CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY

U.S. Monetary policy & “The Fed”

● Federal Reserve System was founded by Congress in 1913.

● Bank of Canada in 1935.● The oldest is Sweden's Riksbank – 1668.● Bank of England – 1694.● Bank of France – 1800.● ECB (European Central Bank) – 1998.

Federal Reserve's Core Functions

● As a central bank its function is to manage the expansion and cost of money and credit, as a means of achieving the predetermined goals.

● Conducting Monetary Policy.● Maintaining the stability of the financial system.● Performing banking supervision and regulation.● Providing financial services.

Structure of The FRS

12 Federal Reserve

Banks

Board of GovernorsWashington D.C.

FOMC (federal open market

committee)

● instrument independence - the ability of the central bank to set monetary policy instruments

● goal independence - the ability of the central bank to set the goals of monetary policy.

● BoC has less goal independence.

● BoC is not fully isolated from other branches of government. Ultimate responsibility for monetary policy goes to the government.

● BoC is less instrument independent.

● This independence story is important because independent Central Banks are able to achieve their goals (such as inflation reduction) better.

Monetary Policy Objectives

“ ...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.”

i.e. to balance growth in M with growth in Y

(see quantity theory of money equation)

● Cost of Unemployment (from too little money growth) lost opportunities from idle resources, emotional pain

● Cost of Inflation (from too much money growth)

destruction of savings, losses to creditors, shoeleather costs, menu costs, risk of entrenching inflation in people’s expectations.

deflation also poses risks, primarily the risk that people postpone purchases and investments.

● What number should FOMC shoot for?

● Remember: objective is price stability. so inflation should be 0% right?

If you aim for 0% you might accidentally undershoot and achieve deflation. little inflation “greases the wheels” , motivates people to look for higher-paying jobs and find a better fit for their skills.

economists have decided that inflation of 2% does little harm, so better to shoot for that and avoid risk of deflation, unemployment.

“The Synthesis”

● The prevalent and core view among the central bankers about how growth and inflation interact emerged as a result of:

● Great Depression (1930s) Keynesians, short run Keynesians believe that in the short run, when demand is depressed, increasing the money supply

and stimulating demand will not lead to inflation

● Great Inflation (1970s) New Classicalists, long run New Classicalists, like Austrians, believe that in the long run, money is neutral in its

effects on the economy, because prices will adjust to balance money with output. Growth in output and employment must come from improved productivity.

● Governors have to understand and accept both.

In the short run, for a given level of expected inflation, and for a given supply curve, monetary policy moves the AD curve up and down the supply curve. Therefore there is a tradeoff between unemployment and inflation, as shown in the Phillips curve.

If inflation gets too high i.e. the Central Bank stimulates AD too much, people will begin to expect higher inflation. The Aggregate Supply curve will shift towards the origin as people demand higher wages and higher rentals, leases, etc.

NAIRU ParadigmModel of Growth and Inflation

● NAIRU stands for non-accelerating inflation rate of unemployment. It is the lowest you can push unemployment/the most you can stimulate aggregate demand without causing inflation.

● NAIRU is achieved at Yn, the “full-employment” level of GDP that we have used in our diagrams of AD/AS equilibrium.

● FOMC watches for NAIRU since it is the limit where a rise in the inflation rate will show up.

More on NAIRU● Very difficult to pin-point an exact number – it changed over the years.

● Controversial. Where is it? - 6% prior to 1995. Around 4.5% late 1990s

● Recent estimates by many put it at 4.5% to 5.0%.

● Really, you should think of it as concept not an exact number. It is a balancing point. A rough measure but a key one.

● The NAIRU is a moving target, estimated imprecisely, and with a lag that may be long enough to make it an uncertain guide for policy.

● “Point of heated” debate in the Fed meetings. Hawks vs. doves.

● Politicians do not like it the idea of cooling the economy (thereby raising unemployment) when the unemployment rate falls below NAIRU.

● NAIRU has decreased over the years due to:

– Ease of internet job search– Aging population– Rising prison population – Decline in power of minimum wage– Decline in power of unions.

How fast can the economy grow?

POTENTIAL OUTPUT GROWTH (POG) is about 2.5-3% in the US.

OKUN’s Law is a rule-of-thumb that predicts by what percentage unemployment will rise for every percentage point that output growth is below POG. In the US, the Okun coefficient seems to be about 0.4.

SUMMARY

• Traditional way of operating if U rate falls below NAIRU, economy overheats and rate of inflation increases, so reduce money supply.

• Mid 1990s “temporary bliss” U rate fell well below NAIRU (3.8%) but inflation kept falling as well due to increases in productivity and competition from international trade. There seemed to be no need to reduce the money supply.

• In the 2000s the Fed kept the interest rate low to help the economy recover from the dot-com bubble, and then the 9/11 scare.

• House prices and stock prices bubbled.

• The Fed felt it was better to live with a bubble than to pop it as Japan did in the late 80s. Inflation was feared less than deflation.

The Conduct of the Monetary policy

● The role of policy is to move the economy to some preferred state.

● Decisions are made at the FOMC meeting.

● They can use:

– Reserve Requirements – seldom changed

– Discount Window – amount charged/paid to chartered banks for their loans/deposits.

– Federal Funds Rate (i.e. overnight lending rate to chartered banks)– most often used tool. The announced rate is backed up by open market operations which work in the same direction. Once the FFR has been reduced to near zero, the Fed must find another tool if it wants to stimulate the economy any further.

– Big changes in the monetary base. This is called quantitative easing/tightening.

Federal Funds Rate

● Is the interest rate charged on overnight loans from the Central Bank to commerical banks or from one commercial bank to another.

● Determined in the market for federal reserve balances (market for reserves)

● FED influences the price at which this lending/borrowing is being done through Open Market Operations

Open Market Operations

• buying and selling of U.S. gov. bonds – affects the federal funds rate and interest rates generally

• Most of it done in US Treasury securities most liquid market

• Buying bonds increases currency in circulation and selling bonds decreases it.

Taylor Rule• How should the target FFR be chosen?

• The Fed wants to decrease unemployment AND decrease inflation, if possible, but in the short run there is a tradeoff between these two goals.

• Fed funds rate target = inflation rate + equilibrium real fed funds rate + 1/2 (inflation gap) +1/2 (output gap)

• Simple policy rules like the Taylor rule are only rules of thumb, and reasonable people can disagree about important details of the construction of such rules. Moreover, simple rules necessarily leave out many factors that may be relevant to the making of effective policy in a given episode.

• The next graph shows that the Fed has behaved in a way consistent with the Taylor Rule.

Channels

• How do changes in the Fed Funds Rate work their way to the economy?

• Raising or lowering the FFR influences 4 major channels linked to aggregate demand:

1. Higher (lower) interest rates discourage (encourage) business and consumer spending

2. Weaken (raise) the value of the stock and housing market (mortgage rates) wealth effect

3. Appreciate (depreciate) the value of the currency, decreasing (increasing) net exports.

4. Credit channel: Discourages (encourages) banks from lending, since the value of collateral has fallen (risen). (See point 2.)

Credit Channel

• Wealth effect from houses and stocks not the whole story

• homes and stocks are used as collateral for loans

• tighter monetary policy decreases the value of homes and stocks lower collateral for borrowing

• tighter monetary policy weaker economic outlook (incomes & profits)

• Result: tougher standards for lending by banks in the credit market can harm economic growth

• Financial Accelerator is reduced when firms lack access to credit. The financial accelerator describes how firms increase their investment in response to improved sales.