Transcript Monetary Policy

ECON 521
Special Topics in Economic Policy
CHAPTER FIVE
Monetary Policy
I. Overview
• This chapter looks at Monetary Policy, the most
frequent use of policy to correct the economy.
• Monetary Policy -- The Central Bank (Federal
Reserve) changing bank loaning conditions to affect
the supply of financial capital, investment, and
aggregate demand.
• The main goal for the Central Bank is to stabilize the
economy through controlling……using………
Fundamental decision -- how to allocate their assets to
make reasonable profits and to service depositor
withdrawals.
• Reserves – do not earn interest (not a source of
revenue), are used to back up depositor withdrawals.
• Loans – earn interest for the bank (their major source
of revenue), but funds committed to loans are not
accessible to the bank.
II. Basic Strategy of Monetary Policy
• Expansionary (Y* < YN) -- Federal Reserve seeks to
increase the supply of financial capital by
“encouraging bank loaning”.
• Contractionary (Y* > YN) -- Federal Reserve seeks to
decrease the supply of financial capital by
“discouraging bank loaning”.
• Instruments (tools) that initiate monetary policy:
(A) Determining the Discount Rate
(B) Open Market Operations
(C) Setting the Required Reserve Ratio
(A) Changing The Discount Rate
• The Discount Rate -- the rate of interest charged to
banks that borrow from the Federal Reserve.
• Expansionary Policy -- Fed lowers discount rate.
• Contractionary Policy -- Fed raises discount rate.
(B) Changing the Required Reserve Ratio
• Designed to change the minimum amount of reserves
the bank must hold.
• Expansionary Policy -- Fed lowers the reserve ratio.
• Contractionary Policy -- Fed raises the reserve ratio.
(C) Open Market Operations
• Open Market Operations -- the buying or selling of
bonds by the Federal Reserve in the open market (the
Fed’s predominant policy tool).
• Expansionary -- Fed buys bonds (gives banks new
reserves)
• Contractionary -- Fed sells bonds (drains reserves
from banks)
III. Effectiveness of the Monetary Tools
First: Open Market Operations
They are the most important monetary policy tool because they
are the primary determinants of changes in interest rates and the
monetary base, which is the main source of fluctuations in the
money supply.
1. Complete control over the size of operations and
securities traded by the Central Bank.
2. Flexible and precise.
3. Easily reversed.
4. Quickly implemented.
Second: Discount Policy
•Lender of last Resort: It prevents financial panics by
providing banks with reserves when no one else would do so.
• Announcement Effect: it can be used to signal the central
bank’s intentions about future monetary policy.
----Advantages
Performing the role of lender of last resort, therefore
strengthening financial institutions.
----Disadvantages
No guarantee that banks will follow the announcement of
the discount policy because the decision of borrowing is for
commercial bank. Thus, this tool is not completely controlled
by the fed compared to OMOs.
Third: Reserve Requirements
It affects money supply by affecting reserves and
the money multiplier.
----Advantages:
It affects all banks equally and has a powerful effect on
money supply
----Disadvantages:
1. Not practical because small changes in required reserve
ratio leads to large changes in money supply, making
mistakes too costly.
2. Raising reserve requirements may cause liquidity problems
for banks with low excess reserves.
IV. The Process of Monetary Policy
Example;
CBK buys a 1000 KD bond from NBK. NBK receives new
reserves, can make new loans. Therefore, the potential to
increase the supply of financial capital is increased.
• The Interbank Rate (Federal Funds Rate) -- the
interest rate paid by one bank to borrow reserves
from another bank.
• The “thermostat” of monetary policy. Changes in
target Federal Funds rate prompt the execution of
open market operations. Open market operations stop
when new target is achieved.
(1) Expansionary Policy
• If CB wants to lower the target Federal Funds Rate.
• To achieve this target, the CB buys bonds from banks,
supplying more reserves to the system.
• CB does this until the target Federal Funds rate is achieved.
• Increased bank loaning due to having greater reserves implies
an increase in the supply of financial capital, shifting the
supply of capital curve rightward.
• The shift in the supply of financial capital implies that the
interest rate (r*) decreases and Investment (I*) increases.
• The increase in I* shifts AD rightward, increasing Y* and P*.
(2) Contractionary Policy
• If CB wants to increase the target Federal Funds Rate.
• To achieve this target, the CB sells bonds to banks, removing
reserves to the system.
• CB does this until the target Federal Funds rate is achieved.
• Decreases in bank loaning due to having less reserves implies
a decrease in the supply of financial capital, shifting the supply
of capital curve leftward.
• The shift in the supply of financial capital implies that the
interest rate (r*) increases and Investment (I*) decreases.
• The decrease in I* shifts AD leftward, decreasing Y* and P*.
V. Obstacles to Monetary Policy Effectiveness
• When does monetary policy have difficulty in
changing Y* to improve the economy?
• Particularly applies to expansionary monetary policy
-- getting the economy out of sluggishness or
recession.
A Potential Obstacle
(1) Banks don’t want to loan the added reserves (doubt
about prospects of loan default or fears of inflation).
No shifts in demand or supply for financial capital.
(2) Banks want to loan, but firms and consumers don’t
want to borrow the funds (e.g. pessimism about state
of economy).
Described as leftward shift in the demand for
financial capital coupled with a rightward shift in the
supply of financial capital.
VI. Conducting Monetary Policy
• Monetary policy tools are used to achieve its ultimate
economic goals through monetary targets .
• The tools and goals are connected by a number of
targets that make it easier for the tools to affect the
goals.
• Monetary tools cannot affect the economic goals
directly. Thus, the CB uses a number of monetary
variables that lie between them.
Goals of Monetary Policy
1. High Employment (How!!)
2. Economic Growth (How!!)
3. Price Stability (How!!)
4. Interest Rate Stability (How!!)
5. Stability of Financial Markets (How!!)
6. Stability in Foreign Exchange Markets (How!!)
The strategy is as follows:
• The CB selects one or more economic goals,
• The CB chooses variables called intermediate targets,
such as monetary aggregates (e.g. M1, M2) or interest
rates (short or long term), which have a direct effect on
the goals.
• Then, the CB chooses a number of variables called
operating targets, they can be either monetary aggregates
(e.g. reserves, monetary base), or interest rates (e.g.
interbank rate and T-bill rate). These targets are more
responsive to the tools.
Monterey Tools
OMO
Operating Targets
Intermediate Target
MB
R
M1
M2
i
iTB
i
i
DL
RRR
ff
SR
LR
Monetary Goals
(1) Employment
(2) Price Stability
(3)Financial Stability
(4)Economic Growth
(5)Interest Rate
Stability
(6) Stability in
Foreign Exchange
Markets
VII. Monetary Policy Targets
CB attempts to control either the money supply (monetary target),
or interest rate (interest rate target) to achieve the goals.
•Can the CB control both at the same time to achieve the goal?
Money Supply Target
1. M d fluctuate between M d'
and M d''
2. With M-target at M*, i
fluctuates between i' and i''
Interest Rate Target
1. M d fluctuates between M d'
and M d''
2. To set i-target at i* Ms
fluctuates between M' and
M''
Monetary Targeting
To achieve price stability, the CB announces that it will target an
annual growth rate in a particular monetary aggregate (M1, M2).
Once the rate is set, the CB is responsible for hitting this target. This
policy is Flexible, transparent, accountable.
Advantages
- Almost immediate accountability.
- Almost immediate signals help fix inflation expectations and
produce less inflation.
Disadvantages
- Must be a strong and reliable relationship between the goal
variable and the targeted monetary aggregate.
Inflation Targeting
 Why not directly target inflation??. With inflation target, the CB
makes public announcement of the inflation target.
 Institutional commitment to price stability as the primary, longrun goal of monetary policy and a commitment to achieve the
inflation goal.
 Many information are used in making decisions.
Increased transparency of the strategy.
Increased accountability of the central bank.
Implications of Monetary & Inflation Targets

Monetary Targeting
(…i.e. USA, Japan.)
-Case of USA
– Monetary targeting, particularly fed announces iff operating target.

Inflation Targeting
(…i.e. New Zealand (3-5%), Canada (1-3%), EU (2%), UK(2.5%))
-Case of Canada
– Incorporating short term- i & exchange rate for Canadian dollar.
Sidebar:
Monetary Policy: From Greenspan to Bernanke
• 2000: Contractionary (Y* > YF),
• 2001-03: Expansionary (Y* < YF.). Policy
experienced difficulty getting economy back to
YF.
• 2004-06: Contractionary. Economy caught up
to YF, concern about overstimulated economy
and increased energy prices.
• 2007-11: Expansionary. Addressing slowdown
and ultimate recession of 2008.