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174Hubbard & OBrienMoney, Banking, and the Financial System, First Edition

Chapter 15Monetary Policy175

Chapter 15Monetary Policy

(Brief Chapter Summary and Chapter Objectives

15.1The Goals of Monetary Policy (pages 443446)

Describe the Goals of Monetary Policy.

(The Fed has many goals for monetary policy, including price stability, high employment, economic growth, stability of financial markets and institutions, interest rate stability, and foreign exchange market stability.

15.2Monetary Policy Tools and the Federal Funds Rate (pages 446452)

Understand how the Fed uses monetary policy tools to influence the federal funds rate.

(Although the Fed sets a target for the federal funds rate, the actual rate is determined by the interaction of demand and supply for bank reserves in the federal funds market.

(To analyze the determinants of the federal funds rate, we need to examine the banking systems demand for and the Feds supply of reserves.

(Though other tools are available, the Fed uses open market operations to hit its target for the federal funds rate.

15.3More on the Feds Monetary Policy Tools (pages 452458)

Trace how the importance of different monetary policy tools have changed over time.

(Open market operations have traditionally been the Feds preferred tool in conducting monetary policy.

(Discount policy was used extensively in response to the Financial Crisis of 20072009.

(Interest on reserves is a new tool introduced during the recent financial crisis.

15.4Monetary Targeting and Monetary Policy (pages 459470)

Explain the role of monetary targeting in monetary policy.

(Traditionally, the Fed has relied on two types of targets: (1) policy instruments, sometimes called operating targets, and (2) intermediate targets; this is no longer the favored approach.

(The Taylor rule summarizes the factors typically used in setting a target for the federal funds rate.

(Inflation targeting has become an increasingly popular approach to monetary policy, particularly before the recent financial crisis.

(Although there are institutional differences in the ways in which central banks conduct monetary policy, most use short-term interest rates as a policy instrument to achieve an ultimate goal such as low inflation.

(Key Terms and Concepts

Discount policy The policy tool of setting the discount rate and the terms of discount lending.Discount window The means by which the Fed makes discount loans to banks, serving as the channel for meeting the liquidity needs of banks.

Economic growth Increases in the economys output of goods and services over time; a goal of monetary policy.Federal funds rate The interest rate that banks charge each other on very short-term loans; determined by the demand and supply for reserves in the federal funds market.Open market operations The Federal Reserves purchases and sales of securities, usually U.S. Treasury securities, in financial markets.Primary credit Discount loans available to healthy banks experiencing temporary liquidity problems.Quantitative easing A central bank policy that attempts to stimulate the economy by buying long-term securities.

Reserve requirement The regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

Seasonal credit Discount loans to smaller banks in areas where agriculture or tourism is important.Secondary credit Discount loans to banks that are not eligible for primary credit.

Taylor rule A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate.

Chapter Outline

Bernankes Dilemma

During the financial crisis of 20072009, the Fed undertook extraordinary policy actions to keep the financial system from imploding. Unfortunately, as Bernanke testified before Congress in late July 2010, the economy was recovering at a slower rate than the Fed had hoped.

15.1The Goals of Monetary Policy (pages 443446)

Learning Objective: Describe the Goals of Monetary Policy.

A.Price Stability

Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and as a unit of account. In a market economy, in which prices communicate information about costs and about demand for goods and services to households and firms, inflation makes prices less useful as signals for resource allocation. Severe inflation inflicts even greater economic costs.

B.High Employment

High employment, or a low rate of unemployment, is another key monetary policy goal. Unemployed workers and underused factories and machines lower output. Unemployment causes financial distress for workers who lack jobs. Although the Fed is committed to high employment, it does not seek a zero percent rate of unemployment. Instead, the Fed attempts to reduce levels of cyclical unemployment, which is unemployment associated with business cycle recessions.

C.Economic Growth

Policymakers seek steady economic growth, or increases in the economys output of goods and services over time. Economic growth provides the only source of sustained real increases in household incomes. Policymakers attempt to encourage stable economic growth because a stable business environment allows firms and households to plan accurately and encourages the long-term investment that is needed to sustain growth.

D. Stability of Financial Markets and Institutions

The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The financial crisis led to renewed debate over whether the Fed should take action to forestall asset price bubbles such as those associated with the dot-com boom on the U.S. stock market in the late 1990s and the U.S. housing market in the 2000s.

E.Interest Rate Stability

Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms. In addition, sharp interest rate fluctuations cause problems for banks and other financial firms.

F.Foreign-Exchange Market Stability

A stable dollar simplifies planning for commercial and financial transactions. In addition, fluctuations in the dollars value change the international competitiveness of U.S. industry.

15.2Monetary Policy Tools and the Federal Funds Rate (pages 446452)

Learning Objective: Understand how the Fed uses monetary policy tools to influence the federal funds rate.

The Feds traditional policy tools include open market operations, discount policy, and reserve requirements. During the financial crisis, the Fed added new tools including interest on reserve balances and term deposit facility.

A.The Federal Funds Market and the Feds Target Federal Funds Rate

Although the Fed sets a target for the federal funds rate, the actual rate is determined by the interaction of demand and supply for bank reserves in the federal funds market. To analyze the determinants of the federal funds rate, we need to examine the banking systems demand for and the Feds supply of reserves. Banks demand reserves both to meet their legal obligation to hold required reserves and because they may wish to hold excess reserves to meet their short-term liquidity needs. The Fed supplies borrowed reserves, in the form of discount loans, and nonborrowed reserves, through open market operations.

Teaching Tips

It may prove beneficial to spend a little extra time developing the graph of the federal funds market, Figure 15.1 on page 447. Students can easily gloss over it and treat it as a regular supply and demand graph (i.e., upward sloping supply curve). Making it clear that the supply curve is vertical due to the supply of reserves being independent of the federal funds rate due to the Feds control over reserves should help students understand the concept. Also, careful explanation as to the reasoning behind the horizontal portions of each curve will help students gain a better understanding of the unique shapes of the supply and demand for reserves (compared to the curves that they have seen before).

B.Open Market Operations and the Feds Target for the Federal Funds Rate

The Fed uses open market operations to hit its target for the federal funds rate. An open market purchase increases the supply of reserves, which decreases the federal funds rate.

C.The Effect of Changes in the Discount Rate and in Reserve Requirements

Typically, the Fed has raised or lowered the discount rate at the same time that it raises or lowers the target for the federal funds rate. As a result, changes in the discount rate have no independent effect on the federal funds rate. The Fed rarely changes the required reserve ratio. If the other factors underlying the demand and supply curves for reserves are held constant, an increase in the required reserve ratio increases the demand for reserves because banks have to hold more reserves, resulting in a higher federal funds rate.

15.3More on the Feds Monetary Policy Tools (pages 452-458)

Learning Objective: Trace how the importance of different monetary policy tools have changed over time.

A.Open Market Operations

When the Fed carries out an open market purchase of Treasury securities, the prices of these securities increase, thereby decreasing their yield. Because the purchase will increase the monetary base, the money supply will expand. At the end of each meeting, the FOMC issues a statement that includes its target for the federal funds rate and its assessment of the economy, particularly with respect to its policy goals of price stability and economic growth. In conducting the Feds open market operations, the trading desk makes both dynamic, or permanent, open market operations and defensive, or temporary, open market operations. Open market operations have several benefits that other policy tools lack: control, flexibility, and ease of implementation. During the recent financial crisis, with the federal funds already near zero, the Fed engaged in quantitative easing with the intent of reducing long-term interest rates instead of the federal funds rate.

Teaching Tips

Though the first round of quantitative easing was generally supported by most economists, the second round announced in November 2010 was much more controversial. Opponents see it as a new approach to monetary policy with the risk of significantly higher inflation without effectively stimulating economic growth. Many see it as monetizing the national debt. Supporters of the policy basically state that it is an extension of the traditional use of open market operations in that the Fed normally conducts open market purchases to stimulate the economy when it is perceived to be too weak. The difference is that this was typically evidenced by a decline in the federal funds rate. In this case, since the federal funds rate is already near zero, it is evidenced by an increase in the Feds balance sheet or the monetary base. Have students evaluate the two sides of the debate to better understand what the realities of quantitative easing in the context of the economy of late 2010.

B.Discount Policy

Since 1980, all depository institutions have had access to the discount window. The Feds discount loans to banks fall into three categories: primary credit, secondary credit, and seasonal credit. Primary credit is available to healthy banks with adequate capital and supervisory ratings. Secondary credit is intended for banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings. Seasonal credit consists of temporary, short-term loans to satisfy seasonal requirements of smaller banks in geographic areas where agriculture or tourism is important. During the financial crisis of 2007-2009, the Fed set up a variety of temporary lending facilities.

C.Interest on Reserve Balances

Paying interest on reserve balances gives the Fed another monetary policy tool. By increasing the interest rate, the Fed can increase the level of reserves banks are willing to hold, thereby restraining bank lending and increases in the money supply.

15.4Monetary Targeting and Monetary Policy (pages 459-470)

Learning Objective: Explain the role of monetary targeting in monetary policy.

The central banks objective in conducting monetary policy is to use its policy tools to achieve monetary policy goals. But the Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high economic growth and low inflation. Although it hopes to encourage economic growth and price stability, it has no direct control over real output or the price level. The Fed also faces timing difficulties in using its monetary policy tools.

A.Using Targets to Meet Goals

Targets are variables that the Fed can influence directly and that help achieve monetary policy goals. Traditionally, the Fed has relied on two types of targets: policy instruments sometimes called operating targets, and intermediate targets; this no longer the favored approach. The Fed controls intermediate target variables, such as the mortgage interest rate or M2, only indirectly because private-sector decisions also influence these variables. The Fed would therefore need a target that was a better link between its policy tool and intermediate targets. Policy instruments, or operating targets, are variables that the Fed controls directly with its monetary policy tools and that are closely related to intermediate targets.

B.The Choice between Targeting Reserves and Targeting the Federal Funds Rate

Traditionally, the Fed has used three criteria (measurable, controllable, and predictable) when evaluating variables that might be used as policy instruments. The Feds main policy instruments have been reserve aggregates, such as total reserves or nonborrowed reserves, and the federal funds rate. A key point to understand is that the Fed can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate, but it cannot choose both.

C.The Taylor Rule: A Summary of Fed Policy

Actual Fed deliberations are complex and incorporate many factors about the economy. John Taylor of Stanford University has summarized these factors in the Taylor rule for federal funds rate targeting:

Federal funds target current inflation rate equilibrium real federal funds rate

0.5 ( inflation gap 0.5 ( output gap

According to the Taylor rule, the Fed should raise the federal funds in response to a positive inflation gap or positive output gap. The Taylor rule tracks the actual federal funds rate fairly closely, which confirms the view that the Fed has been attempting to reach its policy goals directly through manipulating the federal funds rate rather than indirectly through using an intermediate target.

D.Inflation Targeting

With inflation targeting, a central bank publically sets an explicit target for the inflation rate over a period of time, and the government and the public then judge the performance of the central bank on the basis of its success in hitting the target. Arguments in favor of the Fed using an explicit inflation target focus on four points: First, announcing explicit targets for inflation would draw the publics attention to what the Fed can actually achieve in practice. Second, the establishment of transparent inflation targets for the United States would provide an anchor for inflationary expectations. Third, announced inflation targets would help institutionalize effective U.S. monetary policy. Finally, inflation targets would promote accountability for the Fed by providing a yardstick against which its performance could be measured. Opponents of inflation targets also make four points: First, rigid numerical targets for inflation diminish the flexibility of monetary policy to address other policy goals. Second, because monetary policy influences inflation with a lag, inflation targeting requires that the Fed depend on forecasts of future inflation, uncertainty about which can create problems for the conduct of policy. Third, holding the Fed accountable only for a goal of low inflation may make it more difficult for elected officials to monitor the Feds support for good economic policy overall. Finally, uncertainty about future levels of output and employment can impede economic decision making in the presence of an inflation target.

E.International Comparisons of Monetary Policy

Although there are institutional differences in the ways in which central banks conduct monetary policy, there are two important similarities in recent practices. First, most central banks in industrial countries have increasingly used short-term interest ratessimilar to the federal funds rate in the United Statesas the policy instrument, or operating target, through which goals are pursued. Second, many central banks are focusing more on ultimate goals such as low inflation than on particular intermediate targets.

(Solutions to the End-of-Chapter Questions and Problems

Answers to Thinking Critically Questions

1.

The Federal Reserve would be under less pressure to buy Treasury securities, which would lessen the likelihood of an increase in the inflation rate in the future. An additional benefit would result if the private sector responded to this development by increasing investment and employment. But projections of future deficits differ from actual deficits. If, for example, Congress and the president reached agreement on a budget that was expected to reduce deficits by raising taxes on businesses, this would have a negative impact on investment and employment. The result could be lower tax revenue and greater actual deficits. Cuts in spending programs, rather than higher taxes, would likely have a positive impact on business spending, but political opposition makes spending cuts difficult to achieve.

2.

The graph shows that the initial interest rate on bank reserve deposits, irb1, is raised to irb2. The new, higher equilibrium interest rate on federal funds, iff2, is equal to the interest rate on bank reserve deposits. The Fed increases interest rates without changing its target for bank reserves.

15.1The Goals of Monetary Policy

Learning objective: Describe the goals of monetary policy.

Review Questions

1.1Monetary policy aims to advance the economic well-being of the countrys citizens. Economic well-being is typically determined by the quantity and quality of goods and services that individuals can enjoy.

1.2 a.Price stability means a stable overall price level throughout the economy and is often interpreted as low and steady inflation.

b.High employment means a low rate of unemployment equal to the natural rate of unemployment.

c.Economic growth means increases in the economys output of goods and services over time.

d.Stability of financial markets and institutions refers to financial markets and institutions working to match savers and borrowers without panics and excessive closures.

e.Interest rate stability means stable interest rates.

f.Foreign-exchange market stability means limited fluctuations in the foreign-exchange value of the dollar.

1.3The Fed seeks to reduce cyclical unemployment. The Fed does not seek to reduce the unemployment rate to zero because the tools of monetary policy are aimed at affecting economic conditions throughout the economy and are ineffective in reducing the levels of frictional and structural unemployment.

1.4Interest rates represent the cost of borrowing by firms and households. Fluctuating interest rates make investment decisions by firms and households more difficult because the cost of borrowing becomes more uncertain.

1.5Excess fluctuations in the foreign exchange value of the dollar would make it difficult to know the cost of your products abroad, the cost of imported intermediate goods, and dollar value of foreign assets.

1.6The severity of the 2007-2009 financial crisis and resulting recession has put the monetary policy goal of stability of financial markets and institutions front and center. Until recently, most economists probably considered price stability to be the Feds top priority. Problems and Applications

1.7Deflation, just like inflation, complicates the ability to distinguish overall price changes from relative price changes, which determine resource allocation. Unanticipated deflation redistributes income just as unanticipated inflation does, as when borrowers suffer losses from unanticipated deflation.

1.8For its goal of high employment, the Fed seeks an unemployment rate equal to the natural rate of unemployment with zero cyclical unemployment. The Fed would need to be aware of changes in the natural rate of unemployment in order to know if cyclical unemployment exists or not.

1.9Nominal interest rates include an inflation premium. The nominal interest rate equals the real interest rate plus the expected inflation rate. High and variable inflation rates lead to high and variable nominal interest rates.

1.10In the long run foreign exchange rates depend upon inflation rate differentials across countries. The foreign exchange value of the U.S. dollar will decline and fluctuate as the U.S. inflation rate rises and fluctuates.

1.11If the exchange rate between the Japanese yen and the U.S. dollar changes from 85 $1 to 95 $1, the U.S. dollar would have appreciated and U.S. industries will be less competitive relative to Japanese industries. The appreciation of the dollar makes U.S. exports more expensive and Japanese imports to the U.S. cheaper.

15.2Monetary Policy Tools and the Federal Funds Rate

Learning objective: Understand how the Fed uses monetary policy tools to influence the federal funds rate.

Review Questions

2.1The Feds three traditional monetary policy tools are open market operations, discount policy, and reserve requirements. Open market operations is the purchase or sale of securities, typically U.S. Treasury securities, in financial markets. Discount policy is setting the discount rate and the terms of discount lending. The reserve requirement is regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed. The most important of the three tools is open market operations.

2.2The two new policy tools available to the Fed are the interest rate on reserve balances and the term deposit facility.

2.3The financial asset traded is bank reserves. The federal funds rate is the interest rate that banks charge each other on very short-term loans, where as the discount rate is the interest rate that the Federal Reserve charges banks on loans.

2.4The FOMC is the Federal Open Market Committee of the Federal Reserve. The FOMC determines the target for the federal funds rate and directs the buying and selling of securities in order to reach the federal funds rate target.

2.5Banks demand reserves both to meet their legal obligation to hold required reserves and their desire to hold excess reserves to meet their short-term liquidity needs. An increase in the federal funds rate decreases the quantity of reserves demanded. As the federal funds rate increases, the opportunity cost to banks of holding excess reserves increases because the return they could earn from lending out those reserves goes up. The demand curve for reserves becomes perfectly elastic at the interest rate the Fed pays on banks reserve balances.

2.6The supply of reserves is determined by the Fed supplying nonborrowed reserves, through open market operations, and borrowed reserves in the form of discount loans. The discount rate sets a ceiling on the federal funds rate, causing the supply curve for reserves to become horizontal. Banks would not pay a higher interest rate to borrow from other banks than the discount rate they can pay to borrow from the Fed.

Problems and Applications

2.7If the federal funds rate was below the interest rate the Fed pays on bank reserves, then banks would borrow at the lower federal funds rate and deposit the funds in their reserve balances at the Fed and earn a risk-free return. Competition among banks to obtain the funds to carry out this risk-free arbitrage would force up the federal funds rate to the rate the Fed pays on banks reserve balances.

2.8a.A decrease in the required reserve ratio would decrease the demand for reserves.

b.A decrease in the discount rate would lower the interest rate at which the supply for reserves becomes horizontal.

c. A decrease in the interest rate paid on reserves would lower the interest rate at which the demand curve becomes horizontal.

d.An open market sale of government securities would decrease the supply of reserves.

2.9To lower its target for the federal funds rate, the Fed can conduct an open market purchase of securities and to raise its target for the federal funds rate, the Fed can conduct an open market sale of securities. In the graphs below, the discount rate is also assumed to be lowered and raised along with the target for the federal funds rate.

2.10a.To raise the federal funds rate, the Fed could sell securities.

b.To offset the effect on the federal funds rate of an increase in the demand for reserves, the Fed could buy securities. In the graph below, the Fed also lowers the discount rate.

c.To offset the effect of an increase in the required reserve ratio which would increase the demand for reserves, the Fed could buy securities. The graph is the same as for part b. above.

2.11An open market sale of Treasury securities by the Fed decreases the supply of reserves, raising the federal funds rate, unless the new supply curve of reserves intersects the demand curve for reserves on the horizontal portion at the interest rate the Fed pays on reserves.

2.12 a.See the graph below.

b.See the graph for part a. above. The Fed would sell Treasury securities.

2.13a.See the graph below.

b. See the graph for part a. above. The Fed would buy Treasury securities.

15.3More on the Feds Monetary Policy Tools

Learning objective: Trace how the importance of different monetary policy tools has changed over time.

Review Questions

3.1a.The policy directive is the general directive after each FOMC meeting to the Federal Reserve Systems account manager stating the FOMCs overall objectives for interest rates and open market operations.

b.The account manager is the Federal Reserve Systems account manager, who is a vice president of the Federal Reserve Bank of New York and who has the responsibility of implementing open market operations and hitting the FOMCs target for the federal funds rate.

c.The trading desk is the Open Market Trading Desk at the Federal Reserve Bank of New York. The trading desk is linked electronically to about 18 primary dealers.

d.A primary dealer is a private securities firm that the Fed has selected to participate in open market operations.

3.2An open market sale of Treasury securities decreases the price of Treasury securities, thereby increasing the yield on Treasury securities. The sale of Treasury securities decreases the monetary base and the money supply.

3.3Dynamic open market operations are intended to change monetary policy as directed by the FOMC. Defensive open market operations are intended to offset temporary fluctuations in the demand or supply for reserves, not to change monetary policy. Dynamic open market operations are likely to be conducted as outright purchases and sales of Treasury securities, whereas defensive open market operations are conducted through repurchase agreements and reverse repurchase agreements.

3.4Open market operations have the advantages over other policy tools of control, flexibility, and ease of implementation. The Fed initiates open market operations and completely controls the volume of open market purchases and sales. Open market operations are flexible because the Fed can make both large and small open market operations, and the Fed can easily implement open market operations by the trading desk placing buy or sell orders with the primary dealers.

3.5Quantitative easing is the central bank policy that attempts to stimulate the economy by buying long-term securities. The Fed, traditionally, purchases short-term Treasury securities, but with the federal funds rate already near zero by December 2008, the Fed purchased mortgage-backed securities and 10year Treasury securities to reduce the interest rates on mortgages and other long-term rates.

3.6The three categories of discount loans are primary credit, secondary credit, and seasonal credit. Primary credit is discount loans to healthy banks experiencing temporary liquidity problems. Secondary credit is discount loans to banks that are not eligible for primary credit because they have inadequate capital or low supervisory ratings. Seasonal credit is discount loans to smaller banks in areas where agriculture or tourism is important. When economists and policymakers refer to the discount rate, they are referring to the interest rate on primary credit.

3.7Before 1980, only member banks of the Federal Reserve System could receive discount loans. After 1980, all depository institutions could receive discount loans. During the financial crisis of 20072009, the Feds discount lending expanded to include temporary lending facilities that made loans to primary dealers (investment banks and large securities firms), financial firms with mortgage-backed securities, nonfinancial corporations that issue commercial paper, and investors that purchase asset-backed securities.

Problems and Applications

3.8To hit the target federal funds rate, the account manager adjust the supply of reserves by using open market purchases and sales of Treasury securities. On most days, the trading desk carries out defensive open market operations to offset temporary fluctuations in the demand or supply for reserves.

3.9Agree. The Fed cannot manage both the level of reserves and the federal funds rate. If it manages the federal funds rate, then the level of reserves must change when the demand for reserves changes in order to maintain the desired federal funds rate. Likewise, if the Fed manages the level of reserves, then the federal funds rate will change when the demand for reserves changes.

3.10The Fed typically purchases short-term Treasury securities, but with quantitative easing the Fed purchases long-term securities such as mortgage-backed securities and 10-year Treasury bonds. During the financial crisis, the Fed turned to quantitative easing because they had already pushed the federal funds rate to nearly zero but the economy continued to linger in recession. The policy of quantitative easing has raised concerns of higher inflation rates in the future because these bond purchases greatly expanded the monetary base.3.11By increasing the interest rate it pays on bank reserves, the Fed can increase the level of reserves banks are willing to hold, thereby restraining bank lending and increases in the money supply. Additionally, the term deposit facility, the Feds other new policy tool, could to used to restrain banks from lending large amounts of excess reserves all at once. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply.

3.12Disagree. The target for the federal funds rate is set by the FOMC, but not the actual federal funds rate, which is determined by the demand and supply of reserves.

3.13If only banks could borrow and lend in the federal funds market, then the actual federal funds rate could not drop below the interest rate the Fed pays on reserve deposits because banks could borrow in the federal funds market and turn around and deposit the funds in their reserve balances at the Fed and earn a risk-free return. Competition among banks to obtain the funds on the federal funds market would drive the federal funds rate up to the interest rate the Fed payson reserves.

3.14The Primary Dealer Credit Facility was designed to help primary dealers by providing emergency loans with mortgage-backed securities as collateral. The Term Securities Lending Facility was designed to help financial firms by providing loans of Treasury securities in exchange for mortgage-backed securities. The Commercial Paper Funding Facility was designed to help nonfinancial corporations that issued commercial paper by the Fed directly purchasing new issues of three-month commercial paper. The Term Asset-Backed Securities Loan Facility was designed to help firms that raised funds through asset-backed securities. The Fed extended three-year or five-year loans to help investors purchase asset-backed securities.

15.4Monetary Targeting and Monetary Policy

Learning objective: 15.4: Explain the role of monetary targeting in monetary policy.

Review Questions

4.1In attempting to reach high economic growth or high employment, the Fed would pursue expansionary monetary policy, but this same policy could cause higher inflation.

4.2The two timing difficulties the Fed faces in using its monetary policy tools are the information lag and the impact lag? The information lag is the Feds inability to observe instantaneously changes in GDP, inflation or other economic variables, and the impact lag is the time that is required for monetary policy changes to affect output, employment, or inflation.

4.3The Fed can more directly control and can more quickly observe intermediate or operating targets than policy goals.

4.4From the most influence to the least influence: policy tools, policy instruments, intermediate targets, and policy goals.

4.5The criteria of predictablea predictable impact of the policy instrument on the Feds policy goalslead the Fed to use the federal funds rate as its policy instrument instead of the level of reserves.

4.6The Taylor rule is a monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate. The Taylor rule serves as a summary measure of Fed policy and can be compared to the Feds actual target for the federal funds rate to get a sense of whether Fed policy is too restrictive or too accommodative.

4.7Inflation targeting refers to the conducting of monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. With the financial crisis, the policy goal of stability of financial markets and institutions has become more pressing than the goal of stable prices.

4.8The Bank of Canada uses inflation targeting and a focus on the exchange value of the Canadian dollar. The Bank of England uses inflation targeting. The Bank of Japan has not adopted a formal inflation target, but does emphasize price stability. The European Central Bank has an inflation target and attaches a significant role to the monetary aggregate M3.

Problems and Applications

4.9The Fed could more aggressively attempt to reduce high cyclical unemployment when the inflation rate is low because the expansionary monetary policy used to decrease cyclical unemployment would increase inflation. The increase in inflation would be less of a problem if the inflation rate is low.

4.10State whether each of the following variables is most likely to be a goal, an intermediate target, an operating target, or a monetary policy tool.

a.M2 would be an intermediate target.

b.Monetary base would be an intermediate target.

c.Unemployment rate would be a policy goal.

d.Open market purchases would be a policy tool.

e.Federal funds rate would be an operating target.

f.Nonborrowed reserves would be an operating target.

g.M1 would be an intermediate target.

h.Real GDP growth would be a policy goal.

i.Discount rate would be a policy tool.

j.Inflation rate would be a policy goal.

4.11If the Fed uses the federal funds rate as a policy instrument, then increases in the demand for reserves will lead to an increase in the level of reserves. Conversely, if the Fed uses the level of reserves as a policy instrument, then increases in the demand for reserves will lead to an increase in the federal funds rate.

4.12Congress authorized NOW accounts on which banks can pay interest and banks developed automated transfer of saving accounts, which move checkable deposit balances into higher-interest CDs each night and then back into checkable deposit balances in the morning, and sweep accounts, which move checkable deposits of businesses into money market deposit accounts at the end of each week and then move the funds back into checkable deposits at the beginning of the following week. With M1 becoming more of a store of value than a pure medium of exchange the short-run link between M1 and spending and therefore M1 and inflation was broken.

4.13a.M2

b.Changes in the money supply are no longer useful for forecasting inflation in the short-term, but are useful in forecasting inflation in the long-term.

4.14

Agree. The Fed cannot manage both the level of reserves and the federal funds rate. If it manages the federal funds rate, then the level of reserves must change when the demand for reserves changes in order to maintain the desired federal funds rate. Likewise, if the Fed manages the level of reserves, then the federal funds rate will change when the demand for reserves changes.4.15Taylor rule federal funds rate target 2 2 0.5(1.2 2) 0.5(-7) 0.10. This Taylor rule federal funds rate target fits within the Feds actual target range of 0.00 to 0.25%.

4.16a.Monetary excesses in this context would refer primarily to the federal funds rate being too low.

b.The evidence of monetary excesses is that the FOMC kept the federal funds rate at levels well below those indicated by the Taylor rule from 2002 to 2006.

Data Exercises

D15.1The most recent FOMC press release will change over time. The answers below apply to the press release of November 3, 2010.

a.The FOMC maintained the range for the target for the federal funds rate at 0 to 1/4 percent, and indicated that economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

b.The FOMC is more concerned about slow economic growth.

c.No mention of the discount rate?

d.No mention of the interest rate paid on bank reserves or the Term Deposit Facility. The Fed announced another round of quantitative easing (Q.E.II) with the purchase of $600 billion of longer-term securities between November, 2010 and the end of the second quarter of 2010.

D15.2a.As of the early December 2010, the upper limit of the target for the federal funds rate has not changed over the last year, remaining at 0.25%.

b.The effective federal funds rate fluctuated considerably varying from 0.04 to 0.22%.

2012 Pearson Education, Inc. Publishing as Prentice Hall

2012 Pearson Education, Inc. Publishing as Prentice Hall

2012 Pearson Education, Inc. Publishing as Prentice Hall