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Federal Reserve Bank of Atlanta Monetary Policy Amy B. Hennessy Federal Reserve Bank of Atlanta Federal Reserve Bank of Atlanta Key points Tools of monetary policy Importance of independence of the central bank Using economic indicators to guide monetary policy Federal Reserve Bank of Atlanta What is the broad purpose of the Fed? Financial system stability Economic stability Federal Reserve Bank of Atlanta The Fed’s Dual Mandate Growth Price stability Federal Reserve Bank of Atlanta Types of Policy Fiscal policy Taxing and spending by the President and Congress, affecting the government’s budget Monetary policy Changing the growth of the money supply to achieve price stability and long-run economic growth Federal Reserve Bank of Atlanta FOMC Federal Open Market Committee • 7 Governors • 1 NY Fed President • 4 voting positions rotate among other 11 Fed Presidents 8 meetings a year What does the FOMC decide? Federal Reserve Bank of Atlanta Normal tools of monetary policy Reserve requirements • little used Discount window Open market operations (federal funds rate) Federal Reserve Bank of Atlanta Reserve Requirements Portion of funds banks are required to hold in reserve Not changed for monetary policy since early 1990s Federal Reserve Bank of Atlanta Discount Window Loans directly to banks • Short-term Discount rate—generally higher than federal funds rate Set by Board of Governors with regional requests Changing role of discount window Federal Reserve Bank of Atlanta Open market operations Federal funds rate Overnight rate between financial institutions • Fed not directly lending • Buys and sells treasuries Established by FOMC Primary dealers Federal Reserve Bank of Atlanta How do open market operations work? Banks provide most money in overnight market Fed expands or contracts amount of money • Expand = buy Treasuries • lower interest rate • Contract (shrink) = sell Treasuries • higher interest rate Why? Federal Reserve Bank of Atlanta Reserves Affect Money, Credit, and Interest Rates = Reserves When reserves go up (if the Fed buys government securities), money and credit increase and short-term interest rates may fall. = Money = Credit Short-Term Interest Rates When reserves go down (if the Fed sells government securities), money and credit decrease and short-term interest rates may rise. Reserves Money = Credit = = Short-Term Interest Rates Federal Reserve Bank of Atlanta Interest Rates Affect Economic Activity Short-term interest rates Spending and investment When interest rates go down, people and businesses tend to borrow and spend more, increasing GDP and employment. Additional demand for goods and services puts upward pressure on prices. GDP and price levels Employment Federal Reserve Bank of Atlanta Interest Rates Affect Economic Activity Short-term interest rates Spending and investment GDP and price levels When interest rates go up, people and businesses tend to borrow and spend less, which can decrease GDP and employment. However, the decrease in demand for goods and services should cause price levels to stabilize, thus bringing down inflation pressures. Employment Federal Reserve Bank of Atlanta Normal monetary policy uses 3 main tools But, these are not normal times Why is the Fed involved? • Still goes back to the Fed’s broad purpose: economic and financial system stability What is the Fed doing now? • Targeted actions Federal Reserve Bank of Atlanta Anecdotal Information Data • Data inherently lags • Can miss turning points Anecdotal information • Directors • Business leaders • Regional information centers Federal Reserve Bank of Atlanta What does changing interest rates do? The car analogy • Increasing interest rates = brakes on the economy • Lowering interest rates = gas pedal on the economy Federal Reserve Bank of Atlanta Tool lags Time lag Backward looking data Importance of • Forecasts • Anecdotal information Federal Reserve Bank of Atlanta When and how to use those tools… For example: • 4% GDP growth and high inflation? • Negative GDP growth and low inflation? Those are easy extremes Federal Reserve Bank of Atlanta Limitations of monetary policy Only limited tools Need fiscal policy as well Example: Hurricane Katrina Federal Reserve Bank of Atlanta Why does the Fed need to be independent? Your thoughts? Pressures on politicians Long-term vs shortterm concerns Federal Reserve Bank of Atlanta Increased transparency Announce target rate FOMC statement Recent changes • Publishing economic forecasts 4 times a year • Minutes come out faster—3 weeks after the meeting Federal Reserve Bank of Atlanta Using your new skills What kind of indicators would economists use to work towards their dual mandate? Federal Reserve Bank of Atlanta Conclusions Tools of monetary policy Importance of independence of the central bank Using economic indicators to guide monetary policy