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Chapter 16The Conduct of Monetary Policy:
Strategy and Tactics
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Price stability using nation’s PL (or MS) Economic growth Price stability and full employment stability of financial markets interest-rate stability stability in foreign exchange markets
Goals of Monetary Policy
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Public announcement of medium-term numerical target for inflation
Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal
Information-inclusive approach in which many variables are used in making decisions
Increased transparency of the strategy
Increased accountability of the central bank
Inflation Targeting
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Inflation Targeting
Figure 1
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The Fed’s Monetary Policy Strategy
U.S. has achieved excellent macroeconomic performance (including low and stable inflation) until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation target
History: Fed began to announce publicly targets for money supply growth in 1975 Paul Volker (1979) focused more in nonborrowed reserves
Greenspan (July 1993): monetary aggregates no longer used Now:
No nominal anchor in the form of an overriding concern for the Fed Forward looking behavior and periodic “preemptive strikes” The goal is to prevent inflation from getting started
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Raising and lowering the discount rate has no effect on reserves
28 Q
iff
SR3
SR4
Discount Rate in Normal Mode
DR
2
Federal Funds Market
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Raising and lowering the discount rate has no effect on reserves
28 Q
iff
SR3
SR4
Discount Rate in Normal Mode
DR
2
Federal Funds Market
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Required Reserves Ratio in Normal Mode
Raising the required reserve ratio raises, the federal funds rate, increases discount lending, can increase excess reserves, and shrink MS.
28 Q
iff
2
SR3
DR
31
Federal Funds Market
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Federal Funds Rate in Normal Mode
Normal fluctuations in economic activity cause reserves demand to fluctuate
28 Q
iff
SR3
DR
Target 2
Federal Funds Market
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DR
SR
Federal Funds Rate in Normal Mode
Inflation targeting: OMOs are used to keep iff at its target
Q
iff
3
OMS DR
SR
Target 2
OMP
If each oscillation in R equals $100b and m = 4, then
each oscillation in MS equals $400b
28
Federal Funds Market
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DR
SR
Federal Funds Rate in Normal Mode
Money targeting: OMOs are used to keep MS growing at 3%
Q
iff
3
2
28
OMS > OMP
Federal Funds Market
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DR
SR
Federal Funds Rate in Normal Mode
Q
iff
3
2
OMP > OMS
28
Federal Funds Market
Money targeting: OMOs are used to keep MS growing at 3%
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DR
SR
Federal Funds Rate in Normal Mode
Federal Funds Marketiff
3
2
OMS > OMP
28
Money targeting: OMOs are used to keep MS growing at 3%
Q
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DR
SR
Federal Funds Rate in Normal Mode
iff
3
2
OMP > OMS
28
Federal Funds Market
Money targeting: OMOs are used to keep MS growing at 3%
Q
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DR
SR
Federal Funds Rate in Normal Mode
iff
3
2
OMP > OMS
28
Federal Funds Market
Money targeting: OMOs are used to keep MS growing at 3%
Q
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DR
SR
Federal Funds Rate in Normal Mode
iff
When R are grown at a rate that grows MS
at its desired rate,iff fluctuates.
3
2
OMP > OMS
28
Federal Funds Market
Money targeting: OMOs are used to keep MS growing at 3%
Q
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Raising and lowering the discount rate has no effect on reserves
Q
iff
iff = ior =
SR3
SR4
Discount Rate in CRISIS Mode
DR2
28
Federal Funds Market
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DR
Raising and lowering the discount rate has no effect on reserves
28 Q
iff
SR3
SR4
Discount Rate in CRISIS Mode
iff = ior = 2
Federal Funds Market
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DR DR
Required Reserves Ratio in CRISIS Mode
Raising the required reserve ratio raises, the federal funds rate, increases discount lending, can increase excess reserves, and shrink MS.
28 Q
iff
SR3
29
iff = ior = 2
Federal Funds Market
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Federal Funds Rate in CRISIS Mode
Normal fluctuations in economic activity cause reserves demand to fluctuate
28 Q
iff
SR3
DRiff = ior =
With ior setiff & R
do not change
2
Federal Funds Market
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Federal Funds Rate in CRISIS Mode
28 Q
iff
3
DRiff = ior = 2
OMOs have no effect on MS or iff
with ior set.
Federal Funds Market
Inflation targeting: OMOs are used to keep iff at its target?
SR
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Federal Funds Rate in CRISIS Mode
id and ior can be raised together
without affectingR or MS
SR
DR
28 Q
iff
3
iff = ior = 2
Federal Funds Market
Inflation targeting: OMOs are used to keep iff at its target?
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DR
Required Reserves Ratio in CRISIS Mode
28 Q
SR
iff
3
iff = ior = 2
OMPs increase the amount of excess Reserves
OMP
Federal Funds Market
Money targeting: Can OMOs be used to keep MS growing steady?
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DR
Required Reserves Ratio in CRISIS Mode
28 Q
SR
iff
3
iff = ior = 2
OMP
Federal Funds Market
Money targeting: Can OMOs be used to keep MS growing steady?
OMPs increase the amount of excess Reserves
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DR
Required Reserves Ratio in CRISIS Mode
28 Q
SR
iff
3
iff = ior = 2
OMP
Federal Funds Market
Money targeting: Can OMOs be used to keep MS growing steady?
OMPs increase the amount of excess Reserves
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DR
Required Reserves Ratio in CRISIS Mode
28 Q
SR
iff
3
iff = ior = 2
The Fed can’t target money
OMP
Federal Fundsmarket is in
a liquidity trap
Federal Funds Market
Money targeting: Can OMOs be used to keep MS growing steady?
OMPs increase the amount of excess Reserves
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Sept 2008
6.1%
The red line suggests unemployment is on the rise. It was 6.1% in September, 2008.
The Taylor Rule, NAIRU, and the Phillips Curve
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4.9%
The blue line suggests inflation is beginning to decline. It was about 4.9% in September, 2008.
Sept 2008
6.1%
The Taylor Rule, NAIRU, and the Phillips Curve
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0.8%
The green line suggests that the economic growth rate is falling rapidly. It was only about 0.8% in September, 2008.
Sept 2008
4.9%
6.1%
The Taylor Rule, NAIRU, and the Phillips Curve
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Augmented Phillips Curve(monthly CPI, 1982-2008)
Dp = -0.6118x + 3.4359
R2 = 0.3076
-6
-5
-4
-3
-2
-1
0
1
2
3
4
0 2 4 6 8 10 12
Thus, inflation should
fall by about 1.6% per year
This curve demonstrates how inflation reacts to unemployment in
the economy
Suppose the Fed expects future
unemployment to rise to 8%
Unemployment rate
Cha
nge
in th
e in
flat
ion
rate
The Taylor Rule, NAIRU, and the Phillips Curve
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1%
With the inflation rate expected to fall by 1.6%,
2.6%
the Implicit Price Deflator inflation rate
should fall from 2.6% to 1%
-1.6%
The Taylor Rule, NAIRU, and the Phillips Curve
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The red line represents full-employment output, while the blue line represents actual economic output.
The Taylor Rule, NAIRU, and the Phillips Curve
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When the red line lies above the blue one the economyis underperforming.
The Taylor Rule, NAIRU, and the Phillips Curve
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When the red line lies below the blue one the economyis overheating.
The Taylor Rule, NAIRU, and the Phillips Curve
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ln(GDP) – ln(GDP potential)
9.3699.404
Thus, the Projected GDP gap = (9.369 – 9.404)100%
Jan
-3.5%
Suppose the Federal Reserve expects the gap to continue to widen
= -3.5%
The Taylor Rule, NAIRU, and the Phillips Curve
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Fed Inflation target
2%
Expected future inflation (GDP
Deflator)1%
Equilibrium interest rate
2%
Expected GDP gap
–3.5%
1%
Substituting in these values yields a Federal Funds rate target of
1.5 0.5 0.5( )r y yp p 1.5( ) 0.5( ) 0.51 (2 2 3 ).5 ffi
The Taylor Rule, NAIRU, and the Phillips Curve
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Source: Federal Reserve; www.federalreserve.gov/releases and author’s calculations.
The Taylor Rule, NAIRU, and the Phillips Curve
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Lessons from the Global Financial Crisis
Developments in the financial sector have a far greater impact on economic activity than was earlier realized
The zero-lower-bound on interest rates can be a serious problem The cost of cleaning up after a financial crisis is very high Price and output stability do not ensure financial stability How should Central banks respond to asset price bubbles?
Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst.
Types of asset-price bubbles Credit-driven bubbles (subprime financial crisis) Bubbles driven irrational exuberance OR bad housing & monetary policies
Strong argument for not responding to bubbles driven by irrational exuberance
Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time (Isn’t this going on now?)
Monetary policy should not be used to prick bubbles (or create them)
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Macropudential policy: regulatory policy to affect what is happening in credit markets in the aggregate.
Monetary policy: Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction. What laissez-faire attitude? let credit-driven bubbles proceed without any reaction OR inflate
them with bad easy credit and bad housing policy?
Lessons from the Global Financial Crisis