Chapter 14: Monetary Policy

Objectives of U.S. monetary policy and the framework for setting and achieving them

Federal Reserve interest rate policy

Channels through which the Federal Reserve influences the inflation rate

Alternative monetary policy strategies

Monetary Policy Objectives and Framework

Federal Reserve Act of 1913 states:

The Fed and the FOMC shall maintain long-term 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.

Equation of exchange:

RGDPVMP %%%%

Monetary Policy Objectives and Framework

Goals of Monetary Policy

Maximum employment, stable prices, and moderate long-term interest rates

In the long run, these goals are in harmony and reinforce each other, but in the short run, they might be in conflict.

• increasing employment in short term may create inflation and higher long term interest rates in long term.

Price stability is essential for maximum employment and moderate long-term interest rates.

Monetary Policy Objectives and Framework

“Stables Prices” Goal

• Fed pays close attention to the CPI excluding fuel and food—the core CPI.

• The rate of increase in the core CPI is the core inflation rate.

• Core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation.

Monetary Policy Objectives and Framework

“Maximum Employment” GoalPrice stabilization is the primary goal but the Fed pays attention to the business cycle.

output gap—the percentage deviation of real GDP from potential GDP.

A positive output gap unempl<natural rate & inflationary pressures.

A negative output gap unemployment > natural rate & deflationary pressures

The Fed tries to minimize the output gap

• Reduce interest rates if there is a negative output gap• Raise interest rates if there is a positive output gap

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis. The GDP gap is the difference between real GDP and its estimated potential level.

The GDP Gap

The Conduct of Monetary Policy

Choosing a Policy InstrumentThe monetary policy instrument is a variable that the Fed can directly control or closely target.

Possible targets:

• monetary growth rate (base, M1, M2)• interest rates (federal funds rate, long term bonds, etc.)• exchange rate• inflation rate• unemployment rate• Difficult to target more than one variable.

The Conduct of Monetary Policy

The Federal Funds RateCurrently, the Fed’s choice of policy instrument is a short-term interest rate (federal funds rate).

Given this choice, the exchange rate and the quantity of money find their own equilibrium values.

Fed funds rate rises during expansions and is cut during recessions.

To adjust FFR, Fed tends to increase growth of monetary base during recessions.

How does Fed Decide on Fed Funds Rate?

The Fed could adopt either

An instrument rule

• Set the policy instrument (e.g. FFR) at a level based on the current state of the economy.• Taylor rule (later) is an instrument rule.

A targeting rule

•set the policy instrument (e.g. fed funds rate) at a level that makes the forecast of the ultimate policy target equal to the target.•e.g. if policy goal is 2% inflation and the instrument is the federal funds rate, then targeting rule sets FFR so the forecast of the inflation rate equals 2%.• requires large amounts of information to forecast inflation and effect of Fed Funds rate and other economic variables on inflation.

The Conduct of Monetary Policy

Taylor rule (Stanford economist John Taylor)

• set federal funds rate (FFR) at equilibrium real interest rate (which Taylor says is 2 percent a year) plus amounts based on the inflation rate (INF) and the output gap (GAP) according to the following formula (all values are in percentages):

FFR = 2 + INF + 0.5(INF – 2) + 0.5GAP

FFR will increase if inflation rises or GDP-gap rises

The Conduct of Monetary Policy

FOMC minutes suggest that the Fed follows a targeting rule strategy.

Some economists think that the interest rate settings decided by FOMC are well described by the Taylor Rule.

The Fed believes that because it uses much more information than just the current inflation rate and the output gap, it is able to set the overnight rate more intelligently than any simple rule can set.

The Conduct of Monetary Policy

The Fed hits the Federal Funds Rate Target using Open Market OperationsWhen the Fed buys securities, it pays for them with newly created reserves held by the banks.

When the Fed sells securities, they are paid for with reserves held by banks.

Open market operations influence banks’ reserves, the supply of loans, and interest rates.

•Short term rates track FFR more closely than long term rates.•Fed has greater control over short term rates than long term rates.

Fed control over interest rates

• Fed has better control over short term than long term bonds• Inflation expectations and future movements in short term rates affect the long term rate•Shifts in the yield curve reflect changes in expectations about future interest rates

–steepens when interest rates are expected to rise over time–flattens when interest rates are expected to fall over time.

• Changes in the “risk premium” alter spread between government bonds and other types of loans

• risk premium rose in recent financial crisis.

Monetary Policy Transmission

When the Fed lowers the federal funds rate:

1. Other short-term interest rates and the exchange rate fall.

2. The quantity of money and the supply of loanable funds increase.

3. The long-term interest rate falls.

4. Consumption expenditure, investment, and net exports increase.

5. AD increases.

6. Real GDP growth and the inflation rate increase.

When the Fed raises the federal funds rate, the ripple effects go in the opposite direction.

Monetary Policy Transmission

Exchange Rate FluctuationsThe exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential.

If U.S. interest rates fall relative to rest of world,

•Demand for dollar decreases• Supply of dollar increases• P of $ drops (cheaper dollar)

–exports increase, imports decrease–AD rises

Other factors are also at work (e.g. inflation expectations) which make the exchange rate hard to predict.

Monetary Policy Transmission

Loose Links and Long and Variable LagsLong-term interest rates that influence spending plans are linked loosely to the federal funds rate.

The response of the real long-term interest rate to a change in the nominal rate depends on how inflation expectations change.

The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way

• can be like “pushing on a string” during recessions.