monetary policy · loans directly to banks • short-term discount rate—generally higher than...

Federal Reserve Bank of Atlanta

Monetary Policy

Presented By:


District Education Team


Key points

Tools of monetary policy

Importance of independence

of the central bank

Using economic indicators

to guide monetary policy

Let’s start at the

very beginning…

Bank Panic of 1907

Federal Reserve Act of 1913


What is the broad

purpose?


Financial system stability

Economic stability

The Fed’s Dual

Mandate


Growth

Price stability


Types of Policy

Fiscal policy

Taxing and spending by

the President and

Congress, affecting the

government’s budget

Monetary policy

Changing the growth of

the money supply to

achieve price stability

and long-run economic

growth


FOMC

Federal Open Market

Committee

• 7 Governors

• 1 NY Fed President

• 4 voting positions

rotate among other 11

Fed Presidents

8 meetings a year

What does the FOMC

decide?


Normal tools of

monetary policy

Reserve requirements

• little used

Discount window

Open market operations

(federal funds rate)


Reserve

Requirements

Portion of funds banks are

required to hold in reserve

Not changed for monetary

policy since early 1990s


Discount Window

Loans directly to banks• Short-term

Discount rate—generally higher than federal funds rate

Set by Board of Governors with regional requests

Changing role of discount window


Open market

operations

Federal funds rate

Overnight rate between

financial institutions

• Fed not directly lending

• Buys and sells

treasuries

Established by FOMC

Primary dealers


How do open

market operations

work?Banks provide most money in

overnight market

Fed expands or contracts

amount of money

• Expand = buy Treasuries

• lower interest rate

• Contract (shrink) = sell

Treasuries

• higher interest rate

Why?


Reserves Affect

Money, Credit, and

Interest Rates

When reserves go up (if the Fed

buys government securities), money

and credit increase and short-term

interest rates may fall.

When reserves go down (if the Fed

sells government securities), money

and credit decrease and short-term

interest rates may rise.

Reserves Money Credit

Short-Term

Interest

Rates

Reserves Money Credit Short-Term

Interest

Rates

=

=

=

=

=

=


Interest Rates Affect

Economic Activity

Short-term

interest rates

Spending and

investmentGDP and

price levelsEmployment

When interest rates go down, people and

businesses tend to borrow and spend more,

increasing GDP and employment. Additional

demand for goods and services puts upward

pressure on prices.


Interest Rates Affect

Economic Activity

Short-term

interest rates

Spending and

investmentGDP and

price levelsEmployment

When interest rates go up, people and

businesses tend to borrow and spend less, which

can decrease GDP and employment. However,

the decrease in demand for goods and services

should cause price levels to stabilize, thus

bringing down inflation pressures.


Normal monetary policy

uses three main tools

But, these are not normal

times

Why is the Fed involved?

• Still goes back to the

Fed’s broad purpose:

economic and financial

system stability

What is the Fed doing

now?

• Targeted actions


Anecdotal

Information

Data

• Data inherently lags

• Can miss turning

points

Anecdotal information

• Directors

• Business leaders

• Regional information

centers


What does

changing interest

rates do?

The car analogy

• Increasing interest rates =

brakes on the economy

• Lowering interest rates =

gas pedal on the economy


Models

Phillips Curve

• Short-run Phillips Curve:

short-run trade-off between

employment and wage

growth.

• Long-run Phillips Curve: A

vertical line because the

level of employment is not

influenced by price levels,

but by the economy’s

capacity to produce.

Long Run

Phillips Curve

C

A

U1U2

4.5%

3.5%

B

Unemployment Rate (%)

Infl

ati

on

Rate

(%

)


Models

The Taylor Rule

Monetary policy rule that

stipulates how much the

central bank should

change the nominal

interest rate in response

to divergences of actual

GDP from potential GDP

and divergences of

actual rates of inflation

from a target rate of

inflation


Tool lags

Time lag

Backward looking data

Importance of

• Forecasts

• Anecdotal information


When and how to

use those tools…

For example:

• 4% GDP growth and

high inflation?

• Negative GDP growth

and low inflation?

Those are easy extremes


Limitations of

monetary policy

Only limited tools

Need fiscal policy as well

Example: Hurricane Katrina


Why does the Fed

need to be

independent?Your thoughts?

Pressures on politicians

Long-term vs short-term

concerns

Increased transparency


Announce target rate

FOMC statement

Recent changes

• Publishing economic

forecasts 4 times a year

• Minutes come out

faster—3 weeks after

the meeting


Using your new

skills

What kind of indicators

would economists use to

work towards their dual

mandate?


Activity

Now convene your own FOMC

Discuss your scenario

Write a policy statement


Activity: Scenario 1

There have been fewer jobless claims over the past

several months. Workers have been reporting higher

wages as the labor market becomes tighter. The FOMC

has kept rates steady during its last two meetings.



High energy prices are beginning to be passed on to

consumers, but the economy remains strong. Core

inflation has been near 3% over the past six months.

Jobless claims and the unemployment rate are low. The

FOMC increased the fed funds rate at its last meeting.



The economy has slowed dramatically, and energy prices

and core inflation have fallen. Due to lower durable goods

orders, manufacturing firms are laying off workers.

Business investment has also declined.



The economy is strong, spurred by consumer demand

and business investment in technology. Unemployment is

low, hovering at 4.25%. The economic expansion has

been spurred by rising housing prices caused by

speculation in major metropolitan areas. Those housing

prices appear to be stabilizing.


Conclusions

Tools of monetary policy

Importance of independence of the central bank

Using economic indicators to guide monetary policy

monetary policy · loans directly to banks • short-term discount rate—generally higher than...

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