Monetary Policy

Question 1

What are the MP goals?

Answer 1

• Price stability
• High employment
• Economic growth
• Stability of financial markets and instiutions
• Interest rate stability
• Foreign-Exchange market stability

Question 2

How are the MP goals prioritised?

Answer 2

• Price stability and employment are the most important, as they are drivers of the others
  
  • Some central banks (the Fed) have a dual mandate for both of these
    
    • Whether or not this position is consistent with financial market stability is an open question
  • Some have a hierarchical mandate (RBA): most important thing is price stability
    
    • These will have a target inflation rate

Question 3

What are the full set of MP tools?

Answer 3

• Open Market Operations
• Discount policy
• Reserve requirements
• New GFC Tools

Question 4

What are OMO’s?

Answer 4

• Fed’s purchases and sales of securities in financial markets
• These are generally T Bonds
• Starting in 2008, long term assets (e.g. long term corporate bonds) have been utilised: quantitative easing

Question 5

What is the discount policy?

Answer 5

• Setting the discount rate and the terms of discount lending
• Discount window is the means by which the Fed makes discount loans to banks
• This serves as the channel for meeting the liquidity needs of banks

Question 6

What new GFC MP tools are there?

Answer 6

• Interest on reserve balances
  
  • Raising the interest rate is pays to banks (i.e. from 0), the Fed can increase banks’ holding of reserves, potentially increasing MS
  • By reducing the interest rate, can decrease MS
• Term deposit facility
  
  • Similar to certificates of deposit, the Fed’s term deposits are offered to banks in periodic auctions
  • The interest rates have been slightly above the interest rate the Fed offers on reserve balances
  • The more funds banks place in term deposits, the less they will have available to expand loans and the MS

Question 7

What is the federal funds market?

Answer 7

• Demand and supply in the market for reserves
• Reserves demanded by banks vs federal funds rate
  
  • The rate banks charge each other on v short term loans
• Excess reserves are insurance against deposit outflows
  
  • The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves (ior)

Question 8

What is federal funds demand?

Answer 8

• Banks demand reserves
  
  • To meet their required reserves requirements
  • To meet their short term liquidity needs
• Since the GFC the Fed has paid interest on reserves (ior) at a level that is set at a fixed amount below the federal funds rate (iff) target
• When the federal funds rate is above the rate paid on excess reserves, (ior), as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises
• Downward sloping demand curve that becomes infinitely elastic at (ior)
  
  • If (iff) < (ior) Banks would not lend

Question 9

What is federal funds supply?

Answer 9

• CB supplies reserves
• Two components: non borrowed (OMO) and borrowed reserves (Discount loans)
• Cost of borrowing from the Fed is the discount rate (id))
• Borrowing from the Fed (at (iff)) is a substitute for borrowing from other banks (at (id))
• If iff < id, then banks will not borrow form the fed and borrowed reserves are zero
  
  • The supply curve will be vertical
• If iff > id, banks will borrow more at id, and re-lend at iff
  
  • The supply curve is perfectly elastic at id

Question 10

What is the federal funds market response to an OMO?

Answer 10

• Effects of an OMO depend on whether the supply curve initially intersects the demand curve in its downward or flat section
• An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward sloped section)
• OMO’s have no effect on the federal funds rate when the intersection occurs at the flat section

Question 11

What is the federal funds market response to a change in the discount rate?

Answer 11

• Since 2003, the Fed has kept the discount rate higher than the target for the federal funds rate
• So, the discount rate is a penalty rate, as banks pay a penalty by borrowing form the Fed rather than from other banks
• If the intersection of supply and demand occurs on the vertical section of the S curve, a change in the discount rate will have no effect on the federal funds rate
• If the intersection of supply and demand occurs on the horizontal section of the S curve, a change in the discount rate will shift that portion of the supply curve and the federal funds rate may change

Question 12

What is the federal funds market response to a change in RRD?

Answer 12

• The Fed rarely changes this ratio
• This action will likely carry out offering OMO’s to keep the target for the federal funds rate unchanged
• A decrease in the required reserve ratio will decrease the demand for reserves because banks would need to hold fewer reserves. The demand curve will shift to the left
• When the Fed raisers the reserve requirement, the federal funds rate rises and vice versa

Question 13

What is the Response to a change in the interest rate on reserves?

Answer 13

As flat bit of RD moves up and down, it may or may not cross RS

Question 14

How are fluctuations limited in the federal funds markets?

Answer 14

• Discount rate is an upper bound on the federal funds rate
• Interest rate on reserves is an upper bound
• Fluctuates between id and ior

Question 15

Why can’t the Fed always hit its Federal Funds Target?

Answer 15

• Fed can only set a target, actual rate is determined in the market
• Fed has done a goof job in using OMO’s to keep the actual federal funds rate close to the target rate
• Also, zero lower bound: new phenomenon

Question 16

Why are OMO’s preferred?

Answer 16

• Benefits of OMO’s include control, flexibility and ease of implementation
• Discount loans depend in part on the willingness to banks to request the loans and so are not completely under Fed control
• Can make both large and small OMO’s. Often dynamic operations require large purchases or sales whereas defensive operations can be small
• Reversing OMO’s is simple enough. Discount loans and reserve requirement changes are more difficult to reverse quickly
• The Fed can implement its open market operations with no administrative delays. Changing the discount rate or reserve requirements requires lengthier deliberation

Question 17

What is the Fed’s ultimate trade off in the federal funds market?

Answer 17

• It can choose a reserve aggregate for its policy instruments, or it can choose the federal funds rate, but not both
• Using reserves will cause the federal funds rate to fluctuate in response to changes in the demand for reserves
• Using the federal funds rate will cause the level of reserves to fluctuate in response to changes in the demand for reserves
• Federal funds rate has been favoured by the Fed for 30 years

Question 18

What is the taylor rule?

Answer 18

• A monetary policy guideline for determining the target federal funds rate
• Estimate of the value of the federal funds rate (after inflation) to be consistent with real GDP being equal to potential GDP in the long run
• According to the Taylor rule, the Fed should set its current federal funds rate target equal to the current inflation rate, the equilbiurm real federal funds rate, and two additional terms
• Federal funds target = current inflation rate + equilibrium real funds rate (2%) + (1/2 x inflation gap) + (1/2 x output gap)

Question 19

What is the inflation gap?

Answer 19

Inflation gap (% terms) : current inflation rate - target inflation rate

Question 20

What is the output gap?

Answer 20

Output gap (% terms): (real gdp - potential real gdp)/real gdp

Question 21

What does the taylor rule imply?

Answer 21

• If π > πtarget, πGap > 0, and iff should increase

- If real GDP < target, GDPGap < 0, and iff should decrease

Question 22

What are the pros/cons of inflation targeting?

Answer 22

• Typically 2%
• Argument for
  
  • Would draw attention to what the Fed can actually achieve
  • Would provide an anchor for inflationary expectations
  • Would help institutionalise effective US monetary policy
  • It would promote accountability
• Argument against
  
  • Rigid numerical targets diminish flexibility
  • Reliance on uncertain forecasts of future inflation can create problems
  • The focus on inflation may make it more difficult for elected officals to monitor the Fed’s support for good economic policy overall
  • Uncertainy about future levels of output and employment can impede economic decision making in the presence of an inflation target

Question 23

With short-term interest rates at or near zero and long-term interest rates at historic lows, do you think that additional quantitative easing by the Fed would amount to little more than pushing on a string?

Answer 23

Additional quantitative easing will have limited effects in lowering long-term interest rates, but increases in the monetary base and the money supply have other channels through which to affect total spending. Whether the effect of the slightly lower interest rates and these other channels outweigh the increased risk of inflation due to additional quantitative easing is debatable.