Chapter 12 Monetary Policy What is Monetary Policy o Monetary Policy strategy and actions the Federal Reserve takes to manage the money supply and interest rates for pursuing certain economic objectives o Goals The fed has set four monetary policy goals that are intended to promote a well functioning economy 1 Price Stability 2 Economic Growth 3 High Employment 4 Stability of financial markets and institutions o The Fed chairman and governors are not elected but appointed by the president and confirmed by the Senate for staggered terms not coinciding with elections They are not members of an administration o Thus the Fed is largely insulated from political pressures Chairmen are however subject to being reappointed every four years and protecting their own reputation o The Fed looks after the long term interest of the nation s economy and financial system o Price Stability Following the great inflationary spike of the 70s and 80s the Fed maintains an anti inflation bias High amongst its goals is containing inflation The Goals of Monetary Policy o Economic Growth Policymakers aim to encourage stable economic growth allowing households and firms to effectively trust the economy and encouraging long run investment needed to sustain growth In the US tis translates to an ideal GDP growth rate of 3 to 4 annually Growth levels must provide increasing living standards and comfortable employment levels o High Employment The Labor market produced the most political pressure The Fed along with other agencies concerned with the economy are keen to ensure the economy allows for low levels of unemployment and solid wages o Stability of Financial Markets and Institutions The Fed works with other agencies to ensure long term viability and security It will intervene against market bubbles select major institutional to the banking and financial industry There are always critics who applaud or deride Fed actions Regardless the Fed can exercise enormous power if it so chooses The Money Market and Monetary Policy Targets o Monetary Policy Targets The fed tries to keep both the unemployment and inflation rates low but it can t affect either of these economic variables directly The Fed uses variables called monetary policy targets that it can affect directly and in turn affect variables such as real GDP employment and the price level closely related to the Fed s policy goals o Demand for Money o Short term Rates Shifts in the Money demand curve in the Money Market o How the Fed Manages the Money Supply A quick review equilibrium o Equilibrium in the Money Market o Short Term vs Long Term Interest Rates Why both Loanable Funds and Money Market models for determining the interest rate Loanable funds models are concerned with the long term real rate of interest Money Market models are concerned with the short term nominal rate of interest Economic growth models are focused upon long and longer term scenarios demonstrating changes in real variables o Recall the Fed does not actually set interest rates it sets targets for rates The chief rate in question is the federal funds rate the interest rate banks charge one another for very shor often overnight loans needed to cover reserve requirements o How does it work lower the target Based upon economic conditions the Fed may decide to raise or Via Open Market Operations the Fed will buy treasuries US debt notes creating bank reserves increasing available money ultimately the supply of loanable funds The Fed will sell Treasuries if it hopes to raise rates taking money out of the system Based upon the actions of the Fed banks will have larger or smaller supply of reserve money In turn this will influence the rate they charge to one another Monetary Policy and Economic Activity o How interest rates Affect Aggregate Demand Changes in interest rate will largely not affect government purchases but they will affect the other three components of aggregate demand Consumption higher rates make consumer loans more expensive raising the cost of consumption Investment higher rates makes capital development projects costlier This raises the threshold for viability and causes many projects to be deferred or cancelled Net Exports higher relative rates will produce a stronger currency value This will make exports more expensive relative to imports Net exports will decline o The effects of Monetary Policy on Real GDP and the Price level an initial look Expansionary monetary policy the Fed increases the money supply and having the effect of lowering interest rates to increase real GDP Contractionary monetary policy the Fed slows down money supply growth to increase interest rates to reduce inflation o Can the Fed Eliminate Recessions No The Fed cannot control every aspect of economic political and world events shaping and influencing the US economy What the Fed can do is work to control inflation help prevent or work to contain market aberrations sector bubbles bad behavior damage control after a blow up Generally speaking the US has witnessed the Fed has kept recessions shorter and milder than in times when the Fed either did not exist or in pre Depression times The Fed Fights a Recession o A summary of how Monetary Policy Works o Can the Fed Get the Timing Right Monetary Policy o One caveat to the does not affect government spending o It certainly can change state and local budgets if the cost of development raises infrastructure projects or other developments funded through the issuance of bonds will be more expensive for governments to undertake The Fed s Monetary Policy Targets o Should the Fed Target the Money Supply Some economists have argued that rather than use an interest rate as its monetary policy target the Fed should use the money supplu Many of the economists who make this argument belong to a school of thought known as monetarism The leader of the monetarist school was Nobel laureate Militon Friedman Friedman and his followers favored replacing monetary policy with monetary growth rule o Why doesn t the Fed target both the money supply and the interest o The Taylor Rule A rule developed by John Taylor that links the Fed s target for the federal funds rate to economic variables Federal funds target rate current inflation rate Real equilibrium federal funds rate 1 2 Inflation Gap 1 2 Output Gap o Should the Fed Target Inflation Inflation targeting monetary policy committing the central bank to maintain a publicly announced level of inflation May prevent the bank