Download Monetary Policy: Goals and Targets

Monetary Policy
Monetary policy can be categorized by four characteristics
Goals
Intermediate
Targets
Monetary
Policy
Discretion
Instruments
Instruments refer to the policy options the
Fed has to control the supply of money…
Discount Window Loans
Open Market Operations
By purchasing or selling
US Treasuries, the Fed can
alter the supply of bank
reserves (MB)
The Fed can also influence
reserves by altering the
interest rate charged on
loans to commercial
banks. (MB)
Reserve Requirements
This is the most
often used
instrument!
Reserve Requirements
influence the ability of
banks to create new loans
which affects the broader
aggregates (M1,M2,M3)
Monetary Policy goals address the central bank’s
agenda in general terms
The Bank of England Follows an explicit Inflation Target.
Specifically, the goal is to maintain 2% annual inflation.
The Bank of China appears to have export driven growth
as their primary objective
The ECB (European Central Bank) and the Federal
Reserve follow policies of stable prices and
maintenance of full employment
Intermediate Targets address the question: “How will I meet my
goals?”. Targets are variables that the central bank can more directly
control.
Goals vs. Targets
For Tiger Woods, the
goal is to win the golf
tournament
The target is to score
18 under par (the
number he thinks he
needs to win)
The Bank of China is currently targeting the exchange rate
at 8.28 Yuan per dollar
The Federal Reserve is currently targeting the Federal
Funds Rate at 2.75%
The Bank of England is currently targeting the repo rate at
4.75%
Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
Suppose that the Federal Government could
influence the supply of oranges and wanted to
regulate the orange market
Price
Lowering the price to
$4 (price target) and
Raising the quantity to
1,500 (quantity target)
are both describing the
same policy
(expanding the orange
market)
Supply
$5/Lb
$4/Lb
Demand
1,000 1,500
Quantity of
Oranges
Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
However, your response to demand changes
will differ across policies
Price
If demand for oranges
increases and the Fed
is following a price
target, they must
respond by increasing
supply
Supply
Target
Range
$5/Lb
Demand
Quantity of
Oranges
Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
However, your response to demand changes
will differ across policies
Target
Range
Price
Supply
If demand for oranges
increases and the Fed
is following a quantity
target, they must
respond by decreasing
supply
Demand
1000Lbs
Quantity of
Oranges
Suppose that the Fed wants to lower its
target to 4% (expansionary monetary policy)
M2 Multiplier = 8
Interest Rate (i)
M2 = mm(MB)
A $250 purchase of
Treasuries would be
required
2,000
= $250
8
5%
4%
Md(y,t)
M
P
Change in M2 = $2,000
Suppose that the Fed is Targeting the
Interest Rate at 5%
M2 Multiplier = 8
Interest Rate (i)
Suppose an increase in
GDP raises Money
Demand
M2 = mm(MB)
The Fed needs to
increase the
monetary base by
5%
Md(y,t)
M
P
Change in M2 = $1,000
1,000
= $125
8
(An Open Market
Purchase of
Treasuries)
During the late 70’s, the federal reserve changed its policy
from an interest rate target to a money target. The money
target was abandoned in the mid eighties.
25
20
Fed Funds
Discount
Prime
15
10
5
Jan-84
Jan-82
Jan-80
Jan-78
Jan-76
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Jan-72
Jan-70
0
Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular course of
action?
The Chinese have pre-committed to maintaining a
fixed exchange rate while the British have precommitted to a fixed inflation rate.
The ECB (European Central Bank) and the Federal
Reserve both follow discretionary policies (i.e.
policy is decided at the FOMC meeting)
Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular course of
action?
Benefits of Rules
A states monetary
policy rule is easy
top forecast (i.e. it
has less
uncertainty)
Costs of Rules
A fixed policy rule
allows the
possibility of
speculative attacks
(i.e. exploiting the
monetary policy
rule for profit)
For most of its history, the US has followed
a gold standard
US Treasury
A Gold Standard has two rules:
The government sets an
official price of gold ($35/oz)
The government guarantees
convertibility of currency into
gold at a fixed price
Assets
200 oz. Gold
@ $35/oz
Liabilities
$10,000 (Currency)
$7,000 (Gold)
$3,000 (T-Bills)
Reserve Ratio = 70%
Value of Gold Reserves
Reserve Ratio = Currency Outstanding
=
$7,000
$10,000
During most of the gold standard era, the Government had a reserve
ratio of around 12%
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
US Treasury (P = $35%)
Assets
200 oz. Gold
@ $35/oz
Liabilities
Price
Supply
$10,000 (Currency)
$7,000 (Gold)
$35
$3,000 (T-Bills)
100 oz. Gold
@ $35/oz
$3,500 (Currency)
Reserve Ratio = 70%
Suppose that the Treasury purchased gold to increase the supply of
currency outstanding (i.e. increase the money supply)
Demand
Q
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
US Treasury (P = $35%)
Assets
200 oz. Gold
@ $35/oz
Liabilities
Price
Supply
$10,000 (Currency)
$7,000 (Gold)
$35
$3,000 (T-Bills)
Demand
Reserve Ratio = 70%
As the market price rises above $35 (due to increased demand),
households start buying gold from the Treasure @ $35.oz and sell it in
the open market. This reverses the original transaction
Q
The gold standard and prices:
Recall that in the long run, the price level
is directly proportional to the ratio of
money to output:
$35(Gold Reserves)
M=
Reserve Ratio
s
M
 k (i, t ) y
P
With a (relatively) fixed supply of money, prices remained stable in the
long run
The gold standard and the supply of gold:
US Treasury (P = $35%)
Assets
200 oz. Gold
@ $35/oz
Liabilities
Price
Supply
$10,000 (Currency)
$7,000 (Gold)
$35
$3,000 (T-Bills)
100 oz. Gold
@ $35/oz
$3,500 (Currency)
Demand
Reserve Ratio = 70%
From time to time, new gold deposits were discovered. This increased
supply would push down the market price. In response, households
would buy the cheap gold and sell it to the Treasury for $35. This would
increase the money supply.
Q
The gold standard and the business cycle:
US Treasury (P = $35%)
Assets
200 oz. Gold
@ $35/oz
Liabilities
Price
Supply
$10,000 (Currency)
$7,000 (Gold)
$35
$3,000 (T-Bills)
(-) Gold
(-) Currency
Demand
Reserve Ratio = 70%
Typically, during recessions, the price of gold would rise (flight to
quality). High gold prices would cause households to buy gold from
the Treasury to sell in the market. This would force the treasury to lose
reserves and contract the money supply.
Q
Gold Standard: Long Run vs. Short Run
Long Run: By restricting the long run supply
of money, the gold standard produced
constant, low average rates of inflation
(bankers are happy)
Short Run: By forcing monetary policy to be
subject to fluctuating gold prices, the gold
standard exacerbated the business cycle
(farmers are unhappy)
Currently, the Fed follows an interest rate target.
The target interest rate (Fed Funds Rate) is
adjusted according to a ‘Taylor Rule”
FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation – 2%)
1% Cyclical Unemployment = 2.5% Output Gap
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)
Currently, the Fed follows an interest rate target. The
target interest rate (Fed Funds Rate) is adjusted
according to a ‘Taylor Rule”
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)
Long Run: When the economy is at full employment ( Unemployment = 5%)
and inflation is at its long run target (2%), the Fed targets the Fed Funds
Rate (Nominal) at
FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4%
Short Run: During recessions (when inflation is low and unemployment is
high), the Fed lowers its target. During expansions, when inflation is high
and unemployment is low), the Fed raises its target.
Case study: Productivity Growth during the
late 90’s
i
i
S
Ms
4%
4%
I + (G-T)
Md
M
P
Loanable
Funds
During the late 90’s, rapid income growth and productivity raised
consumer spending (savings falls) and raised investment spending.
Higher spending raised the demand for money. As unemployment
dropped to 4.5% (above capacity), prices began to rise.
Case study: Productivity Growth during the
late 90’s
i
i
S
Ms
4%
4%
I + (G-T)
Md
M
P
Loanable
Funds
The Fed responded by raising interest rates (contracting the money
supply). The Fed was able to “slow down” the economy before
inflation became a problem.
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6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
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May-99
Late 90’s Expansion
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May-94
Jan-94
End of 1992 Recession
Asian Financial Crisis
Stock Market Bubble
Fed Funds
Discount
Case study: Stock Market Crash and
Liquidity Shocks
i
i
S
Ms
4%
4%
I + (G-T)
Md
M
P
Loanable
Funds
After the market crash, demand (primarily investment) slowed down
and interest rates started falling. Further, the economy was operating
well below capacity (Unemployment hit 6%) and inflation was hovering
around zero.
Case study: Stock Market Crash and
Liquidity Shocks
i
i
S
Ms
4%
4%
I + (G-T)
Md
M
P
Loanable
Funds
Lowering the Fed funds target allowed the fed to increase the money
supply and stimulate spending.
Stock Market Crash
Beginning of Recovery?
Recession of 2001
7
6
5
4
Fed Funds
Discount Rate
3
2
1
Oct-02
Jul-02
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Jan-02
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