Slide 1 School of Public Policy Urban Affairs

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					What can Government do to
foster Economic Growth and

The Role of Monetary Policy

Cathy Minehan
Economic Growth with Equity
Open Classroom PPS 225
February 11, 2009
                  Monetary Policy

   What is it?
   Why is it necessary?
   How does it work?
   Goals:
     Price stability
     Financial stability
 Current challenges
     Was monetary policy part of the problem?
     What’s happening now

            What is Monetary Policy?
   Money: Anything that acts as a medium of exchange

   Monetary Policy: Controls the supply of money

   Economic growth requires money; money demand fluctuates with
    pace of growth

   Monetary policy seeks to get money supply right as a condition to
    solid growth

   Too much supply: prices rise (inflation)

   Too little: prices fall (disinflation/deflation)

   Monetary policy seeks to reduce supply by raising interest rates:
    increase supply by reducing interest rates
   Why is Monetary Policy Necessary?
 Price Stability - adjust growth of money to desired short-
  term pace of economic growth
    Avoid inflation/deflation
    More importantly – help to achieve higher standards of
 Financial Stability – the central bank is the key responder
  to financial crises
    Historical reason for central banks
          Bank   of England “lend freely at high rates”
          1907   Crisis Federal Reserve formation
          1934   Creation of FOMC
          1951   Treasury/Fed Accord (“independent” central bank)
 Typically Fiscal Policy too slow; Monetary Policy lowers
  interest rates, increases liquidity and bolsters confidence
 Fiscal Stimulus in 2002 and current stimulus packages are
 How Does Monetary Policy Work?

 Banks hold money (reserves) at central bank
 U.S. Central Bank – Federal Reserve System
 Central banks control supply of money and
  its price
 How?
   Buying and selling securities in the Open Market   (Open
    Market operations)
   Lending to banks and others against collateral
    (Discount Window Lending)
   Reserve Requirements

          Open Market Operations
 Governed by Federal Open Market Committee (FOMC);
  Implemented by Open Market Desk at Federal Reserve
  Bank of New York
 Buy a security in the secondary market
    Adds reserves/money to system
    Fed creates money
 Sell a security
    Takes reserves/money out of system
    Fed destroys money
 Add money – interest rates go down
 Subtract money – interest rates go up
 The trick – match interest rates to the pace of growth
  so price stability is maintained (relative vs. absolute?)

Federal Funds Target Rate

          Discount Window and
          Reserve Requirements
 Discount Window Lending
    Traditionally to commercial banks, secured by collateral,
     and made at the “Discount Rate”
    Issue of collateral type and value
 Reserve Requirements
    A portion of commercial bank deposits with the Federal
     Reserve are “required reserves”
    Amount is based on the nature of deposit liabilities
    Reserves are “high powered”
 Traditionally Open Market Operations is key tool
  of Monetary Policy, but new uses of all three tools

    New Federal Reserve Programs
   Lending
     Short-term credit to both commercial banks and primary dealers
     Loans to Bear Stearns and AIG
     “SWAP” lines to foreign central banks
   Reserves
     Paying interest facilitates rate setting
   Market-Based Programs
     Asset Backed Commercial Paper Funding
     Money Market Investor Lending
     Term Asset Backed Securities Loan Facility (TALF)
           Student Loans
           Auto Loans
           Credit Card Loans
           SBA Loans
           *Commercial Real Estate Loans (New)
     In partnership with private sector and Treasury

  Was Monetary Policy Part of the
        Current Problem?
 Yes:
   Interest rates too low for too long
   Reaching for yield leads to under pricing of risk
 No:
   Inflation low and economic growth slow after recession
    of 2001
   Housing boom fueled by demographics, financial
   Inflows from abroad keep interest rates low, demand for
    securities high
 Maybe:
   Stronger regulation could have helped
   Issue of asset price vs. consumer price escalation
Rapid Growth in Wealth
  with Low Inflation

    What is Happening Now?
 Financial markets remain in disarray though
  interbank leading, residential mortgage rates
  and commercial paper markets have stabilized
 Economic growth stalled
 Deflation a concern
 Target Fed Funds Rate range of 0-25
 Good news: Monetary Policy has been
  unusually innovative and various programs
  seem to be working
 Not so good news: Process is slow,
  complicated and uncertain
 Need to start worrying about how to get out

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