MONETARY POLICY MAKING PROCESS

Key bodies of Federal Reserve system

Board of Governors of the Federal Reserve

Federal Open Market ( FOMC )

17.1 MONETARY POLICY MAKING PROCESS

Board of Governors

Composed of 7 governors Appointed by president of U.S With senate confirmation to terms of 14 years One of governors designated by President as

chairman for a 4 year term. 14 year terms for which governors are appointed

and the fact that they cannot be reappointed provide insulation from political process.

Chairman of Board of Governors is – appointed for 4 year term- this term is not concurrent with that of “President of U.S”

Federal Open Market Committee

FOMC has 12 voting member 7 governors and 5 of Presidents of 12 regional

Federal Reserve banks President of regional – serve on rotating basis –with

exception of President of Federal Reserve Bank of New York who is permanent voting member.

FOMC other member - Regional bank president , are appointed by the director of Regional Bank “with approval of Board Governors”.

Open Market Operation –Major tool for FR to conduct monetary policy. –Focus more on FOMC

FOMC meets approximately 8 times a year. At the meetings members review the current

domestic and international economic situation. Consider forecast s of the FR staff concerning

future economic events. On the basis of the information, they formulate a

“directive “ to the Open Market Desk at the NY FR Bank , explaining how open-market operations should be conducted during the period until next FOMC meeting.

Question of an OPTIMAL MONETARY POLICY strategy can be viewed as the choices of a directive by the FOMC.

An incoming president does not immediately get to appoint his choice of chairman.

Important of Federal Reserve

Considerable degree of independence given to monetary policy making authority

Has a degree of independence from the budget appropriates process. ( Because its expenses are paid by interest earnings on holdings government securities.)

FR not completely autonomous and monetary policy is not conducted in a political settings

17.2 Targeting Monetary Aggregates

“Ultimate targets” Monetary authority would like to controls:

Macroeconomi

cs variables

Unemployment rate

Inflation rate

Growth in GDP

Rather than just simply adjusting Monetary policy instrument.

Level of Open Market Operations

Basis of past observation on macroeconomics variables

Forecast of their future behavior.

In the SR , FR has at times tried to influence these “ultimate targets” by influencing “Intermediates Targets” variables.

Intermediates Targets Variables

Is a variables that FR controls not because the variables is important in its own right but because: by controlling it the policy makers believes they are influencing “Ultimate Policy Targets” in predictable way.

With Monetary Authority as an IT, the implicit assumption in FR strategy is that other things being equal:

Higher Rates of growth in MS will ↑ inflation, while

Lowering “unemployment” rising the level of economic activity in SR

Meanwhile, Slower money growth rates are again other things being equal associated with ↓inflation rates and Higher SR rates of unemployment.

What is rationale for such intermediate targetting?

Even if there is a predictable relationship between M growth rates and “ultimate economic target” that FR wants to controls.

Why use an IT rather than control the ultimate Targets directly?

To understand the possible usefulness of the IT approach. We must recognize that: - Monetary Policy(MP) must be made under conditions of Imperfect information and therefore , uncertainty about the behavior of the economy.

If the “ultimate targets” of the policy can be observed at less frequent intervals(quarterly v.s weekly) then as information about such financial market variables becomes available.

It can be used to adjust previous policy making.

*e.g (quarterly v.s weekly) variables such as:

-Interest rate

-Bank Reserve

-Monetary aggregates

The IT approach is one way of employing such financial market information.

As implemented by the FR , IT on MA proceed as follows:

1) At the beginning of each calendar quarter, FOMC chooses the

money growth rate target that it views as consistent with its ultimate policy goals for the next year.

* Committee makes this choices based on past data.

* Staff forecast of the behavior of the economy for given money growth rates.

2) After this choices has been made MP during the quarters proceeds “as if the chosen money growth target is the ultimate target of monetary policy”.

3) Policy action within the quarter are aimed at hitting this money target.

4) At the beginning of the next quarter , the money target is reviewed and adjusted on the basis of new forecast and the experience within the quarter.

Targeting Interest Rate

One of the alternative to the strategy of intermediate targeting on Monetary Aggregates.

The main alternatives been used by FR to focus on the level of an interest rate(IT)

Targeting interest rate will help clarify how a FR strategy focused on IR would work.

FOMC for example, could: -Set a range for coming month of 5 to 6 percent for the rate on 3 month Treasury

bills.

-As with MS targets , the range for the target IR would be chosen to hit the ultimate policy targets(inflation rate)(unemployment rate)(growth rate of economy)

-The IR would replace the MS as an intermediate target.

-Once the target range was set , OPEN MARKET DESK would monitor the market where TREASURY bills rose above the 6% ceiling of the target range →Desk manager begin open market purchases *These could involves TREASURY bills or other govt securities.

The effect of open market purchases, as we have seen is to expend credit and lower IR

The Desk would carry out enough Open Market Purchases to reduces the treasury bills rate below 6%

Alternatively , if Treasury bills rate temporarily fell below 5% → The Open Market Desk would begin sell securities in the open market, and Reducing banks reserves, restricting credit and Rising IR.

Until the Treasury bills Rate rose back above 5%, thus the Open Market Desk would keep the average Treasury bills rate between 5 and 6 % for the month.

*Note that in carrying cost Open Market may Purchases or Sales

Open Market Desk will ↑ or ↓ Bank Reserves , Bank Deposits and MS.

For example – Keeping IR in the target range might requires large open market purchases or sales. Therefore it will be large ∆ in MS.

Focus on IR is an alternatives to targeting Monetary Aggregates(MA)

The federal cannot in general do both.

17.3 Implications of targeting a Monetary Aggregate

The rationale for any strategy of intermediate Targeting depends on the fact that the FR acts under uncertainty about what is going on in the economy.

Targeting Interest rate or Targeting Money Aggregates is the preferable strategy depends on the sources of that uncertainty. Though there are some consideration as well.

The ideal case for Targeting a Monetary Aggregate.

Figure 17.3.1: Ideal case for targeting money aggregates.If the demand for M is totally interest-inelastic and perfectly stable then by

hitting the M supply target M*, the FR fixes the vertical LM schedule at LM(M*) . Income will be at the target level Y* regardless of the IS schedule.

I

The ideal case for targeting MA , in which this is clearly the optimal strategy.

FR has one ultimate target , the level of real income(Y) , the desired level of which is Y*.

Assume that in given quarter, on the basis forecasts, the monetary policy authority concludes that the target level of income will be achieved if the MS is set at M*.

LM schedule in figure 17.2 is vertical, reflecting an assumption that the D for M is totally interest-inelastic.

M D depends only in income and assume that D for M function is perfectly stable. There are no shifts in the function- no ∆ in the amount M D for a given income level.

On the S side- FR assumed to offset ∆ in the MS that result from the behavior of the public and the banking system.

If FR achieves it target level of the MS (M*), LM schedule will be perfectly stable at LM(M*) in figure 17.2→ Successfully hitting the ultimate income target(Y*)

To see the outcome we must consider the situation depicted in the figure.

Assume That FR x predict with certainty the position of IS schedule.

Also assume that predicted position for the curve is Iso Real sector like export , autonomous investment and govt

spending may turn weaker than predicted causing IS schedule shift to the left from Iso to IS1.

When real sector D factor may be stronger than predicted causing the IS shift to the right from ISo to IS2

Less Than Ideal Cases for Intermediate Targeting a Monetary Aggregate

Figure 17.3: Less Than Ideal Cases for targeting Money

Part a shows that , if MD is not totally interest-inelastic and the LM schedule is upward-sloping , hitting the MS target will cause income to be at the target level Y* only if the IS schedule is at the predicted position Iso.If, because of unpredicted shocks , the IS schedule is instead at IS1 or IS2 , income will be away from Y*, at Y 1or Y2 even though M is at M*.

In part B, we assume that FR hits the MS target M* , which is n the basis of its forecast of MD should set LM scheduled at LMo(M*) and hit the income target Y*. If because of unpredicted shock to the MD function, the LM curve shifts either LM1(M*) orLM2(M*) income will be at Y1 or Y2 and the income target will be miss even if the MS is at the target level M*

Implications of targeting The interest rate

Ignore the range within which IR might be targeted and simply assume that there is single targeted level r*, for the IR.

As MS target , policy maker is assumed to have one ultimate target , that keeping real income (Y) at desired level (Y*).

If FR targets the IR , then IS –LM framework of LM schedule becomes horizontal. The LM schedule depicts equilibrium in the Money Market.

To peg the IR , FR supplies whatever amount M is necessary for money market equilibrium at the target IR.

To see how strategy of targeting IR works , we consider the same cases as we did for a MS target.

Uncertainty about IS schedule

Figure 17. 4 : Targeting the IR with IS uncertainty : Zero Interest elasticity of Demand

Figure 17. 5 : Targeting the interest rate with IS uncertainty : Non zero Interest elasticity of MD

If the IR is targeted and the IS schedule is at IS1, Income will be at Yr1, below the target level. If the MS is the intermediate target , with non vertical LM schedule , income will also fell below the target level , but by less only to Y1.

Uncertainty about Money Demand Figure 17.6 : Targeting the IR with LM uncertainty. If the IR is targeted the LM schedule is horizontal and does

not shift he there is a shocks to MD. MD shock does not displace income from target level. If the MS is IT a positive shock to MD will shift the LM schedule from Lmo(M*) to LM1 (M*) to LM 1(M*); income will fall below the target level to Y1

17. 5 Money Supply VS Interest Rate TargetAdv and Disadvantages of Monetary aggregates versus interest

rate as an intermediate target for monetary aggregate.

The source of Uncertainty and the choices of a Monetary Policy strategy. If the predominant sources of uncertainty are unpredictable shifts in

IS schedule, a MS target is superior to an interest rate target. The implication for actual economy is that , when uncertainty comes from sources such as unpredictable shifts in the business sector investment spending, residential construction investment and consumer durable purchases –all private- sector demand for output-the money supply target is preferable.

The IR target was seen to be superior when uncertainty stems from the shifts in the LM schedule due to unstable MD.

In the IS-LM models, asset split into 2 groups: one termed money and composite , nonmoney asset termed bonds. Any factor that changes that changes the relatives desirable of the 2 asset shift the model’s LM schedule

Implication to actual economy: When predominant sources of uncertainty centers on shifts in asset demands (Bond and money) the IR is the superior IT.