Download Monetary policy

Monetary policy How the Federal Reserve manages
the money supply and interest rates to pursue its
economic goals.
The Goals of Monetary Policy
The Fed has set four monetary policy goals that
are intended to promote a well-functioning
economy:
1 Price stability
2 High employment
3 Economic growth
4 Stability of financial markets and institutions
How Does the Fed Measure Inflation?
Personal Consumption Expenditure Price Index:
A Chained Index
The Money Market and the Fed’s Choice
of Monetary Policy Targets
Monetary Policy Targets
The Fed tries to keep both the unemployment
and inflation rates low, but it can’t affect either
of these economic variables directly.
The Fed uses variables, called monetary
policy targets, that it can affect directly and
that, in turn, affect variables that are closely
related to the Fed’s policy goals, such as real
GDP, employment, and the price level.
The federal funds rate is the Fed’s most important direct target variable
The federal funds rate affects the money supply.
Money supply growth affects inflation, unemployment, and growth.
The Money Market and the Fed’s Choice
of Monetary Policy Targets
The Demand for Money
(An increase in the
price of bonds)
Substitute away from bonds toward
money.
Shifts in the Money Demand Curve
Equilibrium in the Money Market
The Impact on the Interest Rate When
the Fed Increases the Money Supply
People try to buy
bonds. Bond prices
fall.
The Money Market and the
Fed’s Choice of Monetary Policy Targets
The Importance of the Federal Funds Rate
Federal Funds Rate
Targeting, January 1998–
July 2009
The Fed does not set the
federal funds rate, but its
ability to increase or decrease
bank reserves quickly through
open market operations
keeps the actual federal funds
rate close to the Fed’s target
rate.
The orange line is the Fed’s
target for the federal funds
rate, and the jagged green
line represents the actual
value for the federal funds
rate on a weekly basis.
Monetary Policy and Economic Activity
Changes in interest rates will affect three components of aggregate demand
• Consumption
• Investment
• Net exports
Expansionary monetary policy The Federal Reserve increasing the
money supply and decreasing interest rates to increase real GDP.
Contractionary monetary policy The Federal Reserve adjusting
the money supply to increase interest rates to reduce inflation.
Monetary Policy and Economic Activity
The Effects of Monetary Policy on Real GDP and
the Price Level: An Initial Look
The Fed in
Crisis
The Fed Responds to the Terrorist
Attacks of September 11, 2001
The day after the terrorist attacks of
September 11, 2001, the Fed made
massive discount loans to banks and
succeeded in preventing a financial
panic. Alan Greenspan, pictured here,
was the chairman of the Fed at the time
of the attacks.
The Inflation and Deflation of the
Housing Market “Bubble”
Too Low for Zero: The Fed
Tries "Quantitative Easing”
• Buy long-term gov’t
bonds
• Buy Mortgage Backed
Securities
The Fed pushed interest
rates to very low levels
during 2008 and 2009.
Banks reduced their lending
Monetary Policy and Economic Activity
A Summary of How Monetary Policy Normally Works
BEST: Buy Ease Sell Tighten
Some Issues Regarding the Conduct of Monetary Policy
1. Should the Fed Target the Money Supply?
Rather than use an interest rate as its monetary policy target, the Fed
should target the money supply.
Economists who make this argument belong to the Monetarist School.
The leader of the monetarist school was Nobel laureate Milton Friedman.
Friedman and his followers favored replacing monetary policy with a
monetary growth rule.
Steady money growth  steady, predictable inflation
Steady money growth  automatic stabilizer.
Problem is, it’s hard to get the money supply where you want it.
The public’s changing split of its money holdings between currency
and demand deposits changes the money multiplier.
2. Why Doesn’t the Fed Target Both the Money Supply
and the Interest Rate?
The Fed Can’t Target
Both the Money Supply
and the Interest Rate
Monetary Policy and Economic Activity
3. Can the Fed Get Timing Right?
The Effect of a Poorly
Timed Monetary Policy
on the Economy
Friedman’s complaint about discretionary monetary policy:
“Too much too late”
4. Should the Fed adhere to a simple rule … or exercise discretion?
Taylor rule A rule developed by John Taylor -- a Stanford
professor and advisor to Presidents Bush -- that links the Fed’s
target for the federal funds rate to economic variables.
Federal funds target rate = Current inflation rate
+ Real equilibrium federal funds rate
+ (1/2) x Inflation gap
+ (1/2) x Output gap
According to Taylor rule, if inflation rises by one percentage point, the
Federal Funds rate should rise by 1 ½ percentage points.
The real federal funds rate then rises by ½ %, slowing inflation.
5. Should the Fed Target Inflation?
Inflation targeting Conducting monetary policy so as to commit the
central bank to achieving a publicly announced level of inflation.
6. Is the Independence of the
Federal Reserve a Good Idea?
The Case for Fed Independence
The More Independent the
Central Bank, the Lower the
Inflation Rate
Fed Policies During the
2007-2009 Recession
The Inflation and Deflation of the Housing Market “Bubble”
The Housing Bubble
Sales of new homes in
the United States went
on a roller-coaster ride,
rising by 60 percent
between January 2000
and July 2005, before
falling by 76 percent
between July 2005 and
January 2009.
The Wonderful
World of Leverage
During the housing boom, many people
purchased houses with down payments of 5
percent or less. In this sense, borrowers were
highly leveraged, which means that their
investment in their house was made mostly with
borrowed money.
RETURN ON YOUR INVESTMENT FROM . . .
DOWN PAYMENT
100%
Making a very small down
payment on a home mortgage
leaves a buyer vulnerable to
falling house prices.
A 10 PERCENT
INCREASE IN THE PRICE
OF YOUR HOUSE
A 10 PERCENT
DECREASE IN THE PRICE
OF YOUR HOUSE
10%
-10%
20
50
-50
10
100
-100
5
200
-200
Fed Policies During the 2007-2009 Recession
The Changing Mortgage Market
• By the 1990s, a large secondary market existed in mortgages, with funds flowing from
investors through Fannie Mae and Freddie Mac to banks and, ultimately, to
individuals and families borrowing money to buy houses.
• Major commercial and investment banks borrowed heavily to buy these mortgages
(and other loans), bundled them into Collateralized Debt Obligations (CDOs, one
flavor of which is Mortgage Backed Securities, MBSs), and sliced and diced these
securities into tranches of varying risk.
• They sold off these exotic financial products to insurance companies, pension funds,
and other investors but held on to a goodly amount of them themselves.
• By mid-2007, the decline in the value of mortgage-backed securities and the large
losses suffered by commercial and investment banks began to cause turmoil in the
financial system. Many investors refused to buy mortgage-backed securities, and
some investors would only buy bonds issued by the U.S. Treasury.
• But these large commercial banks and investment banks were TOO BIG TO FAIL
• The Fed and the U.S. Treasury (taxpayers) acted as lenders of last resort.
Fed Policies During the
2007-2009 Recession
The Fed and the Treasury Department Respond
Initial Fed and Treasury Actions
First, although the Fed traditionally made loans only to commercial banks, in March
2008 it announced the Primary Dealer Credit Facility, under which primary dealers—
firms that participate in regular open market transactions with the Fed—are eligible for
discount loans.
Second, also in March, the Fed announced the Term Securities Lending Facility, under
which the Fed will loan up to $200 billion of Treasury securities in exchange for
mortgage-backed securities.
Third, once again in March, the Fed and the Treasury helped JPMorgan Chase
acquire the investment bank Bear Stearns, which was on the edge of failing.
Finally, in early September, the Treasury moved to have the federal government take
control of Fannie Mae and Freddie Mac, two government sponsored enterprises
(GSEs) that held a lot of mortgages and securities that had fallen in value.
Fed Policies During the
2007-2009 Recession
The Fed and Treasury Department Respond
Responses to the Failure of Lehmann Brothers
• After the failure of Lehman Brothers, a major investment bank that many thought
was Too Big to Fail, panic gripped financial markets. The major players stopped
lending to each other ... There was a silent run on major financial institutions.
• In October 2008, Congress passed the Troubled Asset Relief Program (TARP),
under which the Treasury attempted to stabilize the commercial banking system
by providing funds to banks in exchange for stock. Taking partial ownership
positions in private commercial banks was an unprecedented action for the federal
government.
• The recession of 2007–2009, and the accompanying financial crisis, had led the
Fed and the Treasury to implement new approaches to policy. Many of these new
approaches were controversial because they involved partial government
ownership of financial firms, implicit guarantees to large (TBTF) financial firms that
they would not be allowed to go bankrupt, and unprecedented intervention in
financial markets.
Key Terms
Contractionary monetary policy
Expansionary monetary policy
Federal funds rate
Inflation targeting
Monetary policy
Taylor rule