The Conduct of Monetary Policy • The specific “nuts and bolts” of monetary policy, from beginning (policy tools) to end (key macroeconomic variables such as the price level and real GDP).
How Monetary Policy is Done -- A Diagram Policy Tools Operating Target Intermediate Target Final Targets
Important Terms • Policy Tools -- The Federal Reserve’s policy instruments, usually open market operations (OMOs). • Final Targets -- Overall goal variables for the economy, such as real GDP (Y) or the price level (P).
Intermediate Targets • Intermediate Targets -- Variables which are known to have a direct effect on final targets. • Possible Candidates – an interest rate (short-term and long-term), M1, M2, other money supply measures.
Operating Targets • Operating Targets -- Variables which are known to have a direct effect on intermediate targets. • Possible Candidates -- the Federal Funds rate (iFF), Reserves (R), the Monetary Base (H), the Nonborrowed Base (HNON), Nonborrowed Reserves (RNON).
Criteria for Choosing Intermediate Targets • Measurability -- The variable must be accurately measured and available on a frequent basis. • Controllability -- The Fed should be able to hit the target with reasonable accuracy on a consistent basis.
Predictive Accuracy -- Given the value of the intermediate target, the Fed should be able to predict with reasonable accuracy the final targets. • The Money Supply -- not great at controllability, stronger on predictive accuracy.
Criteria for Choosing Operating Targets • Same as choosing intermediate targets. • Controllability more important. • Predictive ability -- applies to intermediate target.
The Current Conduct of US Monetary Policy Policy Tools Operating Target Intermediate Target Final Targets Since 1988: OMOs iFF M2 Y, P
Setting Monetary Policy -- Expansionary • The FOMC lowers the target Federal Funds Rate. • To achieve this target, the Open Market Manager buys bonds, supplying more reserves to the system. • The Fed does this until the new equilibrium iFF equals its newly set target rate.
Setting Monetary Policy -- Contractionary • The FOMC raises the target Federal Funds Rate. • To achieve the FOMC’s new target, the Open Market Manager sells bonds, thereby removing reserves from the system. • The Fed does this until the equilibrium iFF equals its target.
Maintaining Monetary Policy (Increased Loan Demand) • Income (Y) or Loan Demand increases. • This change increases the Demand for Reserves, shifting the curve rightward, and threatening to increase the equilibrium iFF. • The Open Market Manager increases the Supply of Reserves until the equilibrium iFF equals its mandated target rate.
The Procyclical Money Supply • Outcome of Federal Funds rate targeting, due to policy maintenance. • Money supply misses its target in the direction of the business cycle (e.g. too much during inflation). • Potentially destabilizing on economy, money supply miss aggravates the existing macro problem.
Monetary Policy -- Current Issues and Developments • M1 is becoming obsolete -- sweep programs. • Less reliance on money supply for short-term policy, used for longer-term growth targets instead. • Greater reliance on iFF as an operating target. Has it in fact become the intermediate target?
More Developments • The end of stand-alone investment banks? (merging with banks or converting into banks) • The restructuring of Fannie Mae and Freddie Mac • Another look at mortgages and mortgage securitization
Developments -- Banking • Getting out of the mortgage foreclosure problem and stabilizing the banking system. • Harsher bank regulations coming down (as with FIRREA)? • More global cooperation and coordination of banking and financial market regulations? • Continuous Financial innovation -- a given.