Transcript Slide 7–3

Chapter Seven
Conduct of Monetary Policy:
Tools, Goals, and Targets
The Federal Reserve Balance Sheet
• Monetary Base = Currency + Reserves
Slide 7–3
The Federal Reserve Balance Sheet
• Open Market Purchase from Public
Public
Assets
The Fed
Liabilities
Securities
–$100
Deposits
+$100
Assets
Liabilities
Securities
Reserves
+$100
+$100
Banking System
Assets
Reserves
Liabilities
Deposits
+$100
+$100
Result R  $100, MB $100
Slide 7–4
The Federal Reserve Balance Sheet
• Discount Loans
Banking System
Assets
Reserves
Liabilities
Discount loans
+$100
+$100
The Fed
Assets
Liabilities
Discount loans Reserves
+$100
+$100
Result R  $100, MB $100
Slide 7–5
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
Figure 7.1: Equilibrium in the Market for Reserves
Slide 7–6
Figure 7-2: 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 
Slide 7–7
Figure 7-3: Response to Change
in Required Reserves
1. RR , Rd
shifts to right,
iff 
Slide 7–8
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.
2.
3.
4.
Fed has complete control
Flexible and precise
Easily reversed
Implemented quickly
Information about the FOMC
http://www.federalreserve.gov/fomc
Slide 7–9
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
Slide 7–10
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
FOMC calendar and meeting minutes
http://www.federalreserve.gov/fomc/#calendars
Slide 7–11
Goals of Monetary Policy
• Goals
1.
2.
3.
4.
5.
6.
High employment
Economic growth
Price stability
Interest rate stability
Financial market stability
Foreign exchange market stability
• Goals often in conflict
Slide 7–12
Figure 7-4: Central Bank Strategy
Slide 7–13
Money Supply Target
1. Md fluctuates
between Md'
and Md''
2. With M-target
at M*,
i fluctuates
between
i' and i''
Figure 7-5: Result of Targeting on the Money Supply
Slide 7–14
Interest Rate Target
1. Md fluctuates
between Md'
and Md''
2. To set i-target
at i*,
Ms fluctuates
between
M' and M''
Figure 7-6: Result of Targeting on the Interest Rate
Slide 7–15
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
1. 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
Slide 7–16
History of Fed Policy Procedures
• Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 1920–1921
• 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
Slide 7–17
History of Fed Policy Procedures
• Pegging of Interest Rates: 1942–1951
1. To help finance war, T-bill at 3/8%, T-bond at 21/2%
2. Fed-Treasury Accord in March 1951
• Money Market Conditions: 1950s and 1960s
1. Free reserves = ER  DL
2. Interest rates
Slide 7–18
History of Fed Policy Procedures
• Targeting Monetary Aggregates: 1970s
1. Federal funds rate as operating target with narrow band
2. Procyclical Ms
• New Operating Procedures: 1979–1982
1. Deemphasis on federal funds rate
2. Nonborrowed reserves operating target
3. The Fed still using interest rates to affect economy
and inflation
• Deemphasis of Monetary Aggregates:
1982–Early 1990s
1. Borrowed Reserves (DL) operating target
Slide 7–19
History of Fed Policy Procedures
• Fed Funds Targeting Again
1. Federal funds target now announced
• International Considerations
1. M  in 1985 to lower exchange rate, M  in 1987
to raise it
2. International policy coordination
Slide 7–20
Figure 7-7:
Federal Funds
Rate and
Money Growth
Before and
After October
1979
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
Slide 7–22
Monetary Targeting Abroad
• Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful
as monetary indicator
3. High money growth 1987–1989:
“bubble economy,” then tight money policy
Slide 7–23
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”
Slide 7–24
Inflation Targeting (cont.)
• 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
Slide 7–25
Using a Fed Watcher
• Fed watcher predicts monetary tightening, i 
1. Acquire funds at current low i
2. Buy $ in FX market
• Fed watcher predicts monetary loosening, i 
1. Make loans now at high i
2. Buy bonds, price rise in future
3. Sell $ in FX market
Slide 7–26