Chapter 22: Monetary Policy

Created to promote maximum employment, while keeping inflation low and stable

The Federal Reserve

The Fed can’t (BLANK) change inflation or employment

directly

The Fed uses (BLANK) to influence the economy

interest rates

the process of setting interest rates in an effort to influence economic conditions

Monetary policy

Controls monetary policy in the United States

The Federal Reserve

The Fed uses monetary policy to nudge people and businesses to (BLANK) today, which in turn affects (BLANK), and therefore both (BLANK).

spend more or less, output, employment and inflation

If the Fed raises interest rates…

people spend less, lower output, lower inflationary pressure

If the Fed lowers interest rates…

people spend more, higher output, higher employment

The Fed’s dual mandate of promoting maximum employment while keeping inflation low is achieved when actual output is (BLANK) to potential output

equal

Comprised of the Board of Governors in Washington, D.C., and 12 Federal Reserve district banks scattered across the country

The Federal Reserve System

The 12 district banks are designed to avoid concentrating too much (BLANK) in one part of the country.

control

The Federal Reserve Board of Governors is an independent government agency that acts as a check for

fiscal policy

Board governors are selected by the (BLANK) and confirmed by the (BLANK)

president, senate

The Fed governors and the district Fed presidents form the

Federal Open Market Committee (FOMC)

The goal of the FOMC is to decide on U.S.

interest rates

What is asked during the FOMC meeting

economy forecasts, policy choices, public communication

a communication style that relied on intentionally vague and bureaucratic language

Fedspeak

The logic of fedspeak is that vagueness reduces

market reactions

The Feds new communication goal is

transparency

The Fed’s two key goals of maximum sustainable employment and price stability are called

dual mandate

Fed’s goal as of 2021: Aim to achieve

2% inflation on average

The Fed wants inflation to be

low and predictable

The Fed is trying to set in motion a (BLANK)
- If people believe inflation will be low and stable

- Price increases will be small

- Inflation remains low and stable

virtuous cycle

Why is the Fed targeting inflation instead of employment?
1. Because inflation is (BLANK) targeted by monetary policy.

2. Because hitting the inflation target also promotes maximum sustainable (BLANK)

easily, employment

High unemployment means the economy is operating with excess capacity and leads inflation rate to

decline below Fed’s target

Low unemployment means the economy will hit its capacity constraint and leads inflation rate to

rise above Fed’s target

Four reasons why the Fed doesn’t target zero inflation:

1. Inflation greases the wheels of the labor market
2. The Fed can lower real interest rates by more when inflation is above zero
3. A 0% inflation target runs the risk of deflation
4. Measured inflation may be overstated

Inflation greases the wheels of the labor market as employers can quietly (BLANK) by simply not giving employees a raise

cut real wages

Zero inflation would cause employers to

lay off more workers leading to higher unemployment

If inflation were 0%, then the Fed would be unable to stimulate a recovery from a recession by

lowering real interest rates

The Fed can’t set nominal interest rates below zero

zero lower bound

starts if people expect future prices to fall further and further

vicious cycle of deflation

Measured inflation is overstated as it fails to account for

quality improvements and new products

A measured inflation rate of zero would probably actually mean

deflation

Interest rate when the economy is not operating above or below its potential

neutral real interest rate

The four factors that shape Fed policy are

1. The neutral real interest rate

2. The nominal interest rate

3. The difference between actual inflation and target inflation

4. The output gap

The Fed controls a nominal interest rate called the (BLANK), which the Fed uses to influence the real interest rate

federal funds rate

nominal interest rate =

real interest rate + inflation

The Fed uses the the gap between inflation and the target inflation to assess how to change the

real interest rate

The Fed uses the output gap to assess whether to

cool or stimulate the economy

If inflation is higher than the target…Fed sets real interest rates (BLANK) than the neutral interest rates which leads to people spending (BLANK) and (BLANK)

higher, less, reduces inflationary pressure

If inflation is lower than the target…Fed sets real interest rates (BLANK) than the neutral interest rates which leads to people spending (BLANK) and (BLANK)

lower, more, boosts inflation

If actual output exceeds potential…Fed sets real interest rates (BLANK) than the neutral interest rate which encourages people to spend (BLANK) and (BLANK)

higher, less, cools the economy

If actual output is lower than potential…Fed sets real interest rates (BLANK) than the neutral interest rate which encourages people to spend (BLANK) and (BLANK)

lower, more, stimulates the economy

The general framework the Fed uses for setting the real interest rate is

Real interest rate = neutral interest rate + adjustments for deviations

The formula for the Fed rule-of-thumb is

Federal funds rate - Inflation = Neutral real interest rate + 1/2 x (Inflation - 2%) + Output gap

The interest rate that the Fed uses as its policy tool, which is the nominal interest rate that banks pay to borrow from each other overnight in the federal funds market

federal funds rate

the cash that banks need to keep on hand to make payments

reserves

The forces of (BLANK) determine the interest rate charged on bank overnight loans

supply and demand

The Fed doesn’t directly set the

federal funds rate

The Fed uses a number of tools to encourage banks to hold more or less in

reserves

Tools the Fed uses to influence the federal funds rate:

1. Pays interest to banks on their reserves
2. Borrows money overnight from financial institutions
3. Lends directly through the discount window
4. Buys and sells government bonds

If the Fed wants to increase the federal funds rate…The Fed (BLANK) the interest rate it pays on reserves, (BLANK) incentive for banks to hold reserves, federal funds rate (BLANK)

increases, increases, increases

When the Fed engages in overnight borrowing as a demand…(BLANK) demand for overnight loans, leads to (BLANK) interest rates

increases, increased

how the Fed effectively sets a lower bound on how low the federal funds rate will go

floor framework

The Fed uses these two tools to raise the opportunity cost of lending in the federal funds market

1. pays interest to banks on their reserves

2. borrows money overnight from financial institutions and pays them interest

Banks offer collateral and get a loan from the Fed that helps them meet their reserve requirement

discount window

The interest rate that the Fed offers through the discount window

discount rate

acts as an upper bound for the federal funds rate

discount rate

When the Fed sells bonds…(BLANK) demand for overnight loans and (BLANK) supply, Federal funds rate is pushed (BLANK)

increases, decreases, up

When the Fed adjusts the federal funds rate banks (BLANK) the rates they charge borrowers, and some rates move (BLANK) with the federal funds rate

reset, directly

When the Fed adjusts the federal funds rate your choices about (BLANK) change

consumption

When the Fed adjusts the federal funds rate causing U.S. interest rates to fall, investing in the U.S. becomes (BLANK) attractive, (BLANK) net exports

less, increasing

The Fed does not (BLANK) anymore

buy and sell government bonds

A limitation of the federal funds rate is that it has a

zero lower bound

Other tools the Fed uses to encourage additional spending by pushing longer-term rates interest rates down are

forward guidance and quantitative easing

providing information about the future course of monetary policy in order to influence market expectations of future interest rates

forward guidance

Use communication to shape expectations about the future path of interest rates

Forward guidance

A tool the Fed can use to encourage additional spending even if the federal funds rate is at zero

forward guidance

If the Fed promises that rates will stay low in the future, banks can (BLANK) the interest rate they charge for longer-term loans, leads (BLANK) people to buy houses and cars, and make business investments

lower, more

If the Fed uses forward guidance to say that rates will stay low then

additional spending takes place

the Fed’s strategy of purchasing large quantities of longer-term government bonds and other securities in an effort to put downward pressure on long- term interest rates, including mortgages.

quantitative easing

Aims to push interest rates below zero

quantitative easing

When the Fed buys longer-term government bonds…(BLANK) the amount of government debt available for savers like you to purchase, (BLANK) savers to supply their long-term borrowers, this increased supply of longer-term loans pushes (BLANK) interest rates

reduces, encourages, down

The Fed is the lender of

last resort

The place financial institutions turn to when they need cash right away, but they’re having trouble getting a loan elsewhere

The Federal Reserve

to prevent widespread bank runs, business failures, and general financial panic

lender of last resort

Downsides of lender of last resort: Fed can (BLANK) money, incentivize borrowers to take (BLANK)

lose, bigger risks

0% inflation target will lead unemployment to (BLANK) during recessions

rise

Real wage =

nominal wage contract - inflation x nominal wage

A lower inflation rate makes it more likely that the Fed will be unable to deliver (BLANK) to stimulate recovery

low interest rate

inflation going down

disinflation

inflation below zero

deflation

The Fed rule-of-thumb is also called the

Taylor rule