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Introduction to Monetary Policy

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1 Introduction to Monetary Policy
Chapter 6 Introduction to Monetary Policy

2 Interest Rates as an Equilibrating Mechanism
Theoretically, “the” interest rate equilibrates investment and saving, and hence the product and income sides of the economy However, there are many interest rates. In particular, long and short term rates have different characteristics. The yield spread between these rates is an important determinant of GDP. In practice this means the availability as well as the cost of credit are both important.

3 Monetary Policy Monetary policy is supposed to adjust the cost and availability of credit to keep inflation at low stable levels and keep real growth growing at its maximum sustainable rate. When used properly, monetary policy mitigates and reduces business cycles. Only rarely does it intensify them.

4 Tools of Monetary Policy
The tools of monetary policy utilized by the central bank – in the U.S., the Federal Reserve Bank – have changed substantially over the past decades. Currently, the major tool of monetary policy is the change in the Federal funds rate. The Fed can also buy or sell Treasury securities to influence the amount of bank credit available.

5 Goals of Monetary Policy
Central bankers often state that their only goal is to keep inflation at low, stable levels. However, in fact, they are generally required to ease policy when real GDP declines and the unemployment rate rises. Also, they should always insure an adequate flow of liquidity for the needs of commerce and industry

6 Can/Should the Fed Try to Control Fluctuations in the Stock Market?
“Moral suasion” and statements about “irrational exuberance” have proved spectacularly unsuccessful. Exhortations to buy stock when prices are low have never been successful either. However, if the stock market seems too high, the Fed could substantially boost interest rates. It could also raise margin requirements on stocks, although that is usually consider a “sledgehammer” approach that was not tried even in the runaway market of 2000.

7 The Federal Funds Rate The determinants of the Federal funds rate have varied substantially under different Fed chairman. Since Alan Greenspan became chairman of the Fed in mid-1987, however, fluctuations in the funds rate have been closely tied to the rate of core inflation, the growth rate, and the unemployment rate.

8 The Taylor Rule Empirically, this relationship was first proposed by John Taylor in the early 1990s and has been reestimated many times since then. Currently, the regression shows that the if the economy were at full employment (4% unemployment) and growing 4% per year, the Federal funds rate would be 2% plus 2 times the rate of inflation. Every 1% rise in the unemployment reduces the Fed funds rate by 2% (these coefficients change slightly over time). Thus for 2% inflation, the Fed funds rate would be set at 6%. If the unemployment rate rose to 6%, the funds rate would then fall to 2%, and it would fall to 1% if the unemployment rate rose to 6 ½%, as happened in 2003.

9 Credit Availability The role of the banking system has changed substantially since it was deregulated in 1982. Most bank deposits are no longer are subjected to ceiling interest rates, which had restricted the amount of deposits they could attract. Currently, individual banks may offer whatever interest rate they think is appropriate to attract deposits. In that case, where are the constraints?

10 Restraints on Bank Credit
When interest rates rise, consumers and businesses are likely to borrow less because of the higher cost or repayment. In the late 1980s, improper and possibly illegal loans made by some banks caused much stricter regulation, and a cutback in the amount of money banks would lend. Earlier, credit controls were imposed in 1980, but the authority has since lapsed.

11 How the Yield Spread Affects Economic Activity
Suppose the Fed boosts the funds rate above the government bond rate. Banks would then be more likely to invest in short-term assets with no market risk and no default risk. Borrowers are more likely to default on loans at high interest rates. As a result, banks make fewer loans, and real growth declines.

12 What Determines Bond Yields
Short-term rates are closely correlated with the rate of inflation and the rate of unemployment. The spread between long and short-term rates varies substantially over the business cycle. Thus, other factors must determine bond yields. The principal factor is the expected rate of inflation. While expectations can never be measured or predicted exactly, that expected rate generally depends on the current stance of monetary policy and the size of the Federal government budget surplus or deficit relative to GDP (the budget ratio).

13 The Importance of the Budget Ratio
In 2002 and 2003, the Federal budget deficit increased significantly, yet both short and long-term interest rates declined sharply. An increase in the budget deficit does not raise interest rates during periods of economic slack and a large trade deficit. An increase in the budget deficit does raise interest rates if it boosts the expected rate of inflation. If investors think large deficits now will lead to higher inflation later, the yield spread will widen. If they do not think inflation will rise, it will be unaffected.

14 How Current Monetary Policy Affects Expectations
As long as the Fed retains credibility that it will tighten as soon as inflationary pressures start to build, negative real interest rates will not necessarily worsen inflationary expectations. During the 1960s and 1970s, it was widely believed that the Fed funds rate would lag behind inflation, so bond rates rose in anticipation of higher inflation. Since the mid-1980s, that has no longer been the case.

15 Transmission of Monetary Policy (case of tightening)
Higher Cost of Debt Capital Reduced Availability of Bank Loans Negative Impact of Lower Stock Prices on Equity Capital Negative Impact of Lower Stock Prices on Availability of Bank Loans

16 Higher Cost of Debt Capital
Key link is the rise in real interest rates. Capital spending declines because projects must now generate a higher rate of return. Consumer spending declines because the cost of time payments increases. Higher interest rates generally boost the value of the dollar, which decreases net exports.

17 Reduced Availability of Bank Loans
Higher interest rates cause banks to reduce their loans to consumers and businesses. Higher interest rates also boost the cost of debt service, hence diminishing profit margins.

18 Negative Impact of Lower Stock Prices on Equity Capital
When the cost of equity capital rises, many firms – especially smaller firms and those in the high-tech sector – cannot raise money through stock offerings. In businesses where “the assets go down the elevator every night”, banks are less likely to offer business loans based on existing assets, so equity capital financing becomes increasingly important.

19 Negative Impact of Lower Stock Prices on Bank Loans
When the stock market declines, the perceived risk of failure of smaller firms rises, so banks are less likely to offer loans. Also, as equity falls, the debt/equity ratio of many firms rises, putting them in danger of violating loan covenants, hence further reducing the opportunities for financing.

20 The Yield Spread as a Predictive Tool
Ever since 1969, an inverted yield curve has always been followed by a recession the next year in the U.S. economy. There are no exceptions to this rule. Furthermore, there has never been a recession that has not been preceded by an inverted yield curve.

21 The “Conundrum” If the Fed boosts the funds rate but it is still below equilibrium as defined by the Taylor rule, inflationary expectations may remain high, necessitating further hikes in that rate. However, once the Fed has boosted the rate high enough that inflationary expectations have subsided, the funds rate is now too high and needs to be reduced. However, lowering it too quickly will rekindle inflationary expectations.

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