ECON 521 Special Topics in Economic Policy

CHAPTER FIVE

Monetary Policy

I. I. OverviewOverview

• This chapter looks at Monetary Policy, the most frequent use of policy to correct the economy.

• Monetary Policy -- The Central Bank (Federal Reserve) changing bank loaning conditions to affect the supply of financial capital, investment, and aggregate demand.

• The main goal for the Central Bank is to stabilize the economy through controlling……using………

Fundamental decision -- how to allocate their assets to make reasonable profits and to service depositor withdrawals.

• Reserves – do not earn interest (not a source of revenue), are used to back up depositor withdrawals.

• Loans – earn interest for the bank (their major source of revenue), but funds committed to loans are not accessible to the bank.

II. Basic Strategy of Monetary PolicyII. Basic Strategy of Monetary Policy

• Expansionary (Y* < YN) -- Federal Reserve seeks to increase the supply of financial capital by “encouraging bank loaning”.

• Contractionary (Y* > YN) -- Federal Reserve seeks to decrease the supply of financial capital by “discouraging bank loaning”.

• Instruments (tools) that initiate monetary policy:

(A) Determining the Discount Rate

(B) Open Market Operations

(C) Setting the Required Reserve Ratio

(A) Changing The Discount Rate

• The Discount Rate -- the rate of interest charged to

banks that borrow from the Federal Reserve.

• Expansionary Policy -- Fed lowers discount rate.

• Contractionary Policy -- Fed raises discount rate.

(B) Changing the Required Reserve Ratio

• Designed to change the minimum amount of reserves

the bank must hold.

• Expansionary Policy -- Fed lowers the reserve ratio.

• Contractionary Policy -- Fed raises the reserve ratio.

(C) Open Market Operations

• Open Market Operations -- the buying or selling of bonds by the Federal Reserve in the open market (the Fed’s predominant policy tool).

• Expansionary -- Fed buys bonds (gives banks new reserves)

• Contractionary -- Fed sells bonds (drains reserves from banks)

III. Effectiveness of the Monetary ToolsIII. Effectiveness of the Monetary Tools

First: Open Market Operations They are the most important monetary policy tool because they

are the primary determinants of changes in interest rates and the monetary base, which is the main source of fluctuations in the money supply.

1. Complete control over the size of operations and securities traded by the Central Bank.

2. Flexible and precise.

3. Easily reversed.

4. Quickly implemented.

Second: Discount Policy

• Lender of last Resort: It prevents financial panics by providing banks with reserves when no one else would do so.

• Announcement Effect: it can be used to signal the central bank’s intentions about future monetary policy.

----Advantages Performing the role of lender of last resort, therefore

strengthening financial institutions.

----Disadvantages No guarantee that banks will follow the announcement of the

discount policy because the decision of borrowing is for commercial bank. Thus, this tool is not completely controlled by the fed compared to OMOs.

Third: Reserve Requirements

It affects money supply by affecting reserves and the money multiplier.

----Advantages: It affects all banks equally and has a powerful effect on

money supply

----Disadvantages: 1. Not practical because small changes in required reserve

ratio leads to large changes in money supply, making mistakes too costly.

2. Raising reserve requirements may cause liquidity problems for banks with low excess reserves.

IV. The Process of Monetary Policy IV. The Process of Monetary Policy Example;

CBK buys a 1000 KD bond from NBK. NBK receives new reserves, can make new loans. Therefore, the potential to increase the supply of financial capital is increased.

• The Interbank Rate (Federal Funds Rate) -- the interest rate paid by one bank to borrow reserves from another bank.

• The “thermostat” of monetary policy. Changes in target Federal Funds rate prompt the execution of open market operations. Open market operations stop when new target is achieved.

(1) Expansionary Policy • If CB wants to lower the target Federal Funds Rate.

• To achieve this target, the CB buys bonds from banks, supplying more reserves to the system.

• CB does this until the target Federal Funds rate is achieved.

• Increased bank loaning due to having greater reserves implies an increase in the supply of financial capital, shifting the supply of capital curve rightward.

• The shift in the supply of financial capital implies that the interest rate (r*) decreases and Investment (I*) increases.

• The increase in I* shifts AD rightward, increasing Y* and P*.

(2) Contractionary Policy • If CB wants to increase the target Federal Funds Rate.

• To achieve this target, the CB sells bonds to banks, removing reserves to the system.

• CB does this until the target Federal Funds rate is achieved.

• Decreases in bank loaning due to having less reserves implies a decrease in the supply of financial capital, shifting the supply of capital curve leftward.

• The shift in the supply of financial capital implies that the interest rate (r*) increases and Investment (I*) decreases.

• The decrease in I* shifts AD leftward, decreasing Y* and P*.

V. Obstacles to Monetary Policy EffectivenessV. Obstacles to Monetary Policy Effectiveness

• When does monetary policy have difficulty in changing Y* to improve the economy?

• Particularly applies to expansionary monetary policy -- getting the economy out of sluggishness or recession.

A Potential Obstacle

(1) Banks don’t want to loan the added reserves (doubt about prospects of loan default or fears of inflation).

No shifts in demand or supply for financial capital.

(2) Banks want to loan, but firms and consumers don’t want to borrow the funds (e.g. pessimism about state of economy).

Described as leftward shift in the demand for financial capital coupled with a rightward shift in the supply of financial capital.

VI. Conducting Monetary PolicyVI. Conducting Monetary Policy

• Monetary policy tools are used to achieve its ultimate economic goals through monetary targets .

• The tools and goals are connected by a number of targets that make it easier for the tools to affect the goals.

• Monetary tools cannot affect the economic goals directly. Thus, the CB uses a number of monetary variables that lie between them.

Goals of Monetary Policy

1.High Employment (How!!)

2. Economic Growth (How!!)

3. Price Stability (How!!)

4. Interest Rate Stability (How!!)

5. Stability of Financial Markets (How!!)

6. Stability in Foreign Exchange Markets (How!!)

The strategy is as follows:

• The CB selects one or more economic goals,

• The CB chooses variables called intermediate targets, such as monetary aggregates (e.g. M1, M2) or interest rates (short or long term), which have a direct effect on the goals.

• Then, the CB chooses a number of variables called operating targets, they can be either monetary aggregates (e.g. reserves, monetary base), or interest rates (e.g. interbank rate and T-bill rate). These targets are more responsive to the tools.

Monterey Tools Operating Targets Intermediate Target Monetary Goals

OMO

DL

RRR

MBR

iff

iTB

M1M2

iSR

iLR

(1) Employment(2) Price Stability(3)Financial Stability(4)Economic Growth(5)Interest Rate Stability(6) Stability in Foreign Exchange Markets

VII. Monetary Policy TargetsVII. Monetary Policy Targets

CB attempts to control either the money supply (monetary target), or interest rate (interest rate target) to achieve the goals.

•Can the CB control both at the same time to achieve the goal?

Money Supply Target

1. M d fluctuate between M d' and M d''

2. With M-target at M*, i fluctuates between i' and i''

Interest Rate Target

1. M d fluctuates between M d' and M d''

2. To set i-target at i* Ms fluctuates between M' and M''

Monetary TargetingMonetary Targeting

To achieve price stability, the CB announces that it will target an annual growth rate in a particular monetary aggregate (M1, M2). Once the rate is set, the CB is responsible for hitting this target. This policy is Flexible, transparent, accountable.

Advantages- Almost immediate accountability.- Almost immediate signals help fix inflation expectations and produce less inflation. Disadvantages- Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate.

Inflation TargetingInflation Targeting

Why not directly target inflation??. With inflation target, the CB makes public announcement of the inflation target.

Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal.

Many information are used in making decisions.

Increased transparency of the strategy.

Increased accountability of the central bank.

Implications of Monetary & Inflation TargetsImplications of Monetary & Inflation Targets

Monetary Targeting (…i.e. USA, Japan.)

-Case of USA– Monetary targeting, particularly fed announces iff operating target.

Inflation Targeting (…i.e. New Zealand (3-5%), Canada (1-3%), EU (2%), UK(2.5%))

-Case of Canada– Incorporating short term- i & exchange rate for Canadian dollar.

Sidebar:Monetary Policy: From Greenspan to Bernanke

• 2000: Contractionary (Y* > YF),

• 2001-03: Expansionary (Y* < YF.). Policy experienced difficulty getting economy back to YF.

• 2004-06: Contractionary. Economy caught up to YF, concern about overstimulated economy and increased energy prices.

• 2007-11: Expansionary. Addressing slowdown and ultimate recession of 2008.