Transcript Goals

Monetary Policy Strategy
Goals
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Stability in the price level(CPI).
Full employment (low unemployment)
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Unemployment rate 4-6%
Greater employment  greater output
Greater unemployment more the employed
must share – food stamps, insurance.
Economic growth – increase in economy’s
output of goods and services.
Stabilizing interest rates.
Stability in foreign currency exchange rates.
Difficulties
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Measurement difficulties.
Policy goals can be competing.
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It may be difficult to achieve both full employment
and low inflation.
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To keep inflation low 
tight monetary policy which pushes up interest rates.
Fed will typically adopt a compromise policy.
Conflicting goals concerning domestic and
international policies.
Employment Act of 1946
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Congress declared the federal government
had responsibility to promote the nation’s
economic welfare – “promote maximum
employment, production, and purchasing
power”.
The act contained no specific reference to the
related problem of inflation, the promotion of
economic growth, or stability in the balance
of payments.
Humphrey-Hawkins Full Employment
and Balanced Growth Act (1978)
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Corrected the Employment Act of 1946.
Set target of 4% unemployment for
workers>16 and 3% for >20 by 1983.
Set target of 3% inflation by 1983.
Problem: the two goals may conflict
with one another. To achieve one goal
you may have to abandon the other at
least in the short run.
Evolution of Monetary Policy
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WWII – 1979: Keynesian Era
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Fiscal policy – use of the federal budget to
achieve economic goals.
60s & 70s revealed serious problems with
Keynesian Policy.
By 1979 inflation > 13%.
Evolution of Monetary Policy
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1979-1982: Target Monetary Growth
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July 1979: Carter appointed Paul Volcker chairman
of the Fed.
1981: Reagan administration cut taxes with no
corresponding cut in spending
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Increase in federal deficit
Steep rise in interest rates
Dollar appreciated
1982: Inflation 4% but unemployment rose to
highest level since the Great Depression.
Evolution of Monetary Policy
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1982-1990:Target Interest Rate
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Retain Monetarist goal of price stability.
Rather than target monetary growth,
target the interest rate.
Longest peacetime expansion on record.
Introduction
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“Federal Open Market Committee (FOMC)
seeks monetary and financial conditions that
will foster price stability and promote
sustainable growth in output”
Examination of the formulation of policy
through the Federal Open Market
Committee’s directive
Review the reasons for the particular course
of action that is followed
The FOMC Directive
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The FMOC meets every five or six weeks
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Review of recent economic and financial
developments
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Prices
Unemployment
Interest rates
Money supply
Balance of payments
Bank credit
Makes projections for the future
Based on anticipated economic conditions,
proposes appropriate monetary policy
The FOMC Directive (Cont.)
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The FOMC directive
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In recent years, FOMC directive usually contains a
single paragraph that begins with a general
qualitative statement of current policy goals
Specifies the immediate prescription for
implementing longer-term objectives
In outlining its operating targets, the
Committee refers to conditions in the reserve
markets, not in terms of money supply growth
The FOMC Directive
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Although Fed emphasizes monetary and
reserve aggregates, in practice it operates
on interest rates (Federal Funds Rate)
After each meeting, the FOMC releases a
statement
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Summarizes the directive
Gives some idea of the Fed’s view of future policy
risks
Indicates whether policy risks are mainly weighted
toward inflationary pressure, economic weakness,
or weighted equally between the two
The Fed’s Strategy
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Humphrey-Hawkins Act of 1978
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Provides policy guidelines to Federal Reserve
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Maximum employment
Price stability
Moderate long-term interest rates
Fed has interpreted maximum employment as full
employment--economy functions at its potential
Meet these three goals by seeking price stability
and sustainable growth since long-term interest
rates are low when expected inflation is low
The Fed’s Game Plan
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Operating and intermediate targets are
more responsive to Fed’s actions
These two steps provide timely feedback so
Fed can judge if their actions are on the right
tract
Steps in Development of the
Fed’s Plan
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Decide upon GDP growth rate consistent with
inflation and unemployment objectives
Set range for monetary growth expected to
generate target GDP growth
Set a target for growth in reserves
Key to the success of Fed’s effectiveness
is understanding and predicting the
linkages between the different steps
Reserves Versus the Federal
Funds Rate
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Different targets selected by Federal Reserve
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Before October 1979—favored federal funds rate
October 1979 to mid-1982—shifted to reserve
aggregates to get control over inflation
After mid-1982—shifted focus back to federal
funds rate
It seems that reserves and the federal funds
rate are two sides of the same coin
Reserves Versus the Federal
Funds Rate
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However, there is often an irreconcilable
conflict that prevents the Fed from
simultaneously targeting reserves and the fed
funds rate
Characteristics of the federal funds
market
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Immediately available funds that are lent between
banks, usually on an overnight basis
Transfer of funds through bookkeeping entry on
reserves held by the Fed
Interest rate charged is the Federal Funds Rate
Reserves Versus the Federal
Funds Rate
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The Federal Funds Rate is established in
the competitive market (supply and
demand of reserves), but is influenced
by the Fed (proactive action)
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Increase reserves—Lower the rate
Decrease reserves—Raise the rate
Reserves Versus the Federal
Funds Rate
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In the real world, demand curves for reserves
fluctuates with the pace of economic activity
These shifts in the demand curve will
complicate the actions of the Fed (reactive
action)
The Fed can target either the level of
reserves or the federal funds rate
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Targeting reserves—the federal funds rate will
vary
Targeting federal funds rate—the level of
reserves will vary
Reserves Versus the Federal
Funds Rate
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The Fed cannot set reserve levels and
the federal funds rate independently
Which target should the Fed choose?
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Select one that produces less variability in GDP
Targeting reserves and letting interest rate
change would be best under some conditions
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Close and predictable relationship between reserves and
spending
Private spending is subject to destabilizing variations
Resulting interest rate changes would stabilize the
economy
Which Target Should the Fed
Choose?
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Targeting interest rates, with fluctuating reserves
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Weak linkage between reserves and spending results in
variation in demand for reserves not related to changes in
spending
In this case, automatic changes in interest rates would not
allow the Fed to stabilize the economy
Under these conditions, the Fed has concluded it is better to
target the federal funds rate
With significant change in economic activity, it might be
necessary to alter targeted federal funds rate
Can the Fed Really Control
Reserves?
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Preceding discussion suggests the Fed has
complete control over supply of reserves
Banking system has ability to affect reserves
through borrowing at the discount window
New discount window system enhances the
Fed’s ability to meet its fed funds rate target
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Fed funds rate below discount--no borrowing
Fed funds rate rising above discount-Discount borrowing by banks increases reserves
thereby lowering fed funds rate
The Taylor Rule and Fed’s Track
Record
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During the Greenspan period at the Fed, the
focus has clearly been on the use of the
federal funds rate to influence interest rates
Interest rates then affect the aggregate
demand for goods/services, the real GDP and
the inflation rate
Although it is difficult to forecast the behavior
of the Fed, it appears the general direction of
interest rate policy can be explained by the
Taylor rule
Taylor Rule
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Federal funds rate target is a function of:
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The difference between actual inflate rate
(INFL) and the target inflation (INFL*)
The percentage difference between actual and
potential real GDP (GAP)
Federal funds rate =
2.5 + INFL + 0.5  (INFL - INFL*) + 0.5  GAP
The Actual Fed Funds Rate and the
Rate Implied by the Taylor Rule
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The fed funds rate seems to have responded
quite well to the concerns of the Fed since it
moves in the directions suggested by the
Taylor rule
However, the actual fed funds rates doesn’t
always follow the Taylor rule
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Impossible to react to certain events such as
September 11 until they influence economic
activity
Suggests an argument for giving the Fed some
discretion in responding to special circumstances