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Chapter 15: Monetary Policy
 Objectives of U.S. monetary policy and the framework for
setting and achieving them
 Federal Reserve interest rate policy
 Channels through which the Federal Reserve influences
the inflation rate
 Alternative monetary policy strategies
Monetary Policy Objectives and Framework
Federal Reserve Act of 1913 states:
The Fed and the FOMC shall maintain long-term
growth of the monetary and credit aggregates
commensurate with the economy’s long-run potential
to increase production, so as to promote effectively
the goals of maximum employment, stable prices, and
moderate long-term interest rates.
Equation of exchange:
%P  %M  %V  %RGDP
Monetary Policy Objectives and Framework
Goals of Monetary Policy
Maximum employment, stable prices, and moderate
long-term interest rates
In the long run, these goals are in harmony and reinforce
each other, but in the short run, they might be in conflict.
• increasing employment in short term may create inflation and
higher long term interest rates in long term.
Price stability is essential for maximum employment and
moderate long-term interest rates.
Monetary Policy Objectives and Framework
“Stables Prices” Goal
• Fed pays close attention to the CPI excluding fuel and
food—the core CPI.
• The rate of increase in the core CPI is the core
inflation rate.
• Core inflation rate provides a better measure of the
underlying inflation trend and a better prediction of future
CPI inflation.
Monetary Policy Objectives and Framework
“Maximum Employment” Goal
Price stabilization is the primary goal but the Fed pays
attention to the business cycle.
To gauge the overall state of the economy, the Fed uses
the output gap—the percentage deviation of real GDP from
potential GDP.
A positive output gap indicates inflationary pressures.
A negative output gap indicates unemployment above
the natural rate.
The Fed tries to minimize the output gap
• Reduce interest rates if there is a negative output gap
• Raise interest rates if there is a positive output gap
The Conduct of Monetary Policy
Choosing a Policy Instrument
The monetary policy instrument is a variable that the Fed
can directly control or closely target.
Possible targets:
• monetary growth rate (base, M1, M2)
• interest rates (federal funds rate, long term bonds, etc.)
• exchange rate
• inflation rate
• unemployment rate
• Difficult to target more than one variable.
The Conduct of Monetary Policy
The Federal Funds Rate
Currently, the Fed’s choice of policy instrument is a
short-term interest rate (federal funds rate).
Given this choice, the exchange rate and the quantity of
money find their own equilibrium values.
Fed funds rate rises during expansions and is
cut during recessions.
To adjust FFR, Fed tends to increase growth of monetary
base during recessions.
How does Fed Decide on Fed Funds Rate?
The Fed could adopt either
 An instrument rule
• Set the policy instrument (e.g. FFR) at a level based on the current
state of the economy.
• Taylor rule (later) is an instrument rule.
 A targeting rule
•set the policy instrument (e.g. fed funds rate) at a level that makes
the forecast of the ultimate policy target equal to the target.
•e.g. if policy goal is 2% inflation and the instrument is the federal
funds rate, then targeting rule sets FFR so the forecast of the
inflation rate equal to 2%.
• requires large amounts of information to forecast inflation and
effect of Fed Funds rate and other economic variables on inflation.
The Conduct of Monetary Policy
Taylor rule (Stanford economist John Taylor)
• set federal funds rate (FFR) at equilibrium real interest rate (which
Taylor says is 2 percent a year) plus amounts based on the inflation
rate (INF) and the output gap (GAP) according to the following
formula (all values are in percentages):
FFR = 2 + INF + 0.5(INF – 2) + 0.5GAP
FFR will increase if inflation rises or GDP-gap rises
According to Taylor’s rule, if inflation
increases by 2% and the output gap is
unchanged, the Fed should
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Currently, the output gap is estimated at -8% of
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The Conduct of Monetary Policy
FOMC minutes suggest that the Fed follows a targeting
rule strategy.
Some economists think that the interest rate settings
decided by FOMC are well described by the Taylor Rule.
The Fed believes that because it uses much more
information than just the current inflation rate and the
output gap, it is able to set the overnight rate more
intelligently than any simple rule can set.
The Conduct of Monetary Policy
The Fed hits the Federal Funds Rate Target using Open
Market Operations
When the Fed buys securities, it pays for them with
newly created reserves held by the banks.
When the Fed sells securities, they are paid for with
reserves held by banks.
Open market operations influence banks’ reserves, the
supply of loans, and interest rates.
•Short term rates track FFR more closely than long term rates.
•Fed has greater control over short term rates than long term rates.
Monetary Policy Transmission
When the Fed lowers the federal funds rate:
1. Other short-term interest rates and the exchange rate fall.
2. The quantity of money and the supply of loanable funds
increase.
3. The long-term interest rate falls.
4. Consumption expenditure, investment, and net exports
increase.
5. AD increases.
6. Real GDP growth and the inflation rate increase.
When the Fed raises the federal funds rate, the ripple effects
go in the opposite direction.
Monetary Policy Transmission
Exchange Rate Fluctuations
The exchange rate responds to changes in the interest rate
in the United States relative to the interest rates in other
countries—the U.S. interest rate differential.
If U.S. interest rates fall relative to rest of world,
•Demand for dollar decreases
• Supply of dollar increases
• P of $ drops (cheaper dollar)
–exports increase, imports decrease
–AD rises
Other factors are also at work (e.g. inflation expectations)
which make the exchange rate hard to predict.
Monetary Policy Transmission
Loose Links and Long and Variable Lags
Long-term interest rates that influence spending plans
are linked loosely to the federal funds rate.
The response of the real long-term interest rate to a
change in the nominal rate depends on how inflation
expectations change.
The response of expenditure plans to changes in the
real interest rate depends on many factors that make the
response hard to predict.
The monetary policy transmission process is long and
drawn out and doesn’t always respond in the same way
• can be like “pushing on a string” during recessions.