Chapter 18. Conduct of Monetary Chapter 18. Conduct of Monetary PolicyPolicy

Chapter 18. Conduct of Monetary Chapter 18. Conduct of Monetary PolicyPolicy

• Goals of monetary policy

• Using targets

• A History of monetary policy

• Policy Rules

• Goals of monetary policy

• Using targets

• A History of monetary policy

• Policy Rules

I. GoalsI. GoalsI. GoalsI. Goals

• desirable goals for the economy

• Fed uses monetary policy to achieve these goals• directly control tools,

to influence goals

• desirable goals for the economy

• Fed uses monetary policy to achieve these goals• directly control tools,

to influence goals

High employmentHigh employmentHigh employmentHigh 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.

• 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 GrowthEconomic GrowthEconomic GrowthEconomic Growth

• annual % change in real GDP

• U.S. long run average -- 3%

• 2004 GDP growth 4.4%

• annual % change in real GDP

• U.S. long run average -- 3%

• 2004 GDP growth 4.4%

Price stabilityPrice stabilityPrice stabilityPrice 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

• 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

tradeofftradeofftradeofftradeoff

• between price stability & economic growth• controlling inflation can mean

slowing down economic growth

• between price stability & economic growth• controlling inflation can mean

slowing down economic growth

Financial Market StabilityFinancial Market StabilityFinancial Market StabilityFinancial Market Stability

• stability of financial institutions

• stability of interest rates

• stability of exchange rates

• Fed stabilized markets• October 1987• Summer 1998• September 2001

• stability of financial institutions

• stability of interest rates

• stability of exchange rates

• Fed stabilized markets• October 1987• Summer 1998• September 2001

II. Using targetsII. Using targetsII. Using targetsII. 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?

• 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?

TargetsTargetsTargetsTargets

• related to tools and goals

• used by Fed to judge if they are on track

• related to tools and goals

• used by Fed to judge if they are on track

goalintermediatetarget

operatingtarget

tool(OMO)

operating targetsoperating targetsoperating targetsoperating targets

• respond immediately to changes in the tools

• examples• bank reserves• FF rate• Tbill rate

• respond immediately to changes in the tools

• examples• bank reserves• FF rate• Tbill rate

intermediate targetsintermediate targetsintermediate targetsintermediate targets

• affected by operating target

• closely associated with goals

• examples• M1, M2 or M3• prime rate• Tnote or Tbond yields

• affected by operating target

• closely associated with goals

• examples• M1, M2 or M3• prime rate• Tnote or Tbond yields

exampleexampleexampleexample

• 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%

• 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 targetseffective targetseffective targetseffective targets

• frequently and accurately measured

• controllable by the Fed

• predictably related to goals

• frequently and accurately measured

• controllable by the Fed

• predictably related to goals

2 types of targets2 types of targets2 types of targets2 types of targets

• monetary targets• reserves, MB• M1, M2, or M3

• interest rate targets• FF rate • other short or medium-term rates

• monetary targets• reserves, MB• M1, M2, or M3

• interest rate targets• FF rate • other short or medium-term rates

target tradeofftarget tradeofftarget tradeofftarget tradeoff

• Fed can target money supply OR interest rates

• NOT BOTH!

• why?

• Fed can target money supply OR interest rates

• NOT BOTH!

• why?

• suppose Fed targets M* for MS:• suppose Fed targets M* for MS:

M

i MS

M*

MD’’

i’’

• but as MD fluctuates, i will change:• but as MD fluctuates, i will change:

M

i MS

M*

MD’’

i’’ MD’’’

i’’’

MD’

i’

• so if target M*, lose control of i• so if target M*, lose control of i

M

i MS

M*

MD’’

i’’ MD’’’

i’’’

MD’

i’

• suppose Fed targets i*• suppose Fed targets i*

M

i

MD’’

i*

MS

M’’

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

M

i MS

M’’

MD’’

i* MD’’’

MD’

M’

MS’

M’’’

MS’’’

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

M

i MS

M’’

MD’’

i* MD’’’

MD’

M’

MS’

M’’’

MS’’’

TargetsTargetsTargetsTargets

• If Fed targets MS, loses control of interest rates

• If Fed targets interest rates, loses control of MS

• If Fed targets MS, loses control of interest rates

• If Fed targets interest rates, loses control of MS

III. A History of Fed PolicyIII. A History of Fed PolicyIII. A History of Fed PolicyIII. A History of Fed Policy

• Early years (1913-1929)

• The Great Depression

• WWII

• 1950s, 60s

• 1970s

• 1979-82

• 1982-92

• 1992-present

• Early years (1913-1929)

• The Great Depression

• WWII

• 1950s, 60s

• 1970s

• 1979-82

• 1982-92

• 1992-present

The Early YearsThe Early YearsThe Early YearsThe Early Years

• 1913-1929

• main tool: discount loans

• real bill doctrine• use discount loans for production

loans• result: inflation

• 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

• 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 DepressionThe Great DepressionThe Great DepressionThe 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

• 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

• mid 1930s• recovering from GD but• Fed increases reserve requirement

-- recession 1937-38

1942-511942-511942-511942-51

• 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

• 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 - 1960s1950s - 1960s1950s - 1960s1950s - 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.

• 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?Why?Why?Why?

• chain reaction:• chain reaction:

economicexpansion

income rises

MD rises

interest rate rise

ER declineDL riseFR decline

increaseMS

Fed increasesMB

• procyclical money growth is not a good thing• rapid MS growth in expansion

leads to inflation• slow MS growth in recession

makes it worse

• 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

• MS should be countercyclical• “lean against the wind”• keep inflation under control• help prevent or end recessions

1970s1970s1970s1970s

• 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 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

• Fed criticized in 1970s for failure to control inflation• energy crisis of 1973-74 did not

help

1979-821979-821979-821979-82

• inflation over 10% by 1979

• Paul Volcker

• target nonborrowed reserves• reserves - discount loans• slow MS growth to bring down

inflation

• large interest rate fluctuations

• 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

• 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

1982-921982-921982-921982-92

• 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

• 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

• exchange rate markets• $ too high• Fed, with other central banks

intervened to bring $ down

1992 - present1992 - present1992 - present1992 - present

• 1990s longest expansion in U.S. history

• announced FF rate target 1994

• 1994-95 “soft landing”• prevent rising inflation by

increasing FF rate

• 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

• 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

• 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 RulesIV. Policy RulesIV. Policy RulesIV. Policy Rules

• how to choose a target for monetary policy?

• how to respond to changing economic conditions?

• how to choose a target for monetary policy?

• how to respond to changing economic conditions?

The Taylor RuleThe Taylor RuleThe Taylor RuleThe Taylor Rule

• John Taylor

• equation• FF rate target based on

-- current inflation

-- inflation target

-- gap between actual GDP &

full employment GDP

• John Taylor

• equation• FF rate target based on

-- current inflation

-- inflation target

-- gap between actual GDP &

full employment GDP

Taylor ruleTaylor ruleTaylor ruleTaylor rule

• Fed responds to both• price stability• business cycle

• Fed responds to both• price stability• business cycle

FFrate

= inflation + LR FF rate

+ .5(inflation gap)

+ .5(output gap)

NAIRUNAIRUNAIRUNAIRU

• nonaccelerating inflation rate of unemployment• lowest unemployment rate

possible without triggering inflation

• possible goal for Fed

• 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

• problem: what is NAIRU?• prior to 1995 may would have said

5%• but unemployment below 4% in

late 1990s without causing inflation