What can Government do to foster Economic Growth and Equity? The Role of Monetary Policy Cathy Minehan Economic Growth with Equity Open Classroom PPS 225.

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What can Government do to foster Economic Growth and Equity? The Role of Monetary Policy Cathy Minehan Economic Growth with Equity Open Classroom PPS 225 February 11, 2009

Monetary Policy  What is it?  Why is it necessary?  How does it work?  Goals:  Price stability  Financial stability  Current challenges  Was monetary policy part of the problem?  What’s happening now 2

 Money: Anything that acts as a medium of exchange  Monetary Policy: Controls the supply of money  Economic growth requires money; money demand fluctuates with pace of growth  Monetary policy seeks to get money supply right as a condition to solid growth  Too much supply: prices rise (inflation)  Too little: prices fall (disinflation/deflation)  Monetary policy seeks to reduce supply by raising interest rates: increase supply by reducing interest rates What is Monetary Policy? 3

 Price Stability - adjust growth of money to desired short- term pace of economic growth  Avoid inflation/deflation  More importantly – help to achieve higher standards of living  Financial Stability – the central bank is the key responder to financial crises  Historical reason for central banks  Bank of England “lend freely at high rates”  1907 Crisis Federal Reserve formation  1934 Creation of FOMC  1951 Treasury/Fed Accord (“independent” central bank)  Typically Fiscal Policy too slow; Monetary Policy lowers interest rates, increases liquidity and bolsters confidence  Fiscal Stimulus in 2002 and current stimulus packages are exceptions Why is Monetary Policy Necessary? 4

 Banks hold money (reserves) at central bank  U.S. Central Bank – Federal Reserve System  Central banks control supply of money and its price  How?  Buying and selling securities in the Open Market (Open Market operations)  Lending to banks and others against collateral (Discount Window Lending)  Reserve Requirements How Does Monetary Policy Work? 5

 Governed by Federal Open Market Committee (FOMC); Implemented by Open Market Desk at Federal Reserve Bank of New York  Buy a security in the secondary market  Adds reserves/money to system  Fed creates money  Sell a security  Takes reserves/money out of system  Fed destroys money  Add money – interest rates go down  Subtract money – interest rates go up  The trick – match interest rates to the pace of growth so price stability is maintained (relative vs. absolute?) Open Market Operations 6

Federal Funds Target Rate 7

 Discount Window Lending  Traditionally to commercial banks, secured by collateral, and made at the “Discount Rate”  Issue of collateral type and value  Reserve Requirements  A portion of commercial bank deposits with the Federal Reserve are “required reserves”  Amount is based on the nature of deposit liabilities  Reserves are “high powered”  Traditionally Open Market Operations is key tool of Monetary Policy, but new uses of all three tools Discount Window and Reserve Requirements 8

 Lending  Short-term credit to both commercial banks and primary dealers  Loans to Bear Stearns and AIG  “SWAP” lines to foreign central banks  Reserves  Paying interest facilitates rate setting  Market-Based Programs  Asset Backed Commercial Paper Funding  Money Market Investor Lending  Term Asset Backed Securities Loan Facility (TALF)  Student Loans  Auto Loans  Credit Card Loans  SBA Loans  *Commercial Real Estate Loans (New)  In partnership with private sector and Treasury New Federal Reserve Programs 9

 Yes:  Interest rates too low for too long  Reaching for yield leads to under pricing of risk  No:  Inflation low and economic growth slow after recession of 2001  Housing boom fueled by demographics, financial innovation  Inflows from abroad keep interest rates low, demand for securities high  Maybe:  Stronger regulation could have helped  Issue of asset price vs. consumer price escalation Was Monetary Policy Part of the Current Problem? 10

Rapid Growth in Wealth with Low Inflation 11

 Financial markets remain in disarray though interbank leading, residential mortgage rates and commercial paper markets have stabilized  Economic growth stalled  Deflation a concern  Target Fed Funds Rate range of 0-25  Good news: Monetary Policy has been unusually innovative and various programs seem to be working  Not so good news: Process is slow, complicated and uncertain  Need to start worrying about how to get out What is Happening Now? 12