Download Reserve requirements are the amount of funds that a depository

Introduction
What is Monetary Policy
The term "monetary policy" refers to the actions undertaken by a central bank,
such as the Federal Reserve, to influence the availability and cost of money and
credit to help promote national economic goals. The Federal Reserve Act of 1913
gave the Federal Reserve responsibility for setting monetary policy for the
country.
Monetary Policy Goals (Single or Dual)
 Maintain price stability
 Maintain full employment growth
U.S. is in the dual group, New Zealand is in the single group, for example.
Current Consensus
 Low, stable inflation is important for market-driven growth
 Monetary policy is the most direct determinant of inflation
 Monetary policy is the most flexible instrument for achieving median term
stabilization objectives.
Tools
The Federal Reserve controls the three tools of monetary policy—
 Open market operations,
 The discount rate
 Reserve requirements.
The Board of Governors of the Federal Reserve System is responsible for the
discount rate and reserve requirements, and the Federal Open Market
Committee is responsible for open market operations. Using the three tools, the
Federal Reserve influences the demand for, and supply of, balances that
depository institutions hold at Federal Reserve Banks and in this way alters the
federal funds rate. The federal funds rate is the interest rate at which depository
institutions lend balances at the Federal Reserve to other depository institutions
overnight.
Changes in the federal funds rate trigger a chain of events that affect other shortterm interest rates, foreign exchange rates, long-term interest rates, the amount
of money and credit, and, ultimately, a range of economic variables, including
employment, output, and prices of goods and services.
Open Market Operations
Open market operations--purchases and sales of U.S. Treasury and federal
agency securities--are the Federal Reserve's principal tool for implementing
monetary policy. The short-term objective for open market operations is specified
by the Federal Open Market Committee (FOMC). This objective can be a desired
quantity of reserves or a desired price (the federal funds rate). The federal funds
rate is the interest rate at which depository institutions lend balances at the
Federal Reserve to other depository institutions overnight.
The Discount Rate
The discount rate is the interest rate charged to commercial banks and other
depository institutions on loans they receive from their regional Federal Reserve
Bank's lending facility--the discount window. The Federal Reserve Banks offer
three discount window programs to depository institutions: primary credit,
secondary credit, and seasonal credit, each with its own interest rate. All discount
window loans are fully secured.
Reserve Requirements
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
Reserve requirements are the amount of funds that a depository institution must
hold in reserve against specified deposit liabilities. Within limits specified by law,
the Board of Governors has sole authority over changes in reserve requirements.
Depository institutions must hold reserves in the form of vault cash or deposits
with Federal Reserve Banks.
Limitations of Monetary Policy
 “Activist” monetary policy in 70’s, i.e., trying to maintain output and
unemployment close to their “full employment” level, failed.
 Policy impact with a lag
 There is no long-term trade-off between inflation and unemployment
(benefits associated with expansionary policy are transitory, while costs
related are permanent)
Rule-based Monetary Policy

Why rule-based: Credibility Issue.
Example: Taylor’s Rule
yt  yt*
rt   t  rt  0.5*( t   )  0.5*[(
)*100]
yt*
*
*
t
Where rt is the Fed Fund rate, rt* is the real rate,  t is inflation,  t* is the targeted
inflation, yt is the output, and yt* is the potential output.
Taylor’s Rule: Federal Funds Rate
30
Federal Funds Rate
rT 
Federal Funds Taylor's Rule Target
t 
25
gt 
20
Rt 
 
g 
 t  Rt  1 ( t   T )  0.5 ( gt  gT )
 t  3   t  2   t  1   t   t 1
5
gt  3  gt  2  gt 1  gt  gt 1
5
real federal funds rate
inflation
real GDP growth
15
10
5
0
1966Q4 1971Q4 1976Q4 1981Q4 1986Q4 1991Q4 1996Q4 2001Q4 2006Q4 2011Q4
-5
Three variables are unobserved: rt* ,  t* , and yt* . For the real rate, we usually take
the ex post difference between nominal rate and inflation. However, for  t* and
yt* we need to estimate.
Estimate  t*
What is the target? Is it around 1.5%?
The problem here is that if people take an average over a long period time, it
may not fit the most recent period that well. In that case, the Fed would follow an
easing or tightening monetary policy than that it would otherwise be.
We may be able to figure it out by using the basic concept so-called NAIRU
(Non-Accelerate-Inflation-Rate-of-Unemployment), based on the following
relationship, to figure it out.
Inflation = f(lagged inflation, lagged unemployment, change of productivity,
shocks)
Estimation (CBO’s)
CPIt  2.87  lag (CPI )  0.77(runempt )  0.43*(CPIft 1 )  0.06( prodt )  1.84(Wage _ dummy)
R 2  0.77
Where lag (CPI ) is polynomial-distributed-lags; runempt is unemployment rate;
CPIft 1 is lagged food and energy prices change; and prodt is productivity
deviations.
People now can solve the equation for runempt by keeping CPI t constant.
Unemployment Rate vs. NAIRU
12
10
8
6
4
2
0
1949Q1
1958Q1
1967Q1
1976Q1
1985Q1
1994Q1
2003Q1
Source: Economy.com, CBO.
If we think the NAIRU is around 5%, then we derived the inflation associated with
it.
Estimate yt*
Importance of yt* : Benchmark of the economy’s performance at the optimal level.
Starting from the production function
y  f ( L, K , TFP )
Total Factor Productivity is the residuals.
If people can smooth the individual components, they might be able to get the
output level net of the cyclical component.
How to estimate the potential output:
HP Filter (NOT)
Reasons: Data generating process
Potential output, but trend output.
Regression (CBO’s method): (related to Okun’s law)
log( L)   *(ut  ut* )  f (T1953 , T1957 , T1960 , T1969 , T1973 , T1980 , T1990 , T2001 )
Here Tyear is a trend variable whose trend value starting at the beginning of a
business cycle, while (ut  ut* ) is the difference between the actual unemployment
rate and NAIRU.
Other components follow the same model.
SAS Example.
Real GDP vs. Potential GDP
12000
10000
Real GDP
$ billions chained
Potential Real GDP
8000
6000
4000
2000
0
1949Q1
1955Q1
1961Q1
1967Q1
1973Q1
Source: Moody’s Economy.com; DOB staff estimates.
1979Q1
1985Q1
1991Q1
1997Q1
2003Q1
CBO’s Real Potential and Actual GDP vs. NAIRU and Actual Unemployment Rate
10000
8000
6000
4000
2000
0
10
8
6
4
2
1949Q1 1953Q1 1957Q1 1961Q1 1965Q1 1969Q1 1973Q1 1977Q1 1981Q1 1985Q1 1989Q1 1993Q1 1997Q1 2001Q1
Uncertainty of Monetary Policy
Monetary Policy tends to lagged economic impacts, which create uncertainties in
terms of timing of the policy affects. For example, while a central bank tries to
stimulate an economy by cutting interest rates, it has to anticipate what will
happen in the near term.
Any forecast involves risks. Bank of England has a very famous way to evaluate
the forecast risk: red fan chart for inflation, and lately, green river fan chart for
output. (See Presentation).
DOB’s example.
Monte Carlo simulation => mean and variance, plus the forecast errors in history
=> Fan Chart
Forecast Uncertainties
Summary
Taylor’s Rule
NAIRU
Potential Output
Monte Carlo Simulation and Fan Chart