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

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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.

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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

5

Inflation Rate Unemployment Rate Un 2% SRPCbuilt-in expected inflation

= 2%

F LRPC

Fed wants to be at point F

The Fed wants to be a full employment with inflation at target and expected to remain at target.

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.

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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 Fed buys bonds, FFR falls, other ST interest rates fall Steps 2 and 3 Money supply and supply of loanable funds

• increase. Long-

term interest rates fall Steps 4 and 5 C, I , (X – IM) and AD increase Step 6 Real GDP and P increase

• 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

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Monetary Policy Transmission Contractionary Policy

Step 1 Fed sells bonds, FFR increases,

• ther ST

interest rates increase Steps 2 and 3 Money supply and supply of loanable funds

• decrease. Long-

term interest rates rise Steps 4 and 5 C, I ,(X – IM) and AD decrease Step 6 Real GDP and P decrease

Steps 1 through 6 can stretch out over a period of between 12 and 24 months.

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.

Monetary Policy Transmission

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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%

2

= 3.5%

• 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%

2

< 4.0%

• The long-term interest rate will fall to 3.5%.
• Recall bond prices and interest rates move in
• pposite direction.

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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%

2

> 3.0%

• 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% 2

= 4%.

• 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.

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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.

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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.

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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.

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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.

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Monetary Policy Transmission Expansionary Policy – one more time!

Step 1 Fed Reserve buys bonds Steps 2 and 3 Money supply increases and interest rates fall (short-term and long-term) Steps 4 and 5 C, I and (X – IM) increase Step 6 Real GDP and P increase Policy makers need to know how sensitive long- term real interest rates are to changes in short- term interest rates. Need to know how sensitive spending is to changes in long-term real interest rates. Need to know multiplier.

Monetary Policy Transmission Contractionary Policy – one more time!

Step 1 Fed Reserve sells bonds Steps 2 and 3 Money supply decreases and interest rates rise Steps 4 and 5 C, I and (X – IM) decrease Step 6 Real GDP and P decrease Policy makers need to know the same stuff

Money, GDP and the Price Level

Also, what happens to real GDP and the price level depends on the slope of the aggregate supply curve

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Output and Inflationary Effects of Expansionary Monetary Policy

39

Price Level Real GDP 6,400 6,000 SRAS AD0 100 E 103 AD1 B 113 AD2 AD3 If AS is flat, lot of impact on real GDP with little impact on P. If AS is steep, lot

• f impact on P

with little impact

• n real GDP.

Extraordinary Monetary Policy

During the financial crisis and recession of 2008-2009, the Fed lowered the federal funds rate to zero – the zero lower bound. What can the Fed do to stimulate the economy when it cannot lower the federal funds rate? The Key Elements of the Crisis The three main events that put banks under stress were:

• 1. Widespread fall in asset prices
• 2. A significant currency drain
• 3. A run on the bank

Extraordinary Monetary Stimulus

The Policy Actions

• 1. Massive open market operations were used to

increase bank reserves.

• 2. Deposit insurance was expanded from $100,000 to

$250,00.

• 3. The Fed bought mortgages assets from banks.
• 4. The Fed increased loans to banks and also investment

banks. These actions provided banks with more reserves, more secure depositors, and safe liquid assets in place of troubled assets.

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Policy Rules and Clarity

Two approaches to monetary policy that countries have used are

• Inflation rate targeting
• Taylor rule

Inflation Rate Targeting

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment:

• 1. To achieve an explicit inflation target – usually 2%.
• 2. To explain how its policy actions will achieve that target

Approximately 28 central banks practice inflation targeting and have done so since the mid-1990s. The central bank’s primary focus is inflation. This policy framework is very different from the Fed’s dual mandate of low stable price and maximum growth.

Taylor Rule

John Taylor at Stanford The Taylor rule is a formula for setting the interest rate. FFR = 2% + INF + 0.5(INF – 2%) + 0.5(output gap) (inflation gap) By using a rule to set the interest rate, monetary policy reduces uncertainty. With less uncertainty, financial markets, labor markets, and goods markets work better as traders are more willing to make long-term commitments.

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Taylor Rule

How it works (keep in mind the current FFR is 1.0%)

Suppose INF = 2% and the output gap = 0 FFR = 2% + INF + 0.5(INF – 2%) + 0.5(output gap) FFR = 2% + 2% +0.5(0) +0.5(0) FFR = 4% INF is currently 1.6% and the output cap is about -2% FFR = 2% + 1.6% +0.5(-0.4) +0.5(-2) FFR = 2.4% In 2008: INF = 0 and the output gap was about -6% FFR = 2% + 0% +0.5(-2%) +0.5(-6) FFR = -2%