Economics Study Material: Chapter 18 - Monetary Policy and the Taylor Rule

conventional policy tools

The federal funds rate target, the rate for discount window lending, and the deposit rate. (18)

discount lending

Lending by the Federal Reserve, usually to commercial banks. (18)

discount rate

The interest rate at which the Federal Reserve makes discount loans to commercial banks. (16, 18)

ECB's Deposit Facility

Where euro-area banks with excess reserves can deposit them overnight and earn interest. (18)

ECB's Marginal Lending Facility

The facility through which the ECB provides overnight loans to banks; the analog to the Federal Reserve's primary credit facility. (18)

Effective Lower Bound (ELB)

The nominal interest rate level below which people will switch from bank deposits to cash. (18)

Forward Guidance

Communication by the central bank about future policy prospects. (16, 18)

Inflation Targeting

A monetary policy strategy that involves the public announcement of a numerical inflation target, together with a commitment to make price stability a leading objective. (16, 18)

Interest Rate on Excess Reserves (IOER rate)

The interest rate paid by the Federal Reserve on reserves that the banks hold in their accounts at the central bank in excess of reserve requirements. (18)

lender of last resort

The ultimate source of credit to banks during a panic. A role for the central bank. (14, 18)

market federal funds rate

The overnight interest rate at which lending between banks takes place in the market; differs from the federal funds rate target set by the FOMC. (18)

minimum bid rate

The minimum interest rate that banks can bid for reserves in the ECB’s weekly refinancing operation; the European equivalent of the Fed’s target federal funds rate; also known as the target refinancing rate. (18)

natural rate of interest

The real short-term interest rate that prevails when the economy is using resources normally. (18)

natural rate of unemployment

The rate of unemployment that persists in an economy when labor and other resources are used normally. (18)

overnight cash rate

The overnight interest rate on interbank loans in Europe; the European analog to the market federal funds rate. (18)

overnight reverse repo (ON RRP) rate

The interest paid by the Federal Reserve on funds from intermediaries supplied via overnight reverse purchase (repo) agreements. (18)

primary credit

The term used to describe short-term, usually overnight, discount loans made by the Federal Reserve to commercial banks. (18)

primary discount rate

The interest rate charged by the Federal Reserve on primary credit; also known as the discount rate, it is set at a spread above the target federal funds rate. (18)

quantitative easing (QE)

Unconventional monetary policy action by the central bank to supply aggregate reserves beyond the quantity needed to lower the policy rate to zero. (18)

repurchase agreement (repo)

A short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date, as soon as the next day. (12, 18)

Reserve Requirement

Regulation obligating depository institutions to hold a certain fraction of their demand deposits as either vault cash or deposits at the central bank. (18)

Secondary Discount Rate

The interest rate charged on secondary credit; it is usually 50 basis points above the primary discount rate. (18)

Target Federal Funds Rate Range

The Federal Open Market Committee's target range for the interest rate that banks pay on overnight loans from other intermediaries; the FOMC's primary policy instrument. (18)

Targeted Asset Purchases (TAP)

An unconventional monetary policy in which the central bank alters the mix of assets on its balance sheet in order to change their relative prices (and hence interest rates) in a way that stimulates economic activity. (18)

Taylor Rule

A rule of thumb for explaining movements in the federal funds rate; the monetary policy rule developed by economist John Taylor. (18)

Unconventional Policy Tools

Policy mechanisms (including policy duration commitments, quantitative easing, and credit easing) that are usually reserved for extraordinary episodes when conventional interest rate policy is insufficient for economic stabilization. (18)

Unemployment Gap

The difference between the current unemployment rate and the natural rate of unemployment. (18)

Zero Lower Bound (ZLB)

The idea that a nominal interest rate cannot fall below zero. (18, 23)

The Federal Reserve has ____ tools of conventional monetary policy.

four: The target range for the federal funds rate, the interest rate on excess reserves (IOER rate), the discount rate, reserve requirements

The target range for the federal funds rate:

Set by the FOMC, it is the intended range for the interest rate charged by financial intermediaries on overnight, uncollateralized loans to banks.

The target level of the federal funds rate was the primary tool of policy before 2008.

The interest rate on excess reserves (IOER rate):

Set by the FOMC, it is the interest rate paid by the Federal Reserve on excess reserves held by banks.

It determines the short-term market rate (the federal funds rate) because banks prefer to deposit at the Fed rather than lend to others at or below the IOER rate.

It is currently the primary tool for influencing financial conditions in the economy.

The discount rate:

Set by the Reserve Banks, subject to approval by the Federal Reserve Board, it is the interest rate on discount lending, used by the Fed as the lender of last resort to supply funds to banks in need to maintain financial stability.

The "primary rate" for discount lending is set at a spread above the interest rate on excess reserves (IOER rate).

The European Central Bank's primary objective is

price stability.

The ECB provides liquidity to the banking system through

open market purchases of securities and through auctions called refinancing operations.

When reserves are scarce, the minimum bid on the main refinancing operations, also know as the target refinancing rate, is

the interest rate controlled by the ECB Governing Council.

The ECB allows banks to

borrow from its marginal lending facility at an interest rate that is set above the target refinancing rate.

Banks with excess reserves can deposit them at national central banks and receive

interest at a spread below the target refinancing rate. Banks will not lend to others below this riskless deposit rate, which is equivalent to the Fed's IOER rate.

Monetary policymakers use several tools to meet their objectives:

The best tools are observable, controllable, and tightly linked to objectives.

Short-term interest rates are the primary tools for monetary policymaking

Most modern central banks employ inflation targeting, a policy strategy that involves the public announcement of a numerical inflation target, underscoring the central bank's commitment to price stability.

The Taylor rule is a simple equation that describes movements in the target federal funds rate. It suggests that:

When inflation rises, the FOMC raises the target by 1 1/2 times the increase in inflation.

When output rises above potential by 1 percent, the FOM raises the target rate by 1/2 percentage point.

Unconventional monetary policy can supplement conventional policy when

policymakers are no longer willing or able to lower the target rate or when an impaired financial system prevents conventional interest rate policy from working.

Central banks have three principal tools of unconventional monetary policy:

Forward guidance: communication regarding expected future policy target rates.

Quantitative easing: supplying aggregate reserves beyond the quantity need to lower the policy rate to the target.

Targeted asset purchases: changing the mix of assets at the central bank to alter their relative market prices.

Unconventional monetary policy is less predictable than conventional policy and potentially disruptive, so it is used only when

the conventional toolkit is insufficient to stabilize the economy. One conventional policy tool--the payment of interest on reserves--can help a central bank exit smoothly from unconventional monetary policy.

Explain how the Federal Reserve would implement a rise in the target range for the federal funds rate.

The Federal Reserve would ____ the interest rate on excess reserves (IOER), an interest rate that it controls directly. This ____ the minimum rate at which banks would be willing to lend to other institutions because they can earn the IOER rate risk-free by depositing these funds with the Fed.

How does its action influence the market federal funds rate?

This change in the IOER rate ____ the rate at which banks would be willing to borrow in the money markets from nonbank participants that cannot earn interest on deposits at the Fed. This therefore puts ____ pressure on the market federal funds rate to bring it into the new higher target range.

increase

raises

raises

upward

Considering the market for bank reserves, how can the Fed control independently both the price and quantity of aggregate bank reserves in the post-2008 environment?

The Fed can control the price in the market for reserves by changing the ____ When the Fed raises this rate, banks would be willing to pay a(n) ____ rate to borrow from nonbank participants in the federal funds market in order to deposit these funds at the IOER at the Fed. This process ____ the supply of aggregate reserves. It is reflected in an upward shift in the ____ portion of the demand curve for reserves.

interest rate it pays on reserves

higher

does not change

an upward shift in the flat

Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase. Explain how the Fed's actions are intended to work.

By purchasing mortgage-backed securities (MBS), the Fed sought to ____ mortgage rates in order to ____ home sales, ____ house prices, and ____ housing construction.

lower

increase

raise

promote

Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 8 percentage points. Target federal funds rate = Natural rate of interest + Current inflation + 1/2(Inflation gap) + 1/2(Output gap)

If inflation goes up by 8 percentage points, the target (nominal) federal funds rate goes up by ____ percentage points ( ____ percentage points due to the direct impact of inflation and another ____ percentage points due to an increase in the inflation gap).

Consider the Fisher equation. Given the increase in the nominal interest rate you just calculated and the 8 percentage point increase in inflation we started with, the real interest rate must have increased by _____ percentage points.

If inflation goes up by 8 percentage points, the target (nominal) federal funds rate goes up by 12 percentage points (8 percentage points due to the direct impact of inflation and another 4 percentage points due to an increase in the inflation gap).

To calculate the impact on the real interest rate, we can use the Fisher equation from Chapter Four: Nominal interest rate = Real interest rate + Inflation.

So, if the nominal rate increases by 12 percentage points and inflation increases by 8 percentage points, the real interest rate must have increased by 4 percentage points.

The conventional Taylor rule [Target federal funds rate = Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap)] places weights of one-half on the inflation gap and output gap, corresponding to the "dual mandate" of the U.S. central bank.

Taking into account what you know about the policy goals of the ECB, how might you amend the Taylor Rule to better approximate policymaking behavior by the ECB?

A weight on the inflation gap greater than 1/2 may be more appropriate in the ECB's case. However, the central bank is sensitive to output fluctuations, so the weight on the inflation gap should remain less than 1.

The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it was not low enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009, what might you advise this central bank to do?

You should advise the central bank to use unconventional monetary policy tools such as quantitative easing, where aggregate reserves are provided beyond the level needed to lower the policy rate to zero, or credit easing, a policy in which the central bank alters the composition of its balance sheet. The central bank could also inform markets of its commitment to keep interest rates low (forward guidance).

Suppose ECB officials ask your opinion about their operational framework for monetary policy. You respond by commenting on their success at keeping short-term interest rates close to target but also express concern about the complexity of their process for managing the supply of reserves. What specific changes would you suggest the ECB should make to its system in the future?

You might suggest that the ECB concentrate its operations in Frankfurt instead of having to coordinate these operations at all the national central banks simultaneously. You might also suggest that the ECB narrow the relatively long list of institutions that qualify as counterparties to open market operations and reduce the range of assets it accepts as collateral for these operations.

Suppose you receive the following information about two inflation-targeting economies:

Economy A has been volatile historically, with the unemployment rate fluctuating widely around the natural rate, and the neutral real interest rate estimated to be around 1.5 percent. Despite the economic volatility, the well-designed central bank has enjoyed many decades of credibility.

Economy B has seen unemployment rates stay relatively close to the natural rate with the neutral real interest rate estimated to be around 3 percent. Despite the stable unemployment rate, the credibility of the central bank is somewhat fragile.

Based on this information and assuming all other things are equal, which economy would be more likely to need the use of unconventional policy tools?

Economy A. The low neutral rates and high unemployment volatility increase the probability of needing to use unconventional policy tools.

Federal funds loans are

unsecured loans.

Today, reserve requirements are

not often used as a direct tool of monetary policy.

If the current market federal funds rate equals the target rate and the demand for reserves increases, the likely response in the federal funds market will be

no change; reserve supply is so high that the market federal funds rate will be unchanged.

Within the European Central Bank, banks with excess reserves

can deposit them with the ECB and earn an interest rate below the target refinancing rate.

The conventional policy tools available to the Fed include each of the following, except which one?

currency-to-deposit ratio

Reserve demand becomes horizontal at the IOER rate because

banks will not make loans at less than the IOER rate.

During the 1990s many countries developed a monetary policy framework that focused on inflation targeting. This is an example of policymakers focusing

directly on an objective.

A good monetary policy instrument is

tightly linked to monetary policy objectives.

Use the following formula for the Taylor rule

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap)

to determine what would happen if output in the economy were to fall by an additional one percent below potential. Then, the target federal funds rate would

decrease by 0.5 percent.

Use the following formula for the Taylor rule to determine the target federal funds rate.

target federal funds rate = natural rate of interest + current inflation + ½(inflation gap) +½(output gap)

where the current rate of inflation is 5 percent, the natural rate of interest is 2 percent, the target rate of inflation is 2 percent, and output is 3 percent above its potential, the target federal funds rate is

10 percent.

Unconventional monetary policy tools include all of the following, except which one?

reserve requirement

Forward guidance includes

statements today about policy targets in the future.

Suppose ECB officials ask your opinion about their operational framework for monetary policy. You respond by commenting on their success at keeping short-term interest rates close to target but also express concern about the complexity of their process for managing the supply of reserves. What specific changes would you suggest the ECB should make to its system in the future?

You might suggest that the ECB concentrate its operations in Frankfurt instead of having to coordinate these operations at all the national central banks simultaneously. You might also suggest that the ECB narrow the relatively long list of institutions that qualify as counterparties to open market operations and reduce the range of assets it accepts as collateral for these operations.

Suppose you receive the following information about two inflation-targeting economies:

Economy A has been volatile historically, with the unemployment rate fluctuating widely around the natural rate, and the neutral real interest rate estimated to be around 1.5 percent. Despite the economic volatility, the well-designed central bank has enjoyed many decades of credibility.

Economy B has seen unemployment rates stay relatively close to the natural rate with the neutral real interest rate estimated to be around 3 percent. Despite the stable unemployment rate, the credibility of the central bank is somewhat fragile.

Based on this information and assuming all other things are equal, which economy would be more likely to need the use of unconventional policy tools?

Economy A. The low neutral rates and high unemployment volatility increase the probability of needing to use unconventional policy tools.

Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 4 percentage points.

Target federal funds rate = Natural rate of interest + Current inflation + 1/2(Inflation gap) + 1/2(Output gap)

If inflation goes up by 4 percentage points, the target (nominal) federal funds rate goes up by ____ percentage points (____ percentage points due to the direct impact of inflation and another ____ percentage points due to an increase in the inflation gap).

Consider the Fisher equation. Given the increase in the nominal interest rate you just calculated and the 4 percentage point increase in inflation we started with, the real interest rate must have increased by ____ percentage points.

If inflation goes up by 4 percentage points, the target (nominal) federal funds rate goes up by 6 percentage points (4 percentage points due to the direct impact of inflation and another 2 percentage points due to an increase in the inflation gap).

To calculate the impact on the real interest rate, we can use the Fisher equation from Chapter Four: Nominal interest rate = Real interest rate + Inflation.

So, if the nominal rate increases by 6 percentage points and inflation increases by 4 percentage points, the real interest rate must have increased by 2 percentage points.

The conventional Taylor rule [Target federal funds rate = Natural rate of interest + Current inflation + ½ (Inflation gap) + ½ (Output gap)] places weights of one-half on the inflation gap and output gap, corresponding to the "dual mandate" of the U.S. central bank.

Taking into account what you know about the policy goals of the ECB, how might you amend the Taylor Rule to better approximate policymaking behavior by the ECB?

A weight on the inflation gap greater than 1/2 may be more appropriate in the ECB's case. However, the central bank is sensitive to output fluctuations, so the weight on the inflation gap should remain less than 1.

The central bank of a country facing economic and financial market difficulties asks for your advice. The bank cut its policy interest rate to the effective lower bound, but it was not low enough to stabilize the economy. Drawing on the actions taken by the Federal Reserve during the financial crisis of 2007-2009, what might you advise this central bank to do?

You should advise the central bank to use unconventional monetary policy tools such as quantitative easing, where aggregate reserves are provided beyond the level needed to lower the policy rate to zero, or credit easing, a policy in which the central bank alters the composition of its balance sheet. The central bank could also inform markets of its commitment to keep interest rates low (forward guidance).

Federal Reserve buying of mortgage-backed securities is an example of a targeted asset purchase. Explain how the Fed's actions are intended to work.

By purchasing mortgage-backed securities (MBS), the Fed sought to ____ mortgage rates in order to ____ home sales, ____ house prices, and ____ housing construction.

lower

increase

raise

promote

Considering the market for bank reserves, how can the Fed control independently both the price and quantity of aggregate bank reserves in the post-2008 environment?

The Fed can control the price in the market for reserves by changing the ____. When the Fed raises this rate, banks would be willing to pay a(n) ____ rate to borrow from nonbank participants in the federal funds market in order to deposit these funds at the IOER at the Fed. This process ____ the supply of aggregate reserves. It is reflected in ____ portion of the demand curve for reserves.

interest rate it pays on reserves

higher

does not change

an upward shift in the flat