Monetary Policy

GOVERNMENT & THE ECONOMY

RecessionsA significant decline in activity across the economy,

lasting longer than a few months It is visible in industrial production, employment,

real income and wholesale-retail tradeThe technical indicator of a recession is two

consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP)although the National Bureau of Economic Research

(NBER) does not necessarily need to see this occur to call a recession.

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InflationThe rate at which the general level of prices for goods

and services is rising, and, subsequently, purchasing power is falling.

Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum. 

As inflation rises, every dollar will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in a year. 

Most countries' central banks will try to sustain an inflation rate of 2-3%.

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Monetary PolicyUsed by Federal Reserve System to

influence money supply and availability of creditInduces changes in interest rates to influence

prices, employment & spending

Lessons from the Great Depression Video

Monetary PolicyThe actions of a central bank, currency

board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates.

Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).

Monetary PolicyIn the U.S., the Federal Reserve is in charge of

monetary policy. Monetary policy is one of the ways that the

U.S. government attempts to control the economy. If the money supply grows too fast, the rate of

inflation will increaseIf the growth of the money supply is slowed too

much, then economic growth may also slow. In general, the U.S. sets inflation targets that are

meant to maintain a steady inflation of 2% to 3%.

Monetary policy can be categorized by four characteristics

Monetary Policy

Goals

InstrumentsIntermediate Targets

Discretion

Instruments refer to the policy options the Fed has to control the supply of money…

Open Market Operations

By purchasing or selling US Treasuries, the Fed can alter the supply of bank reserves (MB)

Discount Window Loans

The Fed can also influence reserves by altering the interest rate charged on loans to commercial banks. (MB)

Reserve Requirements

Reserve Requirements influence the ability of banks to create new loans which affects the broader aggregates (M1,M2,M3)

This is the most often used instrument!

Monetary Policy goals address the central bank’s agenda in general terms

The Bank of England Follows an explicit Inflation Target. Specifically, the goal is to maintain 2% annual inflation.

The Bank of China appears to have export driven growth as their primary objective

The ECB (European Central Bank) and the Federal Reserve follow policies of stable prices and maintenance of full employment

Intermediate Targets address the question: “How will I meet my goals?”. Targets are variables that the central bank can more directly control.

For Tiger Woods, the goal is to win the golf tournament

The target is to score 18 under par (the number he thinks he needs to win)

The Bank of China is currently targeting the exchange rate at 8.28 Yuan per dollar

The Federal Reserve is currently targeting the Federal Funds Rate at 2.75%

The Bank of England is currently targeting the repo rate at 4.75%

Goals vs. Targets

Targets can be broadly classified into either “Price Targets” or “Quantity Targets”

Suppose that the Federal Government could influence the supply of oranges and wanted to regulate the orange market

Quantity of Oranges

Price

Demand

Supply

$5/Lb

Lowering the price to $4 (price target) and Raising the quantity to 1,500 (quantity target) are both describing the same policy (expanding the orange market) 1,00

01,500

$4/Lb

Targets can be broadly classified into either “Price Targets” or “Quantity Targets”

Quantity of Oranges

Price

Demand

Supply

$5/Lb

If demand for oranges increases and the Fed is following a price target, they must respond by increasing supply

Target Range

However, your response to demand changes will differ across policies

Targets can be broadly classified into either “Price Targets” or “Quantity Targets”

Quantity of Oranges

Price

Demand

Supply

If demand for oranges increases and the Fed is following a quantity target, they must respond by decreasing supply

1000Lbs

Target Range

However, your response to demand changes will differ across policies

Suppose that the Fed wants to lower its target to 4% (expansionary monetary policy)

Interest Rate (i) M2 =

mm(MB)

M P

Md(y,t)

5%

M2 Multiplier = 8

Change in M2 = $2,000

4%

2,000 8

= $250

A $250 purchase of Treasuries would be required

Suppose that the Fed is Targeting the Interest Rate at 5%

Interest Rate (i) M2 =

mm(MB)

M P

Md(y,t)

5%

M2 Multiplier = 8

Suppose an increase in GDP raises Money Demand

Change in M2 = $1,000

The Fed needs to increase the monetary base by

1,000 8

= $125

(An Open Market Purchase of Treasuries)

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Fed FundsDiscountPrime

During the late 70’s, the federal reserve changed its policy from an interest rate target to a money target. The money target was abandoned in the mid eighties.