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Chapter 6 Monetary Policy

BA 543 Financial Markets and Institutions

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

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

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 Reduce Volatility But allow changes How do interest rates impact growth?

Stabilizing Interest Rates

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?

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

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 ratesas Fed increases reserves it reduces short-term rates and vice versa Variable outside the control of the Feddemand for moneythus rates and reserves can not be simultaneously determined

Chapter 6 Monetary Policy

Choosing the Intermediate Targets Suitable Target must be observable

Money Supply
Early standard targetsome 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

Believed to have better linkage to ultimate goals Many Europeans using price indexes for sensitive productsGreenspan said to be gold follower

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 GrowthGreenspans Visible Hand with the Feds Fund Rate