Chapter 6

MONETARY POLICY

Goals of Monetary Policy

Price StabilityFull EmploymentEconomic GrowthStable Interest RatesStable Foreign Exchange Rate

Trade-Offs and Conflicts Among Policies

Monetary Policy Tools Increase rate of growth in money supply

by supplying more reserves to banking system

Decrease rate of growth in money supply by supplying fewer reserves to banking system

Conflicts between monetary policies and monetary goals

Monetary Goals and Targets

Monetary GoalsOperating Targets

monetary and financial variablesIntermediate Targets

interest rates and monetary aggregates

Characteristics of Targets

Linkage

Observability

Responsiveness

Choosing Operating Targets

Operating Targets Level of federal funds rate Level of borrowed and non-borrowed

bank reserves The Fed cannot target both interest

rates and reserves at the same time

Choosing Intermediate Targets

Monetary aggregatesExchange ratesLevel of national outputLevel of actual or expected inflationInterest rates

Targeting the Fed Funds Rate: 1970-1979

Fed’s Target: Fed funds rate Indicator of supply of loanable funds Use of open market operations

Fed funds rate varies with economic conditions

Monetarist Experiment: 1979-1982

Fed’s Target: Non-borrowed reserves Use of open market operations

Intermediate Target: Monetary aggregates

Operating Target: Quantity of non-borrowed reserves

Money Multiplier: Link between reserves and monetary aggregates

Back to the Fed Funds Rate: 1983 - 1991

Operating Target: Borrowed reserves Closely linked to spread between fed

funds rate and discount rateUse of open market operations

Major Developments in the Mid-1980s

Level and Stability of U.S. Dollar Plaza Agreement in September 1985 Louvre Accord in February 1987

Stability in Financial Markets Stock market crash in October 1987

Same Policy, But With a Twist: 1991 - 1995

Fed’s Target: Short-term interest ratesUpward pressure placed on fed funds

rateLess emphasis on monetary aggregatesPrimary focus on:

prices of sensitive commodities level of industrial capacity

The Last Half of the 1990s: Exploring the New Paradigm

New Paradigm: Increased productivity due to new technology

and accelerated capital expenditures Capital deepening, increased labor productivity

and sustainable economic growthEclectic Approach:

No longer focused only on absolute level of fed funds rate, monetary aggregates or commodity prices

Main Policy Tool: Fed funds rate