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.
Fundamental decision-- how to allocate their assets to make reasonable profits and to service depositor withdrawals.
(A) Determining the Discount Rate
(B) Open Market Operations
(C) Setting the Required Reserve Ratio
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
Performing the role of lender of last resort, therefore strengthening financial institutions.
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.
It affects all banks equally and has a powerful effect on money supply
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
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.
(2) Contractionary Policy
V. Obstacles to Monetary Policy Effectiveness
(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
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!!)
(2) Price Stability
(5)Interest Rate Stability
(6) Stability in Foreign Exchange Markets
Monterey ToolsOperating Targets Intermediate Target Monetary Goals
CB attempts to control either the money supply (monetary target), or interest rate (interest rate target) to achieve the goals.
1. M d fluctuate between M d' and M d''
2. With M-target at M*, i fluctuates between i' and i''
1. M dfluctuates between M d' and M d''
2. To set i-target at i* Ms fluctuates between M' and M''
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.
- Almost immediate accountability.
- Almost immediate signals help fix inflation expectations and produce less inflation.
- Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate.
(…i.e. USA, Japan.)
-Case of USA
(…i.e. New Zealand (3-5%), Canada (1-3%), EU (2%), UK(2.5%))
-Case of Canada
Monetary Policy: From Greenspan to Bernanke