Monetary Policy & Stabilization

Monetary Policy and Stabilization

Monetary Policy Objectives and Framework

• Monetary policy objectives and the framework for setting and achieving them are derived from the relationship between the central bank and the government.
• Monetary policy objectives stem from the mandate of the Board of Governors of the Federal Reserve System as set out in the Federal Reserve Act of 1913 and its amendments.
• The law states that the Fed and the FOMC (Federal Open Market Committee) shall maintain long-term growth of monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
• The Fed's monetary policy objective has two distinct parts:
  1. A statement of the goals or ultimate objectives.
  2. A prescription of the means by which the Fed should pursue its goals.
• Goals of monetary policy are maximum employment, stable prices, and moderate long-term interest rates.
• In the long run, these goals are in harmony and reinforce each other, but in the short run, they might be in conflict.
• The key goal is price stability, which is the source of maximum employment and moderate long-term interest rates.
• The Fed is expected to maintain full employment and keep the price level stable by keeping the growth rate of the quantity of money in line with the growth rate of potential GDP.
• The Fed pays attention to two measures of inflation: the CPI (Consumer Price Index) and the personal consumption expenditure (PCE) deflator.
• The Fed’s operational guide is the PCE deflator excluding fuel and food—the core PCE deflator.
• The rate of increase in the core PCE deflator is the core inflation rate.
• The Fed believes that the core inflation rate is less volatile than the CPI inflation rate and provides a better measure of the underlying inflation trend.
• Stable prices is the primary goal, but the Fed also pays attention to the business cycle.
• To gauge the overall state of the economy, the Fed uses the output gap—the percentage deviation of real GDP from potential GDP.
• A positive output gap indicates increasing inflation.
• A negative output gap indicates unemployment above the natural rate.
• The Fed tries to minimize the output gap.
• The Fed’s FOMC makes monetary policy decisions.
• Congress plays no role in making monetary policy decisions.
• The Fed makes two reports a year, and the Chairman testifies before Congress (February and June).
• The formal role of the President is limited to appointing the members and Chairman of the Board of Governors.

The Conduct of Monetary Policy

• The monetary policy instrument is a variable that the Fed can directly control or closely target.
• The Fed has two possible instruments:
  1. Monetary base
  2. Federal funds rate—the interest rate at which banks borrow and lend overnight from other banks.
• The Fed’s choice of policy instrument is the federal funds rate (the same choice as that made by most other major central banks).
• The Fed sets a target for the federal funds rate and then takes actions to keep it close to its target.
• When the Fed wants to avoid recession, it lowers the Federal funds rate.
• When the Fed wants to check rising inflation, it raises the Federal funds rate.
• Although the Fed can change the federal funds rate by any reasonable amount that it chooses, it normally changes the rate by only a quarter of a percentage point.
• The Fed uses open market operations to adjust the quantity of the monetary base to move the federal funds rate to the target level.
• The demand for reserves slopes downward because the federal funds rate is the opportunity cost of holding reserves, and the higher the federal funds rate, the fewer are the reserves demanded.
• The Fed uses open market operations to make the quantity of reserves supplied equal to the quantity demanded at the target rate.
• Equilibrium in the market for reserves determines the actual federal funds rate.
• By using open market operations, the Fed adjusts the supply of reserves to keep the federal funds rate on target.
• The Fed’s decision begins with an intensive assessment of the current state of the economy.
• Then the Fed forecasts three variables:
  • Inflation rate
  • Unemployment rate
  • Output gap
• If the inflation rate is above the comfort zone or expected to move above it, the Fed considers raising the federal funds rate target.
• If the inflation rate is below the comfort zone or expected to move below it, the Fed considers lowering the federal funds rate target.
• If the unemployment rate is below the natural unemployment rate, a labor shortage might put pressure on wage rates to rise, which might feed into inflation. The Fed might consider raising the federal funds rate.
• If the unemployment rate is above the natural unemployment rate, a lower inflation rate is expected. The Fed might consider lowering the federal funds rate.
• If the output gap is positive, it is an inflationary gap, and the inflation rate will most likely accelerate. The Fed might consider raising the federal funds rate.
• If the output gap is negative, it is a recessionary gap, and inflation might ease. The Fed might consider lowering the federal funds rate.

Monetary Policy Transmission

• When the Fed lowers the federal funds rate, it buys securities in an open market:
  1. Other short-term interest rates and the exchange rate fall.
  2. The quantity of money and the supply of loanable funds increase.
  3. The long-term real interest rate falls.
  4. Consumption expenditure, investment, and net exports increase.
  5. Aggregate demand increases.
  6. Real GDP growth and the inflation rate increase.
• When the Fed raises the federal funds rate, it sells securities in an open market, and the ripple effects go in the opposite direction.
• Short-term rates move closely together and follow the federal funds rate.
• Long-term rates move in the same direction as the federal funds rate but are only loosely connected to the federal funds rate.
• The exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential.
• When the Fed lowers the federal funds rate, the quantity of money and the quantity of bank loans increase.
• Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate.
• A change in the federal funds rate changes aggregate expenditure plans, which in turn change aggregate demand, real GDP, and the price level.
• If inflation is low and the output gap is negative, the FOMC lowers the federal funds rate target. An increase in the monetary base increases the supply of money, and the short-term interest rate falls. The increase in the supply of money increases the supply of loanable funds. The real interest rate falls, and investment increases. The increase in investment increases aggregate planned expenditure. Real GDP increases to potential GDP.
• If inflation is too high and the output gap is positive, the FOMC raises the federal funds rate target. A decrease in the monetary base decreases the supply of money, and the short-term interest rate rises. The decrease in the supply of money decreases the supply of loanable funds. The real interest rate rises, and investment decreases. The decrease in investment decreases aggregate planned expenditure. Real GDP decreases and closes the inflationary gap.
• The Fed influences the inflation rate and the output gap.

Extraordinary Monetary Stimulus

• Two other approaches to monetary policy that other countries have used are:
  • Inflation rate targeting
  • Taylor rule

Inflation Rate Targeting

• Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment:
  1. To achieve an explicit inflation target
  2. To explain how its policy actions will achieve that target
• Several central banks practice inflation targeting and have done so since the mid-1990s.
• Inflation targeting is a strategy that avoids serious inflation and persistent deflation.

Taylor Rule

• The Taylor rule is a formula for setting the interest rate.
• By using a rule to set the interest rate, monetary policy contributes toward lessening uncertainty.
• With less uncertainty, financial markets, labor markets, and goods markets work better as traders are more willing to make long-term commitments.