econ chapter 22: monetary policy

monetary policy

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

federal reserve can’t…

change inflation or employment directly. instead it uses interest rates as a tool to influence the economy

dual mandate

the fed’s 2 goals of stable prices and maximum sustainable employment

the federal reserve was created

in 1913 in wake of chaotic bank runs

key features of the fed is that…

1. the fed system is regionally diverse

2. central bank independence is important for macroeconomic stability

3. there is a lot of government oversight of the fed

federal open market committee (fomc)

is a federal reserve committee that decides on us interest rates that consist of fed governors and fed bank presidents

fomc members prepare to answer these 3 questions…

1. what are the forecasts for the us economy

2. what are the right policy choices give the economic outlook

3. how should the fed communicate its plans effectively to the public

inflation target

a publicly stated goal for the inflation rate

price stability means inflation that is

near or at the fed’s inflation target

4 reasons why the fed doesn’t target 0 inflation

1. inflation greases the wheels of the labor market

2. the fed can lower real interest rates by more when inflation is above 0

3. a 0% inflation target runs risk of deflation

4. measured inflation may be overstated

neutral real interest rate

the real interest rate at which real gdp is equal to potential gdp and the output gap would be 0

federal funds rate

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

4 factors that shape fed policy

1. the neutral real interest rate

2. the nominal interest rate

3. the difference between actual inflation and targeted inflation

4. the output gap

the fed-rule-of-thumb

the recipe to how the fed often sets the interest rate

formula:

federal funds rate - inflation = neutral real interest rate + ½ x (inflation -2%) + output gap

reserves

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

interest rates on reserves

the interest rate the fed pays to banks on reserves

open market trading desk

a trading desk at new york federal reserve bank and sells government bonds

overnight reserve repurchase agreements

when the desk sells a government bond to a financial institution with an agreement to buy it back the next day at a higher price

floor framework

the fed’s approach of setting other interest rates to put a lower bound on how low the federal funds rate will go

discount rate

the interest rate on loans that the fed offers to baks through the discount window

open market operations

the federal reserve’s buying and selling of government bonds to influence the federal funds rate

tools the fed uses to influence the federal funds rate

1. pays interest to banks on reserves

2. borrows money overnight from financial institutions

3. lends directly through the discount window

4. buys and sells government bonds

forward guidance

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

quantitative easing (QE)

purchasing large quantities of longer term government bonds and other securities in an effort to lower long term interest rates

lender of last resort

the fed’s role as the lender that financial institutions turn to when theyre having trouble getting loans

features of the lender of last resort include…

1. can prevent a financial crisis

2. the fed can lose money when it acts as a ender of last resort

3. the fed’s willingness to be a lender of last resort can lead borrowers to take bigger risks