MonetaryMonetary PolicyPolicy

ChapterChapter 14.414.4 andand 16.116.1

slide 0 OutlineOutline

HowHow thethe FedFed conductsconducts monetarymonetary policypolicy

MonetaryMonetary policypolicy rulesrules

slide 1 14.414.4 HOWHOW THETHE FEDFED CONDUCTSCONDUCTS MONETARYMONETARY POLICYPOLICY

HowHow shouldshould thethe FedFed useuse itsits powerpower toto achieveachieve itsits objectivesobjectives ofof keepingkeeping inflationinflation lowlow andand economiceconomic fluctuationsfluctuations small?small?

DecisionsDecisions aboutabout monetarymonetary policypolicy inin thethe UnitedUnited StatesStates areare mademade byby thethe FederalFederal OpenOpen MarketMarket CommitteeCommittee (FOMC).(FOMC).

slide 2 SettingSetting InterestInterest RatesRates oror MoneyMoney GrowthGrowth

FOMCFOMC alternativesalternatives forfor monetarymonetary policy:policy:

SetSet thethe growthgrowth raterate ofof thethe moneymoney supply.supply.

SetSet thethe shortshort --termterm interestinterest rate.rate.

MoneyMoney supplysupply settingsetting isis preferablepreferable ifif shiftsshifts inin thethe ISIS curvecurve dominate.dominate.

InterestInterest raterate settingsetting preferablepreferable ifif shiftsshifts inin thethe LMLM curvecurve dominate.dominate.

slide 3 TheThe ZeroZero BoundBound onon NominalNominal InterestInterest RatesRates

WhatWhat areare thethe implicationsimplications forfor thethe conductconduct ofof monetarymonetary policypolicy whenwhen nominalnominal interestinterest ratesrates approachapproach oror equalequal zero?zero?

TheThe constraintconstraint ofof aa zerozero boundbound onon thethe nominalnominal interestinterest raterate limitslimits thethe scopescope ofof monetarymonetary policy.policy.

IfIf thethe nominalnominal interestinterest raterate isis zero,zero, itit cannotcannot bebe loweredlowered anyany furtherfurther toto stimulatestimulate thethe economy.economy.

slide 4 TheThe ZeroZero BoundBound onon NominalNominal InterestInterest RatesRates

DeflationDeflation isis negativenegative inflationinflation (falling(falling prices).prices).
WithWith deflation,deflation, aa zerozero nominalnominal interestinterest raterate producesproduces aa positivepositive realreal interestinterest rate.rate.
ThisThis maymay bebe tootoo highhigh toto stimulatestimulate thethe economy,economy, andand cannotcannot bebe loweredlowered anyany further.further.

slide 5 16.116.1 MONETARYMONETARY POLICYPOLICY RULESRULES

AA monetarymonetary policypolicy rulerule describesdescribes aa systematicsystematic responseresponse ofof monetarymonetary policypolicy toto eventsevents inin thethe economy.economy.

TheThe centralcentral bankbank cancan setset eithereither thethe growthgrowth raterate ofof thethe moneymoney supplysupply oror thethe shortshort --termterm nominalnominal interestinterest rate.rate.

AlmostAlmost allall centralcentral banks,banks, includingincluding thethe Fed,Fed, nownow conductconduct monetarymonetary policypolicy byby settingsetting thethe shortshort --termterm nominalnominal interestinterest rate.rate.

slide 6 16.116.1 MONETARYMONETARY POLICYPOLICY RULESRULES

TheThe FedFed doesdoes notnot actuallyactually setset thethe shortshort --termterm nominalnominal interestinterest rate.rate.

TheThe FOMCFOMC setssets aa targettarget levellevel ofof aa veryvery shortshort -- termterm (overnight)(overnight) nominalnominal interestinterest rate,rate, thethe federalfederal fundsfunds rate,rate, andand thenthen keepskeeps thethe federalfederal fundsfunds raterate closeclose toto itsits targettarget byby increasingincreasing oror decreasingdecreasing thethe moneymoney supplysupply throughthrough openopen -- marketmarket operations.operations.

slide 7 ReactingReacting toto EventsEvents inin thethe EconomyEconomy

LikeLike manymany otherother centralcentral banks,banks, thethe FedFed hashas aa targettarget inflationinflation raterate

TheThe levellevel ofof inflationinflation itit wouldwould likelike toto seesee onon averaverageage overover thethe longlong term.term.

TheThe FedFed isis lessless explicitexplicit aboutabout itsits targettarget inflationinflation rate,rate, butbut itit hashas anan implicitimplicit inflationinflation --raterate targettarget ofof aboutabout 22 percent.percent.

slide 8 ReactingReacting toto EventsEvents inin thethe EconomyEconomy

HowHow dodo thethe FedFed andand otherother centralcentral banksbanks setset thethe interestinterest raterate toto achieveachieve theirtheir longlong --runrun inflationinflation andand outputoutput --stabilitystability goals?goals?

AA convenientconvenient wayway toto describedescribe thethe actionsactions ofof aa centralcentral bankbank isis throughthrough aa monetarymonetary policypolicy rule,rule, oror reactionreaction functionfunction

AA monetarymonetary policypolicy rulerule isis simplysimply aa functionfunction thatthat describesdescribes howhow thethe Fed,Fed, oror anyany otherother centralcentral bank,bank, setssets thethe interestinterest raterate inin responseresponse toto variablesvariables inin thethe economy.economy.

slide 9 TheThe TaylorTaylor RuleRule

TheThe TaylorTaylor rulerule statesstates thatthat thethe FedFed raisesraises thethe nominalnominal interestinterest raterate rr whenwhen realreal GDPGDP isis greatergreater thanthan potentialpotential GDP,GDP, andand whenwhen inflationinflation isis greatergreater thanthan thethe targettarget inflationinflation rate.rate.

∧ r=+π βδ π π Y +( −* ) + R * (16.1)

wherewhere rr isis thethe shortshort --termterm nominalnominal interestinterest raterate setset byby thethe FedFed (the(the federalfederal fundsfunds rate)rate)

slide 10 TheThe TaylorTaylor RuleRule

AnAn importantimportant attributeattribute ofof thethe TaylorTaylor rulerule isis thatthat iitt isis stabilizing.stabilizing.

When real GDP is greater than potential GDP or when inflation is greater than the target inflation rate, following t he Taylor rule smoothes out fluctuations. ∧ r=+(1 δπδ π β ) + Y +− R * * (16.2)

When inflation rises above the target inflation rate, the Fed raises the nominal interest rate by more than inflation rises.

slide 11 TheThe TaylorTaylor RuleRule

TheThe importanceimportance ofof raisingraising thethe nominalnominal interestinterest raterate moremore thanthan oneone --forfor --oneone withwith thethe inflationinflation rate,rate, soso thatthat thethe realreal interestinterest raterate risesrises whenwhen inflationinflation increases,increases, isis knownknown asas thethe TaylorTaylor principle.principle.

AA monetarymonetary policypolicy rulerule isis stabilizingstabilizing onlyonly ifif itit obeysobeys thethe TaylorTaylor principle.principle.

slide 12 WhatWhat isis thethe rationalerationale forfor thethe TaylorTaylor rule?rule?

TheThe FedFed isis concernedconcerned withwith keepingkeeping inflationinflation closeclose toto targettarget andand keepingkeeping outputoutput andand unemploymentunemployment fluctuationsfluctuations small,small, andand thethe TaylorTaylor rulerule helpshelps accomplishaccomplish bothboth objectives.objectives.

TheThe TaylorTaylor rulerule isis anan exampleexample ofof inflationinflation targeting,targeting, butbut oneone thatthat targetstargets bothboth currentcurrent andand expectedexpected futurefuture inflation.inflation.

slide 13 TaylorTaylor rulerule andand ExchangeExchange RateRate

TheThe TaylorTaylor rulerule requiresrequires aa flexibleflexible exchangeexchange rate.rate.

FixingFixing thethe exchangeexchange raterate isis incompatibleincompatible withwith conductingconducting monetarymonetary policypolicy accordingaccording toto thethe TaylorTaylor rule.rule.

slide 14 NumericalNumerical ExampleExample

SupposeSuppose thatthat ββ == 0.5,0.5, δδ == 0.5,0.5, ππ** == 0.02,0.02, andand R*R* == 0.02.0.02. Then,Then, thethe TaylorTaylor rulerule inin EquationEquation 16.116.1 becomesbecomes

∧ r π π=+π 0.5 Y + 0.5( −+* ) 0.02 ∧ r=1.5π + 0.5 Y + 0.01

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