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Chapter 18. Conduct of Monetary Policy. Goals of monetary policy Using targets A History of monetary policy Policy Rules. I. Goals. desirable goals for the economy Fed uses monetary policy to achieve these goals directly control tools, to influence goals. High employment.

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chapter 18 conduct of monetary policy
Chapter 18. Conduct of Monetary Policy
  • Goals of monetary policy
  • Using targets
  • A History of monetary policy
  • Policy Rules
i goals
I. Goals
  • desirable goals for the economy
  • Fed uses monetary policy to achieve these goals
    • directly control tools,

to influence goals

high employment
High employment
  • i.e., low unemployment
  • federal government has a commitment to full employment
  • goal: natural rate of unemployment
    • about 4-5%
    • today: 5.1% (3/05)
    • 7.7% in Oswego Co.
economic growth
Economic Growth
  • annual % change in real GDP
  • U.S. long run average -- 3%
  • 2004 GDP growth 4.4%
price stability
Price stability
  • i.e., low inflation
    • annual % change in CPI
  • primary goal of Fed since 1980s
  • how high is too high?
    • over 4%
    • goal: 2% or less
  • 2004
tradeoff
tradeoff
  • between price stability & economic growth
    • controlling inflation can mean slowing down economic growth
financial market stability
Financial Market Stability
  • stability of financial institutions
  • stability of interest rates
  • stability of exchange rates
  • Fed stabilized markets
    • October 1987
    • Summer 1998
    • September 2001
ii using targets
II. Using targets
  • Fed directly controls tools (like OMO), not goals
  • it can take a year for tools to impact the goals
    • how to gauge progress in between?
targets

tool

(OMO)

operating

target

intermediate

target

Targets
  • related to tools and goals
  • used by Fed to judge if they are on track

goal

operating targets
operating targets
  • respond immediately to changes in the tools
  • examples
    • bank reserves
    • FF rate
    • Tbill rate
intermediate targets
intermediate targets
  • affected by operating target
  • closely associated with goals
  • examples
    • M1, M2 or M3
    • prime rate
    • Tnote or Tbond yields
example
example
  • Fed wants 5% nominal GDP growth
    • intermediate target 4% M2 growth
    • operating target 3% MB growth
    • conduct open market purchases to increase MB by 3%
effective targets
effective targets
  • frequently and accurately measured
  • controllable by the Fed
  • predictably related to goals
2 types of targets
2 types of targets
  • monetary targets
    • reserves, MB
    • M1, M2, or M3
  • interest rate targets
    • FF rate
    • other short or medium-term rates
target tradeoff
target tradeoff
  • Fed can target money supply OR interest rates
  • NOT BOTH!
  • why?
slide20

i

MS

i’’

MD’’

M

M*

  • suppose Fed targets M* for MS:
slide21

i

MS

i’’’

i’’

MD’’’

i’

MD’’

MD’

M

M*

  • but as MD fluctuates, i will change:
slide22

i

MS

i’’’

i’’

MD’’’

i’

MD’’

MD’

M

M*

  • so if target M*, lose control of i
slide23

i

MS

i*

MD’’

M

M’’

  • suppose Fed targets i*
slide24

i

MS

MS’

MS’’’

i*

MD’’’

MD’’

M

MD’

M’’

M’

M’’’

  • but as MD fluctuates, Fed must shift MS to maintain i*
slide25

i

MS

MS’

MS’’’

i*

MD’’’

MD’’

M

MD’

M’’

M’

M’’’

  • Fed targets i*, lose control of M
targets26
Targets
  • If Fed targets MS, loses control of interest rates
  • If Fed targets interest rates, loses control of MS
iii a history of fed policy
III. A History of Fed Policy
  • Early years (1913-1929)
  • The Great Depression
  • WWII
  • 1950s, 60s
  • 1970s
  • 1979-82
  • 1982-92
  • 1992-present
the early years
The Early Years
  • 1913-1929
  • main tool: discount loans
  • real bill doctrine
    • use discount loans for production loans
    • result: inflation
slide29
cut back on discount loans
    • recession/deflation 1920-21
  • discovered OMO in 1920s
    • make up for lost revenue from discount loans by holding Treasuries
the great depression
The Great Depression
  • Fed failed to act as lender of last resort and prevent bank failures 1930-33
  • why?
    • initial failures were small banks
    • Fed failed to recognize domino effect on larger banks & economy
slide31
mid 1930s
    • recovering from GD but
    • Fed increases reserve requirement

-- recession 1937-38

1942 51
1942-51
  • during WWII Fed targeted Tbill rate
    • kept rate low to help finance war
    • large MS growth

-- but price controls kept inflation low

  • post WWII inflation
    • Fed abandoned Tbill rate target
1950s 1960s
1950s - 1960s
  • targeting “money market conditions”
    • short term interest rates
    • free reserves

= excess reserves - discount loans

  • result: procyclical monetary policy
    • MS rose during expansions,

fell during recessions.

slide34

interest

rate

rise

income

rises

MD

rises

ER decline

DL rise

FR decline

Fed

increases

MB

increase

MS

Why?
  • chain reaction:

economic

expansion

slide35
procyclical money growth is not a good thing
    • rapid MS growth in expansion leads to inflation
    • slow MS growth in recession makes it worse
slide36
MS should be countercyclical
    • “lean against the wind”
    • keep inflation under control
    • help prevent or end recessions
1970s
1970s
  • Fed announces target of money aggregates (M1, M2)
    • but FOMC targets both aggregates & FF rate

-- cannot do both

    • Fed really targeting FF rate,

& MS growth still procyclical

1979 82
1979-82
  • inflation over 10% by 1979
  • Paul Volcker
  • target nonborrowed reserves
    • reserves - discount loans
    • slow MS growth to bring down inflation
  • large interest rate fluctuations
slide40
recession 1981-82
    • “Volcker recession”
  • inflation below 4% by 1982
  • signaled change at Fed
    • price stability # 1 goal
    • fight inflation inflation before it gets to be a problem
1982 92
1982-92
  • targeting “borrowed reserves” or interest rates
    • procyclical policy
  • stopped setting targets for M1, M2
  • Alan Greenspan 1987
    • intervened 1987 crash
    • slow to act for 90-91 recession
slide44
exchange rate markets
    • $ too high
    • Fed, with other central banks

intervened to bring $ down

1992 present
1992 - present
  • 1990s longest expansion in U.S. history
  • announced FF rate target 1994
  • 1994-95 “soft landing”
    • prevent rising inflation by

increasing FF rate

slide46
1994 exchange rates
    • this time Fed intervened for a $ that was too low
  • 1998 Russian debt/ Asia crisis
    • lower FF rate to keep U.S. economy expanding
slide47
1999-2000
    • Fed hiked FF rate to prevent inflation
  • 2000-2001
    • Fed reversed FF rate hikes as economy slowed
  • 2002-present
    • FF rate targets have slowly risen
    • but not LT rates
iv policy rules
IV. Policy Rules
  • how to choose a target for monetary policy?
  • how to respond to changing economic conditions?
the taylor rule
The Taylor Rule
  • John Taylor
  • equation
    • FF rate target based on

-- current inflation

-- inflation target

-- gap between actual GDP &

full employment GDP

taylor rule

LR FF

rate

FF

rate

= inflation +

+ .5(inflation gap)

+ .5(output gap)

Taylor rule
  • Fed responds to both
    • price stability
    • business cycle
nairu
NAIRU
  • nonaccelerating inflation rate of unemployment
    • lowest unemployment rate possible without triggering inflation
  • possible goal for Fed
slide53
problem: what is NAIRU?
    • prior to 1995 may would have said 5%
    • but unemployment below 4% in late 1990s without causing inflation
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