Three Tools of Monetary Policy Open market operations Discount rate Reserve requirements
Open Market Operations 2 Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB, typically uses repos Advantages of Open Market Operations 1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly
Discount Rate as Ceiling on Fed Funds Rate Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2
Discount Rate Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting discount rate changes 2.Fluctuations in discount loans cause unintended fluctuations in money supply 3.Not fully controlled by Fed
Reserve Requirements Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks
Goals of Monetary Policy Goals 1.Price Stability 2.Economic Growth 3.High Employment 4.Interest Rate Stability 5.Financial Market Stability 6.Foreign Exchange Market Stability Goals often in conflict
Time Inconsistency Problem Rules versus discretion Solution: Fixed Rules
Hierarchical Mandate “The primary objective of the European System of Central Banks [ESCB] shall be to maintain price stability. Without prejudice to the objective price stability, the ESCB shall support the general economic policies in the Community.”
Dual Mandate “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Money Supply Target 1. M d fluctuates between M d' and M d'' 2. With M-target at M*, i fluctuates between i' and i''
Interest Rate Target 1.M d fluctuates between M d' and M d'' 2.To set i-target at i* M s fluctuates between M' and M''
Criteria for Choosing Targets 1.Measurability 2.Controllability 3.Ability to predictably affect goals Interest rates aren’t clearly better than M s on criteria 1 and 2 because hard to measure and control real interest rates