Transcript Policy Instrument - Porterville College

Macroeconomics
Introduction to
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 23
Strategies and Rules
for Monetary Policy
Dolan, Economics Combined Version 4e, Ch. 23
The Federal Reserve System
 The Federal Reserve System (“the Fed”) serves as the
central bank for the United States.
 A central bank typically has the following functions:
 It is the banks’ bank: it accepts deposits from and makes loans
to commercial banks.
 It acts as banker for the federal government.
 It controls the money supply.
 Performs certain regulatory functions for the financial industry.
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Structure of the
Federal Reserve System
The primary elements in the Federal Reserve System
are:
1. The Board of Governors
2. The Regional Federal Reserve District Banks
(FRBs)
3. The Federal Open Market Committee (FOMC)
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The Federal Reserve Banks
 12 District banks
 Nine directors
 The directors appoint the district president who is
approved by the Board of Governors
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The Federal Reserve System
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The Board of Governors
 Seven members
 Appointed by the President
 Confirmed by the Senate
Ben Bernanke, FED Chairman
 Serve 14-year term
 Terms are staggered so that one comes vacant every two
years
 President appoints a member as Chairman to serve a
four-year term
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Federal Open Market Committee (FOMC)
 Meets approximately every six weeks to review
the economy
 Made up of the following voting members:
 7 members of the Board of Governors
 5 of the FRB presidents (they rotate yearly)
= 12 FOMC members
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Functions of the Fed (1)
 Banking Services and Supervision
 It supplies currency to banks through its 12 district banks.
 It holds the reserves of banks in the district bank of each bank.
 It processes and routes checks to banks through its district banks and
processing centers.
 It makes loans to banks—it is the “lender of last resort”, the “banker’s
bank”.
 It supervises and regulate banks, ensuring that they operate in a sound and
prudent manner.
 It is the banker for the U.S. government. It sells government securities for
the U.S. Treasury.
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Functions of the Fed (2)
 Controlling the Money Supply
 The money supply is varied through the course of the
year to meet seasonal fluctuations in the demand for
money. This helps keep interest rates less volatile.
 Example: 4th quarter holiday season creates an increased
demand for money to buy gifts.
 The Fed also changes the money supply to achieve
policy goals set by the FOMC.
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Policy Goals of the Fed
 Ultimate Goal:
Economic growth with stable prices. This means greater output (GDP) and a
low, steady rate of inflation.
 Intermediate Targets:
 The Fed does not control output or the prices directly. It does
control the money supply.
 The Fed establishes target growth rates for the money supply,
which it believes are consistent with its ultimate goals.
 The money supply growth rate becomes an intermediate target,
an objective used to achieve some ultimate policy goal.
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Vocabulary
 Contractionary Policy: A government policy intending
to slow the economy to prevent inflation.
Monetary Policy Examples: Reduce money supply,
increase interest rate, increase foreign exchange rate
Policy Instrument (Tool): Sell Bonds, Increase the
Discount Rate, Increase required reserve ratio, sell foreign
currency/buy dollars in foreign exchange markets
Vocabulary
Expansionary Policy: A government policy
intending to speed or expand the economy to bring an
end to recession, increase employment, or prevent
deflation.
Monetary Policy Examples: Expand money supply,
decrease interest rate, decrease foreign exchange rate
Policy Instrument (Tool): Buy Bonds, Decrease the
discount rate, Decrease required reserve ration, buy foreign
currency/sell dollars in foreign exchange markets
Lags
 Inside lags are delays
between the time a problem
develops and the time a
decision is taken to do
something about it
 Examples:
 Delays in data collection
 Time needed to conduct
meetings, prepare reports, and
reach decisions
 Outside lags are delays
between the time a decision is
made and the time actions
affect the economy
 Examples:
 Delays in implementing a
decision
 Delays in movements along and
shifts in aggregate supply and
demand curves
Dolan, Economics Combined Version 4e, Ch. 23
Inside lag: Example
(AKA: Recognition Lag)
 The U.S. had a mild recession in
Jan-Nov 2001
 May 2001 vintage data (the data
available in the middle of the
recession) did not show start of
recession, even when it was half
over
 Fully revised data shows the start
of the recession clearly
Dolan, Economics Combined Version 4e, Ch. 23
Outside Lag: Example
(AKA: Impact Lag)
 After an increase in interest
rates shifts the AD curve, real
output first falls, and then
returns to the natural level
after the AS curve shifts
 These estimates show that the
process involves a total lag of
1 to 3 years, or longer
 Different studies, based on
different periods and methods,
do not agree on how long the
lag is
Dolan, Economics Combined Version 4e, Ch. 23
Forecasting Errors
 To overcome the problem of lags, policymakers must try
to act in advance, based on forecasts
 However, forecasts are not accurate. On average,
forecasts of GDP growth have an error of about
 1 percent for 1 year forecasts in developed countries
 2 percent for 2 year forecasts in developed countries
 3 percent for 2 year forecasts in developing countries
 Forecasts are least accurate at turning points in the
business cycle, just when they are needed most
Dolan, Economics Combined Version 4e, Ch. 23
Time-Inconsistency
 Time-inconsistency means the tendency to make
decisions that have good consequences in the short run,
but bad consequences in the long run
 Example from everyday life: You stop taking your
antibiotic medication because of bad side effects before
you are completely cured
 Example from macroeconomics: Before an election,
policymakers use excessive expansionary policy or avoid
needed contractionary policy
Dolan, Economics Combined Version 4e, Ch. 23
Fine-Tuning in the U.S. Economy
 U.S. policymakers attempted to
fine-tune the economy in the
1960s and 1970s
 Because of lags, forecasting
errors, and time-inconsistency,
the result was a series of
business cycles with increasing
inflation and unemployment
Dolan, Economics Combined Version 4e, Ch. 23
Fine-tuning vs. Policy Rules
 Fine-tuning uses frequent
discretionary policy to make
small adjustments to
aggregate demand
 Preset policy rules aim to
provide a transparent and
credible framework for
business and household
decisions
“The notion that central banks
can provide a low-cost, overthe-counter “aspirin” that
will alleviate almost any ill
that a society can face is no
longer credible”
— Robert Poole
President, Federal Reserve
Bank of St. Louis
Dolan, Economics Combined Version 4e, Ch. 23
Instruments, Targets, and Goals
 A policy instrument is a variable that is directly under
control of policymakers.
 An operating target is a variable that responds
immediately, or almost immediately, to the use of a
policy instrument.
 An intermediate target is a variable that responds to the
use of a policy instrument or a change in operating target
with a significant lag.
 A policy goal is a long-run objective of economic policy
that is important for economic welfare.
Dolan, Economics Combined Version 4e, Ch. 23
Monetarism
 Monetarists like Milton
Friedman advocated the use of
a steady rate of money
growth, approximately equal
to the long-run rate of growth
of real output, as an
intermediate target
 If velocity was reasonably
stable, a money growth rule
would avoid excessive
inflation or deflation
Equation of Exchange
MV = PQ
Where




M is the money stock
V is velocity
P is the price level
Q is the rate of GDP growth
If V is constant and growth of M
equals growth of Q, P will be
constant
Dolan, Economics Combined Version 4e, Ch. 23
Inflation targeting
 The rate of inflation averaged over one or two years is
the main intermediate target
 Interest rates are used as the operating target
 Open market operations are used as the main policy
instrument
Dolan, Economics Combined Version 4e, Ch. 23
The interest rate operating target
 The Fed sets the discount rate charged on loans to banks and the
deposit rate paid on reserves to form a corridor
 The federal funds target rate is set in the middle of the corridor
 Open market operations are used to adjust the supply of reserves
to keep the federal funds rate close to its target
Dolan, Economics Combined Version 4e, Ch. 23
Adjusting the Interest Rate Target
 Inflation targeting policy sets an upper and lower limit for growth
of the price level to form a cone around the intended inflation
target
 If the actual inflation rate threatens to move outside the cone, the
interest rate target is raised to slow growth of aggregate demand
Dolan, Economics Combined Version 4e, Ch. 23
A Taylor Rule:
An example of a potential “rule”
 A Taylor Rule uses both the inflation rate and the output
gap as intermediate targets
 The interest rate operating target is raised if either the
inflation rate or output gap increases
 The interest rate is lowered if inflation or the output gap
decreases
 To avoid lags in measuring the output gap, a variation of
the Taylor rule uses employment data
Dolan, Economics Combined Version 4e, Ch. 23
The Foreign Exchange Market
 The exchange rate of the peso
to the dollar depends on
supply and demand
 Dollars are supplied by U.S.
residents who want to buy
Mexican goods or services, or
to make investments in
Mexico
 Dollars are demanded by
Mexican residents who want
to buy U.S. goods and
services, or make investments
in the United States
Dolan, Economics Combined Version 4e, Ch. 23
A Change in Supply
 In 2009, an outbreak of swine
flu in Mexico reduced tourist
travel, shifting the supply curve
of dollars to the left
 The result was a depreciation of
the peso (appreciation of the
dollar), that is, an equilibrium
exchange rate with more pesos
per dollar
Dolan, Economics Combined Version 4e, Ch. 23
A change in demand
 Suppose an increase in U.S.
interest rates makes U.S.
securities more attractive to
Mexican investors
 The result is an increased
demand for dollars
 The peso depreciates (the
dollar appreciates)
Dolan, Economics Combined Version 4e, Ch. 23
An exchange rate operating target
 Some central banks use the
exchange rate as an
operating target
 If the demand for dollars
increases, the peso would
depreciate if nothing was
done
 To prevent depreciation, the
Mexican central bank
increases the supply of
dollars by selling dollars
from its foreign currency
reserves
Dolan, Economics Combined Version 4e, Ch. 23
Reasons for an Exchange Rate Target
Two principal reasons to
maintain an exchange rate
target
 To reduce the risks and costs
of international trade in goods
and services
 To anchor the domestic
currency to a stable foreign
currency in order to fight
inflation
When in works
 An exchange rate target works
best for small countries with
flexible economies, strong
trading links to the currency
partner, and low exposure to
external shocks
 Countries that do not want to
use an exchange rate in the
long run can use an exchange
rate target temporarily to stop
inflation, but then they should
have an exit strategy
Dolan, Economics Combined Version 4e, Ch. 23
Appendix to Chapter 23
Demand and Supply for Money
Dolan, Economics Combined Version 4e, Ch. 23
The Demand for Money
 The demand for real
money balances means
the real quantity of money
people want to hold, other
tings being equal
 A decrease in the interest
rate decreases the
opportunity cost of
holding money, and
causes a movement along
the demand curve (A to B)
 An increase in real income
causes the money demand
curve to shift to the right
(A to C)
Dolan, Economics Combined Version 4e, Ch. 23
A Change in the Interest Rate
 The supply of money is
controlled by the central bank
using open market operations
or other instruments
 The following could cause an
increase in the interest rate:
 An increase in real GDP,
shifting the demand curve
 An increase in the price level,
shifting the supply curve by
reducing the real quantity of
money with nominal money
constant
 An open market purchase,
reducing the nominal supply of
money with prices and real
GDP constant
Dolan, Economics Combined Version 4e, Ch. 23