Transcript Monetary Policy

R. GLENN
HUBBARD
ANTHONY PATRICK
O’BRIEN
Money,
Banking, and
the Financial
System
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CHAPTER
15
Monetary Policy
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
15.1
Describe the goals of monetary policy
15.2
Understand how the Fed uses monetary policy tools to influence
the federal funds rate
15.3
Trace how the importance of different monetary policy tools has
changed over time
15.4
Explain the role of monetary targeting in monetary policy
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CHAPTER
15
Monetary Policy
BERNANKE’S DILEMMA
•During the financial crisis of 2007–2009, the Fed took extraordinary policy
actions, including huge asset purchases that expanded bank reserves and the
monetary base.
•The Fed had hoped for a strong recovery, where it could begin its “exit strategy”
of returning bank reserves and the monetary base to more normal levels.
Unfortunately, as of July 2010, the economy was recovering more slowly than
the Fed had hoped.
•Since most macroeconomic policy consists of monetary policy, it was not
surprising that Bernanke was the center of attention as the economy struggled
through a slow recovery in 2010.
•For a discussion of some of the policy options open to the Fed, read AN
INSIDE LOOK AT POLICY on page 472.
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Key Issue and Question
Issue: During the financial crisis, the Federal Reserve employed a
series of new policy tools in an attempt to stabilize the financial system.
Question: Should price stability still be the most important policy goal
of central banks?
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15.1 Learning Objective
Describe the goals of monetary policy
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The Fed has set six monetary policy goals that are intended to promote a wellfunctioning economy:
1.
Price stability
2.
High employment
3.
Economic growth
4.
Stability of financial markets and institutions
5.
Interest rate stability
6.
Foreign-exchange market stability
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Price Stability
Inflation, or persistently rising prices, erodes the value of money as a medium
of exchange and as a unit of account.
Most industrial economies have set price stability as a policy goal.
Inflation makes prices less useful as signals for resource allocation. Uncertain
future prices complicate decisions households and firms have to make.
Inflation can also arbitrarily redistribute income.
Rates of inflation in the hundreds or thousands of percent per year—known as
hyperinflation—can severely damage an economy’s productive capacity.
The range of problems caused by inflation—from uncertainty to economic
devastation—make price stability a key monetary policy goal.
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High Employment
High employment, or a low rate of unemployment, is another key monetary
policy goal.
Unemployment reduces output and causes financial and personal distress.
Congress and the president share responsibility for the goal of high
employment.
Even under the best economic conditions, some frictional and structural
unemployment always remains. The tools of monetary policy are ineffective in
reducing these types of unemployment. Instead, the Fed attempts to reduce
levels of cyclical unemployment, which is unemployment associated with
business cycle recessions.
Most economists estimate that the natural rate of unemployment is between
5% and 6%.
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Economic Growth
Economic growth Increases in the economy’s output of goods and services
over time; a goal of monetary policy.
Economic growth provides the only source of sustained real increases in
household incomes.
Economic growth depends on high employment. With high unemployment,
businesses have unused productive capacity and are much less likely to invest
in capital improvements.
Stable economic growth allows firms and households to plan accurately and
encourages the long-term investment that is needed to sustain growth.
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Stability of Financial Markets and Institutions
When financial markets and institutions are not efficient in matching savers and
borrowers, the economy loses resources.
The stability of financial markets and institutions makes possible the efficient
matching of savers and borrowers.
The Fed responded vigorously to the financial crisis that began in 2007, but it
initially underestimated its severity and was unable to head off the deep
recession of 2007–2009.
Some economists believe that actions to deflate asset bubbles may be
counterproductive, but the severity of the 2007–2009 recession has made
financial stability a more important Fed policy goal.
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Interest Rate Stability
Like fluctuations in price levels, fluctuations in interest rates make planning and
investment decisions difficult for households and firms.
The Fed’s goal of interest rate stability is motivated by political pressure as well
as by a desire for a stable saving and investment environment.
Sharp interest rate fluctuations cause problems for banks and other financial
firms. So, stabilizing interest rates can help to stabilize the financial system.
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Foreign-Exchange Market Stability
In the global economy, foreign-exchange market stability, or limited fluctuations
in the foreign-exchange value of the dollar, is an important monetary policy goal
of the Fed.
A stable dollar simplifies planning for commercial and financial transactions.
Fluctuations in the dollar’s value change the international competitiveness of
U.S. industry: A rising dollar makes U.S. goods more expensive abroad,
reducing exports, and a falling dollar makes foreign goods more expensive in
the United States.
In practice, the U.S. Treasury often originates changes in foreign-exchange
policy, although the Fed implements these policy changes.
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15.2 Learning Objective
Understand how the Fed uses monetary policy tools to influence the
federal funds rate.
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The Fed’s three traditional policy tools are:
1.
Open market operations.
Open market operations The Federal Reserve’s purchases and sales of
securities, usually U.S. Treasury securities, in financial markets.
2.
Discount policy.
Discount policy The policy tool of setting the discount rate and the terms of
discount lending.
Discount window The means by which the Fed makes discount loans to
banks, serving as the channel for meeting the liquidity needs of banks.
3.
Reserve requirements.
Reserve requirement The regulation requiring banks to hold a fraction of
checkable deposits as vault cash or deposits with the Fed.
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During the financial crisis, the Fed introduced two new policy tools connected
with bank reserve accounts that were still active in the fall of 2010:
1.
Interest on reserve balances.
By raising the interest rate it pays, the Fed can increase banks’ holdings of
reserves, potentially restraining banks’ ability to extend loans and increase the
money supply. By reducing the interest rate, the Fed can have the opposite
effect.
2.
Term deposit facility.
Similar to certificates of deposit, the Fed’s term deposits are offered to banks in
periodic auctions. The interest rates are determined by the auctions and have
been slightly above the interest rate the Fed offers on reserve balances. The
more funds banks place in term deposits, the less they will have available to
expand loans and the money supply.
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The Federal Funds Market and the Fed’s Target Federal Funds Rate
Federal funds rate The interest rate that banks charge each other on very
short-term loans; determined by the demand and supply for reserves in the
federal funds market.
The target for the federal funds rate is set at meetings of the Federal Open
Market Committee (FOMC).
We use a graph of the banking system’s demand for and the Fed’s supply of
reserves to see how the Fed uses its policy tools to influence the federal funds
rate and the money supply.
Demand for and Supply of Reserves The figure that follows shows both the
demand and supply curves for reserves.
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Equilibrium in the Federal Funds Market
Figure 15.1
Equilibrium in the
Federal Funds Market
Equilibrium in the federal
funds market occurs at the
intersection of the demand
curve for reserves, D, and
the supply curve for
reserves, S.
The Fed determines the
level of reserves, R, the
discount rate, id, and the
interest rate on banks’
reserve balances at the
Fed, irb.
Equilibrium reserves are
R*, and the equilibrium
federal funds rate is i*ff.•
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Open Market Operations and the Fed’s Target for the Federal Funds Rate
Figure 15.2 (1 of 2)
Effects of Open Market
Operations on the
Federal Funds Market
In panel (a), an open
market purchase of
securities by the Fed
increases reserves in the
banking system, shifting
the supply curve to the
right from S1 to S2.
The equilibrium level of
reserves increases from
R*1 to R*2 while the
equilibrium federal funds
rate falls from 1.5% to
1%.
The discount rate is also
cut from 1.75% to 1.25%.
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Open Market Operations and the Fed’s Target for the Federal Funds Rate
Figure 15.2 (2 of 2)
Effects of Open Market
Operations on the
Federal Funds Market
In panel (b), an open
market sale of securities
by the Fed reduces
reserves, shifting the
supply curve to the left
from S1 to S2.
The equilibrium level of
reserves decreases from
R*1 to R*2 while the
equilibrium federal funds
rate rises from 5% to
5.25%.
The discount rate is also
increased from 6% to
6.25%.•
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The Effect of Changes in the Discount Rate and in Reserve Requirements
Changes in the Discount Rate Since 2003, the Fed has kept the discount rate
higher than the target for the federal funds rate. This makes the discount rate a
penalty rate, which means that banks pay a penalty by borrowing from the Fed
rather than from other banks in the federal funds market.
Changes in the Required Reserve Ratio The Fed rarely changes the required
reserve ratio. Changing the required reserve ratio without also engaging in
open market operations would cause a change in the equilibrium federal funds
rate. If the Fed changes the required reserve ratio, it will likely carry out
offsetting open market operations to keep the target for the federal funds rate
unchanged (see figure 15-3).
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Figure 15.3
The Effect of a Change in the Required Reserve Ratio on the Federal Funds Market
In panel (a), the Fed increases the required reserve ratio, which shifts the demand curve for
reserves from D1 to D2.
The equilibrium federal funds rate rises from i*ff1 to i*ff2.
In panel (b), the Fed increases the required reserve ratio, which shifts the demand curve
from D1 to D2.
The Fed offsets the effects of the increase in the required reserve ratio with an open market
purchase, shifting the supply curve from S1 to S2.
The level of reserves increases from to R*1 to R*2, while the target federal funds rate
remains unchanged, at i*ff1.•
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Solved Problem
15.2
Analyzing the Federal Funds Market
Use demand and supply graphs for the federal funds market to analyze the
following two situations. Be sure that your graphs clearly show changes in the
equilibrium federal funds rate and equilibrium level of reserves, and also any
shifts in the demand and supply curves.
a. Suppose that banks decrease their demand for reserves. Show how the Fed
can offset this change through open market operations in order to keep the
equilibrium federal funds rate unchanged.
b. Suppose that in equilibrium the federal funds rate is equal to the interest rate
the Fed is paying on reserves. If the Fed carries out an open market purchase,
show the effect on the equilibrium federal funds rate.
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Solved Problem
15.2
Analyzing the Federal Funds Market
Solving the Problem
Step 1 Review the chapter material.
Step 2 Answer part (a) by drawing the appropriate graph.
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Solved Problem
15.2
Analyzing the Federal Funds Market
Solving the Problem
Step 3 Answer part (b) by drawing the appropriate graph.
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15.3 Learning Objective
Trace how the importance of different monetary policy tools has changed over time.
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Open Market Operations
In 1935, Congress established the FOMC to guide open market operations.
An open market purchase of Treasury securities causes the prices to increase,
thereby decreasing their yield. Because the purchase will increase the
monetary base, the money supply will expand. An open market sale has the
opposite effects.
Because open market purchases reduce interest rates, they are considered an
expansionary policy. Open market sales increase interest rates and are
considered a contractionary policy.
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Implementing Open Market Operations The FOMC issues a policy directive
to the Federal Reserve System’s account manager, who is a vice president of
the Federal Reserve Bank of New York and who has the responsibility of
implementing open market operations and hitting the FOMC’s target for the
federal funds rate.
The Open Market Trading Desk is linked electronically through the Trading
Room Automated Processing System (TRAPS) to about 18 primary dealers.
Each morning, the trading desk notifies the primary dealers of the size of the
open market purchase or sale being conducted and asks them to submit offers
to buy or sell Treasury securities.
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Dynamic open market operations are intended to change monetary policy as
directed by the FOMC.
Defensive open market operations are intended to offset temporary fluctuations
in the demand or supply for reserves, not to carry out changes in monetary
policy.
Dynamic open market operations are likely to be conducted as outright
purchases and sales of Treasury securities to primary dealers. Defensive open
market operations are much more common, and are conducted through
repurchase agreements.
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Making the Connection
A Morning’s Work at the Open Market Trading Desk
7:00 A.M. The account manager receives an estimate of the supply of reserves
for that day and for the remaining days of the current maintenance period.
8:00 A.M.–9:00 A.M. The account manager begins to assess conditions in the
government securities market, and estimates the demand for reserves and how
the prices of government securities will change during the trading day.
9:10 A.M. The account manager studies the FOMC’s directive, or the level of
the federal funds rate desired, and designs dynamic open market operations
and defensive open market operations to offset temporary disturbances to
reserves as predicted by the staff.
9:30 A.M. Traders notify primary dealers of the Fed’s desired transactions and
request quotations for asked/bid prices.
9:40 A.M. The primary dealers submit their propositions to the trading desk.
9:41 A.M. The trading desk selects the lowest prices (for purchases) and
highest prices (for sales) and returns the results to dealers.
10:30 A.M. By this time, the transactions have been completed.
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Open Market Operations versus Other Policy Tools The benefits of open
market operations include control, flexibility, and ease of implementation.
Discount loans depend in part on the willingness of banks to request the loans
and so are not as completely under the Fed’s control.
The Fed can make both large and small open market operations. Often,
dynamic operations require large purchases or sales whereas defensive
operations call for small.
Reversing open market operations is simple for the Fed. Discount loans and
reserve requirement changes are more difficult to reverse quickly. This is a key
reason that the Fed has left reserve requirements unchanged since 1992.
The Fed can implement its open market operations rapidly, with no
administrative delays. Changing the discount rate or reserve requirements
requires lengthier deliberation.
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“Quantitative Easing”: Fed Bond Purchases during the Financial Crisis of
2007–2009 The policy of a central bank attempting to stimulate the economy by
buying long-term securities is called quantitative easing.
The Fed took the unusual step of buying more than $1.7 trillion in mortgagebacked securities and longer-term Treasury securities during 2009 and early
2010. In November 2010, the Fed announced a second round of quantitative
easing (dubbed QE2). With QE2 the Fed would buy an additional $600 billion in
long-term Treasury securities through June 2011.
Some economists and policymakers worried that they would eventually lead to
higher inflation.
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Making the Connection
Why Can’t the Fed Always Hit Its Federal Funds Target?
The Fed can only set a target for the
federal funds rate. The actual federal
funds rate is determined by the
demand and supply for reserves in the
federal funds market.
The New York Fed uses open market
operations to try to keep the actual
federal funds rate as close as possible
to the target rate.
Overall, the trading desk has done a
good job of keeping the actual rate
close to the target rate.
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Discount Policy
Since 1980, all depository institutions have had access to the discount window.
Each Federal Reserve Bank maintains its own discount window, although all
Reserve Banks charge the same discount rate.
Categories of Discount Loans The Fed’s discount loans to banks fall into
three categories: (1) primary credit, (2) secondary credit, and (3) seasonal
credit.
Primary credit Discount loans available to healthy banks experiencing
temporary liquidity problems.
Secondary credit Discount loans to banks that are not eligible for primary
credit.
Seasonal credit Discount loans to smaller banks in areas where agriculture or
tourism is important.
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Discount Lending during the Financial Crisis of 2007–2009 The initial
stages of the financial crisis involved shadow banks rather than commercial
banks. When the crisis began, the Fed was handicapped in its role as a lender
of last resort because it had no recent tradition of lending to anyone but banks.
The Fed did, however, use its authority to set up several temporary lending
facilities:
Primary Dealer Credit Facility. This facility was intended to allow the investment
banks and large securities firms that are primary dealers to obtain emergency
loans.
Term Securities Lending Facility. This facility was intended to allow financial
firms to borrow against illiquid assets, such as mortgage-backed securities. It
was established in March 2008 and closed in February 2010.
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Commercial Paper Funding Facility. Under this facility, the Fed purchased
three-month commercial paper directly from corporations so they could
continue normal operations.
Term Asset-Backed Securities Loan Facility (TALF). Under this facility, the
Federal Reserve Bank of New York extended three-year or five-year loans to
help investors fund the purchase of asset-backed securities. Asset-backed
securities are securitized consumer and business loans, apart from mortgages.
The Fed also set up a new way for banks to receive discount loans under the
Term Auction Facility. In this facility, the Fed for the first time began auctioning
discount loans at an interest rate determined by banks’ demand for the funds.
The Fed ended these innovative discount programs in 2010, with the financial
system having recovered from the worst of the crisis.
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Interest on Reserve Balances
Banks had long complained that the Fed’s failure to pay interest on the banks’
reserve deposits amounted to a tax.
Paying interest on reserve balances gives the Fed another monetary policy tool.
By increasing the interest rate, the Fed can increase the level of reserves banks
are willing to hold, thereby restraining bank lending and increases in the money
supply. Lowering the interest rate would have the opposite effect.
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15.4 Learning Objective
Explain the role of monetary targeting in monetary policy.
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The Fed often faces trade-offs in attempting to reach its goals, particularly the
goals of high economic growth and low inflation.
In an attempt to spur economic growth, the Fed could lower the target for the
federal funds rate and cause other market interest rates to fall through open
market purchases, which increase the monetary base and money supply,
potentially increasing the inflation rate in the longer run.
With economic growth having slowed and the unemployment rate seemingly
stuck well above 9%, the Fed contemplated taking further expansionary actions
despite their consequences.
Adding insult to injury, the Fed has no direct control over real output or the price
level. The tools of monetary policy don’t permit the Fed to achieve its monetary
policy goals directly.
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The Fed also faces timing difficulties. The information lag refers to the Fed’s
inability to observe instantaneously changes in GDP, inflation, or other
economic variables.
A second timing problem is the impact lag. This is the time that is required for
monetary policy changes to affect output, employment, or inflation. The Fed’s
actions may affect the economy at the wrong time, and the Fed might not be
able to recognize its mistakes soon enough to correct them.
One possible solution to the problems caused by the information lag and
impact lag is for the Fed to use targets to meet its goals. Unfortunately, targets
also have problems.
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Using Targets to Meet Goals
Targets are variables that the Fed can influence directly and that help achieve
monetary policy goals.
Traditionally, the Fed has relied on two types of targets: policy instruments—
sometimes called operating targets—and intermediate targets.
Although using policy instruments and intermediate targets is no longer the
favored approach at the Fed, reviewing how they work can provide some
insight into the difficulties the Fed faces in executing monetary policy.
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Intermediate Targets By using prospective intermediate targets, typically
either monetary aggregates or interest rates, the Fed can try to achieve a
goal outside of its direct control better than it would if it had focused solely on
the goal.
Using intermediate targets can also provide helpful feedback about the Fed’s
policy actions.
Policy Instruments, or Operating Targets Policy instruments, or operating
targets, are variables that the Fed controls directly with its monetary policy
tools and that are closely related to intermediate targets.
Examples of policy instruments include the federal funds rate and
nonborrowed reserves.
Most major central banks use interest rates as policy instruments.
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Figure 15.4
Achieving Monetary Policy Goals
The Federal Reserve establishes goals for such economic variables as the rate of inflation
and the rate of unemployment. The Fed directly controls only its policy tools. It can use
targets—intermediate targets and policy instruments—which are variables that the Fed can
influence, to help achieve monetary policy goals. In recent years, the Fed has
deemphasized the use of targeting procedures of this type.•
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Making the Connection
What Happened to the Link between Money and Prices?
In the United States, the money supply has grown more rapidly during decades
when the inflation rate has been relatively high.
Prior to 1980, there was significant evidence that the link between money and
prices held up in the short run of a year or two. In fact, many economists were
convinced that the acceleration in inflation during the late 1960s and 1970s was
due to the Fed’s having allowed the growth rate of the money supply to sharply
increase during those years.
The economists who argued this point most forcefully were known as
monetarists. The most prominent monetarist was Nobel laureate Milton
Friedman of the University of Chicago.
Under Paul Volcker, the Fed shifted its policy to emphasize nonborrowed
reserves as a policy instrument, or operating target. This episode, referred to
as “The Great Monetarist Experiment,” produced mixed results.
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Making the Connection
What Happened to the Link between Money and Prices?
After 1980, the short-run link between the growth of the money supply and inflation
broke down.
The reason for the breakdown in the relationship between the growth of the money
supply and inflation is that the nature of M1 and M2 had changed. As a result of
changes and innovations in financial markets, a rapid increase in M1 need not
translate directly into spending increases that would lead to higher inflation.
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The Choice between Targeting Reserves and Targeting
the Federal Funds Rate
Traditionally, the Fed has used three criteria when evaluating variables that
might be used as policy instruments. The main policy instruments have been
reserve aggregates and the federal funds rate.
1. Measurable. The variable must be measurable in a short time frame to
overcome information lags. Both reserve aggregates and the federal funds rate
are easily measurable.
2. Controllable. Open market operations can keep both variables close to
whatever target the Fed selects.
3. Predictable. The complexity of the impact a change in either reserves or the
federal funds rate has on goals such as economic growth or price stability
compromises predictability. Thus, economists continue to discuss which policy
instrument is best.
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Figure 15.5 (1 of 2)
Choosing between
Policy Instruments
The Fed chooses the level
of reserves as its policy
instrument by keeping
reserves constant, at R*.
With demand for reserves at
D1, the equilibrium federal
funds rate is i*ff1.
If the demand for reserves
shifts to the right from D1 to
D2, the equilibrium federal
funds rate increases from
from i*ff1 to i*ff2.
Similarly, if the demand for
reserves shifts to the left
from D1 to D3, the
equilibrium federal funds
rate decreases from i*ff1 to
i*ff3.
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Figure 15.5 (2 of 2)
Choosing between
Policy Instruments
In panel (b), the Fed
chooses the federal funds
rate as its policy instrument
by keeping the rate
constant, at R*.
If the demand for reserves
increases from D1 to D2, the
Fed will have to increase
the supply of reserves from
S1 to S2 in order to maintain
its target for the federal
funds rate at i*ff.
If the demand for reserves
decreases from D1 to D3,
the Fed will have to
decrease the supply of
reserves from S1 to S3 to
maintain its target for the
federal funds rate.•
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The Fed faces a trade-off. It can choose a reserve aggregate for its policy
instrument, or it can choose the federal funds rate, but it cannot choose both.
Using reserves as the Fed’s policy instrument will cause the federal funds rate
to fluctuate in response to changes in the demand for reserves.
Using the federal funds rate as the policy instrument will cause the level of
reserves to fluctuate in response to changes in the demand for reserves.
By the 1980s, the Fed had concluded that the link between the federal funds
rate and its policy goals was closer than the link between the level of reserves
and its policy goals. So, for the past 30 years, the Fed has used the federal
funds rate as its policy instrument.
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The Taylor Rule: A Summary Measure of Fed Policy
Actual Fed deliberations are complex and incorporate many factors about the
economy. John Taylor of Stanford University has summarized these factors in
the Taylor rule.
Taylor rule A monetary policy guideline developed by economist John Taylor
for determining the target for the federal funds rate.
The Taylor rule begins with an estimate of the value of the real federal funds
rate, which is the federal funds rate—adjusted for inflation—that would be
consistent with real GDP being equal to potential real GDP in the long run. With
real GDP equal to potential real GDP, cyclical unemployment should be zero,
and the Fed will have attained its policy goal of high employment.
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Figure 15.6
The Taylor Rule
The blue line shows the level of the federal funds rate that would have occurred if the Fed
had strictly followed the Taylor rule, and the red line shows the target federal funds rate.
The figure shows that the Taylor rule does a reasonable job of explaining Federal Reserve
policy during some periods, but it also shows the periods in which the target federal funds
rate diverges from the rate predicted by the Taylor rule.
The shaded areas represent periods of recession.•
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Inflation Targeting
Before the financial crisis, many economists and central bankers expressed
significant interest in using inflation targeting as a framework for monetary
policy.
With inflation targeting, a central bank publically sets an explicit target for the
inflation rate over a period of time, and the government and the public then
judge the performance of the central bank on the basis of its success in hitting
the target.
While the Fed has never gone beyond using an unannounced and informal
target for the inflation rate, several countries have adopted formal inflation
targets.
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Arguments in favor of an explicit inflation target focus on four points:
1. It would draw attention to what the Fed can actually achieve in practice.
2. It would provide an anchor for inflationary expectations.
3. It would help institutionalize effective U.S. monetary policy.
4. It would promote accountability.
Opponents of inflation targets also make four points:
1. Rigid numerical targets for inflation diminish flexibility.
2. Reliance on uncertain forecasts of future inflation can create problems.
3. The focus on inflation may make it more difficult for elected officials to
monitor the Fed’s support for good economic policy overall.
4. Uncertainty about future levels of output and employment can impede
economic decision making in the presence of an inflation target.
Monetary Targeting and Monetary Policy
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International Comparisons of Monetary Policy
Central banks in industrial countries have increasingly used short-term interest
rates as the policy instrument, or operating target, through which goals are
pursued. Many central banks are focusing more on ultimate goals such as low
inflation than on particular intermediate targets.
The Bank of Canada
•Gradually reduced the growth rate of M1 in the early 1970s as inflation
became a concern.
•Shifted its policy toward an exchange rate target in the late 1970s.
•Reinstated its commitment to price stability in 1988 through declining inflation
targets and operational target bands for the overnight rate.
•Focused on exchange rates, reflecting the importance of exports to the
Canadian economy.
•Received praise for helping the Canadian financial system avoid the heavy
losses suffered by many banks during the 2007-2009 financial crisis.
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The German Central Bank
•Experimented with monetary targets in the late 1970s to combat inflation.
•Used an aggregate called central bank money, or M3, which is a weighted
sum of currency, checkable deposits, and time and savings deposits.
•Succeeded in maintaining its target ranges for M3 growth in the early 1980s,
but in the late 1980s, in an effort to devaluate its currency relative to the U.S.
dollar, the Bundesbank increased money growth faster than its announced
targets.
•Confronted problems with reunification, as differences between West and East
German currencies brought inflationary pressures.
•Used changes in the lombard rate (a short-term repurchase agreement rate) to
achieve its M3 target.
•Relinquished its control of monetary policy to the European Central Bank after
introduction of the euro in 2002.
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The Bank of Japan
•Adopted explicit money growth targets and reduced money growth after the oil
shock of 1973, when the inflation rate was in excess of 20%.
•Having fulfilled its promises, the bank gained the public’s belief in its
commitment to lower money growth and lower inflation.
•Used a short-term interest rate in the Japanese interbank market—similar to
the U.S. federal funds market—as its operating target.
•Relied less on its M2 aggregate after deregulation in the 1980s.
•Does not have formal inflation targets, although emphasizes price stability.
•Adopted deflationary monetary policy in the late 1990s and 2000s, which
played a significant role in the weakness of the economy.
•Began to stimulate both economic growth and inflation in the mid-2000s.
•Intervened to reverse the soaring value of the yen against the U.S. dollar,
which was hampering exports and impeding an economic recovery.
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The Bank of England
•Announced money supply targets in late 1973 in response to inflationary
pressures, but the targets were not pursued aggressively.
•In response to accelerating inflation in the late 1970s, the government
introduced in 1980 a strategy for gradual deceleration of M3 growth, but had
difficulty achieving M3 targets.
•Shifted its emphasis toward targeting growth in the monetary base beginning
in 1983.
•Adopted inflation targets in 1992, and used short-term interest rates as the
primary instrument of monetary policy.
•Was led to take several dramatic policy actions during the financial crisis,
cutting its overnight base rate.
•Rapidly lowered the interest rate it paid banks on reserves, and engaged in
quantitative easing.
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The European System of Central Banks
•The ESCB consists of the European Central Bank (ECB) and the national
central banks of all member states of the European Union.
•In operation since 1999 following the Treaty of Maastricht, the bank was
modeled after the German Bundesbank, with price stability as its primary goal.
•Has secondary objective to support the general economic policies of the
European Union.
•Attaches significant role to monetary aggregates—in particular, the growth rate
of the M3 aggregate.
•Despite emphasis on price stability, has not committed to either a monetarytargeting or an inflation-targeting approach.
•Struggled to forge a monetary policy appropriate to the very different needs of
the member countries during the financial crisis and its aftermath.
•Received further strains in 2010 by intervening in Greece’s sovereign debt
crisis.
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Answering the Key Question
At the beginning of this chapter, we asked the question:
“Should price stability still be the most important policy goal of central
banks?”
As we have seen in this chapter, economists debate whether central banks
should have an explicit target for the inflation rate. Doing so would make
price stability the most important goal of central banks. Although price
stability in and of itself can increase economic well-being, most economists
and policymakers see price stability as having broader benefits. In
particular, few economies have managed to sustain high rates of economic
growth and high rates of employment in the long run without also
experiencing price stability. Whatever the merits of making price stability the
focus of monetary policy, the severity of the financial crisis and recession
pushed to the back burner further consideration of the Fed adopting an
explicit target for the inflation rate.
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AN INSIDE LOOK AT POLICY
The Fed May Buy More Bonds to Boost Sluggish Economy
WASHINGTON POST, Federal Reserve to Buy U.S. Debt, Shifts Policies as Recovery Slows
Key Points in the Article
• Responding to a slowdown in the U.S. economy’s recovery from the 2007–
2009 recession, the FOMC announced that it would increase its holdings of
long-term Treasury bonds rather than replace its holdings of maturing
mortgage securities.
• Fed leaders preferred not to favor housing over other sectors, especially
because the mortgage market seemed to be functioning reasonably well.
• However, the purchase of Treasury bonds posed the threat of higher inflation
because, in effect, the Fed would print money to finance U.S. government
budget deficits.
• The FOMC elected to keep its target for short-term interest rates near zero, as
it had since December 2008, but it did not strengthen its previous pledge to
keep rates near zero for an “extended period.”
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AN INSIDE LOOK AT POLICY
The graph illustrates a possible response by the Fed to the threat of higher inflation. It could
sell Treasury securities to raise the federal funds rate from i*ff1 to a higher target rate, i*ff2.
The open market sale would shift the supply curve for reserves from S1 to S2, which would
decrease the equilibrium level of bank reserves from to R*1 to R*2.
The graph also shows an increase in the discount rate from id1 to id2.
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