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Chapter Eight THE CONDUCT OF MONETARY POLICY: TOOLS, GOALS, AND TARGETS Copyright © 2000 Addison Wesley Longman Slide #8-1 The Federal Reserve Balance Sheet Monetary Base = Currency + Reserves Open Market Purchase from Bank The Banking System Assets Securities - $100 Reserves + $100 Liabilities Copyright © 2000 Addison Wesley Longman The Fed Assets Securities + $100 Liabilities Reserves + $100 Result: R $100, MB $100 Slide #8-2 The Federal Reserve Balance Sheet Open Market Purchase from Public Public Assets Liabilities Securities - $100 Deposits + $100 Banking System Assets Liabilities Reserves Deposits + $100 + $100 Copyright © 2000 Addison Wesley Longman The Fed Assets Liabilities Securities Reserves + $100 +$100 Result: R $100, MB $100 Slide #8-3 The Federal Reserve Balance Sheet Discount Loans Banking System Assets Reserves + $100 Liabilities Discount loan + $100 The Fed Assets Discount loan + $100 Liabilities Reserves + $100 Result: R $100, MB $100 Copyright © 2000 Addison Wesley Longman Slide #8-4 Market for Reserves and the Fed Funds Rate 1. Demand curve slopes down because iff , ER and Rd up 2. Supply curve slopes down because iff , DL , Rs 3. Equilibrium iff where Rd = Rs Copyright © 2000 Addison Wesley Longman Slide #8-5 Response to Open Market Operation or Change in Discount Rate 1. Open market purchase, Rs shifts to right and iff 2. id , DL , Rs shifts to right and iff Copyright © 2000 Addison Wesley Longman Slide #8-6 Response to Change in Required Reserves 1. RR , Rd shifts to right, iff Copyright © 2000 Addison Wesley Longman Slide #8-7 Tools of Monetary Policy Open Market Operations 1. Dynamic: Meant to change Reserves 2. Defensive: Meant to offset other factors affecting Reserves, typically uses repos Advantages of Open Market Operations 1. Fed has complete control 2. Flexible and precise 3. Easily reversed 4. Implemented quickly Copyright © 2000 Addison Wesley Longman Slide #8-8 Discount Loans 3 Types 1. Adjustment Credit 2. Seasonal Credit 3. Extended Credit Lender of Last Resort Function 1. To prevent banking panics FDIC fund not big enough Examples: Continental Illinois and Franklin National Banks 2. To prevent nonbank financial panics Example: 1987 stock market crash Announcement Effect 1. Problem: False signals Copyright © 2000 Addison Wesley Longman Slide #8-9 Reserve Requirements Advantages 1. Powerful effect Disadvantages 1. Small changes have very large effect on Ms 2. Raising causes liquidity problems for banks 3. Frequent changes cause uncertainty for banks 4. Tax on banks Copyright © 2000 Addison Wesley Longman Slide #8-10 Goals of Monetary Policy Goals 1. High Employment 2. Economic Growth 3. Price Stability 4. Interest Rate Stability 5. Financial Market Stability 6. Foreign Exchange Market Stability Goals often in conflict Copyright © 2000 Addison Wesley Longman Slide #8-11 Central Bank Strategy Copyright © 2000 Addison Wesley Longman Slide #8-12 Money Supply Target 1. Md fluctuates between Md' and Md'' 2. With Mtarget at M*, i fluctuates between i ' and i '' Copyright © 2000 Addison Wesley Longman Slide #8-13 Interest Rate Target 1. Md fluctuates between Md' and Md'' 2. To set itarget at i*, Ms fluctuates between M ' and M '’ Copyright © 2000 Addison Wesley Longman Slide #8-14 Criteria for Choosing Targets Criteria for Intermediate Targets 1. Measurability 2. Controllability 3. Ability to predictably affect goals Interest rates aren't clearly better than Ms on criteria 1 and 2 because hard to measure and control real interest rates Criteria for Operating Targets Same criteria as above Reserve aggregates and interest rates about equal on criteria 1 and 2, but for 3 if intermediate target is Ms then reserve aggregate is better Copyright © 2000 Addison Wesley Longman Slide #8-15 History of Fed Policy Procedures Early Years: Discounting as Primary Tool 1. Real bills doctrine 2. Rise in discount rates in 1920: recession 1920-21 Discovery of Open Market Operations 1. Made discovery when purchased bonds to get income in 1920s Great Depression 1. Failure to prevent bank failures 2. Result: sharp drop in Ms Copyright © 2000 Addison Wesley Longman Slide #8-16 History of Fed Policy Procedures Pegging of Interest Rates: 1942-51 1. To help finance war, T-bill at 3/8%, T-bond at 1/2% 2. Fed-Treasury Accord in March 1951 2 Money Market Conditions: 1950s and 60s 1. Free reserves = ER - DL 2. Interest rates Copyright © 2000 Addison Wesley Longman Slide #8-17 History of Fed Policy Procedures Targeting Monetary Aggregates: 1970s 1. Fed funds rate as operating target with narrow band 2. Procyclical Ms New Operating Procedures: 1979-82 1. Deemphasis on fed funds rate 2. Nonborrowed reserves operating target 3. Fed still using interest rates to affect economy and inflation Deemphasis of Monetary Aggregates: 1982 -Early 1990s 1. Borrowed Reserves (DL) operating target Copyright © 2000 Addison Wesley Longman Slide #8-18 History of Fed Policy Procedures Fed Funds Targeting Again 1. Fed funds target now announced International Considerations 1. M in 1985 to lower exchange rate, M in 1987 to raise it 2. International policy coordination Copyright © 2000 Addison Wesley Longman Slide #8-19 Federal Funds Rate and Money Growth Before and After October 1979 Copyright © 2000 Addison Wesley Longman Slide #8-20 Monetary Targeting Abroad United Kingdom 1. Targets M3 and later M0 2. Problems of M as monetary indicator Canada 1. Targets M1 till 1982, then abandons it 2. 1988: declining π targets, M2 as guide Germany 1. Targets central bank money, then M3 in 1988 2. Allows growth outside target for 2-3 years, but then reverses overshoots 3. 1990s: dilemma of restrain π, but keep exchange rate in EMS Copyright © 2000 Addison Wesley Longman Slide #8-21 Monetary Targeting Abroad Japan 1. Forecasts M2 + CDs 2. Innovation and deregulation makes less useful as monetary indicator 3. High money growth 1987-89: "bubble economy", then tight money policy Copyright © 2000 Addison Wesley Longman Slide #8-22 Inflation Targeting Lessons from Monetary Targeting 1. Success requires correcting overshoots 2. Operating procedures not critical 3. Breakdown of relationship between M and goals made M-targeting untenable: Led to inflation targeting Inflation Targeting: New Zealand, U.K., Canada 1. Announcement of numerical π goal 2. Commitment to price stability 3. Communication with "Inflation Report" Lessons from Inflation Targeting 1. Decline in π still led to output loss 2. Worked to keep π low 3. Kept π in public eye: reduced political pressures for inflationary policy Copyright © 2000 Addison Wesley Longman Slide #8-23 Using a Fed Watcher Fed watcher predicts monetary tightening, i 1. 2. Acquire funds at current low i Buy $ in FX market Fed watcher predict monetary loosening, i 1. 2. 3. Make loans now at high i Buy bonds, price rise in future Sell $ in FX market Copyright © 2000 Addison Wesley Longman Slide #8-24