Monetary Policy

Monetary policy can be categorized by four characteristics

Goals

Intermediate Monetary
Instruments
Policy
Targets

Discretion
 Instruments refer to the policy options the
Fed has to control the supply of money

Discount Window Loans

Open Market Operations
By purchasing or selling
US Treasuries, the Fed can
alter the supply of bank
reserves (MB)
The Fed can also influence
reserves by altering the
interest rate charged on
loans to commercial
banks. (MB)

Reserve Requirements
Reserve Requirements
This is the most influence the ability of
often used banks to create new loans
instrument! which affects the broader
aggregates (M1,M2,M3)
Monetary Policy goals address the central banks
agenda in general terms

The Bank of England Follows an explicit Inflation Target.

Specifically, the goal is to maintain 2% annual inflation.

The Bank of China appears to have export driven growth

as their primary objective

The ECB (European Central Bank) and the Federal

Reserve follow policies of stable prices and
maintenance of full employment
Intermediate Targets address the question: How will I meet my
goals?. Targets are variables that the central bank can more directly
control.

Goals vs. Targets

The target is to score

For Tiger Woods, the
18 under par (the
goal is to win the golf
number he thinks he
tournament
needs to win)

The Bank of China is currently targeting the exchange rate

at 8.28 Yuan per dollar

The Federal Reserve is currently targeting the Federal

Funds Rate at 2.75%

The Bank of England is currently targeting the repo rate at

4.75%
 Targets can be broadly classified into either Price
Targets or Quantity Targets

Suppose that the Federal Government could

influence the supply of oranges and wanted to
regulate the orange market

Price Supply

Lowering the price to

$4 (price target) and
Raising the quantity to $5/Lb
1,500 (quantity target) $4/Lb
are both describing the
same policy
Demand
(expanding the orange
market) Quantity of
1,000 1,500 Oranges
 Targets can be broadly classified into either Price
Targets or Quantity Targets

However, your response to demand changes

will differ across policies

Price Supply

If demand for oranges

increases and the Fed Target
is following a price $5/Lb
Range
target, they must
respond by increasing
supply
Demand

Quantity of
Oranges
 Targets can be broadly classified into either Price
Targets or Quantity Targets

However, your response to demand changes

will differ across policies

Target
Range

Price Supply

If demand for oranges

increases and the Fed
is following a quantity
target, they must
respond by decreasing
supply
Demand

Quantity of
1000Lbs Oranges
Suppose that the Fed wants to lower its
target to 4% (expansionary monetary policy)
M2 Multiplier = 8

Interest Rate (i)

M2 = mm(MB)
A $250 purchase of
Treasuries would be
required
2,000
5% = $250
8

4%

Md(y,t)
M
P

Change in M2 = $2,000
Suppose that the Fed is Targeting the
Interest Rate at 5%
M2 Multiplier = 8

Interest Rate (i) Suppose an increase in

M2 = mm(MB) GDP raises Money
Demand

The Fed needs to

5% increase the
monetary base by
1,000
= $125
8
Md(y,t) (An Open Market
M Purchase of
P Treasuries)

Change in M2 = $1,000
During the late 70s, the federal reserve changed its policy
from an interest rate target to a money target. The money
target was abandoned in the mid eighties.
Rules vs. Discretion
Should the Federal Reserve pre-commit to a particular course of
action?

The Chinese have pre-committed to maintaining a

fixed exchange rate while the British have pre-
committed to a fixed inflation rate.

The ECB (European Central Bank) and the Federal

Reserve both follow discretionary policies (i.e.
policy is decided at the FOMC meeting)
Rules vs. Discretion
Should the Federal Reserve pre-commit to a particular course of
action?

Benefits of Rules Costs of Rules

A states monetary A fixed policy rule
policy rule is easy allows the
top forecast (i.e. it possibility of
has less speculative attacks
uncertainty) (i.e. exploiting the
monetary policy
rule for profit)
For most of its history, the US has followed
a gold standard

US Treasury
A Gold Standard has two rules: Assets Liabilities
The government sets an
200 oz. Gold $10,000 (Currency)
official price of gold ($35/oz)
@ $35/oz
The government guarantees
$7,000 (Gold)
convertibility of currency into
gold at a fixed price $3,000 (T-Bills)

Reserve Ratio = 70%

Value of Gold Reserves $7,000

Reserve Ratio = Currency Outstanding =
$10,000

During most of the gold standard era, the Government had a reserve
ratio of around 12%
 By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
US Treasury (P = $35%)

Assets Liabilities Price Supply

200 oz. Gold

@ $35/oz $10,000 (Currency)
$7,000 (Gold)
$35
$3,000 (T-Bills)

100 oz. Gold

@ $35/oz $3,500 (Currency) Demand

Reserve Ratio = 70% Q

Suppose that the Treasury purchased gold to increase the supply of

currency outstanding (i.e. increase the money supply)
 By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply

US Treasury (P = $35%)
Price Supply
Assets Liabilities

200 oz. Gold $10,000 (Currency)

@ $35/oz
$7,000 (Gold) $35
$3,000 (T-Bills)

Demand

Q
Reserve Ratio = 70%

As the market price rises above $35 (due to increased demand),

households start buying gold from the Treasure @ $35.oz and sell it in
the open market. This reverses the original transaction
The gold standard and prices:

Recall that in the long run, the price level

is directly proportional to the ratio of
money to output:
$35(Gold Reserves)
M=
Reserve Ratio

s
M
k (i, t ) y
P
With a (relatively) fixed supply of money, prices remained stable in the
long run
 The gold standard and the supply of gold:

US Treasury (P = $35%)
Price Supply
Assets Liabilities

200 oz. Gold $10,000 (Currency)

@ $35/oz
$7,000 (Gold) $35
$3,000 (T-Bills)
100 oz. Gold
@ $35/oz $3,500 (Currency) Demand

Q
Reserve Ratio = 70%

From time to time, new gold deposits were discovered. This increased
supply would push down the market price. In response, households
would buy the cheap gold and sell it to the Treasury for $35. This would
increase the money supply.
 The gold standard and the business cycle:

US Treasury (P = $35%)
Price Supply
Assets Liabilities

200 oz. Gold $10,000 (Currency)

@ $35/oz
$7,000 (Gold) $35
$3,000 (T-Bills)

(-) Gold (-) Currency Demand

Q
Reserve Ratio = 70%

Typically, during recessions, the price of gold would rise (flight to

quality). High gold prices would cause households to buy gold from
the Treasury to sell in the market. This would force the treasury to lose
reserves and contract the money supply.
Gold Standard: Long Run vs. Short Run

Long Run: By restricting the long run supply

of money, the gold standard produced
constant, low average rates of inflation
(bankers are happy)

Short Run: By forcing monetary policy to be

subject to fluctuating gold prices, the gold
standard exacerbated the business cycle
(farmers are unhappy)
 Currently, the Fed follows an interest rate target.
The target interest rate (Fed Funds Rate) is
adjusted according to a Taylor Rule

FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation 2%)

1% Cyclical Unemployment = 2.5% Output Gap

FF = 2% + (Inflation) - 1.25(Unemployment 5%) + .5(Inflation 2%)

Currently, the Fed follows an interest rate target. The
target interest rate (Fed Funds Rate) is adjusted
according to a Taylor Rule

FF = 2% + (Inflation) - 1.25(Unemployment 5%) + .5(Inflation 2%)

Long Run: When the economy is at full employment ( Unemployment = 5%)

and inflation is at its long run target (2%), the Fed targets the Fed Funds
Rate (Nominal) at

FF = 2% + (2%) - 1.25(5% 5%) + .5(2% 2%) = 4%

Short Run: During recessions (when inflation is low and unemployment is

high), the Fed lowers its target. During expansions, when inflation is high
and unemployment is low), the Fed raises its target.
Case study: Productivity Growth during the
late 90s

i i S
Ms

4% 4%

I + (G-T)
Md
M Loanable
Funds
P

During the late 90s, rapid income growth and productivity raised
consumer spending (savings falls) and raised investment spending.
Higher spending raised the demand for money. As unemployment
dropped to 4.5% (above capacity), prices began to rise.
Case study: Productivity Growth during the
late 90s
i
i S
Ms

4% 4%

I + (G-T)
Md
M Loanable
Funds
P

The Fed responded by raising interest rates (contracting the money

supply). The Fed was able to slow down the economy before
inflation became a problem.
End of 1992 Recession Asian Financial Crisis

Late 90s Expansion Stock Market Bubble

Case study: Stock Market Crash and
Liquidity Shocks
i
i S
Ms

4% 4%

I + (G-T)
Md
M Loanable
Funds
P

After the market crash, demand (primarily investment) slowed down

and interest rates started falling. Further, the economy was operating
well below capacity (Unemployment hit 6%) and inflation was hovering
around zero.
Case study: Stock Market Crash and
Liquidity Shocks
i
i S
Ms

4% 4%

I + (G-T)
Md
M Loanable
Funds
P

Lowering the Fed funds target allowed the fed to increase the money
supply and stimulate spending.
Stock Market Crash

Beginning of Recovery?
Recession of 2001