CENTRAL BANKING AND THE CONDUCT OF MONETARY POLICY U.S. Monetary policy

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CENTRAL BANKING AND THE CONDUCT OF MONETARY
POLICYU.S. Monetary policy The Fed
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• Federal Reserve System was founded by Congress in
  1913.
• Bank of Canada in 1935.
• The oldest is Sweden's Riksbank 1668.
• Bank of England 1694.
• Bank of France 1800.
• ECB (European Central Bank) 1998.

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Federal Reserve's Core Functions

• As a central bank its function is to manage the
  expansion and cost of money and credit, as a
  means of achieving the predetermined goals.
• Conducting Monetary Policy.
• Maintaining the stability of the financial
  system.
• Performing banking supervision and regulation.
• Providing financial services.

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Structure of The FRS
12 Federal Reserve Banks
Board of Governors Washington D.C.
FOMC (federal open market committee)
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• instrument independence - the ability of the
  central bank to set monetary policy instruments
• goal independence - the ability of the central
  bank to set the goals of monetary policy.
• BoC has less goal independence.
• BoC is not fully isolated from other branches of
  government. Ultimate responsibility for monetary
  policy goes to the government.
• BoC is less instrument independent.
• This independence story is important because
  independent Central Banks are able to achieve
  their goals (such as inflation reduction) better.

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• Monetary Policy Objectives
• ...maintain long run growth of the monetary and
  credit aggregates commensurate with the economy's
  long run potential to increase production, so as
  to promote effectively the goals of maximum
  employment, stable prices, and moderate long-term
  interest rates.
• i.e. to balance growth in M with growth in Y
• (see quantity theory of money equation)

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• Cost of Unemployment (from too little money
  growth) ? lost opportunities from idle resources,
  emotional pain
• Cost of Inflation (from too much money growth)
• ? destruction of savings, losses to creditors,
  shoeleather costs, menu costs, risk of
  entrenching inflation in peoples expectations.
• ? deflation also poses risks, primarily the risk
  that people postpone purchases and investments.
• What number should FOMC shoot for?
• Remember objective is price stability. ? so
  inflation should be 0 right?
• ? If you aim for 0 you might accidentally
  undershoot and achieve deflation. ? little
  inflation greases the wheels , motivates people
  to look for higher-paying jobs and find a better
  fit for their skills.
• ? economists have decided that inflation of 2
  does little harm, so better to shoot for that and
  avoid risk of deflation, unemployment.

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The Synthesis

• The prevalent and core view among the central
  bankers about how growth and inflation interact
  emerged as a result of
• Great Depression (1930s) ? Keynesians, short run
  Keynesians believe that in the short run, when
  demand is depressed, increasing the money supply
  and stimulating demand will not lead to inflation
• Great Inflation (1970s)? New Classicalists, long
  run New Classicalists, like Austrians, believe
  that in the long run, money is neutral in its
  effects on the economy, because prices will
  adjust to balance money with output. Growth in
  output and employment must come from improved
  productivity.
• Governors have to understand and accept both.

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• In the short run, for a given level of expected
  inflation, and for a given supply curve, monetary
  policy moves the AD curve up and down the supply
  curve. Therefore there is a tradeoff between
  unemployment and inflation, as shown in the
  Phillips curve.

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• If inflation gets too high i.e. the Central
  Bank stimulates AD too much, people will begin to
  expect higher inflation. The Aggregate Supply
  curve will shift towards the origin as people
  demand higher wages and higher rentals, leases,
  etc.

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NAIRU ParadigmModel of Growth and Inflation

• NAIRU stands for non-accelerating inflation rate
  of unemployment. It is the lowest you can push
  unemployment/the most you can stimulate aggregate
  demand without causing inflation.
• NAIRU is achieved at Yn, the full-employment
  level of GDP that we have used in our diagrams of
  AD/AS equilibrium.
• FOMC watches for NAIRU since it is the limit
  where a rise in the inflation rate will show up.

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More on NAIRU

• Very difficult to pin-point an exact number it
  changed over the years.
• Controversial. Where is it? - 6 prior to 1995.
  Around 4.5 late 1990s
• Recent estimates by many put it at 4.5 to 5.0.
• Really, you should think of it as concept not an
  exact number. It is a balancing point. A rough
  measure but a key one.
• The NAIRU is a moving target, estimated
  imprecisely, and with a lag that may be long
  enough to make it an uncertain guide for policy.
• Point of heated debate in the Fed meetings.
  Hawks vs. doves.
• Politicians do not like it the idea of cooling
  the economy (thereby raising unemployment) when
  the unemployment rate falls below NAIRU.
• NAIRU has decreased over the years due to
• Ease of internet job search
• Aging population
• Rising prison population
• Decline in power of minimum wage
• Decline in power of unions.

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• How fast can the economy grow?
• POTENTIAL OUTPUT GROWTH (POG) is about 2.5-3 in
  the US.
• OKUNs Law is a rule-of-thumb that predicts by
  what percentage unemployment will rise for every
  percentage point that output growth is below POG.
  In the US, the Okun coefficient seems to be
  about 0.4.

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SUMMARY
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• Traditional way of operating ? if U rate falls
  below NAIRU, economy overheats and rate of
  inflation increases, so reduce money supply.
• Mid 1990s temporary bliss ? U rate fell well
  below NAIRU (3.8) but inflation kept falling as
  well due to increases in productivity and
  competition from international trade. There
  seemed to be no need to reduce the money supply.
  
• In the 2000s the Fed kept the interest rate low
  to help the economy recover from the dot-com
  bubble, and then the 9/11 scare.
• House prices and stock prices bubbled.
• The Fed felt it was better to live with a bubble
  than to pop it as Japan did in the late 80s.
  Inflation was feared less than deflation.

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The Conduct of the Monetary policy

• The role of policy is to move the economy to some
  preferred state.
• Decisions are made at the FOMC meeting.
• They can use
• Reserve Requirements seldom changed
• Discount Window amount charged/paid to
  chartered banks for their loans/deposits.
• Federal Funds Rate (i.e. overnight lending rate
  to chartered banks) most often used tool. The
  announced rate is backed up by open market
  operations which work in the same direction.
  Once the FFR has been reduced to near zero, the
  Fed must find another tool if it wants to
  stimulate the economy any further.
• Big changes in the monetary base. This is called
  quantitative easing/tightening.

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Federal Funds Rate

• Is the interest rate charged on overnight loans
  from the Central Bank to commerical banks or from
  one commercial bank to another.
• Determined in the market for federal reserve
  balances (market for reserves)
• FED influences the price at which this
  lending/borrowing is being done through Open
  Market Operations

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Open Market Operations

• buying and selling of U.S. gov. bonds affects
  the federal funds rate and interest rates
  generally
• Most of it done in US Treasury securities ? most
  liquid market
• Buying bonds increases currency in circulation
  and selling bonds decreases it.

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Taylor Rule

• How should the target FFR be chosen?
• The Fed wants to decrease unemployment AND
  decrease inflation, if possible, but in the short
  run there is a tradeoff between these two goals.
• Fed funds rate target inflation rate
  equilibrium real fed funds rate 1/2
  (inflation gap) 1/2 (output gap)
• Simple policy rules like the Taylor rule are only
  rules of thumb, and reasonable people can
  disagree about important details of the
  construction of such rules. Moreover, simple
  rules necessarily leave out many factors that may
  be relevant to the making of effective policy in
  a given episode.
• The next graph shows that the Fed has behaved in
  a way consistent with the Taylor Rule.

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Channels

• How do changes in the Fed Funds Rate work their
  way to the economy?
• Raising or lowering the FFR influences 4 major
  channels linked to aggregate demand
• Higher (lower) interest rates discourage
  (encourage) business and consumer spending
• Weaken (raise) the value of the stock and housing
  market (mortgage rates) ? wealth effect
• Appreciate (depreciate) the value of the
  currency, decreasing (increasing) net exports.
• Credit channel Discourages (encourages) banks
  from lending, since the value of collateral has
  fallen (risen). (See point 2.)

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Credit Channel

• Wealth effect from houses and stocks not the
  whole story
• homes and stocks are used as collateral for loans
• tighter monetary policy decreases the value of
  homes and stocks ? lower collateral for borrowing
• tighter monetary policy ? weaker economic outlook
  (incomes profits)
• Result tougher standards for lending by banks in
  the credit market ? can harm economic growth
• Financial Accelerator is reduced when firms lack
  access to credit. The financial accelerator
  describes how firms increase their investment in
  response to improved sales.