+), but no aggregate was found suitable as a guide for conducting monetary policy. The goal of monetary policy was  containment in the short term and price stability in the long ter

i was the operating target and E was the intermediate target (with the Bank resisting  in E, fearing that depreciation would worsen ) Result:   again (because of a persistent federal budget deficit that made it difficult for the Bank to control M and ). The Bank responded by announcing early in 1988 that short-term issues would henceforth less guide policy and that P stability would be the Bank's long-term objective of monetary policy

（4）Inflation Targeting: 1989-Present In February 1991, the Bank and the minister of finance “jointly” announced explicit targets for , with a band of ±1% around them. The targets were 3% by the end of 1992, falling to 2% by the end of 1995, to remain within a range of 1 to 3% thereafter. The 1% to 3% target range for  was renewed in 1995, in early 1998, and again in May 2001, to apply until the end of 2006

The midpoint of the current  target range, 2%, is regarded as the most desirable outcome In setting its  targets, the Bank uses inflation in "core CPI" which excludes volatile components (such as food, energy, and the effect of indirect taxes) Defining the  targets in terms of ranges gives the Bank sufficient flexibility to deal with supply shocks

Inflation Targeting Five Elements of Inflation Targeting （1）Public announcement of medium-term -target （2） Institutional commitment to price stability （3） Information inclusive strategy （4）Increased transparency through public communication （5）Increased accountability

Interest Rate Targeting or Inflation Targeting Advantages of Inflation Targeting (1) Allows focus on domestic considerations and enables monetary policy to respond to shocks to the domestic economy (2) Not dependent on reliable relationship between M and  (3)Readily understood by the public (4) Reduce political pressures for time-inconsistent policymaking

Puts great stress on making policy transparent and on regular communication with the public Increased accountability of central bank (that can be instrumental in building public support for the central bank’s independence Performance good:  and  e  , and stays low in business cycle upturn

12.4 Interest Rate Target, Inflation Target and Inflation Target Disadvantages of Inflation Targeting (1) Delayed signal (2) Too much rigidity (3) Potential for increased output fluctuations (4) Low economic growth

12.5 The Monetary Policy Transmission Mechanism 1. The Traditional Channels: Interest Rates and Exchange Rates the traditional channels of monetary policy transmission aren’t very powerful

The Monetary Policy Transmission Mechanism 2.Asset Price Channels: Investment and Wealth a fall in the interest rate tends to push stock prices up A fall in interest rate target it drives the mortgage rate down leading to higher demand for residential housing, driving up the prices of existing homes Higher asset prices mean increased wealth and higher consumption

The Monetary Policy Transmission Mechanism 3. Bank Lending and Balance Sheet Channels By altering the supply of funds to the banking system, policymakers can affect banks' ability and willingness to lend. an open market purchase has a direct impact on the supply of loans, increasing their availability to those who depend on banks for financing. as interest rates fall, the supply of loans increases

The Monetary Policy Transmission Mechanism

12.6 The Challenges Modern Monetary Policymakers Face Estimating Potential GDP

The Challenges Modern Monetary Policymakers Face U.S. Inflation, 1960–1980

The Challenges Modern Monetary Policymakers Face

The Challenges Modern Monetary Policymakers Face 1. Deflation and the Zero Nominal Interest Rate Bound Since nominal interest rates can't fall below zero, this places a significant restriction on what monetary policymakers can do The most effective way to expand the monetary base when the overnight interest rate has fallen to zero is to shift to targeting longer-term rates.

The Challenges Modern Monetary Policymakers Face 2. Booms and Busts in Equity and Property Prices Bubbles that inflate and then burst are particularly damaging, because the wealth effects they create cause consumption to explode and then contract just as rapidly.

The Challenges Modern Monetary Policymakers Face

The Challenges Modern Monetary Policymakers Face 3. The Evolving Structure of the Financial System changes in financial structure will change the impact of monetary policy.

The Challenges Modern Monetary Policymakers Face

The Challenges Modern Monetary Policymakers Face 4. International Considerations (1)Globalization (the growing integration and interdependence of national economies) has also affected Bank of U.S policymaking in recent years. Globalization requires international policy cooperation, to improve the functioning of international financial markets and the efficiency of domestic monetary policy.

Iinternational cooperation has been encouraged by the process of international policy coordination (agreements among countries to enact policies cooperatively) that led to the Plaza Agreement in 1985 and the Louvre Accord in 1987.

Chapter 12 End of Chapter