Transcript ch29

Chapter 29
Monetary
Policy
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In this chapter you will learn to
1. Describe the long-term objectives of the Federal Reserve.
2. Explain why the Fed has chosen to express its short-term
monetary policy targets in terms of an interest rate rather
than the money supply.
3. Describe the market for commercial bank reserves.
4. Explain how the Fed uses open market operations to
achieve its short-term objectives in the federal funds
market.
5. Describe the recent track record of monetary policy and
some likely future challenges.
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Objectives of Monetary Policy
Long-Run Objectives of Monetary Policy
Like most central banks, the Fed pursues:
1. maximum employment
2. price stability
3. moderate long-term interest rates
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Short-Term Targets of Monetary
Policy
The Fed has targeted the money supply and the federal funds
rate:
•
Money supply during the late 1970s and early 1980s
•
Federal funds rate — the price of borrowing reserves
— for most of the period since 1970
Regardless of whether the Fed chooses either short-term
targets, both potential target variables will react to any change in
reserves.
• The question for the Fed is not which variable to influence
but rather which variable to watch
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Linking the Short-Run and Long-Run Goals:
The Transmission Process
Monetary policy affects the economy through the monetary
transmission mechanism:
• The Fed sets a target for the federal funds rate
• which influences other market interest rates
• which change desired aggregate expenditure
• which changes aggregate demand
• which affects the price level and the level of real GDP
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Figure 29.1 The Monetary
Transmission Mechanism
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Linking the Short-Run and Long-Run Goals
Policy Procedure
The Fed’s policy procedure is to link short-term targets for
monetary conditions and its long-term objectives.
To close an inflationary gap:
- raise the target federal funds rate
To close a recessionary gap:
- lower the target federal funds rate
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Figure 29.2 The Output Gap,
Inflation, and Monetary Policy
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Money Supply Targets versus Interest
Rate Targets
Long-Run Objectives of Monetary Policy
Monetary policy can be implemented either by pursuing a
target for the money supply or for the interest rate, but not
both. Why?
- For a given money demand curve, both
cannot be set independently.
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Figure 29.3 Two Approaches to the
Implementation of Monetary Policy
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Monetary Policy Target
Why the Fed does not use the money supply as a
target?
The Fed is unable to predict accurately the position of the
MD curve at any given time.
- largely due to innovations in the financial sector
Like the Fed, most central banks choose to influence the
interest rate directly.
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How the Fed Implements
Monetary Policy
Reserve Markets and the Federal Funds Rate
The market for reserves is similar to those for money supply
and money demand.
The Fed has the ability to shift the demand and supply
curves.
APPLYING ECONOMIC CONCEPTS 29.1
The Federal Funds Rate and the
Treasury Bill Rate
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Figure 29.4 The Federal
Funds Market
The Fed uses its
influence over the
supply of reserves to
keep the equilibrium
federal funds rate close
to its target level.
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The Fed’s Monetary Policy Tools
and the Market for Reserves
The three policy tools that the Fed uses to affect conditions
in the market for reserves:
1. open market operations
2. the discount rate
3. reserve requirements
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Table 29.1 Initial Balance Sheet
Changes Caused by an Open Market
Purchase from a Commercial Bank
The Fed can increase the reserves available to the
banking system by purchasing bonds on the open
market.
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The Discount Window
The intention of the discount window was initially that the
Fed would help banks survive a panic by serving as a
“bank for bankers.”
The difference the amount lent and the amount repaid by
the bank is called a “discount.”
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Reserve Requirements
The Fed has the authority to set the required levels of
reserves for banks and other depository institutions
If the Fed raises the required reserve ratio, banks would
lend a smaller fraction of their deposits, which would
decrease the money supply and increase the federal funds
rate.
If the Fed lowers the required reserve ratio, banks would
lend a larger fraction of their deposits, which would
increase the money supply and decrease the federal funds
rate.”
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Figure 29.5 The Fed’s Response to a
Shift in the Demand for Reserves
The Fed responds
to the shift in the
demand curve by
rising the supply of
reserves through
open market
purchase of bonds.
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Achieving the Federal Funds Rate
Target
APPLYING ECONOMIC CONCEPTS 29.2
A Look at a Federal Open Market
Committee Meeting
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Monetary Policy in Action:
Challenges and Issues
The stagflation of the 1970s revealed the cost of allowing
elevated inflation expectations to emerge.
Since the early 1990s, inflation has been relatively low and
stable.
In 2006, Ben Bernanke replaced Alan Greenspan as
chairperson of the Federal Reserve.
Bernanke inherited an economy with a low inflation rate
and a level of real GDP close to its potential level.
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Figure 29.6 The Output Gap
and the Inflation Rate
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Uncertainty about the Monetary
Policy Transmission Process
The Fed faces uncertainty regarding:
1. the magnitude of the policy response
− our analysis does not tell us how much the target for
the federal funds rate needs to change to close an
output gap
2. the timing of the policy response
− the federal funds rate only affects inflation through
a series of chain reactions, each of which can take
months to be complete
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The Stock Market
Stock market performance does not equate the health of
the overall economy.
However, because developments in the stock market can
affect the rest of the economy, the Fed pays attention to the
stock market.
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Deflation, Low Interest Rates,
and the Money Supply
Deflation: when the average price level is falling over time.
Because money wages fall much more slowly than they
rise, a recessionary gap that leads to deflation might last for
a long period of time.
 a prompt monetary policy response is needed
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Inflation Targeting
A number of countries have adopted formal targets for
inflation.
Prior to joining the Fed, Ben Bernanke (the current Fed
Chairman) argued that central banks should announce
explicit targets for the inflation rate.
 speculation that the Fed will eventually adopt an
inflation rate target
Since price stability is achieved only when real GDP is
close to potential, the Fed’s current goals of price stability
and maximum employment is still compatible with an
inflation rate target.
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