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Monetary Policy Goals, Strategy, Tactics. Week 10 (Chap 16). Three Tools of Monetary Policy. Open market operations Discount rate Reserve requirements. Open Market Operations. 2 Types 1. Dynamic: Meant to change MB 2. Defensive:

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Three tools of monetary policy
Three Tools of Monetary Policy

  • Open market operations

  • Discount rate

  • Reserve requirements


Open market operations
Open Market Operations

2 Types

1. Dynamic:

Meant to change MB

2. Defensive:

Meant to offset other factors affecting MB, typically uses repos

Advantages of Open Market Operations

1. Fed has complete control

2. Flexible and precise

3. Easily reversed

4. Implemented quickly


Discount rate as ceiling on fed funds rate
Discount Rate as Ceiling on Fed Funds Rate

Rightward shift of Rs to Rs2 moves equilibrium to point 2 where i2ff = id and discount lending rises from zero to DL2


Discount rate
Discount Rate

Advantages

1. Lender of Last Resort Role

Disadvantages

1. Confusion interpreting discount rate changes

2. Fluctuations in discount loans cause unintended fluctuations in money supply

3. Not fully controlled by Fed


Reserve requirements
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




Goals of monetary policy
Goals of Monetary Policy

Goals

  • Price Stability

  • Economic Growth

    3. High Employment

    4. Interest Rate Stability

    5. Financial Market Stability

    6. Foreign Exchange Market Stability

    Goals often in conflict


Time inconsistency problem
Time Inconsistency Problem

Rules versus discretion

Solution: Fixed Rules


Hierarchical mandate
Hierarchical Mandate

“The primary objective of the European System of Central Banks [ESCB] shall be to maintain price stability. Without prejudice to the objective price stability, the ESCB shall support the general economic policies in the Community.”


Dual mandate
Dual Mandate

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”


Money supply target

1. M d fluctuates between M d' and M d''

2. With M-target at M*, i fluctuates between i' and i''

Money Supply Target


Interest rate target

1. M dfluctuates between M d' and M d''

2. To set i-target at i* Ms fluctuates between M' and M''

Interest Rate Target


Criteria for choosing targets
Criteria for Choosing 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


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