Transcript Monetary Policy Strategy

Chapter 21
Monetary
Policy
Strategy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Learning Objectives
• Realize how the Federal Open Market
Committee chooses an economic target and a
policy lever to reach that target
• Understand the mechanics of the federal funds
market and how the Federal Reserve can interact
in that market
• Define the Taylor rule and explain its
significance to monetary policy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-2
Introduction
• “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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-3
The FOMC Directive
• The FMOC meets every five or six weeks
– Review of recent economic and financial developments
•
•
•
•
•
•
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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-4
The FOMC Directive (Cont.)
• The FOMC directive
– 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-5
The FOMC Directive (Cont.)
• The FOMC directive (Cont.)
– 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
• 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-6
The Fed’s Strategy
• Humphrey-Hawkins Act of 1978
– Provides policy guidelines to Federal Reserve
• 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-7
The Fed’s Strategy (Cont.)
• Figure 21.1 summarizes some of the choices the
Fed must make when deciding upon its strategy
• Ultimate goals are two steps removed from the
Fed’s tools
• 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 track
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-8
FIGURE 21.1 The Fed’s game plan.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-9
The Fed’s Strategy (Cont.)
• Steps in development of the Fed’s plan
– 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-10
Reserves Versus the Federal Funds
Rate
• Different targets selected by Federal Reserve
– 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-11
Reserves Versus the Federal Funds
Rate (Cont.)
• 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
– 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-12
Reserves Versus the Federal Funds
Rate (Cont.)
• Figure 21.2 and Figure 21.3
– The Federal Funds Rate is established in the
competitive market (supply and demand of reserves),
but is influenced by the Fed (proactive action)
• Increase reserves—Lower the rate
• Decrease reserves—Raise the rate
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-13
FIGURE 21.2 The supply and demand for
reserves produces the equilibrium federal
fund rate.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-14
FIGURE 21.3 An increased supply of reserves
lowers the federal funds rate; a lower federal funds
rate requires an increased supply of reserves.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-15
Reserves Versus the Federal Funds
Rate (Cont.)
• Figure 21.4
– 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
• Targeting reserves—the federal funds rate will vary
• Targeting federal funds rate—the level of reserves will vary
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-16
FIGURE 21.4 Controlling reserves (panel (a)) implies volatility in
the federal funds rate, while controlling the federal funds rate
(panel (b)) implies volatility in reserves supplied.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-17
FIGURE 21.4 Controlling reserves (panel (a)) implies volatility in
the federal funds rate, while controlling the federal funds rate
(panel (b)) implies volatility in reserves supplied. (Cont.)
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-18
Reserves Versus the Federal Funds
Rate (Cont.)
• The Fed cannot set reserve levels and the federal
funds rate independently
• Which target should the Fed choose?
– Select one that produces less variability in GDP
– Targeting reserves and letting interest rate change would be
best under some conditions
• Close and predictable relationship between reserves and spending
• Private spending is subject to destabilizing variations
• Resulting interest rate changes would stabilize the economy
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-19
Reserves Versus the Federal Funds
Rate (Cont.)
• Which target should the Fed choose? (Cont.)
– Targeting interest rates, with fluctuating reserves
• 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-20
The Taylor Rule and Fed’s Track Record
• During recent years, the Fed’s 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-21
The Taylor Rule and Fed’s Track
Record (Cont.)
• Taylor rule
– Federal funds rate target is a function of:
• 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-22
The Taylor Rule and Fed’s Track
Record (Cont.)
• Figure 21.5 shows the actual fed funds rate and the rate
implied by the Taylor rule
– 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
• 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
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-23
FIGURE 21.5 The Actual fed funds rate
and the value implied by the Taylor rule.
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
21-24