Chapter 10: monetary policy

Monetary policy

Actions by the central bank to manage money supply and the interest rate

why do we need monetary policy

reduce or counter the effects of the business cycle because the automatic adjustment takes a long time

main goal of monetary policy

macroeconomic goals

the four main goals of the Fed

1. Price stability (low inflation)

2. High unemployment

3. Stability of financial markets

4. Economic growth (by providing incentives for investment)

Dual mandate of the Fed

• price stability

• High unemployment

What specifically does the Fed target

money supply and the interest rate

Federal Funds rate

the specific interest rate that the Fed targets. It is the interbank rate - the rate at which banks borrow from other rates

what happens to interest rate when reserves in the system increase

interest rate falls

what happens to interest rate when reserves in the system decrease

Interest rate rises

open market operations

managing reserves in the banking system by buying and selling government bonds

• To increase reserves, the Fed purchases securities (open market purchase)

• To decrease reserves, the Fed buys securities (open market sale)

Discount policy

the interest rate at which banks borrow from the Fed

• increase in discount rate — less bank reserves — higher interest rate

• Decrease in discount rate — more bank reserves — lower interest rate

Required reserve ratio

the portion of deposits that banks must hold in reserves

• increase in rrr — less excess reserves — higher interest rate

• Decrease in rrr — more excess reserves — lower interest rate

Interest on reserves

Sets the minimum or floor for the federal funds rate (interest rate)

• an increase in IOR — banks hold more reserves than loans — interest rates increase

  • Equivalent to reducing reserves (money supply)

• A decrease in IOR — banks hold less reserves than loans — interest rates decrease

  • Equivalent to increasing reserves (money supply)

Reverse repurchases Agreement

• this is the Fed’s overnight reverse repurchasing facility

• This facility allows non banking financial institutions (mortgage companies and insurance companies) to make short-term loans to the Fed

  • An increase in ON RRP — reduces reserves - increases the interest rate

  • A decrease in ON RRP — increases reserves — decreases the interest rate

Expansionary monetary policy

increases real gdp, reduces unemployment, and reduces the interest rate

contractionary monetary policy

Reduces real gdp to potential gdp and reduces inflation

Actions for expansionary policy

• open market purchase

• Decrease discount rate

• Reduce required reserve ratio

• Reduce interest rate on reserves

• Reduce the reverse repo rate

actions for contractionary policy

• open market sale

• Increase the discount rate

• Increase required reserve ratio

• Increase IOR

• Increase the reverse repo rate

SRAS vs. AD

• SRAS moves when economy fixes itself

• AD moves when monetary policy is used

why does the Fed use monetary policy

to achieve high employment and stable prices

Divine coincidence

when inflation and unemployment targets are divinely met

Stagflation

a combination of stagnant economy, high unemployment, and high inflation

• caused by supply shocks

monetary policy doves

those that believe high employment is more important (expansionary policy)

monetary policy hawks

those that believe stable prices are more important (contractionary)

limitations of monetary policy

• data lag

• Recognition lag

• Implementation lag

• Financial system strength

data lag

the data needed for the Fed to make monetary policy decisions takes time to collect.t his delay makes it hard to ac/know the economy’s true condition

recognition lag

It may take time to recognize the actual state of the economy. This slows down how quickly they can respond with the right policy

implementation lag

it takes time to implement policies after the state of the economy. Thus, the effects of monetary policy may come too late to fix the problem

financially system strength

monetary policy is limited because the Fed can lower interest rates, but it can’t force banks to lend or people and businesses to borrow and spend. So, if the financial system isn’t working well, the Fed’s actions wont have their intended effect on GDP, employment, or prices