What can Government do to foster Economic Growth and Equity?

The Role of Monetary Policy

Cathy MinehanEconomic Growth with EquityOpen Classroom PPS 225February 11, 2009

Monetary Policy

What is it? Why is it necessary? How does it work? Goals:

Price stability Financial stability

Current challenges Was monetary policy part of the problem? What’s happening now

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Money: Anything that acts as a medium of exchange

Monetary Policy: Controls the supply of money

Economic growth requires money; money demand fluctuates with pace of growth

Monetary policy seeks to get money supply right as a condition to solid growth

Too much supply: prices rise (inflation)

Too little: prices fall (disinflation/deflation)

Monetary policy seeks to reduce supply by raising interest rates: increase supply by reducing interest rates

What is Monetary Policy?

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Price Stability - adjust growth of money to desired short-term pace of economic growth Avoid inflation/deflation More importantly – help to achieve higher standards of living

Financial Stability – the central bank is the key responder to financial crises Historical reason for central banks

Bank of England “lend freely at high rates” 1907 Crisis Federal Reserve formation 1934 Creation of FOMC 1951 Treasury/Fed Accord (“independent” central bank)

Typically Fiscal Policy too slow; Monetary Policy lowers interest rates, increases liquidity and bolsters confidence

Fiscal Stimulus in 2002 and current stimulus packages are exceptions

Why is Monetary Policy Necessary?

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Banks hold money (reserves) at central bank U.S. Central Bank – Federal Reserve System Central banks control supply of money and its

price How?

Buying and selling securities in the Open Market (Open Market operations)

Lending to banks and others against collateral (Discount Window Lending)

Reserve Requirements

How Does Monetary Policy Work?

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Governed by Federal Open Market Committee (FOMC); Implemented by Open Market Desk at Federal Reserve Bank of New York

Buy a security in the secondary market Adds reserves/money to system Fed creates money

Sell a security Takes reserves/money out of system Fed destroys money

Add money – interest rates go down Subtract money – interest rates go up The trick – match interest rates to the pace of growth

so price stability is maintained (relative vs. absolute?)

Open Market Operations

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Federal Funds Target Rate

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Discount Window Lending Traditionally to commercial banks, secured by collateral,

and made at the “Discount Rate” Issue of collateral type and value

Reserve Requirements A portion of commercial bank deposits with the Federal

Reserve are “required reserves” Amount is based on the nature of deposit liabilities Reserves are “high powered”

Traditionally Open Market Operations is key tool of Monetary Policy, but new uses of all three tools

Discount Window and Reserve Requirements

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Lending Short-term credit to both commercial banks and primary dealers Loans to Bear Stearns and AIG “SWAP” lines to foreign central banks

Reserves Paying interest facilitates rate setting

Market-Based Programs Asset Backed Commercial Paper Funding Money Market Investor Lending Term Asset Backed Securities Loan Facility (TALF)

Student Loans Auto Loans Credit Card Loans SBA Loans *Commercial Real Estate Loans (New)

In partnership with private sector and Treasury

New Federal Reserve Programs

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Yes: Interest rates too low for too long Reaching for yield leads to under pricing of risk

No: Inflation low and economic growth slow after recession

of 2001 Housing boom fueled by demographics, financial

innovation Inflows from abroad keep interest rates low, demand for

securities high

Maybe: Stronger regulation could have helped Issue of asset price vs. consumer price escalation

Was Monetary Policy Part of the Current Problem?

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Rapid Growth in Wealth with Low Inflation

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Financial markets remain in disarray though interbank leading, residential mortgage rates and commercial paper markets have stabilized

Economic growth stalled Deflation a concern Target Fed Funds Rate range of 0-25 Good news: Monetary Policy has been unusually

innovative and various programs seem to be working

Not so good news: Process is slow, complicated and uncertain

Need to start worrying about how to get out

What is Happening Now?

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