14 MONETARY POLICY Part 2 The Conduct of Monetary Policy The Feds - PDF document

4/28/2019 14 MONETARY POLICY Part 2 The Conduct of Monetary Policy The Fed’s Decision -Making Strategy • The decision to change the target Federal Funds rate begins with an assessment of the current state of the economy. • Three key variables  Inflation gap - inflation rate compared to 2% target  Unemployment rate  Output gap – actual GDP compared to potential GDP. The Conduct of Monetary Policy Inflation Gap • If the inflation rate rises above the 2% target or expected to rise above target , the Fed increases the federal funds rate target. • If the inflation rate is below the target or expected to move below target , the Fed lowers the federal funds rate target. 1

4/28/2019 The Conduct of Monetary Policy Unemployment Rate • If the unemployment rate is below the natural unemployment rate… • a labor shortage might put pressure on wage rates to rise, which might feed into inflation. • The Fed will consider raising the federal funds rate. • If the unemployment rate is above the natural unemployment rate, lower inflation is expected. • The Fed will consider lowering the federal funds rate. Unemployment and Inflation – the Dual Mandate Fed Monetary Policy and The Phillips Curve Inflation Rate LRPC Fed wants to be at point F F 2% SRPC built-in expected inflation = 2% U n Unemployment Rate The Fed wants to be a full employment with inflation at target and expected to remain at target. 5 The Conduct of Monetary Policy Output Gap: actual GDP compared to potential GDP. • If the output gap is positive, have an inflationary gap and the inflation rate will most likely accelerate. • The Fed will consider raising the federal funds rate. • If the output gap is negative, have a recessionary gap and inflation might ease. • The Fed will consider lowering the federal funds rate. 2

4/28/2019 Monetary Policy Transmission The Fed lowers the federal funds rate when it buys securities in the open market. How does this affect real GDP growth and Inflation? Six step transmission mechanism: 1. The Federal Funds rate falls and other short-term interest rates fall because they are near substitutes. 2. The quantity of money and the supply of loanable funds increase. 3. The long-term real interest rate falls. Monetary Policy Transmission 4. Consumption expenditure, investment, and net exports (next chapter) increase. 5. Aggregate demand increases. 6. Real GDP growth and the inflation rate increase. • When the Fed raises the federal funds rate, it sells securities in an open market and the “ripple” effects go in the opposite direction. Monetary Policy Transmission Expansionary Policy Step 1 Steps 2 and 3 Steps 4 and 5 Step 6 Fed buys Money supply C, I , (X – IM) Real GDP and bonds, FFR and supply of P increase and AD increase falls, other ST loanable funds interest rates increase. Long- fall term interest rates fall • Steps 1 through 6 can stretch out over a period of between 12 and 24 months. • While there is a short implementation lag for monetary policy… • the response lag is long and variable 3

4/28/2019 Monetary Policy Transmission Contractionary Policy Step 1 Steps 2 and 3 Steps 4 and 5 Step 6 Fed sells Money supply C, I ,(X – IM) and Real GDP and bonds, FFR and supply of AD decrease P decrease increases, loanable funds other ST decrease. Long- interest rates term interest increase rates rise Steps 1 through 6 can stretch out over a period of between 12 and 24 months. Monetary Policy Transmission Interest Rate Changes Figure 14.5 shows the fluctuations in three interest rates:  The federal funds rate  The short-term Treasury bill rate  The long-term bond rate Monetary Policy Transmission Short-term rates move closely together and follow the federal funds rate. Why? Banks have a choice - lend excess reserves in Federal Funds market or buy short- term Treasury bills. Essentially perfect substitutes. Long-term rates move in the same direction as the federal funds rate but are only loosely connected to the federal funds rate. 4

4/28/2019 Monetary Policy Transmission Long-term Bond Interest rates • Two features to consider we looking at the graph of long-term bond interest rates: • Higher than short-term interest rates • Fluctuate less than short-term rates • Higher because long-term bonds are riskier. Investors require higher compensation. • Fluctuate less because long-term bond interest rates are an average of current and expected short-term bond interest rates . Monetary Policy Transmission Long-term Bond Interest rates • An alternative to investing long-term is to invest using a sequence of short-term bonds. • Suppose current 1-year interest rate on a 1-year bond is 3% and the 1-year interest rate next year is expected to be 4%. • The average return for 2 years is : 3%+4% = 3.5% 2 • The alternative is to buy a 2-year bond. The interest rate for the 2-year bond will be 3.5%. Monetary Policy Transmission Long-term Bond Interest rates • Here’s why: • If the interest rate on the 2-year bond was 4%, investors would buy the 2-year bond because: 3%+4% < 4.0% 2 • The long-term interest rate will fall to 3.5%. • Recall bond prices and interest rates move in opposite direction. 5

4/28/2019 Monetary Policy Transmission Long-term Bond Interest rates • If the interest rate on the 2-year bond was 3%, investors would sell the 2-year bond because: 3%+4% > 3.0% 2 • The long-term interest rate will rise to 3.5%. • The difference in returns is called “arbitrage” and will be eliminated by market forces. Monetary Policy Transmission Long-term Bond Interest rates • Now suppose current 1-year interest rate is 3% and the 1-year interest rate next year is expected to be 5%. • The interest rate on a 2-year bond will be: 3%+5% = 4%. 2 • The short-term interest rate changes by 1 percentage point (from 4% to 5%) and the long-term rate changes by ½ percentage point (from 3.5% to 4%). • The long-term interest rate fluctuates less because the long-term bond interest rate is an average of the current and expected short-term bond interest rates. Monetary Policy Transmission Money Supply and Bank Loans • When the Fed lowers the federal funds rate, the quantity of reserves in the banking system increases • the quantity of bank loans increase. • Long-term real interest rates fall. • Consumption and investment spending increase. 6

4/28/2019 Monetary Policy Transmission The Fed Fights Recession – Expansionary Policy If inflation is low and/or the output gap is negative, the FOMC lowers the target federal funds rate. Monetary Policy Transmission An increase in the monetary base increases the supply of money (chapter 8). The short-term interest rate falls. Monetary Policy Transmission The increase in reserves and the supply of money increases the supply of loanable funds. The real interest rate falls and investment increases. 7

4/28/2019 Monetary Policy Transmission The increase in investment increases aggregate planned expenditure. Real GDP increases to potential GDP. Monetary Policy Transmission The Fed Fights Inflation – Contractionary Policy If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target. Monetary Policy Transmission A decrease in the monetary base decreases the supply of money (chapter 8). The short-term interest rate rises. 8

4/28/2019 Monetary Policy Transmission The decrease in reserves and the supply of money decreases the supply of loanable funds. The real interest rate rises and investment decreases. Monetary Policy Transmission The decrease in investment decreases aggregate planned expenditure. Real GDP decreases and closes the inflationary gap. Monetary Policy Transmission Loose Links and Long and Variable Lags • The link between the federal funds rate and the Fed’s policy goals is very loose and the time lags are “long and variable”. • This is why monetarist say stay out of the policy business and just have the money supply grow at a fixed rate of growth. • The Fed can control short-term interest rates, but not long-term rates. The long-term interest rate is market determined and at best loosely linked to the federal funds rate. 9

4/28/2019 Monetary Policy Transmission Loose Links and Long and Variable Lags • The response of real long-term interest rates is what counts. That response depends on inflationary expectation. • real rate = nominal rate - inflation expectations. • If prices do not change much in the SR and inflation is relatively fixed, changes in the nominal rate translate into changes in the real rate. • real rate = nominal rate - inflation expectations. Monetary Policy Transmission Loose Links and Long and Variable Lags • The response of expenditure plans of business firms and households to changes in the real interest rate depends on many factors that make the response hard to predict. • Need to know if spending plans are sensitive to changes in real interest rates. If not, monetary policy is not effective. • The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way. Monetary Policy Transmission Loose Links and Long and Variable Lags • Most studies show it takes about 1 year for real GDP to respond to changes in the Federal Funds. • It takes an additional year for prices(inflation) to respond to changes in real GDP. 10