Goals of Monetary Policy: Price Stability, Employment, Growth

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: Describe the goals of monetary policy. 15.1 Understand how the Fed uses monetary policy tools to influencethe federal funds rate. 15.2 Trace how the importance of different monetary policy tools haschanged over time. 15.3 Explain the role of monetary targeting in monetary policy. 15.4

3. Bernanke’s Dilemma • During the financial crisis of 2007–2009, the Fed undertook extraordinary policy actions to keep the financial system from collapsing. • The Fed hoped for a strong recovery so that it could begin its “exit strategy” of returning bank reserves and the monetary base to more normal levels. • Unfortunately, as of July 2012, the economy was recovering more slowly than the Fed had hoped. • Since most macroeconomic policy consists of monetary policy, Bernanke was the center of attention as the economy struggled through a slow recovery in 2012.

4. Key Issue and Question Issue: During the financial crisis, the Federal Reserve employed a series of new policy tools in an attempt to stabilize the financial system. Question: Should price stability still be the most important policy goal of central banks?

5. 15.1 Learning Objective Describe the goals of monetary policy.

6. The Goals of Monetary Policy The Goals of Monetary Policy The Fed has set six monetary policy goals: 1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign-exchange market stability

7. The Goals of Monetary Policy Price Stability • Inflation erodes the value of money as a medium of exchange and as a unit of account. • Most industrial economies have set price stability as a policy goal. • Problems caused by inflation: • Inflation makes prices less useful as signals for resource allocation. • Uncertain future prices complicate decisions households and firms have to make. • Inflation can also arbitrarily redistribute income. • Hyperinflation (inflation in the hundreds or thousands of percent per year) can severely damage an economy’s productive capacity.

8. The Goals of Monetary Policy High Employment High employment, or a low unemployment rate, is another key monetary policy goal. Unemployment reduces output and causes financial and personal distress. Congress and the president share responsibility for the goal of high employment. Even under the best economic conditions, some frictional and structural unemployment remain. The tools of monetary policy are ineffective in reducing these types of unemployment. Most economists estimate that the natural rate of unemployment is between 5% and 6%. Instead, the Fed attempts to reduce cyclical unemployment associated with business cycle recessions.

9. The Goals of Monetary Policy Economic Growth Economic growth is an increase in the economy’s output of goods and services over time. Economic growth provides the only source of sustained real increases in household incomes. Economic growth depends on high employment. With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements. Stable economic growth allows firms and households to plan accurately and encourages long-term investment.

10. The Goals of Monetary Policy Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources. The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The Fed responded vigorously to the financial crisis that began in 2007, but it initially underestimated its severity and was unable to avoid the deep recession of 2007–2009. Some economists believe that actions to deflate asset bubbles may be counterproductive, but the severity of the 2007–2009 recession has made financial stability a more important Fed policy goal.

11. The Goals of Monetary Policy Interest Rate Stability Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms. The Fed’s goal of interest rate stability is motivated by political pressure and a desire for a stable financial environment. Sharp interest rate fluctuations cause problems for financial institutions. So, stabilizing interest rates can help to stabilize the financial system.

12. The Goals of Monetary Policy Foreign-Exchange Market Stability In the global economy, stability in the foreign-exchange value of the dollar is an important monetary policy goal of the Fed. A stable dollar simplifies planning for commercial and financial transactions. Fluctuations in the dollar’s value change the international competitiveness of U.S. industry: e.g., a rising dollar makes U.S. goods more expensive abroad, reducing exports. In practice, the U.S. Treasury often originates changes in foreign-exchange policy, and the Fed implements these policy changes.

13. The Goals of Monetary Policy The Fed’s Dual Mandate In fact, all these policy goals are related to two broad goals: price stability and maximum employment. If the Fed can attain these two goals, it will typically attain its other goals as well. So, price stability and maximum employment are also known as the Fed’s dual mandate. Whether the Fed’s dual mandate is necessarily consistent with financial market stability is an open question.

14. 15.2 Learning Objective Understand how the Fed uses monetary policy tools to influence thefederal funds rate.

15. Monetary Policy Tools and the Federal Funds Rate Monetary Policy Tools and the Federal Funds Rate The Fed’s three traditional policy tools are: 1.Open market operations Open market operations are the Fed’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. 2.Discount policy Discount policy is the policy tool of setting the discount rate and the terms of discount lending. Discount window is the means by which the Fed makes discount loans to banks. This serves as the channel for meeting the liquidity needs of banks. 3.Reserve requirements Reserve requirement is the regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

16. Monetary Policy Tools and the Federal Funds Rate During the financial crisis, the Fed introduced two new policy tools connected with bank reserve accounts that were still active in the fall of 2010: 1.Interest on reserve balances By raising the interest rate it pays, the Fed can increase banks’ holdings of reserves, potentially increasing the money supply. By reducing the interest rate, the Fed can have the opposite effect. 2.Term deposit facility Similar to certificates of deposit, the Fed’s term deposits are offered to banks in periodic auctions. The interest rates have been slightly above the interest rate the Fed offers on reserve balances. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply.

17. Monetary Policy Tools and the Federal Funds Rate The Federal Funds Market and the Fed’s Target Federal Funds Rate Federal funds rate is the interest rate that banks charge each other on very short-term loans. The federal funds rate is determined by the demand and supply for reserves in the federal funds market. The target for the federal funds rate is set at FOMC meetings. The federal funds rate is influenced by the demand for and the supply of reserves. Demand for Reserves: determined the banking system. Supply of Reserves: controlled by the Fed.

18. Monetary Policy Tools and the Federal Funds Rate Equilibrium in the Federal Funds Market Figure 15.1 Equilibrium in the Federal Funds Market Equilibrium in the federal funds market occurs at the intersection of the demand curve for reserves (D) and the supply curve for reserves (S). The Fed determines the level of reserves (R), the discount rate (id), and the interest rate on banks’ reserve balances at the Fed (irb). Equilibrium reserves are R*, and the equilibrium federal funds rate is i*ff.•

19. Open Market Operations and the Fed’s Target for the Federal Funds Rate Figure 15.2 The Federal Funds Rate and the Interest Rates on Corporate Bonds and Mortgages The mortgage rate and the corporate bond interest rates generally rise and fall with the federal funds rate.

20. Monetary Policy Tools and the Federal Funds Rate Figure 15.3 (1 of 2) Effects of Open Market Operations on the Federal Funds Market An open market purchase of securities by the Fed shifting the supply curve to the right from S1 to S2. The equilibrium level of reserves increases from R*1 to R*2 while the equilibrium federal funds rate falls from 1.5% to 1%. The discount rate is also cut from 1.75% to 1.25%.

21. Monetary Policy Tools and the Federal Funds Rate Figure 15.3 (2 of 2) Effects of Open Market Operations on the Federal Funds Market An open market sale of securities by the Fed reduces reserves, shifting the supply curve to the left from S1 to S2. The equilibrium level of reserves decreases from R*1 to R*2 while the equilibrium federal funds rate rises from 5% to 5.25%. The discount rate is also increased from 6% to 6.25%.•

22. Monetary Policy Tools and the Federal Funds Rate The Effect of Changes in the Discount Rate and in Reserve Requirements Changes in the Discount Rate Since 2003, the Fed has kept the discount rate higher than the target for the federal funds rate. So, the discount rate is a penalty rate, as banks pay a penalty by borrowing from the Fed rather than from other banks. Changes in the Required Reserve Ratio The Fed rarely changes the required reserve ratio. This action will likely carry out offsetting open market operations to keep the target for the federal funds rate unchanged (see figure 15-4 next).

23. Figure 15.4 The Effect of a Change in the Required Reserve Ratio on the Federal Funds Market In panel (a), an increase in the required reserve ratio shifts the demand curve for reserves from D1 to D2. The equilibrium federal funds rate rises from i*ff1 to i*ff2. In panel (b), the Fed offsets the effects of the increase in the required reserve ratio with an open market purchase, shifting the supply curve from S1 to S2. The level of reserves increases from to R*1 to R*2, while the target federal funds rate remains unchanged, at i*ff1.

24. Solved Problem 15.2 Analyzing the Federal Funds Market Use demand and supply graphs for the federal funds market to analyze the following two situations: a. Suppose that banks decrease their demand for reserves. Show how the Fed can offset this change through open market operations in order to keep the equilibrium federal funds rate unchanged. b. Suppose that in equilibrium the federal funds rate is equal to the interest rate the Fed is paying on reserves. If the Fed carries out an open market purchase, show the effect on the equilibrium federal funds rate. Monetary Policy Tools and the Federal Funds Rate

25. Solved Problem Solved Problem 15.2 Analyzing the Federal Funds Market Solving the Problem Step 1Review the chapter material. Step 2 Answer part (a) by drawing the appropriate graph. Monetary Policy Tools and the Federal Funds Rate

26. Solved Problem Solved Problem 15.2 Analyzing the Federal Funds Market Solving the Problem Step 3Answer part (b) by drawing the appropriate graph. Monetary Policy Tools and the Federal Funds Rate

27. 15.3 Learning Objective Trace how the importance of different monetary policy tools has changed over time.

28. More on the Fed’s Monetary Policy Tools More on the Fed’s Monetary Policy Tools Open Market Operations In 1935, Congress established the FOMC to guide open market operations. An open market purchase of Treasury securities causes their prices to increase, and so their yield to decrease. As the monetary base increases, the money supply will expand. An open market purchase is an expansionary policy because it reduces interest rates. An open market sale has the opposite effects, and so it is called a contractionary policy.

29. More on the Fed’s Monetary Policy Tools Implementing Open Market Operations The FOMC issues a policy directive to the Federal Reserve System’s account manager, who is a vice president of the Federal Reserve Bank of New York. The Open Market Trading Desk is linked electronically through the Trading Room Automated Processing System (TRAPS) to about 20 primary dealers. Each morning, the trading desk notifies the primary dealers of the size of the open market purchase or sale and asks them to submit offers to buy or sell Treasury securities.

30. More on the Fed’s Monetary Policy Tools • Dynamic open market operations are intended to change monetary policy as directed by the FOMC. • likely to be conducted as outright purchases and sales of Treasury securities to primary dealers • Defensive open market operations are intended to offset temporary fluctuations in the demand or supply for reserves, not to carry out changes in monetary policy. • much more common, and are conducted through repurchase agreements • a similar action is changing Federal Reserve float, which increases if there is a delay in check clearing after, e.g., transportation is delayed by a snowstorm

31. Making the Connection A Morning’s Work at the Open Market Trading Desk 7:00 A.M. The account manager receives an estimate of the supply of reserves for that day and for the remaining days of the current maintenance period. 8:00 A.M.–9:00 A.M. The account manager assesses conditions in the government securities market during the trading day. 9:10 A.M. The account manager studies the FOMC’s directive and designs dynamic and defensive open market operations. 9:30 A.M. Traders notify primary dealers of the Fed’s desired transactions and request for asked/bid price quotations . 9:40 A.M. The primary dealers submit their propositions to the trading desk. 9:41 A.M. The trading desk selects the lowest prices (for purchases) and highest prices (for sales) and returns the results to dealers. 10:30 A.M. By this time, the transactions have been completed. More on the Fed’s Monetary Policy Tools

32. Open Market Operations Versus Other Policy Tools The benefits of open market operations include control, flexibility, and ease of implementation. Discount loans depend in part on the willingness of banks to request the loans and so are not as completely under the Fed’s control. The Fed can make both large and small open market operations. Often, dynamic operations require large purchases or sales whereas defensive operations call for small. Reversing open market operations is simple for the Fed. Discount loans and reserve requirement changes are more difficult to reverse quickly. The Fed can implement its open market operations with no administrative delays. Changing the discount rate or reserve requirements requires lengthier deliberation. More on the Fed’s Monetary Policy Tools

33. Making the Connection Why Can’t the Fed Always Hit Its Federal Funds Target? The Fed can only set a target for the federal funds rate. The actual federal funds rate is determined by the demand and supply for reserves. The New York Fed has done a good job in using open market operations to keep the actual federal funds rate close to the target rate. More on the Fed’s Monetary Policy Tools

34. “Quantitative Easing”: Fed Bond Purchases during the Financial Crisis of 2007–2009 Quantitative easing is thecentral bank policy that attempts to stimulate the economy by buying long-term securities. During 2009 and early 2010, the Fed bought more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities. In November 2010, the Fed announced a second round of quantitative easing (QE2), which involved buying $600 billion in long-term Treasury securities. In September 2011, the Fed announced its policy of Operation Twist, which involved buying $400 billion of long-term securities (lowering long-term interest rates) while selling $400 billion of short-term securities (raising short-term interest rates). In September 2012, the Fed announced a third round of quantitative easing (QE3) that focused on purchases of mortgage-back securities. More on the Fed’s Monetary Policy Tools

35. Federal Reserve Assets, 2007-2012 Figure 15.5 After the collapse of Lehman Brothers, the Fed dramatically increased its assets through loans to financial institutions and purchases of assets such as commercial paper and mortgage-backed securities.

36. More on the Fed’s Monetary Policy Tools Discount Policy Since 1980, all depository institutions have had access to the discount window. Each Federal Reserve Bank maintains its own discount window, although all Reserve Banks charge the same discount rate. Categories of Discount Loans The Fed’s discount loans to banks fall into three categories: (1) primary credit, (2) secondary credit, and (3) seasonal credit. Primary credit consists of discount loans available to healthy banks experiencing temporary liquidity problems. Secondary credit consists of discount loans to banks that are not eligible for primary credit. Seasonal credit consists of discount loans to smaller banks in areas where agriculture or tourism is important.

37. More on the Fed’s Monetary Policy Tools • Discount Lending during the Financial Crisis of 2007–2009 • The initial stages of the financial crisis involved shadow banks rather than commercial banks. So, the Fed was handicapped in its role as a lender of last resort because it typically lends to banks. • But then the Fed used its authority to set up temporary lending facilities: • Primary Dealer Credit Facility:Intended to allow investment banks and large securities firms to obtain emergency loans. • Term Securities Lending Facility: Intended to allow financial firms to borrow against illiquid assets.

38. More on the Fed’s Monetary Policy Tools • Commercial Paper Funding Facility: The Fed purchased three-month commercial paper directly from corporations so they could continue normal operations. • Term Asset-Backed Securities Loan Facility (TALF):The New York Fed extended three-year or five-year loans to help investors fund the purchase of asset-backed securities. • Term Auction Facility: The Fed auctioned discount loans at an interest rate determined by banks’ demand for the funds.

39. Lending by the Federal Reserve during the Financial Crisis Figure 15.6 During the financial crisis, lending by the Fed increased from just a few hundred million dollars to $993.5 billion in December 2008.

40. More on the Fed’s Monetary Policy Tools Interest on Reserve Balances Banks had long complained that the Fed’s failure to pay interest on the banks’ reserve deposits amounted to a tax. Paying interest on reserve balances gives the Fed another monetary policy tool. By increasing the interest rate, the Fed can increase the level of reserves banks are willing to hold, thus restraining bank lending and the money supply. Lowering the interest rate would have the opposite effect.

41. 15.4 Learning Objective Explain the role of monetary targeting in monetary policy.

42. Monetary Targeting and Monetary Policy Monetary Targeting and Monetary Policy The Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high economic growth and low inflation. To spur economic growth, the Fed could lower the target for the federal funds rate, which increase the money supply, potentially increasing the inflation rate in the longer run. The tools of monetary policy don’t allow the Fed to have direct control over real output or the price level.

43. Monetary Targeting and Monetary Policy • The Fed also faces timing difficulties: • The information lag refers to the Fed’s inability to observe instantaneously changes in economic variables. • The impact lag is the time that is required for monetary policy changes to affect output, employment, or inflation. • One possible solution to those timing problems is for the Fed to use targets to meet its goals.

44. Monetary Targeting and Monetary Policy Using Targets to Meet Goals • Targets are variables that the Fed can influence directly and that help achieve monetary policy goals. • Traditionally, the Fed has relied on two types of targets: • policy instruments or operating targets • intermediate targets • Although using these targets is no longer the favored approach at the Fed, they provide some insight into the difficulties the Fed faces in executing monetary policy.

45. Monetary Targeting and Monetary Policy • Intermediate Targets • Typically either monetary aggregates or interest rates • The Fed can use an intermediate target to achieve a goal outside of its direct control better than it would if it had focused solely on the goal. • Can also provide helpful feedback about the Fed’s policy actions. • Policy Instruments, or Operating Targets • Policy instruments are variables that the Fed controls directly and they are closely related to intermediate targets. • Examples of policy instruments are the federal funds rate and nonborrowed reserves. • Most major central banks use interest rates as policy instruments.

46. Achieving Monetary Policy Goals Figure 15.7 The Fed establishes goals, but it directly controls only its policy tools. So it can use targets to help achieve monetary policy goals.

47. Making the Connection What Happened to the Link between Money and Prices? In the United States, the money supply has grown more rapidly during decades when the inflation rate has been relatively high. Prior to 1980, strong evidence supports the link between money and prices in the short run of a year or two. The economists who argued this point most forcefully were known as monetarists, notably Nobel laureate Milton Friedman. Under Paul Volcker, the Fed shifted its policy to emphasize nonborrowed reserves as a policy instrument. This episode of “The Great Monetarist Experiment” produced mixed results. Monetary Targeting and Monetary Policy

48. Making the Connection What Happened to the Link between Money and Prices? After 1980, the short-run link between the growth of the money supply and inflation broke down because the nature of M1 and M2 had changed.

49. Monetary Targeting and Monetary Policy The Choice between Targeting Reserves and Targetingthe Federal Funds Rate The main policy instruments have been reserve aggregates and the federal funds rate. The Fed has used three criteria when evaluating potential variables for policy instruments: 1. Measurable: The variable must be measurable in a short time frame to overcome information lags. Both reserve aggregates and the federal funds rate are easily measurable. 2. Controllable:Open market operations can keep both variables close to whatever target the Fed selects. 3. Predictable: The complexity of the impact that a change in either reserves or the federal funds rate has on economic goals compromises predictability.

50. Figure 15.8 (1 of 2) Choosing between Policy Instruments The Fed chooses the level of reserves as its policy instrument by keeping reserves constant, at R*. If the demand for reserves shifts to the right from D1 to D2, the equilibrium federal funds rate increases from from i*ff1 to i*ff2. Monetary Targeting and Monetary Policy