Chapter 6 – Monetary Policy

1. Chapter 6 – Monetary Policy BA 543 Financial Markets and Institutions

2. Chapter 6 – Monetary Policy • Goals of the Federal Monetary Policy • Stability in Price Level • Unstable Prices retard economic growth, provoke volatility in interest rates, stimulate consumption, deter savings, and cause capricious redistribution of income and wealth with attendant social disturbances • “Controlling Inflation” with a supply shock • Accommodate with increase in money supply – inflation is essentially unchecked • Do not accommodate (Jimmy Carter) – higher initial interest rates and short term decline in economic activity

3. Chapter 6 – Monetary Policy • Goals of the Federal Monetary Policy • High Employment (Low Unemployment) • Frictional Unemployment (Job Changers) • Target 4% to 6% of labor force • Increase in Money Supply can bring about: • Economic Expansion • Stimulate Investment • Encourage Consumption • Lead to the Creation of New Jobs • Kindle Inflation • Raise Interest Rates

4. Chapter 6 – Monetary Policy • Goals of the Federal Monetary Policy • Economic Growth (Increase in Output of Goods and Services) • What is the appropriate rate of growth? • Sustainable Growth • Reasonable Growth • Steady Growth • Stabilizing Interest Rates • Reduce Volatility – But allow changes • How do interest rates impact growth?

5. Chapter 6 – Monetary Policy • Goals of the Federal Monetary Policy • Stability in Foreign Exchange • Strong Dollar Means (Indirect Quote goes up) • Exchange Rates are moving so that $1 can buy more foreign currency or U.S. Products are becoming relatively more expensive “overseas” • Trade-Imbalance: Foreign goods purchased more in U.S. and Less U.S. goods purchased abroad • Weak Dollar Means (Indirect Quote goes down) • More U.S. goods purchased abroad and fewer Foreign goods purchased in U.S. • Who Benefits from Strong Dollar vs. Weak Dollar?

6. Chapter 6 – Monetary Policy • Goals are not always Aligned • Tradeoffs between Goals • Fed “selects” goal most in jeopardy • Fed works through • Operating Targets – impacts on monetary and financial variables that tend to change • Intermediate Targets – that have reasonable linkage to • Ultimate Objectives – price level stability, employment, growth and foreign exchange rates

7. Chapter 6 – Monetary Policy • Choosing the Operating Targets (Simulation Game at the Federal Reserve in KC) • U.S. Targets: Short-Term Interest Rates or Bank Reserves via money supply • Can not do both simultaneously, Why? • Negative Correlation between reserves and interest rates…as Fed increases reserves it reduces short-term rates and vice versa • Variable outside the control of the Fed…demand for money…thus rates and reserves can not be simultaneously determined

8. Chapter 6 – Monetary Policy • Choosing the Intermediate Targets • Suitable Target must be observable • Money Supply • Early standard target…some discussion on which measure and concern that it does not have linkage with the ultimate objectives • GNP (GNP growth rate) • Measurability big issues, data is quarterly • Inflation • Believed to have better linkage to ultimate goals • Many Europeans using price indexes for sensitive products…Greenspan said to be “gold” follower

9. Chapter 6 – Monetary Policy • Historical Trip through Targets • 1970s – Feds Fund Rate (Keynesian) • 1979 – 1982 Nonborrowed Reserves (Monetarists) let interest rates fluctuate • 1983 – 1991 Borrowed Reserves • 1991 – 1995 Borrowed Reserves with attention to sensitive commodities (European approach) • 1996 – 2000 New Paradigm of Higher Sustainable Growth…Greenspan’s Visible Hand with the Feds Fund Rate