Monetary Policy

Monetary Policy

CHAPTER31

After studying this chapter you will be able to

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

Explain how the Federal Reserve makes its interest rate decision and achieves its interest rate target

Explain the transmission channels through which the Federal Reserve influences the inflation rate

Explain and compare alternative monetary policy strategies

What Can Monetary Policy Do?

On eight pre-set dates a year, the Federal Reserve announces whether the interest rate will rise, fall, or remain constant until the next decision date.

How does the Fed make its interest rate decision?

What does the Fed do to keep interest rates where it wants them?

Does the Fed’s interest rate changes influence the economy in the way the Fed wants?

Can the Fed speed up economic growth by lowering interest rates and keep inflation in check by raising them?

Monetary Policy Objectives and Framework

A nation’s monetary policy objectives and the framework for setting and achieving that objective stems from the relationship between the central bank and the government.


Monetary Policy Objectives

The objectives of monetary policy stems from the mandate of the Board of Governors of the federal Reserve System as set out in the Federal Reserve Act of 1913 and its amendments. The law 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.


Goals and Means

Fed’s monetary policy objectives has two distinct parts:

1. A statement of the goals or ultimate objectives

2. A prescription of the means by which the Fed should pursue its goals


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.

Key goal is price stability.

Price stability is the source of maximum employment and moderate long-term interest rates.


Means of Achieving the Goals

By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable.

How does the Fed operate to achieve its goals?


Operational “Stables Prices” Goal

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

The rate if increase in the core CPI is the core inflation rate.

The Fed believes that the core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation.


Figure 31.1 shows the Fed says that the core inflation rate and the CPI inflation rate.

You can see that the CPI inflation rate is volatile and that the core inflation rate is a better indicator of price stability.


Operational “Maximum Employment” GoalStable price is the primary goal but the Fed pays attention to the business cycle.

To gauge the overall state of the economy, the Fed uses the output gap—the percentage deviation of real GDP from potential GDP.

A positive output gap indicates an increase in inflation.

A negative output gap indicates unemployment above the natural rate.

The Fed tries to minimize the output gap.


Responsibility for Monetary Policy

What is the role of the Fed, the Congress, and the President?

The FOMC makes monetary policy decisions.

The Congress makes no role in making monetary policy decisions. The Fed makes two reports a year and the Chairman testifies before Congress (February and June).

The formal role of the President is limited to appointing the members and Chairman of the Board of Governors.

The Conduct of Monetary Policy

Choosing a Policy Instrument

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

As the sole issuer of the monetary base, the Fed is a monopoly.

1. Should the Fed fix the price of U.S. money on the foreign exchange market (the exchange rate)?

2. Should the Fed let the exchange rate be flexible and target the short-term interest rate?

The Fed must decide which variable to target.


The Federal Funds Rate

The Fed’s choice of policy instrument (which is the same choice as that made by most other major central banks) is a short-term interest rate.

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

The specific interest rate that the Fed targets is the federal funds rate, which is the interest rate on overnight loans that banks make to each other.


Figure 31.2 shows the federal funds rate.

The federal funds rate was

raised to 8.25 percent a year in 1990 and 6.5 percent a year in 2000 when inflation was a concern.

and lowered to about 2 percent a year between 2002 and 2004 to avoid recession.


Although the Fed can change the federal funds rate by any (reasonable) amount that it chooses, it normally changes the rate by only a quarter of a percentage point.

How does the Fed decide the appropriate level for the federal funds rate?

And how, having made that decision, does the Fed get the federal funds rate to move to the target level?


The Fed’s Decision-Making Process

The Fed could adopt either

An instrument rule

A targeting rule


Instrument Rule

An instrument rule sets the policy instrument at a level based on the current state of the economy.

The best known instrument rule is the Taylor rule:

Set the federal funds rate at a level that depends on

The deviation of the inflation rate from target

The size and direction of the output gap.


Targeting Rule

A targeting rule sets the policy instrument at a level that makes the forecast of the ultimate policy target equal to the target.

If the ultimate policy goal is a 2 percent inflation rate and the instrument is the federal funds rate, then the targeting rule sets the federal funds rate at a level that makes the forecast of the inflation rate equal to 2 percent a year.


To implement such a targeting rule, the FOMC must gather and process a large amount of information about the economy, the way it responds to shocks, and the way it responds to policy.

The FOMC must then process all this data and come to a judgment about the best level for the policy instrument.

The 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.


Influences on the Federal Funds Rate

The Taylor rule sets the federal funds rate (FFR) at the 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

If inflation is on target and the output gap is zero (full employment), with a 2 percent inflation target, the federal funds rate will be 4 percent a year.

The Fed moves the interest rate up and down by less than the Taylor rule moves it.

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.

Figure 31.3 illustrates.






Hitting the Federal Funds Rate Target: Open Market Operations

An open market operation is the purchase or sale of government securities by the Fed from or to a commercial bank or the public.

When 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.

So open market operations influence banks’ reserves.


Figure 31.4 shows the effects of an open market purchase on the balance sheets of the Fed and the Bank of America.

The open market purchase increases bank reserves.


Figure 31.5 shows the effects of an open market sale on the balance sheets of the Fed and Bank of America.

The open market sale decreases bank reserves.


Equilibrium in the Market for Reserves

Figure 31.6 illustrates the market for reserves.

The x-axis measures the quantity of reserves held.

The y-axis measures the federal funds rate.


The banks’ demand for reserves is the curve RD.

The federal funds rate is the opportunity cost of holding reserves, so the higher the federal funds rate, the fewer are the reserves demanded.

The demand for reserves slopes downward.


The red line shows the Fed’s target for the federal funds rate.

The Fed’s open market operations determine the actual quantity of reserves in banking system.


Equilibrium in the market for reserves determines the federal funds rate.

So the Fed uses open market operations to keep the federal funds rate on target.

Monetary Policy Transmission

Quick Overview

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. Aggregate demand 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.

Figure 31.7 provides a schematic summary of these ripple effects, which stretch out over a period of between one and two years.



Interest Rate Changes

Figure 31.8 shows the fluctuations in three interest rates:

The short-term bill rate

The long-term bond rate

The federal funds rate


Short-term rates move closely together and follow the federal funds rate.

Long-term rates move in the same direction as the federal funds rate but are only loosely connected to the federal funds rate.


Exchange Rate Fluctuations

The 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.

But other factors are also at work, which make the exchange rate hard to predict.


Money and Loans

When the Fed lowers the federal funds rate, the quantity of money and the quantity of loans increase.

Consumption and investment plans change.

Long-Term Real Interest Rate

Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate.

The long-term real interest rate influences expenditure plans.


Expenditure Plans

The ripple effects that follow a change in the federal funds rate change three components of aggregate expenditure:

1. Consumption expenditure

2. Investment

3. Net exports

The change in aggregate expenditure plans changes aggregate demand, real GDP, and the price level, which turn influence the goal of inflation rate and output gap.


The Fed Fights Recession

If inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target.


The Fed Fights Recession

The increase in the supply of money increases the supply of loanable funds in the short-term.


The Fed Fights Inflation

If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target.


The Fed Fights Inflation

The decrease in the supply of money decreases the supply of loanable funds in the short-term.


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 response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.

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


A Final Reality Check

Figure 31.11 shows how monetary policy has worked.

The blue line shows the federal funds rate minus the long-term bond rate.

The red line shows real GDP growth one year later.


A Final Reality Check

When the Fed pushes the federal funds rate above the long-term bond rate, the real GDP growth rate slows in the following year.

When the Fed lowers the federal funds rate below the long-term bond rate, the real GDP growth rate speeds up in the next year.

Alternative Monetary Policy Strategies

The Fed might have chosen any of four alternative monetary policy strategies: One of them are instrument rules and three are alternative targeting rules.

The four alternatives are

Monetary base instrument rule

Monetary targeting rule

Exchange rate targeting rule

Inflation targeting rule


Monetary Base Instrument RuleThe McCallum rule makes the growth rate of the monetary base respond to the long-term average growth rate of real GDP and medium-term changes in the velocity of circulation of the monetary base.

The rule is based on the quantity theory of money.

The McCallum rule does not need an estimate of either the real interest rate or the output gap.

The McCallum rule relies on the demand for money and the demand for monetary base being reasonably stable. The Fed believes that these are too unstable to allow a McCallum rule work well.


Money Targeting Rule

Friedman’s k-percent rule makes the quantity of money grow at a rate of k percent a year, where k equals the growth rate of potential GDP.

Friedman’s idea was tried but abandoned during the 1970s and 1980s.

The Fed believes that the demand for money is too unstable to make the use of monetary targeting reliable.


Exchange Rate Targeting Rule

With a fixed exchange rate, a country has no control over its inflation rate.

The Fed could use a crawling peg exchange.

The disadvantage rate of a crawling peg to target the inflation rate is that the real exchange rate often changes in unpredictable ways.

With crawling peg targeting the inflation rate, the Fed would need to identify changes in the real exchange rate and offset them.


Inflation Targeting Rule

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment

1. To achieve an explicit inflation target

2. To explain how its policy actions will achieve that target

Several central banks practice inflation targeting and have done so since the mid-1990s.

It is not clear whether inflation targeting would deliver a better outcome than the Fed’s current implicit targeting.


Why Rules?

Why do all the monetary policy strategies involve rules?

Why doesn’t the Fed use discretion?

The answer is that monetary policy is about managing inflation expectations.

A well-understood monetary policy rule helps to create an environment in which inflation is easier to forecast and manage.

THE END

Monetary Policy

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