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Monetary Policy: Deliberation and Implementation

Monetary Policy: Deliberation and Implementation. Week 12 – November 9, 2005. Roles of Central Banks. List of central bank roles in Rose (p. 354) Market stabilization Control of money supply Lender of last resort Supervisor of the banking system

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Monetary Policy: Deliberation and Implementation

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  1. Monetary Policy:Deliberation and Implementation Week 12 – November 9, 2005

  2. Roles of Central Banks • List of central bank roles in Rose (p. 354) • Market stabilization • Control of money supply • Lender of last resort • Supervisor of the banking system • Protecting and improveing the flow of payments • Last two are independent of others, and first three all relate to money supply

  3. Control of money supply • Promote economic goals • Full employment • Price stability • Economic growth through improvements in productivity with investment • How good must central banks be? • Theory of optimal currency areas weighs costs of multiple currencies versus local control of money supply to promote above

  4. Robert Mundell “…Many of the political changes in the century have been caused by little-understood perturbations in the international monetary system, while these in turn have been a consequence of the rise of the United States and mistakes of its financial arm, the Federal Reserve System. The twentieth century began with a highly efficient international monetary system that was destroyed in World War I, and its bungled recreation in the interwar period brought on the Great Depression, Hitler, and World War II.” ”A Reconstruction of the Twentieth Century” (Nobel Prize Lecture, December 10, 2002) in American Economic Review, June 2002, p. 327

  5. Roles of Federal Reserve • Control of money supply - to be discussed • Market stabilization • Fed open market operations • Statements of officials • Lender of last resort • Incentive problems • Maintaining and improvement of payments mechanism • Private competitors, pre-Fed arrangements • Supervisor of the banking system • Performed by other agencies

  6. Monetary Policy • Deliberation • Implementation • Prediction • Evaluation • Criticism

  7. Deliberation • Since 1935, monetary policy is the responsibility of the Federal Open Market Committee (FOMC) • FOMC consists of 7 Federal Reserve Governors (Washington based) and five voting Federal Reserve Bank presidents • New York FRB president • Chicago/Cleveland FRB presidents alternate • Three of remaining nine FRB presidents rotate

  8. What is Money? • Fed tracks three money measures • M1 = Currency + checkable accounts + others • M2 = M1 + small savings accounts (including IRAs and Keoghs at banks) + others • M3 = M2 + large CDs + Eurodollars + others • Which is relevant to level of economic activity -- actively debated issues • Which can Fed control?

  9. The Money Multiplier • Fed controls its balance sheet, including the monetary base = currency + reserves • Money multiplier derives relation between supply of money (whichever definition) and the monetary base. Rose (p. 521) has M1 multiplier: • Note factors affecting money supply

  10. Money Multiplier Source: Federal Reserve Bank of St. Louis FRED II

  11. Currency Ratio Source: Federal Reserve Bank of St. Louis FRED II

  12. FOMC meetings • Eight scheduled meetings per year: one today • Next meeting is December 13, 2005 • Last scheduled meeting was November 1, 2005 • Last meeting for which minutes were released was September 20, 2005 (available on Internet) • Format of meetings routine • Discuss financial markets and economy • Adopt formal instructions to the manager of the System Open Market Account (directive)

  13. Input to FOMC Deliberations • Staff projections • Green book • Blue book • Beige book • Conceptual framework • Non-accelerating inflation rate of employment (NAIRU) • Taylor’s rule • Econometric models and projections where i is Fed funds rate and π is inflation and y is output gap (difference between actual and potential GDP)

  14. Implementation • Fed can only control its own balance sheet, or high-powered money consisting of currency and bank reserves • Since 1970, Fed targets growth rates in money supply • Initially two month growth targets • 1975 started announcing six month target and cone • Humphrey-Hawkins required annual target

  15. Fed Balance Sheet: Oct. 30, 2003

  16. Fed Balance Sheet: Oct.28, 2004 (U.S. Securities up 7.4%, FR Notes up 5.6%, reserves down 6.4%)

  17. Fed Balance Sheet: Oct.26, 2005 (U.S. Securities up 4.6%, FR Notes up 8.6%, reserves down 13.6%)

  18. FOMC and Board of Governors • FOMC sets monetary policy • Board of Governors rules on issues concerning regulatory changes, acquisitions under Gramm-Leach-Bliley Act of 1999 • Board reports twice annually to Congress under requirements of Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins) • Testimony to Congress

  19. Problems in Implementation • Monetary statistics reported late and are subject to revision (described as driving by looking in rear-view mirror) • Market rates are instantaneously observable and Fed Funds rate immediately impacted by changes in high-powered money (reserves) • Fed traditionally focussed on rates or credit market conditions

  20. Fed Targets and Base Growth Demand for Reserves and Funds } Narrow Wide } f=Fed Funds rate range range Reserves Non-Borrowed Reserves Borrowed Reserves = Discounts at Fed

  21. Required reserves • Reserve requirements depend on which banks (3% for smaller banks) and level of transactions versus other accounts • Calculation period runs 14 days from a Tuesday to Monday • Maintenance period is 14 days, ending on Wednesday 16 days after calculation period • Vault cash based on previous maintenance period applied to required reserves

  22. Lagged Reserves Tuesday Monday Monday Monday Monday • Reserve calculated on a dollar days basis • Penalties for shortfalls, limited advantage (carry-forward) for excess • Clearing balances affected by Fed wire and Treasury transactions 17 days Wednesday Wednesday Thursday Wednesday Wednesday Calculation Period Maintenance Period

  23. Growth Monthly and Smoothed Source: Federal Reserve Bank of St. Louis FRED II

  24. Monetary Base and Money Source: Federal Reserve Bank of St. Louis FRED II

  25. “Base Drift”

  26. Fed Funds and M1 Growth in ‘70s

  27. Volcker - October 6, 1979 • Focus on growth of aggregates • Widen Fed Funds trading range to 400 basis points • Focus on non-borrowed reserves • Experience • Interest rates • Monetary growth

  28. The Early ‘80s under Volcker

  29. Fed Funds and M1 Growth Now Source: Federal Reserve Bank of St. Louis FRED II

  30. Prediction (“Fed Watching”) • Importance of Fed actions is less than in 1970’s, but still matter to market observers • Fed watching is still common on the street • Fed watching consists of • Observing what they say they are doing • Speeches, testimony, interviews, remarks • Assessing what they have done • Statistical releases • Tracking the market’s reaction

  31. Evaluation • Humphrey-Hawkins specifies monetary policy objectives to be low inflation and economic growth • Last eight years have been a period of low inflation and rapid growth • Basic evaluation is that Greenspan has been a great chairman and his re-appointment by Clinton de-politicized the Fed

  32. Criticism • Theoretical argument by monetarists • “Inflation is always and everywhere a monetary phenomenon” - Milton Friedman • Fed is a giant player and its actions have an immense effect on markets, producing uncertainty • A base growth rule, gold standard, or comprehensible price rule would eliminate uncertainty about Fed policy

  33. Theoretical/Philosophical Issues • The econometric models used for policy are fundamentally flawed (the Lucas critique) • Participants in efficient markets try to anticipate changes and alter behavior accordingly • Parameters of estimated response functions will change constantly, hence are unstable • Data too limited to assess changes on models • Unanticipated changes in policy are risks

  34. Greenspan revisited • What are his (or the FOMC’s under his leadership) guiding principles, or rules? • How do asset prices, representing future value of cash flows, and goods inflation relate to each other and monetary policy? • Fed has increased its transparency with post-FOMC meeting announcements, but what else is being discussed?

  35. Central Banks • European monetary system • The Euro - January, 1999, and beyond • Brief history of European monetary union • Challenges facing the European Central Bank • Bank of Japan • People’s Bank of China • Central banks elsewhere - independence or political domination are the issues

  36. Next Week: November 16 • Read Chapter 18 in text concerning government and consumer debt markets • Bring a Wall Street Journal for next Tuesday to class • Plan team meeting and consultation with me concerning group semester project

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