chapter 6 – monetary policy ba 543 financial markets and institutions

Chapter 6 – Monetary Policy

BA 543 Financial Markets and Institutions


Goals of the Federal Monetary Policy Stability in Price Level

Unstable Prices retard economic growth, provoke volatility in interest rates, stimulate consumption, deter savings, and cause capricious redistribution of income and wealth with attendant social disturbances

“Controlling Inflation” with a supply shock Accommodate with increase in money supply –

inflation is essentially unchecked Do not accommodate (Jimmy Carter) – higher initial

interest rates and short term decline in economic activity


Goals of the Federal Monetary Policy High Employment (Low Unemployment)

Frictional Unemployment (Job Changers) Target 4% to 6% of labor force

Increase in Money Supply can bring about: Economic Expansion Stimulate Investment Encourage Consumption Lead to the Creation of New Jobs Kindle Inflation Raise Interest Rates


Goals of the Federal Monetary Policy Economic Growth (Increase in Output of

Goods and Services) What is the appropriate rate of growth? Sustainable Growth Reasonable Growth Steady Growth

Stabilizing Interest Rates Reduce Volatility – But allow changes How do interest rates impact growth?


Goals of the Federal Monetary Policy Stability in Foreign Exchange

Strong Dollar Means (Indirect Quote goes up) Exchange Rates are moving so that $1 can buy

more foreign currency or U.S. Products are becoming relatively more expensive “overseas”

Trade-Imbalance: Foreign goods purchased more in U.S. and Less U.S. goods purchased abroad

Weak Dollar Means (Indirect Quote goes down) More U.S. goods purchased abroad and fewer

Foreign goods purchased in U.S. Who Benefits from Strong Dollar vs. Weak

Dollar?


Goals are not always Aligned Tradeoffs between Goals Fed “selects” goal most in jeopardy Fed works through

Operating Targets – impacts on monetary and financial variables that tend to change

Intermediate Targets – that have reasonable linkage to

Ultimate Objectives – price level stability, employment, growth and foreign exchange rates


Choosing the Operating Targets (Simulation Game at the Federal Reserve in KC) U.S. Targets: Short-Term Interest Rates or

Bank Reserves via money supply Can not do both simultaneously, Why? Negative Correlation between reserves and

interest rates…as Fed increases reserves it reduces short-term rates and vice versa

Variable outside the control of the Fed…demand for money…thus rates and reserves can not be simultaneously determined


Choosing the Intermediate Targets Suitable Target must be observable

Money Supply Early standard target…some discussion on which

measure and concern that it does not have linkage with the ultimate objectives

GNP (GNP growth rate) Measurability big issues, data is quarterly

Inflation Believed to have better linkage to ultimate goals Many Europeans using price indexes for sensitive

products…Greenspan said to be “gold” follower


Historical Trip through Targets 1970s – Feds Fund Rate (Keynesian) 1979 – 1982 Nonborrowed Reserves

(Monetarists) let interest rates fluctuate 1983 – 1991 Borrowed Reserves 1991 – 1995 Borrowed Reserves with

attention to sensitive commodities (European approach)

1996 – 2000 New Paradigm of Higher Sustainable Growth…Greenspan’s Visible Hand with the Feds Fund Rate

chapter 6 – monetary policy ba 543 financial markets and institutions

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