Reading 15: Monetary Policy

Book 1 Economics

Roles of Central Banks

Sole supplier of currency

Banker to the government and other banks

Regulator and supervisor of payments systems

Lender of last resort

Holder of gold and foreign exchange reserves

Conductor of monetary policy

Other goals of the central bank

Stability in exchange rates with foreign currencies

Full employment

Sustainable positive economic growth

Moderate long-term interest rates

What is the primary goal of the central bank?

Control inflation

Menu Costs

cost to businesses for constantly changing their price

Shoe Leather Costs

costs to individuals for making frequent trips to the bank to minimize their cash holdings due to inflation

What is the general target inflation rate?

1-3 percent

Mean is 2% and standard deviation of 1%

What are the monetary policy tools?

Policy Rate

Reserve Requirements

Open Market Operations

Discount Rate

the rate at which banks in the United States can borrow money from the Fed if they’re low on reserve funds

What does the ECB call the discount rate?

Refinancing Rate

What is a repurchase agreement?

The central bank agrees to buy a bank’s securities in the agreement that the bank will purchase them at a later date for a premiumW

What is the ECB’s repurchase agreement called?

Two-week repo rate

The repurchase agreement is effectively a _____?

rate

Federal Funds Rate

the rate at which banks lend overnight loans to each other

Reserve Requirements (def)

the percentage of deposits that banks are required to have as reserves

Open Market Operations (def)

buying and selling of securities by the central bank

What is the most used Fed tool?

Open Market Operations

Monetary Transmission Mechanism

how a change in the monetary policy rate affects price level and inflation

What channels are affected by policy rate changes?

Other short-term lending rates

Asset values

Currency exchange rates

Expectations

How is the currency exchange rate affected if the fed funds rate increases?

Domestic currency becomes more expensive allowing more imports to be purchased. This reduces the purchasing power of foreign countries for domestic exports and therefore will probably be contractionary

How does a Central Bank Achieve Inflation Targets?

Independence

Credibility

Transparency

Operational Independence

Fed is allowed to independently determine the policy rate

Target Independence

Fed defines the target rate

TRUE or FALSE: central banks target future inflation, not current

True, usually 2 years out

Interest Rate Target

increasing the money supply when specific interest rates rise above a target

Vice versa

Inflation Targeting

target an inflation level

Exchange Rate Target

foreign exchangeMo rate is monitored to another currency, often the dollar

Most common targeting?

Inflation

In Exchange Rate Targeting, what must the foreign country do if their currency falls against the dollar?

Use reserves to purchase domestic currency or sell bonds in the domestic currency

Downfall (or upside) to Exchange Rate Targeting

Targeting country will have the same inflation as the targeted country

Bond Market Vigilates

acting against the Fed’s intentions to profit

Liquidity Trap

when interest rates are lowered and already near zero but consumers prefer to hold cash due to uncertainty

an example of how monetary policy does not always produce the outcome intended