Dolan, Economics Combined Version 4e, Ch. 23 Macroeconomics Rittenberg and Tregarthen 11 Monetary Policy

Dolan, Economics Combined Version 4e, Ch. 23

MacroeconomicsRittenberg and Tregarthen

11Monetary Policy

Monetary VS Fiscal

Monetary: MoneyMoney supplyMoney Price

Interest rateExchange rate

Fiscal: “pertaining to public treasury or revenues”TaxesBudgets

SpendingBalancing

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The Federal Reserve System The Federal Reserve System (“the Fed”)

serves as the central bank for the United States.

A central bank typically has the following functions: It is the banks’ bank: it accepts deposits

from and makes loans to commercial banks.

It acts as banker for the federal government.

It controls the money supply.Performs certain regulatory functions for

the financial industry.


Structure of the Federal Reserve System

The primary elements in the Federal Reserve System are:

1. The Board of Governors

2. The Regional Federal Reserve District Banks (FRBs)

3. The Federal Open Market Committee (FOMC)

5

The Federal Reserve Banks

12 District banks Nine directors The directors appoint the

district president who is approved by the Board of Governors


The Federal Reserve System


The Board of Governors

Seven members Appointed by the President Confirmed by the Senate Serve 14-year term Terms are staggered so that one comes vacant every two

years President appoints a member as Chairman to serve a

four-year term

Ben Bernanke, FED Chairman


Federal Open Market Committee (FOMC)

Meets approximately every six weeks to review the economy

Made up of the following voting members:7 members of the Board of Governors5 of the FRB presidents (they rotate yearly)= 12 FOMC members


Functions of the Fed (1) Banking Services and Supervision

It supplies currency to banks through its 12 district banks. It holds the reserves of banks in the district bank of each bank. It processes and routes checks to banks through its district banks and

processing centers. It makes loans to banks—it is the “lender of last resort”, the “banker’s

bank”. It supervises and regulate banks, ensuring that they operate in a sound and

prudent manner. It is the banker for the U.S. government. It sells government securities for

the U.S. Treasury.


Functions of the Fed (2)

Controlling the Money SupplyThe money supply is varied through

the course of the year to meet seasonal fluctuations in the demand for money. This helps keep interest rates less volatile.Example: 4th quarter holiday season

creates an increased demand for money to buy gifts.

The Fed also changes the money supply to achieve policy goals set by the FOMC.


Policy Goals of the Fed Ultimate Goal:

Economic growth with stable prices. This means greater output (GDP) and a low, steady rate of inflation.

Intermediate Targets:The Fed does not control output or the prices

directly. It does control the money supply.The Fed establishes target growth rates for the

money supply, which it believes are consistent with its ultimate goals.

The money supply growth rate becomes an intermediate target, an objective used to achieve some ultimate policy goal.

Vocabulary

Contractionary Policy: A government policy intending to slow the economy to prevent inflation.

Monetary Policy Examples: Reduce money supply, increase interest rate, increase foreign exchange rate

Policy Instrument (Tool): Sell Bonds, Increase the Discount Rate, Increase required reserve ratio, sell foreign currency/buy dollars in foreign exchange markets

Vocabulary

Expansionary Policy: A government policy intending to speed or expand the economy to bring an end to recession, increase employment, or prevent deflation.Monetary Policy Examples: Expand money supply,

decrease interest rate, decrease foreign exchange rate

Policy Instrument (Tool): Buy Bonds, Decrease the discount rate, Decrease required reserve ratio, buy foreign currency/sell dollars in foreign exchange markets

Clicker

Selling bonds would be a tool for:

A. Expansionary policy

B. Contractionary policy

C. Fiscal policy

D. No policy at all


Lags

• Recognition lag is the delay between the time a macroeconomic problem arises and the time at which policy makers become aware of it.

• Implementation lag is the delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted.

• Impact lag is the delay between the time a policy is enacted and the time that policy has its impact on the economy.


Forecasting Errors

To overcome the problem of lags, policymakers must try to act in advance, based on forecasts

However, forecasts are not accurate. On average, forecasts of GDP growth have an error of about1 percent for 1 year forecasts in developed countries2 percent for 2 year forecasts in developed countries3 percent for 2 year forecasts in developing countries

Forecasts are least accurate at turning points in the business cycle, just when they are needed most

Time-Inconsistency

Time-inconsistency means the tendency to make decisions that have good consequences in the short run, but bad consequences in the long run

Example from everyday life: You stop taking your antibiotic medication because of bad side effects before you are completely cured

Example from macroeconomics: Before an election, policymakers use excessive expansionary policy or avoid needed contractionary policy


Fine-Tuning in the U.S. Economy

U.S. policymakers attempted to fine-tune the economy in the 1960s and 1970s

Because of lags, forecasting errors, and time-inconsistency, the result was a series of business cycles with increasing inflation and unemployment


Fine-tuning vs. Policy Rules

Fine-tuning uses frequent discretionary policy to make small adjustments to aggregate demand

Preset policy rules aim to provide a transparent and credible framework for business and household decisions

“The notion that central banks can provide a low-cost, over-the-counter “aspirin” that will alleviate almost any ill that a society can face is no longer credible”

— Robert Poole

President, Federal Reserve

Bank of St. Louis


Instruments, Targets, and Goals

A policy instrument is a variable that is directly under control of policymakers.

An operating target is a variable that responds immediately, or almost immediately, to the use of a policy instrument.

An intermediate target is a variable that responds to the use of a policy instrument or a change in operating target with a significant lag.

A policy goal is a long-run objective of economic policy that is important for economic welfare.


Monetarism

Monetarists like Milton Friedman advocated the use of a steady rate of money growth, approximately equal to the long-run rate of growth of real output, as an intermediate target

If velocity was reasonably stable, a money growth rule would avoid excessive inflation or deflation

Equation of Exchange

MV = PQ

Where M is the money stock V is velocity P is the price level Q is the rate of GDP growth

If V is constant and growth of M equals growth of Q, P will be constant

Inflation targeting

The rate of inflation averaged over one or two years is the main intermediate target

Interest rates are used as the operating target Open market operations are used as the main

policy instrument


The interest rate operating target

The Fed sets the discount rate charged on loans to banks and the deposit rate paid on reserves to form a corridor

The federal funds target rate is set in the middle of the corridor Open Market Operations are used to adjust the supply of reserves

to keep the federal funds rate close to its target


Adjusting the Interest Rate Target Inflation targeting policy sets an upper and lower limit for growth

of the price level to form a cone around the intended inflation target

If the actual inflation rate threatens to move outside the cone, the interest rate target is raised to slow growth of aggregate demand


The Foreign Exchange Market

The exchange rate of the peso to the dollar depends on supply and demand

Dollars are supplied by U.S. residents who want to buy Mexican goods or services, or to make investments in Mexico

Dollars are demanded by Mexican residents who want to buy U.S. goods and services, or make investments in the United States


A Change in Supply

In 2009, an outbreak of swine flu in Mexico reduced tourist travel, shifting the supply curve of dollars to the left

The result was a depreciation of the peso (appreciation of the dollar), that is, an equilibrium exchange rate with more pesos per dollar


A change in demand

Suppose an increase in U.S. interest rates makes U.S. securities more attractive to Mexican investors

The result is an increased demand for dollars

The peso depreciates (the dollar appreciates)


An exchange rate operating target

Some central banks use the exchange rate as an operating target

If the demand for dollars increases, the peso would depreciate if nothing was done

To prevent depreciation, the Mexican central bank increases the supply of dollars by selling dollars from its foreign currency reserves


Reasons for an Exchange Rate Target

Two principal reasons to maintain an exchange rate target To reduce the risks and costs of international trade in goods and

services To anchor the domestic currency to a stable foreign currency in

order to fight inflation

When in works An exchange rate target works best for small countries with

flexible economies, strong trading links to the currency partner, and low exposure to external shocks

Countries that do not want to use an exchange rate in the long run can use an exchange rate target temporarily to stop inflation, but then they should have an exit strategy

Documents

Dolan, Economics Combined Version 4e, Ch. 23 Macroeconomics Rittenberg and Tregarthen 11 Monetary Policy