1. Chapter 18. Monetary Policy The market for reserves Open market operations Discount lending Reserve requirements Goals of monetary policy Using targets The market for reserves Open market operations Discount lending Reserve requirements Goals of monetary policy Using targets

2. The Market for Reserves interbank lending market  federal funds rate (FF rate) FOMC impacts this market  which impacts other debt markets & economy interbank lending market  federal funds rate (FF rate) FOMC impacts this market  which impacts other debt markets & economy

4. The Fed and the FF rate open market operations  shift the supply of reserves discount loans  setting discount rate affects bank borrowing and supply of reserves reserve requirement  affects demand for reserves open market operations  shift the supply of reserves discount loans  setting discount rate affects bank borrowing and supply of reserves reserve requirement  affects demand for reserves

5. Open Market Operations (OMO) buying & selling Treasuries  large & liquid market open market purchase  increase supply of reserves  decrease FF rate OMO are the Fed’s main policy tool buying & selling Treasuries  large & liquid market open market purchase  increase supply of reserves  decrease FF rate OMO are the Fed’s main policy tool

6. FOMC votes on OMO  votes on FF rate target FRBNY actually buys and sells Treasuries  to achieve the FF rate target FOMC votes on OMO  votes on FF rate target FRBNY actually buys and sells Treasuries  to achieve the FF rate target

8. advantages of OMO Fed has complete control OMO are flexible  buy/sell a little or a lot OMO are easily reversible  sell too much? then buy some back OMO quickly impact reserves, FF rate Fed has complete control OMO are flexible  buy/sell a little or a lot OMO are easily reversible  sell too much? then buy some back OMO quickly impact reserves, FF rate

9. Discount Lending each district bank has a discount window  set discount rate  set discount policy lower discount rate  increase borrowing, reserves  decrease FF rate each district bank has a discount window  set discount rate  set discount policy lower discount rate  increase borrowing, reserves  decrease FF rate

10. why do banks get discount loans?  short-term liquidity problem  serious problems  seasonal reserve fluctuations  but should not ask for help too often discount rate is 50-100 bp. ABOVE the FF rate why do banks get discount loans?  short-term liquidity problem  serious problems  seasonal reserve fluctuations  but should not ask for help too often discount rate is 50-100 bp. ABOVE the FF rate

11. Discount loans & monetary policy discount loans not a good tool not completely under Fed control  banks decide to borrow can give misleading signals  if done for non-policy reasons not easily reversible  cannot change rates on old loans discount loans not a good tool not completely under Fed control  banks decide to borrow can give misleading signals  if done for non-policy reasons not easily reversible  cannot change rates on old loans

12. Reserve requirement set by the Board of Governors higher requirement  increase demand for reserves  increase FF rate today (since 1992)  3% on checking up to $44.3 million  10% above $44.3 million set by the Board of Governors higher requirement  increase demand for reserves  increase FF rate today (since 1992)  3% on checking up to $44.3 million  10% above $44.3 million

13. reserve requirement is very powerful tool  too powerful  not good for small adjustments  expensive to change reserve requirement is very powerful tool  too powerful  not good for small adjustments  expensive to change

14. Goals of Monetary policy desirable goals for the economy Fed uses monetary policy to achieve these goals  directly control tools, to influence goals desirable goals for the economy Fed uses monetary policy to achieve these goals  directly control tools, to influence goals

15. High employment i.e., low unemployment federal government has a commitment to full employment goal: natural rate of unemployment  about 4-5%  today: 4.7%  6% in Oswego Co. i.e., low unemployment federal government has a commitment to full employment goal: natural rate of unemployment  about 4-5%  today: 4.7%  6% in Oswego Co.

16. Economic Growth annual % change in real GDP U.S. long run average -- 3% 2006 real GDP growth 1.5% annual % change in real GDP U.S. long run average -- 3% 2006 real GDP growth 1.5%

17. Price stability i.e., low inflation  annual % change in CPI primary goal of Fed since 1980s how high is too high?  over 4%  goal: 2% or less Oct 2007: about 3.5% i.e., low inflation  annual % change in CPI primary goal of Fed since 1980s how high is too high?  over 4%  goal: 2% or less Oct 2007: about 3.5%

18. Financial Market Stability stability of financial institutions stability of interest rates stability of exchange rates Fed stabilized markets  October 1987  Summer 1998  September 2001 stability of financial institutions stability of interest rates stability of exchange rates Fed stabilized markets  October 1987  Summer 1998  September 2001

19. Using targets Fed directly controls tools (like OMO), not goals it can take a year for tools to impact the goals  how to gauge progress in between? Fed directly controls tools (like OMO), not goals it can take a year for tools to impact the goals  how to gauge progress in between?

20. TargetsTargets related to tools and goals used by Fed to judge if they are on track related to tools and goals used by Fed to judge if they are on track goal intermediate target operating instrument tool (OMO)

21. operating instrument respond immediately to changes in the tools examples  bank reserves  FF rate  Tbill rate respond immediately to changes in the tools examples  bank reserves  FF rate  Tbill rate

22. intermediate targets affected by operating target closely associated with goals examples  M1or M2  Tnote yields affected by operating target closely associated with goals examples  M1or M2  Tnote yields

23. effective instruments observable by everyone controllable and quickly changeable by the Fed predictably related to goals observable by everyone controllable and quickly changeable by the Fed predictably related to goals

24. 2 types of targets/instruments monetary targets  reserves, MB  M1 or M2 interest rate targets  FF rate  other short or medium-term rates monetary targets  reserves, MB  M1 or M2 interest rate targets  FF rate  other short or medium-term rates

25. target tradeoff Fed can target money supply OR interest rates NOT BOTH! why? Fed can target money supply OR interest rates NOT BOTH! why?

26. suppose Fed targets M* for MS: M iMS M* MD’’ i’’

27. but as MD fluctuates, i will change: M iMS M* MD’’ i’’ MD’’’ i’’’ MD’ i’

28. so if target M*, lose control of i M iMS M* MD’’ i’’ MD’’’ i’’’ MD’ i’

29. suppose Fed targets i* M i MD’’ i* MS M’’

30. but as MD fluctuates, Fed must shift MS to maintain i* M iMS M’’ MD’’ i* MD’’’MD’ M’ MS’ M’’’ MS’’’

31. Fed targets i*, lose control of M M iMS M’’ MD’’ i* MD’’’MD’ M’ MS’ M’’’ MS’’’

32. TargetsTargets If Fed targets MS, loses control of interest rates If Fed targets interest rates, loses control of MS If Fed targets MS, loses control of interest rates If Fed targets interest rates, loses control of MS

33. The Taylor Rule How to choose the FF rate target? Base target on  Current inflation  Target inflation  Current real GDP  Potential real GDP How to choose the FF rate target? Base target on  Current inflation  Target inflation  Current real GDP  Potential real GDP

34. FF rate target = 2.5 + current inflation + (1/2)(current-target inflation) + (1/2)(current - potential GDP) A guideline for the Fed FF rate target = 2.5 + current inflation + (1/2)(current-target inflation) + (1/2)(current - potential GDP) A guideline for the Fed