What Should What Should the Fed Do?the Fed Do?

ECO 285 - Macroeconomics - Dr. D. Foster

Policy Tools, Policy Tools, Objectives and Objectives and

Targets.Targets.

Additional Resources on Monetary PolicyAdditional Resources on Monetary Policy

The Mission of the Fed

(Federal Reserve Board of Governors)(Federal Reserve Board of Governors)

What are the Goals of U.S. Monetary Policy?

(Fed’l Reserve Bank of San Francisco)(Fed’l Reserve Bank of San Francisco)

How does Monetary Policy affect the U.S. Economy?

(Fed’l Reserve Bank of San Francisco)(Fed’l Reserve Bank of San Francisco)

FYI:FYI:

The Federal Reserve System: Purposes & FunctionsThe Federal Reserve System: Purposes & Functions

(Federal Reserve Board of Governors)(Federal Reserve Board of Governors)

Federal Reserve Policy ToolsFederal Reserve Policy Tools

• Open Market OperationsOpen Market Operations Buy/sell Treasury bonds to affect bank reserves. The major form of monetary policy. What will the Fed do if we run out of Treasury bonds?

• Discount WindowDiscount Window Lend to member banks to affect bank reserves. Purpose is to target the “federal funds rate” – iff

This is the rate that banks charge each other for very short term loans.

• Required Reserve Ratio (rrRequired Reserve Ratio (rrDD)) Changing this affects bank excess reserves directly. Used more to reflect structural changes. Was used in 1937 and precipitates more Great Depression. Time to let this go? New policy – Pay banks i for ER (!!)

Goals of Monetary PolicyGoals of Monetary Policy

• Inflation goals:Inflation goals:Low/no inflation with limited year-to-year variability.

• Output goals:Output goals:High and stable economic (GDP) growth.

• Employment goals:Employment goals:Stable employment growth with low unemployment.

Intermediate Targets of Monetary PolicyIntermediate Targets of Monetary Policy

• The key rationalekey rationale for intermediate targeting:

The limited long-term informationinformation about the economy available to policymakers.

Choosing an Intermediate Target VariableChoosing an Intermediate Target Variable

• CharacteristicsCharacteristics:Frequently observableobservable ConsistencyConsistency with

ultimate goalsDefinable and

measurablemeasurable ControllableControllable

• Potential variablesPotential variables:Monetary aggregates

M1, M2, MZM Interest rates

(fed’l funds, prime …)Others:

Nominal GDP Credit aggregates Exchange rates

Getting from bond purchases to interest ratesGetting from bond purchases to interest rates

Face value (FV)

$$$

mm/yyyy

$ $ $ $ $ $

Bond

Maturity date(in n

years)

Coupons & value

(C)

When the Fed buys bonds, their prices will ___ and interest rates will ___.sells

• Usually, we talk of annual coupons• Market price of the bond = present value of income stream

discounted at interest rate i:

Some simple bond pricing problemsSome simple bond pricing problems

1. A bond has a face value (FV) of $1000, will mature in April, 2022 and has an annual coupon of $74 and the market rate of interest is 8.1%.a) What is the current market price of this bond?

b) Suppose that the current market interest rate falls to 6.54%. What will be the new market price for this bond?

c) Suppose that when the bond was first sold, it’s market price was $1000. What must have been the market rate of interest then?

2. Consider a bond with FV=$1000, maturity = 4/2024, C=$81 and i=7.25%a) What is the current price of this bond?

b) If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it will affect all interest rates to some extent. If they buy lots of bonds and interest rates fall to 6.88%, what will happen to the price of your bond?

3. The bond in #2 was given to you by your kindly aunt. She told you it matures in 2024, but her eyesight isn’t so good. You take a close look at the bond and see that it matures in 2020. Market i=7.25%.a) What is the price of this bond? Why is it different than what you calculated in #2a?

Is Policy the Right Choice?Is Policy the Right Choice?

Time lagslags make effective policy uncertain.

Discretionary policy promotes uncertainty.

RulesRules and crediblecredible adherence can eliminate bias.

IndependenceIndependence is a likely key requirement.

Time Lags in Monetary (& Fiscal) PolicyTime Lags in Monetary (& Fiscal) Policy

• Policy time lags Recognition lagRecognition lag Response lagResponse lag Transmission lagTransmission lag

time

Real GDP

Business cycle

Monetary Policy may be counterproductiveMonetary Policy may be counterproductive

time

%Real GDP

Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Ideally, policy would dampen the business cycle…

But, dampening the business cycle may lower ave. growth!

Discretion versus RulesDiscretion versus Rules(Milton Friedman)(Milton Friedman)

• Discretionary policy is the sourcesource of instability.

• A policy rulerule can eliminate that instability.Set target for Bank ReservesBank Reserves, Monetary BaseMonetary Base,

Money SupplyMoney Supply to grow in LR sustainable fashion.

This is a commitment to a fixed strategy no matter no matter whatwhat happens to other economic variables.

• To be successful, the commitment must be crediblecredible.The public believes the Fed will act this way.

Rules = Automatic Stabilizer

Has the Fed maintained stable prices?Has the Fed maintained stable prices?

Has the Fed maintained the value of the $?Has the Fed maintained the value of the $?

4%

Making Monetary Policy TransparentMaking Monetary Policy Transparent

FOMC - PRFOMC - PR

March 19, 2014March 19, 2014

Yellen’s Press Yellen’s Press ConferenceConference

March 19, 2014March 19, 2014

Making Monetary Policy Rules Making Monetary Policy Rules CredibleCredible

• Place constitutional limitsconstitutional limits on monetary policy.

• Achieve credibility by establishing a reputationreputation.

• Maintain central bank independenceindependence.

• Establish central banker contractscontracts.

• Appoint a “conservativeconservative” central banker.

Making Monetary Policy Rules Making Monetary Policy Rules CredibleCredible

• Place constitutional limitsconstitutional limits on monetary policy.

• Achieve credibility by establishing a reputationreputation.

• Maintain central bank independenceindependence.

• Establish central banker contractscontracts.

• Appoint a “conservativeconservative” central banker.

What Should What Should the Fed Do?the Fed Do?

ECO 285 – Macroeconomics – Dr. D. Foster

Policy Tools, Policy Tools, Objectives and Objectives and

Targets.Targets.