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Chapter 5 – Monetary Policy

Chapter 5 – Monetary Policy. BA 543 Financial Markets and Institutions. Chapter 5 – Monetary Policy. Goals of the Federal Monetary Policy Stability in Price Level (Inflation)

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Chapter 5 – Monetary Policy

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  1. Chapter 5 – Monetary Policy BA 543 Financial Markets and Institutions

  2. Chapter 5 – Monetary Policy • Goals of the Federal Monetary Policy • Stability in Price Level (Inflation) • Unstable Prices retard economic growth, provoke volatility in interest rates, stimulate consumption, deter savings, and cause capricious redistribution of income and wealth with attendant social disturbances (page 78) • Average Inflation 1982 to 2010 is 2.9% • “Controlling Inflation” after a supply shock • Refuse to Accommodate with matching increase in money supply – leads to higher interest rates and decline in growth • Accommodate– increase money supply above shock and let inflation be unchecked (find new equilibrium)

  3. Chapter 5 – Monetary Policy • Goals of the Federal Monetary Policy • High Employment (Low Unemployment) • Frictional Unemployment (Job Changers) • Target 4% to 6% of labor force currently at 7.9% • See Table 5-2 Page 79 • Increase in Money Supply can bring about: • Economic Expansion • Stimulate Investment • Encourage Consumption • Lead to the Creation of New Jobs • Kindle Inflation – Output near capacity • Raise Interest Rates which reverses the good

  4. Chapter 5 – Monetary Policy • Goals of the Federal Monetary Policy • Economic Growth (Increase in Output of Goods and Services) • What is the appropriate rate of growth? • Sustainable Growth • Reasonable Growth • Steady Growth • Via Stabilizing Interest Rates • Reduce Volatility – But allow changes • How do interest rates impact growth?

  5. Chapter 5 – Monetary Policy • Goals of the Federal Monetary Policy • Stability in Foreign Exchange • Strong Dollar Means (Indirect Quote goes up) • Exchange Rates are moving so that $1 can buy more foreign currency or U.S. Products are becoming relatively more expensive “overseas” • Trade-Imbalance: Foreign goods purchased more in U.S. and less U.S. goods purchased abroad • Weak Dollar Means (Indirect Quote goes down) • More U.S. goods purchased abroad and fewer foreign goods purchased in U.S. • Who Benefits from Strong Dollar vs. Weak Dollar?

  6. Chapter 5 – Monetary Policy • Goals are not always Aligned • Tradeoffs between Goals • Fed “selects” goal most in jeopardy • Fed works through • Operating Targets – impacts on monetary and financial variables that tend to change • Intermediate Targets – that have reasonable linkage to • Ultimate Objectives – price level stability, employment, growth, and foreign exchange rates

  7. Diagram of Fed Tools and Goals Federal Tools – Open Market Operations (Buying and Selling) Operating Targets: Direct Impact from tool (can predict the results of actions) Increase or Decrease in Money Supply Intermediate Targets the Fed indirectly tries to impact Increase in Capital Investing Monetary Goals: Inflation, Economic Growth, Stable Interest Rates and Stable Foreign Exchange Rates – Increase GDP without increasing inflation

  8. Chapter 5 – Monetary Policy • Choosing the Operating Targets • U.S. Targets: Short-Term Interest Rates (Inflation) or Bank Reserves via money supply • Can not do both simultaneously, Why? • Negative Correlation between reserves and interest rates…as Fed increases reserves it reduces short-term rates and vice versa • Variable outside the control of the Fed…demand for money…thus borrowers and lenders impact the supply of money at banks as well as Fed

  9. Chapter 5 – Monetary Policy • Choosing the Intermediate Targets • Suitable Target must be observable • Money Supply • Early standard target…some discussion on which measure and concern that it does not have linkage with the ultimate objectives • GNP (GNP growth rate) • Measurability big issues, data is quarterly • Inflation • Believed to have better linkage to ultimate goals • Many Europeans using price indexes for sensitive products…Bernanke has focused on specific inflation rate • Responsiveness to stimulation is critical

  10. Chapter 5 – Monetary Policy • Historical Trip through Targets • 1970s – Feds Fund Rate (Keynesian) • 1979 – 1982 Nonborrowed Reserves (Monetarists) let interest rates fluctuate • 1983 – 1991 Borrowed Reserves • 1991 – 1995 Borrowed Reserves with attention to sensitive commodities (European approach) • 1996 – 2000 New Paradigm of Higher Sustainable • New century 2001 – today…inflation focus

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