R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 15 Monetary Policy LEARNING OBJECTIVES After studying this chapter, you should be able to: 15.1 Describe the goals of monetary policy 15.2 Understand how the Fed uses monetary policy tools to influence the federal funds rate 15.3 Trace how the importance of different monetary policy tools has changed over time 15.4 Explain the role of monetary targeting in monetary policy © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 15 Monetary Policy BERNANKE’S DILEMMA •During the financial crisis of 2007–2009, the Fed took extraordinary policy actions, including huge asset purchases that expanded bank reserves and the monetary base •The Fed had hoped for a strong recovery, where it could begin its “exit strategy” of returning bank reserves and the monetary base to more normal levels Unfortunately, as of July 2010, the economy was recovering more slowly than the Fed had hoped •Since most macroeconomic policy consists of monetary policy, it was not surprising that Bernanke was the center of attention as the economy struggled through a slow recovery in 2010 •For a discussion of some of the policy options open to the Fed, read AN INSIDE LOOK AT POLICY on page 472 © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During the financial crisis, the Federal Reserve employed a series of new policy tools in an attempt to stabilize the financial system Question: Should price stability still be the most important policy goal of central banks? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 15.1 Learning Objective Describe the goals of monetary policy © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 The Fed has set six monetary policy goals that are intended to promote a wellfunctioning economy: Price stability High employment Economic growth Stability of financial markets and institutions Interest rate stability Foreign-exchange market stability The Goals of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 Price Stability Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and as a unit of account Most industrial economies have set price stability as a policy goal Inflation makes prices less useful as signals for resource allocation Uncertain future prices complicate decisions households and firms have to make Inflation can also arbitrarily redistribute income Rates of inflation in the hundreds or thousands of percent per year—known as hyperinflation—can severely damage an economy’s productive capacity The range of problems caused by inflation—from uncertainty to economic devastation—make price stability a key monetary policy goal The Goals of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 High Employment High employment, or a low rate of unemployment, is another key monetary policy goal Unemployment reduces output and causes financial and personal distress Congress and the president share responsibility for the goal of high employment Even under the best economic conditions, some frictional and structural unemployment always remains The tools of monetary policy are ineffective in reducing these types of unemployment Instead, the Fed attempts to reduce levels of cyclical unemployment, which is unemployment associated with business cycle recessions Most economists estimate that the natural rate of unemployment is between 5% and 6% The Goals of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 Economic Growth Economic growth Increases in the economy’s output of goods and services over time; a goal of monetary policy Economic growth provides the only source of sustained real increases in household incomes Economic growth depends on high employment With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements Stable economic growth allows firms and households to plan accurately and encourages the long-term investment that is needed to sustain growth The Goals of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall of 61 Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers The Fed responded vigorously to the financial crisis that began in 2007, but it initially underestimated its severity and was unable to head off the deep recession of 2007–2009 Some economists believe that actions to deflate asset bubbles may be counterproductive, but the severity of the 2007–2009 recession has made financial stability a more important Fed policy goal The Goals of Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 61 Figure 15.5 (2 of 2) Choosing between Policy Instruments Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall In panel (b), the Fed chooses the federal funds rate as its policy instrument by keeping the rate constant, at R* If the demand for reserves increases from D1 to D2, the Fed will have to increase the supply of reserves from S1 to S2 in order to maintain its target for the federal funds rate at i*ff If the demand for reserves decreases from D1 to D3, the Fed will have to decrease the supply of reserves from S1 to S3 to maintain its target for the federal funds rate.• 47 of 61 The Fed faces a trade-off It can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate, but it cannot choose both Using reserves as the Fed’s policy instrument will cause the federal funds rate to fluctuate in response to changes in the demand for reserves Using the federal funds rate as the policy instrument will cause the level of reserves to fluctuate in response to changes in the demand for reserves By the 1980s, the Fed had concluded that the link between the federal funds rate and its policy goals was closer than the link between the level of reserves and its policy goals So, for the past 30 years, the Fed has used the federal funds rate as its policy instrument Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 61 The Taylor Rule: A Summary Measure of Fed Policy Actual Fed deliberations are complex and incorporate many factors about the economy John Taylor of Stanford University has summarized these factors in the Taylor rule Taylor rule A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate The Taylor rule begins with an estimate of the value of the real federal funds rate, which is the federal funds rate—adjusted for inflation—that would be consistent with real GDP being equal to potential real GDP in the long run With real GDP equal to potential real GDP, cyclical unemployment should be zero, and the Fed will have attained its policy goal of high employment Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 61 Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 50 of 61 Figure 15.6 The Taylor Rule The blue line shows the level of the federal funds rate that would have occurred if the Fed had strictly followed the Taylor rule, and the red line shows the target federal funds rate The figure shows that the Taylor rule does a reasonable job of explaining Federal Reserve policy during some periods, but it also shows the periods in which the target federal funds rate diverges from the rate predicted by the Taylor rule The shaded areas represent periods of recession. â 2012 Pearson Education, Inc Publishing as Prentice Hall 51 of 61 Inflation Targeting Before the financial crisis, many economists and central bankers expressed significant interest in using inflation targeting as a framework for monetary policy With inflation targeting, a central bank publically sets an explicit target for the inflation rate over a period of time, and the government and the public then judge the performance of the central bank on the basis of its success in hitting the target While the Fed has never gone beyond using an unannounced and informal target for the inflation rate, several countries have adopted formal inflation targets Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 52 of 61 Arguments in favor of an explicit inflation target focus on four points: It would draw attention to what the Fed can actually achieve in practice It would provide an anchor for inflationary expectations It would help institutionalize effective U.S monetary policy It would promote accountability Opponents of inflation targets also make four points: Rigid numerical targets for inflation diminish flexibility Reliance on uncertain forecasts of future inflation can create problems The focus on inflation may make it more difficult for elected officials to monitor the Fed’s support for good economic policy overall Uncertainty about future levels of output and employment can impede economic decision making in the presence of an inflation target Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 53 of 61 International Comparisons of Monetary Policy Central banks in industrial countries have increasingly used short-term interest rates as the policy instrument, or operating target, through which goals are pursued Many central banks are focusing more on ultimate goals such as low inflation than on particular intermediate targets The Bank of Canada •Gradually reduced the growth rate of M1 in the early 1970s as inflation became a concern •Shifted its policy toward an exchange rate target in the late 1970s •Reinstated its commitment to price stability in 1988 through declining inflation targets and operational target bands for the overnight rate •Focused on exchange rates, reflecting the importance of exports to the Canadian economy •Received praise for helping the Canadian financial system avoid the heavy losses suffered by many banks during the 2007-2009 financial crisis Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 54 of 61 The German Central Bank •Experimented with monetary targets in the late 1970s to combat inflation •Used an aggregate called central bank money, or M3, which is a weighted sum of currency, checkable deposits, and time and savings deposits •Succeeded in maintaining its target ranges for M3 growth in the early 1980s, but in the late 1980s, in an effort to devaluate its currency relative to the U.S dollar, the Bundesbank increased money growth faster than its announced targets •Confronted problems with reunification, as differences between West and East German currencies brought inflationary pressures •Used changes in the lombard rate (a short-term repurchase agreement rate) to achieve its M3 target •Relinquished its control of monetary policy to the European Central Bank after introduction of the euro in 2002 Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 55 of 61 The Bank of Japan •Adopted explicit money growth targets and reduced money growth after the oil shock of 1973, when the inflation rate was in excess of 20% •Having fulfilled its promises, the bank gained the public’s belief in its commitment to lower money growth and lower inflation •Used a short-term interest rate in the Japanese interbank market—similar to the U.S federal funds market—as its operating target •Relied less on its M2 aggregate after deregulation in the 1980s •Does not have formal inflation targets, although emphasizes price stability •Adopted deflationary monetary policy in the late 1990s and 2000s, which played a significant role in the weakness of the economy •Began to stimulate both economic growth and inflation in the mid-2000s •Intervened to reverse the soaring value of the yen against the U.S dollar, which was hampering exports and impeding an economic recovery Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 56 of 61 The Bank of England •Announced money supply targets in late 1973 in response to inflationary pressures, but the targets were not pursued aggressively •In response to accelerating inflation in the late 1970s, the government introduced in 1980 a strategy for gradual deceleration of M3 growth, but had difficulty achieving M3 targets •Shifted its emphasis toward targeting growth in the monetary base beginning in 1983 •Adopted inflation targets in 1992, and used short-term interest rates as the primary instrument of monetary policy •Was led to take several dramatic policy actions during the financial crisis, cutting its overnight base rate •Rapidly lowered the interest rate it paid banks on reserves, and engaged in quantitative easing Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 57 of 61 The European System of Central Banks •The ESCB consists of the European Central Bank (ECB) and the national central banks of all member states of the European Union •In operation since 1999 following the Treaty of Maastricht, the bank was modeled after the German Bundesbank, with price stability as its primary goal •Has secondary objective to support the general economic policies of the European Union •Attaches significant role to monetary aggregates—in particular, the growth rate of the M3 aggregate •Despite emphasis on price stability, has not committed to either a monetarytargeting or an inflation-targeting approach •Struggled to forge a monetary policy appropriate to the very different needs of the member countries during the financial crisis and its aftermath •Received further strains in 2010 by intervening in Greece’s sovereign debt crisis Monetary Targeting and Monetary Policy © 2012 Pearson Education, Inc Publishing as Prentice Hall 58 of 61 Answering the Key Question At the beginning of this chapter, we asked the question: “Should price stability still be the most important policy goal of central banks?” As we have seen in this chapter, economists debate whether central banks should have an explicit target for the inflation rate Doing so would make price stability the most important goal of central banks Although price stability in and of itself can increase economic well-being, most economists and policymakers see price stability as having broader benefits In particular, few economies have managed to sustain high rates of economic growth and high rates of employment in the long run without also experiencing price stability Whatever the merits of making price stability the focus of monetary policy, the severity of the financial crisis and recession pushed to the back burner further consideration of the Fed adopting an explicit target for the inflation rate © 2012 Pearson Education, Inc Publishing as Prentice Hall 59 of 61 AN INSIDE LOOK AT POLICY The Fed May Buy More Bonds to Boost Sluggish Economy WASHINGTON POST, Federal Reserve to Buy U.S Debt, Shifts Policies as Recovery Slows Key Points in the Article • Responding to a slowdown in the U.S economy’s recovery from the 2007– 2009 recession, the FOMC announced that it would increase its holdings of long-term Treasury bonds rather than replace its holdings of maturing mortgage securities • Fed leaders preferred not to favor housing over other sectors, especially because the mortgage market seemed to be functioning reasonably well • However, the purchase of Treasury bonds posed the threat of higher inflation because, in effect, the Fed would print money to finance U.S government budget deficits • The FOMC elected to keep its target for short-term interest rates near zero, as it had since December 2008, but it did not strengthen its previous pledge to keep rates near zero for an “extended period.” © 2012 Pearson Education, Inc Publishing as Prentice Hall 60 of 61 AN INSIDE LOOK AT POLICY The graph illustrates a possible response by the Fed to the threat of higher inflation It could sell Treasury securities to raise the federal funds rate from i*ff1 to a higher target rate, i*ff2 The open market sale would shift the supply curve for reserves from S1 to S2, which would decrease the equilibrium level of bank reserves from to R*1 to R*2 The graph also shows an increase in the discount rate from id1 to id2 © 2012 Pearson Education, Inc Publishing as Prentice Hall 61 of 61 ... system s demand for and the Fed’s supply of reserves to see how the Fed uses its policy tools to influence the federal funds rate and the money supply Demand for and Supply of Reserves The figure... policy The policy tool of setting the discount rate and the terms of discount lending Discount window The means by which the Fed makes discount loans to banks, serving as the channel for meeting the. .. offers on reserve balances The more funds banks place in term deposits, the less they will have available to expand loans and the money supply Monetary Policy Tools and the Federal Funds Rate ©