Monetary Policy

2. 33 Monetary Policy CHECKPOINTS

3. Checkpoint 33.1 Checkpoint 33.2 Checkpoint 33.3 Problem 1 Problem 1 Clicker version Problem 1 Problem 2 Clicker version Problem 2 Clicker version Problem 2 Problem 3 Problem 3 Clicker version Problem 3 Problem 4 Problem 4 Problem 4 In the news

4. Practice Problem 1 What are the objectives of U.S. monetary policy? CHECKPOINT 33.1

5. Solution The objectives of U.S. monetary policy are to achieve stable prices (interpreted at a core inflation rate of 2 percent a year) and maximum employment (interpreted as full employment). CHECKPOINT 33.1

6. CHECKPOINT 33.1 Study Plan ProblemThe objectives of U.S. monetary policy are to achieve ___. • maximum employment, stable prices, and moderate long-term interest rates • zero unemployment, predictable prices, and long-term interest rates that are lower than short-term interest rates • zero unemployment, stable prices, and moderate long-term interest rates • maximum employment, predictable prices, and short-term interest rates that are lower than long-term interest rates.

7. Practice Problem 2 What is core inflation and how does it differ from total PCE inflation? CHECKPOINT 33.1

8. Solution Core inflation excludes the changes in the prices of food and fuel. The total PCE inflation rate includes the changes in all consumer prices. The core inflation rate fluctuates less than the total PCE inflation rate. CHECKPOINT 33.1

9. CHECKPOINT 33.1 Study Plan ProblemThe core inflation rate is the annual percentage change in the _____. The core inflation rate fluctuates _____ than the total PCE inflation rate. • Personal Consumption Expenditure deflator excluding the prices of food and fuel; more • Personal Consumption Expenditure deflator excluding the prices of food and fuel; less • Personal Consumption Expenditure deflator excluding the prices of food, fuel, and housing; less • GDP deflator; more

10. Practice Problem 3 What is the Fed’s monetary policy instrument and what influences the level at which the Fed sets it? CHECKPOINT 33.1

11. Solution The federal funds rate is the Fed’s monetary policy instrument . The inflation rate and output gap are two variables that Fed tries to influence when it sets the federal funds rate. CHECKPOINT 33.1

12. CHECKPOINT 33.1 Study Plan ProblemWhat is the Fed’s monetary policy instrument, and what influence the level at which the Fed sets it? • monetary base; nominal GDP and real GDP • quantity of money; the output gap and the inflation rate • federal funds rate; the output gap and the inflation rate • core inflation rate; the unemployment rate and the long-term interest rate • federal funds rate; the quantity of money and the monetary base

13. Practice Problem 4 The current quantity of reserves supplied is $20 billion. The Fed wants to set the federal funds rate at 4 percent a year. Illustrate the target on the graph and show the supply of reserves that will achieve the target. Does the Fed conduct an open market operation and if so, does it buy or sell securities? CHECKPOINT 33.1 • The demand for bank reserves, RD.

14. Solution If the initial quantity of reserves supplied was $20 billion, the federal funds rate must have been 5 percent a year at point A. To set the federal funds rate at 4 percent a year, the Fed must conduct an open market purchase to increase the supply of reserves to RS. The equilibrium federal funds rate equals the target of 4 percent a year. CHECKPOINT 33.1

15. In the news Can Fed target jobless rate? Bernanke hints at new policy With little notice, Bernanke seemed to buck conventional wisdom and suggest that the Fed can, and should, try to influence long-term unemployment. Source: CNCB, October 10, 2011 Explain whether trying to influence the long-term unemployment rate is consistent with the Fed’s monetary policy objectives. CHECKPOINT 33.1

16. Solution The objectives of monetary policy are maximum employment and stable prices. The maximum-employment goal means keeping the economy as close as possible to potential GDP. The stable-prices goal means keeping the inflation rate low. In 2011, the inflation rate was low but the unemployment rate and the output gap were high. CHECKPOINT 33.1

17. By focusing on the output gap, the Fed was seeking to re-establish “maximum employment.” The Fed believed that inflation would remain low, so its focus was consistent with its monetary policy objectives. CHECKPOINT 33.1

18. Practice Problem 1 List the sequence of events in the transmission from a rise in the federal funds rate to a change in the inflation rate. CHECKPOINT 33.2

19. Solution When the Fed raises the federal funds rate, other short-term interest rates rise and the exchange rate rises. The quantity of money and supply of loanable funds decrease and the long-term real interest rate rises. Consumption expenditure, investment, and net exports decrease. Aggregate demand decreases. Eventually the real GDP growth rate and the inflation rate decrease. CHECKPOINT 33.2

20. Practice Problem 2 The economy has slipped into recession and the Fed takes actions to lessen its severity. What action does the Fed take? Illustrate the effects of the Fed’s actions in the money market and the loanable funds market. CHECKPOINT 33.2

21. Solution The Fed lowers the federal funds rate. When the Fed lowers the Federal funds rate, other short-term interest rates fall and the supply of money increases. CHECKPOINT 33.2

22. The lower federal funds rate increases the supply of bank loans, which increases the supply of loanable funds. The real interest rate falls. CHECKPOINT 33.2

23. Practice Problem 3 The Fed thinks that the economy is about to slip into recession and takes actions to lessen its severity. Explain how the Fed’s actions change aggregate demand and real GDP. CHECKPOINT 33.2

24. Solution A lower real interest rate (and lower exchange rate) and a greater quantity of money and loans increase aggregate expenditure. Aggregate demand increases and the AD curve shifts to AD0 + ∆E. A multiplier effect increases aggregate demand and the AD curve shifts rightward to AD1. Real GDP increases and recession is avoided. CHECKPOINT 33.2

25. In the news The Fed’s tricky balancing act The FOMC was a bit more optimistic about the economy recovering, but said that policy tightening was not going to happen any time soon. Source: Business Week, June 6, 2009 What are the ripple effects and time lags that the Fed must consider in deciding when to start raising the federal funds rate? CHECKPOINT 33.2

26. Solution The figure describes the ripple effects and the time lags. The Fed can influence interest rates quickly, but several months pass before the quantity of money and loans respond, up to a year before expenditure plans respond, and up to two years before the inflation rate responds to the Fed’s interest rate actions. CHECKPOINT 33.2

27. Practice Problem 1 What are the three alternative monetary policy strategies that the Fed could have adopted? Why is discretionary monetary policy not one of them? CHECKPOINT 33.3

28. Solution The Fed could have adopted three alternative monetary policy strategies: 1 Inflation targeting rule 2 A k-percent monetary targeting rule 3 A nominal GDP targeting rule A rule-based monetary policy beats discretionary monetary policy because it provides a more secure anchor for inflation expectations, which in turn makes long-term contracting in labor and capital markets more efficient. CHECKPOINT 33.3

29. Practice Problem 2 Why does the Fed not target the quantity of money? CHECKPOINT 33.3

30. Solution The Fed does not target the quantity of money because it believes that the demand for money is too unstable. Fluctuations in the demand for money would bring unwanted fluctuations in interest rates, aggregate demand, and real GDP and the inflation rate. CHECKPOINT 33.3

31. CHECKPOINT 33.3 Study Plan Problem The Fed does not target the quantity of money because the Fed believes that _______. • it does not have enough control over the quantity of money because it is the banks that determine the quantity of loans and deposits. • changes in the demand for money would occur, which would increase the interest rate and slow the growth of aggregate demand. • The quantity of money should be fixed. • Technological change in the banking system leads to large and unpredictable shifts in the demand for money curve, which makes the use of money targeting unreliable.

32. Practice Problem 3 Which countries practice inflation targeting? How does inflation targeting work? Does inflation targeting achieve lower inflation rates? CHECKPOINT 33.3

33. Solution The countries that practice inflation targeting are the United Kingdom, Canada, Australia, New Zealand, Sweden and the Eurozone (the European countries that use the euro). CHECKPOINT 33.3

34. Inflation targeting works by Announcing a target inflation rate Setting the overnight interest rate (equivalent to the federal funds rate) to achieve the target Publishing reports that explain how and why the central bank believes that its current policy actions will achieve its ultimate policy goals. Only Eurozone and New Zealand have missed their inflation targets, but the others targeters have achieved their targets. CHECKPOINT 33.3

35. In the news One tool, one goal The one-tool, one-goal rule by which central banks operated has gone. Monetary policy is now a messier business. Source: The Economist, April 25, 2009 What is the tool and the goal that the news clip says is gone? What is the problem with “messy” monetary policy? CHECKPOINT 33.3

36. Solution The tool is the overnight interest rate (the federal funds rate in the United States). There never has been one goal for U.S. monetary policy. The Fed’s “dual mandate” is low inflation and maximum employment. Even the central banks that have a formal inflation target pay attention to the output gap and unemployment rate. The problem with “messy” monetary policy is that it might fail to anchor inflation expectations and lead to a worsening of the short-run policy tradeoff. CHECKPOINT 33.3