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cha6 Monetary policy

Chapter 6

Monetary Policy

?Part I Tools of Monetary Policy

?Part II Conduct of Monetary Policy: Goals and Targets

Demand Curve for Reserves

1. R = RR + ER

2. i ↓, opportunity cost of ER ↓, ER ↑

3. Demand curve slopes down

Supply Curve for Reserves Rn+DL

1. If i ff is below i d , then discount borrowing, R s = R n

2. Supply curve flat (infinitely elastic) at i d because as i ff starts

to go above i d , banks borrow more at i d Market Equilibrium R d = R s at i *ff Supply and Demand for Reserves a. Response to Open Market

Operations

n ,↑and shifts supply

curve to right R s 2:

ff ↑c. Response to Change in Required Reserves §2. Open Market Operations 2 Types 1.Dynamic:Meant to change MB 2.Defensive:

Meant to offset other factors affecting MB, typically uses repos

2.Secondary Credit

3.Seasonal Credit

Lender of Last Resort Function

1.To prevent banking panics

FDIC fund not big enough

Example:Continental Illinois

2.To prevent nonbank financial panics

Examples:1987 stock market crash and September 11 terrorist incident Rightward shift of R s to

moves equilibrium to

point 2 where i 2ff = i d and discount lending rises DL 2How Primary Credit Facility Puts Ceiling on iff Discount Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting discount rate

4. Reserve Requirements Advantages

1.Powerful effect

Disadvantages

1.Small changes have very large effect on M s

2.Raising causes liquidity problems for banks

3.Frequent changes cause uncertainty for banks

4.Tax on banks

§2. Central Bank Strategy

?2006 Pearson Addison-Wesley. All rights reserved17-16

§3. Choosing the Targets

? 2 types of target variables

–Interest rates

–Aggregates (monetary aggregates and reserve

aggregates)

Money Supply Target

and M

-target at M*, i

fluctuates between i'

fluctuates

d'and

-target at i*

fluctuates

M' and M''

Criteria for Choosing Targets

Criteria for Intermediate Targets

1.Measurability

2.Controllability

3.Ability to predictably affect goals

Interest rates aren’t clearly better than M s on criteria 1

and 2 because hard to measure and control real interest

§4. History of Fed Policy Procedures

Early Years: Discounting as Primary Tool

1.Real bills doctrine

2.Rise in discount rates in 1920: recession 1920–21

Discovery of Open Market Operations

1.Made discovery when purchased bonds to get income in 1920s Great Depression

Pegging of Interest Rates: 1942-51

1.To help finance war, T-bill at 3/8%, T-bond at 2 1/2%

2.Fed-Treasury Accord in March 1951

Money Market Conditions: 1950s and 60s

1.Interest Rates

A.Procyclical M

Y ↑?i↑?MB↑?M↑

π↑?πe↑?i↑?MB↑?M↑

Targeting Monetary Aggregates: 1970s

1.Fed funds rate as operating target with narrow band

2.Procyclical M

?2006 Pearson Addison-Wesley. All rights reserved17-22 New Operating Procedures: 1979–82

1.Deemphasis on fed funds rate

2.Nonborrowed reserves operating target

3.Fed still using interest rates to affect economy and inflation Deemphasis of Monetary Aggregates: 1982–Early 1990s

1.Borrowed reserves (DL) operating target

A.Procyclical M

§5. Taylor Rule, NAIRU and the

Phillips Curve

Taylor Rule

Fed funds rate target = inflation rate +

equilibrium real fed funds rate +

1/2 (inflation gap) +

1/2 (output gap)

Phillips Curve Theory

Taylor Rule and Fed Funds Rate

?2006 Pearson Addison-Wesley. All rights reserved17-25

§2. Exchange-Rate Targeting

Advantages

1. Fixes πfor internationally traded goods

2. Anchors πexpectations

3. Automatic rule, avoids time-consistency

4. Easy to understand: “sound currency”as rallying

cry

5. Helps economic integration

6. Successful in reducing π

France, UK, Mexico

?2006 Pearson Addison-Wesley. All rights reserved17-28

Exchange-Rate Targeting Disadvantages

1. Loss of independent monetary policy

Problems after German reunification: UK, French

monetary policy too tight

2. Open to speculative attacks

Europe, Sept. 1992; Mexico: 1994; Asia: 1997

Currency Boards vs. Dollarization Currency Boards

1. Domestic currency exchanged at fixed rate for foreign

currency automatically

2. Fixed exchange rate with very strong commitment

mechanism and no discretion

3. Usual disadvantages of fixed exchange rate

4. Still subject to speculative attack

Summary: Advantages and Disadvantages

of Different Monetary Policy Strategies

?2006 Pearson Addison-Wesley. All rights reserved17-31 Summary: Advantages and Disadvantages

of Different Monetary Policy Strategies

§3. Monetary Targeting

Canada

1. Targets M1 till 1982, then abandons it

2. 1988: declining πtargets, M2 as guide

United Kingdom

1. Targets M3 and later M0

2. Problems of M as monetary indicator

Japan

1. Forecasts M2 + CD s

Monetary Targeting

Advantages

1. Able to cope with domestic considerations

2. Signals are immediate

3. Immediate accountability of central bank Disadvantages

1. Big if: all advantages require reliable relationship

between goal and targeted aggregate

2. In many countries, weak relationship between

goal and M-aggregate

Poor communications device and accountability

§4. Inflation Targeting

Five Elements

1.Public announcement of medium-term -

target

2.Institutional commitment to price stability Inflation

Targeting in

New Zealand,

Canada, and

the UK

17-36

Inflation Targeting

Advantages

1. Allows focus on domestic considerations

2. Not dependent on reliable relationship between

M-aggregate and inflation

3. Readily understood by public

4. Reduce political pressures for time-consistent

policy

5. Focus on transparency and communication

6. Increased accountability of central bank

7. Performance good: πand πe↓, and stays low in

business cycle upturn

Inflation Targeting

Disadvantages

1. Delayed signalling

2. Too much rigidity

3. Potential for increased output fluctuations

4. Low economic growth

§5. Monetary Policy

with an Implicit Nominal Anchor Forward-Looking and Preemptive to Deal

With Long Lags

Advantages

1. Focus on domestic considerations

2. Has worked very well in the U.S.