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Chapter 18. Monetary Policy • The market for reserves • Open market operations • Discount lending • Reserve requirements • Goals of monetary policy • Using targets The Market for Reserves • interbank lending market • federal funds rate (FF rate) FOMC impacts this market which impacts other debt markets & economy The Fed and the FF rate • open market operations • • shift the supply of reserves discount loans setting discount rate affects bank borrowing and supply of reserves reserve requirement affects demand for reserves Open Market Operations (OMO) • buying & selling Treasuries • • large & liquid market open market purchase increase supply of reserves decrease FF rate OMO are the Fed’s main policy tool • FOMC votes on OMO • votes on FF rate target FR actually buys and sells Treasuries to achieve the FF rate target advantages of OMO • • • • Fed has complete control OMO are flexible buy/sell a little or a lot OMO are easily reversible sell too much? then buy some back OMO quickly impact reserves, FF rate Discount Lending • each c bank has a discount window • set discount rate set discount policy lower discount rate increase borrowing, reserves decrease FF rate • why do banks get discount loans? • short-term liquidity problem serious problems seasonal reserve fluctuations but should not ask for help too often discount rate is 50-100 bp. ABOVE the FF rate Discount loans & monetary policy • discount loans not a good tool • not completely under Fed control • • banks decide to borrow can give misleading signals if done for non-policy reasons not easily reversible cannot change rates on old loans Reserve requirement • set by the Board of Governors • higher requirement • increase demand for reserves increase FF rate today (since 1992) 3% on checking up to $44.3 million 10% above $44.3 million • reserve requirement is very powerful tool too powerful not good for small adjustments expensive to change Goals of Monetary policy • desirable goals for the economy • Fed uses monetary policy to achieve these goals directly control tools, to influence goals High employment • i.e., low unemployment • federal government has a • commitment to full employment goal: natural rate of unemployment about 4-5% today: 4.7% Economic Growth • annual % change in real GDP • U.S. long run average -- 3% • 2006 real GDP growth 1.5% Price 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 Oct 2007: about 3.5% Financial Market Stability • stability of financial institutions • stability of interest rates • stability of exchange rates • Fed stabilized markets October 1987 Summer 1998 September 2001 Using targets • Fed directly controls tools (like • OMO), not goals it can take a year for tools to impact the goals how to measure progress in between? Targets • related to tools and goals • used by Fed to judge if they are on track tool (OMO) operating instrument intermediate target goal operating instrument • respond immediately to changes in • the tools examples bank reserves FF rate Tbill rate intermediate targets • affected by operating target • closely associated with goals • examples M1or M2 Tnote yields effective instruments • observable by everyone • controllable and quickly changeable • by the Fed predictably related to goals 2 types of targets/instruments • monetary targets • reserves, MB M1 or M2 interest rate targets FF rate other short or medium-term rates target tradeoff • Fed can target money supply OR • • interest rates NOT BOTH! why? • suppose Fed targets M* for MS: i MS i’’ MD’’ M M* • but as MD fluctuates, i will change: i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • so if target M*, lose control of i i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • suppose Fed targets i* i MS i* MD’’ M’’ M • but as MD fluctuates, Fed must shift MS to maintain i* i MS’ MS i* MS’’’ MD’’’ MD’’ M’ M’’ MD’ M’’’ M • Fed targets i*, lose control of M i MS’ MS i* MS’’’ MD’’’ MD’’ M’ M’’ MD’ M’’’ M Targets • If Fed targets MS, loses control of • interest rates If Fed targets interest rates, loses control of MS The Taylor Rule • How to choose the FF rate target? • Base target on Current inflation Target inflation Current real GDP Potential real GDP • FF rate target = • 2.5 + current inflation + (1/2)(current-target inflation) + (1/2)(current - potential GDP) A guideline for the Fed