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Chapter 18. Monetary Policy

Chapter 18. Monetary Policy. The market for reserves Open market operations Discount lending Reserve requirements Goals of monetary policy Using targets. The Market for Reserves. interbank lending market federal funds rate (FF rate) FOMC impacts this market

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Chapter 18. Monetary Policy

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  1. Chapter 18. Monetary Policy • The market for reserves • Open market operations • Discount lending • Reserve requirements • Goals of monetary policy • Using targets

  2. The Market for Reserves • interbank lending market • federal funds rate (FF rate) • FOMC impacts this market • which impacts other debt markets & economy

  3. The Fed and the FF rate • open market operations • shift the supply of reserves • discount loans • setting discount rate affects bank borrowing and supply of reserves • reserve requirement • affects demand for reserves

  4. Open Market Operations (OMO) • buying & selling Treasuries • large & liquid market • open market purchase • increase supply of reserves • decrease FF rate • OMO are the Fed’s main policy tool

  5. FOMC votes on OMO • votes on FF rate target • FRBNY actually buys and sells Treasuries • to achieve the FF rate target

  6. advantages of OMO • Fed has complete control • OMO are flexible • buy/sell a little or a lot • OMO are easily reversible • sell too much? then buy some back • OMO quickly impact reserves, FF rate

  7. Discount Lending • each district bank has a discount window • set discount rate • set discount policy • lower discount rate • increase borrowing, reserves • decrease FF rate

  8. why do banks get discount loans? • short-term liquidity problem • serious problems • seasonal reserve fluctuations • but should not ask for help too often • discount rate is 50-100 bp. ABOVE the FF rate

  9. Discount loans & monetary policy • discount loans not a good tool • not completely under Fed control • banks decide to borrow • can give misleading signals • if done for non-policy reasons • not easily reversible • cannot change rates on old loans

  10. Reserve requirement • set by the Board of Governors • higher requirement • increase demand for reserves • increase FF rate • today (since 1992) • 3% on checking up to $44.3 million • 10% above $44.3 million

  11. reserve requirement is very powerful tool • too powerful • not good for small adjustments • expensive to change

  12. Goals of Monetary policy • desirable goals for the economy • Fed uses monetary policy to achieve these goals • directly control tools, to influence goals

  13. High employment • i.e., low unemployment • federal government has a commitment to full employment • goal: natural rate of unemployment • about 4-5% • today: 4.7% • 6% in Oswego Co.

  14. Economic Growth • annual % change in real GDP • U.S. long run average -- 3% • 2006 real GDP growth 1.5%

  15. 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 • Oct 2007: about 3.5%

  16. Financial Market Stability • stability of financial institutions • stability of interest rates • stability of exchange rates • Fed stabilized markets • October 1987 • Summer 1998 • September 2001

  17. 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?

  18. tool (OMO) operating instrument intermediate target Targets • related to tools and goals • used by Fed to judge if they are on track goal

  19. operating instrument • respond immediately to changes in the tools • examples • bank reserves • FF rate • Tbill rate

  20. intermediate targets • affected by operating target • closely associated with goals • examples • M1or M2 • Tnote yields

  21. effective instruments • observable by everyone • controllable and quickly changeable by the Fed • predictably related to goals

  22. 2 types of targets/instruments • monetary targets • reserves, MB • M1 or M2 • interest rate targets • FF rate • other short or medium-term rates

  23. target tradeoff • Fed can target money supply OR interest rates • NOT BOTH! • why?

  24. i MS i’’ MD’’ M M* • suppose Fed targets M* for MS:

  25. i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • but as MD fluctuates, i will change:

  26. i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • so if target M*, lose control of i

  27. i MS i* MD’’ M M’’ • suppose Fed targets i*

  28. i MS MS’ MS’’’ i* MD’’’ MD’’ M MD’ M’’ M’ M’’’ • but as MD fluctuates, Fed must shift MS to maintain i*

  29. i MS MS’ MS’’’ i* MD’’’ MD’’ M MD’ M’’ M’ M’’’ • Fed targets i*, lose control of M

  30. Targets • If Fed targets MS, loses control of interest rates • If Fed targets interest rates, loses control of MS

  31. The Taylor Rule • How to choose the FF rate target? • Base target on • Current inflation • Target inflation • Current real GDP • Potential real GDP

  32. FF rate target = 2.5 + current inflation + (1/2)(current-target inflation) + (1/2)(current - potential GDP) • A guideline for the Fed

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