Monetary Policy RulesRole of the fed funds rate termTaylor Rule: ExampleInflation TargetingMonetary Policy RulesTypes of RulesWhat can Monetary Policy do?What can Monetary Policy do?What can Monetary Policy do?Money NeutralityWhat is good Monetary Policy?FOMCOpen Market OperationsExpectations and PolicyExpectations and RulesFriedman RuleFriedman RuleInterest Rate RulesTaylor RuleMonetary Policy RulesMonetary Policy RulesGraduate Macroeconomics IECON 309S. Cunningham2Role of the fed funds rate termRole of the fed funds rate termz Taylor argued that the behavior of the federal funds rate incorporated in his rule is a reasonable approximation to the actual process of adjustment of the funds rate targets the FOMC used between 1987 and 1993—a period during which monetary that generates the operating instructions in the Fed’s current practice.3Taylor Rule: ExampleTaylor Rule: Examplefunds rate(t) = GDP price inflation(t)+ 2.0 + 0.5 × (GDP price inflation(t) - 2.0)+ 0.5 × (output gap(t))4Inflation TargetingInflation Targetingz Another approach to monetary policy, known as inflation targeting, has been instituted by the central banks in several foreign countries.z Its application varies from country to country, started with the Reserve Bank of New Zealand, and has been adopted by the Bank of Canada, the Bank of England, the Bank of Finland, the Swedish Riksbank, and the Reserve Bank of Australia. z These central banks announce in advance their policy objective for an inflation rate. z In none of these cases has the central bank specified the decision rule that it will use to achieve the stated objective.5Monetary Policy RulesMonetary Policy Rulesz A rule can be defined as “nothing more than a systematic decision process that uses information in a consistent and predictable way.”z Poole’s purpose is to examine what we mean by a monetary policy rule followed by a central bank, and to examine what we know about the construction, or design, of the rule.6Types of RulesTypes of Rulesz Rules that govern our interaction with the environment.z Rules that govern our interaction with others.z A third type of rule involves the formulation of policy decisions.– Here, a systematic decision-making process is complicated because individuals and market participants observe or infer the actions of the policymakers and adjust their behavior in ways that work to their benefit, given their understanding of the policy regime. – This is the type of problem faced by monetary policy decision-makers.– Monetary policy is more like poker than like solitaire.7What can Monetary Policy do?What can Monetary Policy do?z There is now a consensus among economists and central bankers that the only long-run effect a monetary authority can have on an economy is to determine the sustained, or trend, rate of inflation. z That rate will result from the rate at which the monetary authority injects money into the economy.8What can Monetary Policy do?What can Monetary Policy do?z The idea—that the general price level and its rate of increase depends primarily on the level of the money stock and its rate of increase—fell out of favor with the rise of Keynesian analysis in the 1930s and 1940s. – The idea was revived in the 1950s by Milton Friedman, who has lived to win the intellectual battle that sustained inflation is everywhere and always will be a monetary phenomenon.– Therefore one role of monetary policy is price stability.9What can Monetary Policy do?What can Monetary Policy do?z A consensus also exists that erratic monetary policy has sometimes produced instabilities in the economy.– Most analysts now agree that Federal Reserve actions contributed significantly to the severity of the Great Depression in the United States.– Monetary policies can make the economy either more or less stable.z It is also generally accepted that central banks are responsible for acting as a lender of last resort in the event of a generalized liquidity crisis to maintain the soundness and function of the payments mechanism.10Money NeutralityMoney Neutralityz A considerable amount of professional opinion, the general popular feeling, and financial-market commentary hold that monetary policy actions initially affect output, unemployment, and real interest rates, even though the long-run impact on these real variables is nil.z Research efforts to quantify these initial effects, however, have failed to provide precise measures of the impact, and at least one school of thought maintains that such short-run effects are negligible.11What is good Monetary Policy?What is good Monetary Policy?z There is a compelling case, I believe, that the success or failure of monetary policy must be judged first and foremost by whether a central bank is able to achieve a low-inflation environment on a sustained basis. z That environment is, in turn, conducive to maximum growth and efficient utilization of the resources available to a society. z High growth and efficient utilization of resources depend on government policies beyond the central bank’s control.z Moreover, a central bank’s contribution should be judged primarily by the average rate of inflation, and secondarily by the stability, or lack thereof, of the overall economy.12FOMCFOMCz Monetary policy decisions are the responsibility of the Federal Open Market Committee (FOMC).– The FOMC consists of the seven governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and four of the presidents of the remaining 11 regional Federal Reserve Banks, on a rotating basis.– This committee meets eight times a year, to discuss the current state of the economy and the prospects for near-term developments.– The committee then votes on instructions—the Directive to the System Open Market Account Manager—that specify a target value for the federal funds interest rate. – The federal funds rate is the rate at which depository institutions borrow and lend to each other their reserves.13Open Market OperationsOpen Market Operationsz Once these instructions have been approved, it is the responsibility of the staff of the Open Market Desk at the Federal Reserve Bank of New York, in consultation with the Chairman and members of the Open Market Committee, to keep the actual funds rate close to the intended rate. z The Desk proceeds by buying and selling U.S. government securities for the Federal Reserve’s account, or by engaging in transactions that