Chapter 18. Monetary PolicyChapter 18. Monetary PolicyChapter 18. Monetary PolicyChapter 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

The Market for ReservesThe Market for ReservesThe Market for ReservesThe 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

The Fed and the FF rateThe Fed and the FF rateThe Fed and the FF rateThe 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

Open Market Operations (OMO)Open Market Operations (OMO)Open Market Operations (OMO)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

• 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

advantages of OMOadvantages of OMOadvantages of OMOadvantages 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

Discount LendingDiscount LendingDiscount LendingDiscount 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

• 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

Discount loans & monetary policyDiscount loans & monetary policyDiscount loans & monetary policyDiscount 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

Reserve requirementReserve requirementReserve requirementReserve 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

• 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

Goals of Monetary policyGoals of Monetary policyGoals of Monetary policyGoals 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

High employmentHigh employmentHigh employmentHigh 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.

Economic GrowthEconomic GrowthEconomic GrowthEconomic 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%

Price stabilityPrice stabilityPrice stabilityPrice 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%

Financial Market StabilityFinancial Market StabilityFinancial Market StabilityFinancial 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

Using targetsUsing targetsUsing targetsUsing 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?

TargetsTargetsTargetsTargets

• 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

goalintermediatetarget

operatinginstrument

tool(OMO)

operating instrumentoperating instrumentoperating instrumentoperating 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

intermediate targetsintermediate targetsintermediate targetsintermediate 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

effective instrumentseffective instrumentseffective instrumentseffective 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

2 types of targets/instruments2 types of targets/instruments2 types of targets/instruments2 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

target tradeofftarget tradeofftarget tradeofftarget tradeoff

• Fed can target money supply OR interest rates

• NOT BOTH!

• why?

• Fed can target money supply OR interest rates

• NOT BOTH!

• why?

• suppose Fed targets M* for MS:• suppose Fed targets M* for MS:

M

i MS

M*

MD’’

i’’

• but as MD fluctuates, i will change:• but as MD fluctuates, i will change:

M

i MS

M*

MD’’

i’’ MD’’’

i’’’

MD’

i’

• so if target M*, lose control of i• so if target M*, lose control of i

M

i MS

M*

MD’’

i’’ MD’’’

i’’’

MD’

i’

• suppose Fed targets i*• suppose Fed targets i*

M

i

MD’’

i*

MS

M’’

• but as MD fluctuates, Fed must shift MS to maintain i*• but as MD fluctuates, Fed must shift MS to maintain i*

M

i MS

M’’

MD’’

i* MD’’’

MD’

M’

MS’

M’’’

MS’’’

• Fed targets i*, lose control of M• Fed targets i*, lose control of M

M

i MS

M’’

MD’’

i* MD’’’

MD’

M’

MS’

M’’’

MS’’’

TargetsTargetsTargetsTargets

• 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

The Taylor RuleThe Taylor RuleThe Taylor RuleThe 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

• 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