Chapter 18. Conduct of Monetary Policy

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Chapter 18. Conduct  of Monetary Policy Powered By Docstoc
					Chapter 18. Conduct of Monetary
             Policy

• Goals of monetary policy
• Using targets
• A History of monetary policy
• Policy Rules
I. Goals

• desirable goals for the economy
• Fed uses monetary policy to achieve
 these goals
  • directly control tools,
     to influence goals
High employment

• i.e., low unemployment
• federal government has a
    commitment to full employment
•   goal: natural rate of unemployment
    • about 4-5%
    • today: 5.1% (3/05)
    • 7.7% in Oswego Co.
Economic Growth

• annual % change in real GDP
• U.S. long run average -- 3%
• 2004 GDP growth 4.4%
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
•   2004
tradeoff

• between price stability & economic
 growth
 • controlling inflation can mean
   slowing down economic growth
Financial Market Stability

• stability of financial institutions
• stability of interest rates
• stability of exchange rates
• Fed stabilized markets
  • October 1987
  • Summer 1998
  • September 2001
II. 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?
 Targets
 • related to tools and goals
 • used by Fed to judge if they are on
  track

tool       operating   intermediate   goal
(OMO)      target      target
operating targets

• respond immediately to changes in
    the tools
•   examples
     • bank reserves
     • FF rate
     • Tbill rate
intermediate targets

• affected by operating target
• closely associated with goals
• examples
  • M1, M2 or M3
  • prime rate
  • Tnote or Tbond yields
example

• Fed wants 5% nominal GDP growth
 • intermediate target 4% M2 growth
 • operating target 3% MB growth
 • conduct open market purchases to
   increase MB by 3%
effective targets

• frequently and accurately measured
• controllable by the Fed
• predictably related to goals
2 types of targets

• monetary targets
     • reserves, MB
     • M1, M2, or M3
•   interest rate targets
     • FF rate
     • other short or medium-term rates
target tradeoff

• Fed can target money supply OR
    interest rates
•   NOT BOTH!
•   why?
• suppose Fed targets M* for MS:
i               MS




i’’


                      MD’’


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


i’’                          MD’’’

i’                      MD’’

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


i’’                            MD’’’

i’                       MD’’

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




i*


                      MD’’


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




 i*                          MD’’’

                         MD’’

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

  i   MS’           MS    MS’’’




 i*                           MD’’’

                          MD’’

                          MD’
      M’                 M’’’ M
              M’’
Targets

• If Fed targets MS, loses control of
    interest rates
•   If Fed targets interest rates, loses
    control of MS
III. A History of Fed Policy

•   Early years (1913-1929)
•   The Great Depression
•   WWII
•   1950s, 60s
•   1970s
•   1979-82
•   1982-92
•   1992-present
The Early Years

• 1913-1929
• main tool: discount loans
• real bill doctrine
  • use discount loans for production
    loans
  • result: inflation
• cut back on discount loans
    • recession/deflation 1920-21
•   discovered OMO in 1920s
    • make up for lost revenue from
      discount loans by holding
      Treasuries
The Great Depression

• Fed failed to act as lender of last
    resort and prevent bank failures
    1930-33
•   why?
     • initial failures were small banks
     • Fed failed to recognize domino
       effect on larger banks & economy
• mid 1930s
  • recovering from GD but
  • Fed increases reserve requirement
    -- recession 1937-38
1942-51
• during WWII Fed targeted Tbill rate
    • kept rate low to help finance war
    • large MS growth
      -- but price controls kept inflation
      low
•   post WWII inflation
    • Fed abandoned Tbill rate target
1950s - 1960s
• targeting “money market conditions”
     • short term interest rates
     • free reserves
       = excess reserves - discount loans
•   result: procyclical monetary policy
     • MS rose during expansions,
       fell during recessions.
Why?
• chain reaction:
                                     interest
economic       income       MD       rate
expansion      rises        rises    rise

        Fed             ER decline
        increases       DL rise      increase
        MB              FR decline   MS
• procyclical money growth is not a
 good thing
 • rapid MS growth in expansion
   leads to inflation
 • slow MS growth in recession
   makes it worse
• MS should be countercyclical
  • “lean against the wind”
  • keep inflation under control
  • help prevent or end recessions
1970s
• Fed announces target of money
 aggregates (M1, M2)
 • but FOMC targets both aggregates
   & FF rate
   -- cannot do both
 • Fed really targeting FF rate,
   & MS growth still procyclical
• Fed criticized in 1970s for failure to
 control inflation
 • energy crisis of 1973-74 did not
   help
1979-82
• inflation over 10% by 1979
• Paul Volcker
• target nonborrowed reserves
     • reserves - discount loans
     • slow MS growth to bring down
       inflation
•   large interest rate fluctuations
• recession 1981-82
     • “Volcker recession”
•   inflation below 4% by 1982
•   signaled change at Fed
     • price stability # 1 goal
     • fight inflation inflation before it
       gets to be a problem
1982-92
• targeting “borrowed reserves” or
    interest rates
     • procyclical policy
•   stopped setting targets for M1, M2
•   Alan Greenspan 1987
     • intervened 1987 crash
     • slow to act for 90-91 recession
• exchange rate markets
  • $ too high
  • Fed, with other central banks
    intervened to bring $ down
1992 - present

• 1990s longest expansion in U.S.
    history
•   announced FF rate target 1994
•   1994-95 “soft landing”
    • prevent rising inflation by
      increasing FF rate
• 1994 exchange rates
    • this time Fed intervened for a $
      that was too low
•   1998 Russian debt/ Asia crisis
    • lower FF rate to keep U.S.
      economy expanding
• 1999-2000
    • Fed hiked FF rate to prevent
      inflation
•   2000-2001
    • Fed reversed FF rate hikes as
      economy slowed
•   2002-present
    • FF rate targets have slowly risen
    • but not LT rates
IV. Policy Rules

• how to choose a target for monetary
    policy?
•   how to respond to changing
    economic conditions?
The Taylor Rule
• John Taylor
• equation
  • FF rate target based on
    -- current inflation
    -- inflation target
    -- gap between actual GDP &
     full employment GDP
Taylor rule
FF   = inflation + LR FF + .5(inflation gap)
rate               rate
                                       + .5(output gap)


•   Fed responds to both
    • price stability
    • business cycle
NAIRU
• nonaccelerating inflation rate of
    unemployment
    • lowest unemployment rate
      possible without triggering
      inflation
•   possible goal for Fed
• problem:    what is NAIRU?
  • prior to 1995 may would have said
    5%
  • but unemployment below 4% in
    late 1990s without causing
    inflation

				
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posted:4/24/2013
language:English
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