CHAPTER 1

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On eight pre-set dates a year, the Federal Reserve
announces whether the interest rate will rise, fall, or remain
constant until the next decision date.
How does the Fed make its interest rate decision?
What does the Fed do to keep interest rates where it wants
them?
Does the Fed’s interest rate changes influence the
economy in the way the Fed wants?
Can the Fed speed up economic growth by lowering
interest rates and keep inflation in check by raising them?

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 Monetary Policy Objectives and
Framework
A nation’s monetary policy objectives and the framework
for setting and achieving that objective stems from the
relationship between the central bank and the government.

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 Monetary Policy Objectives and
Framework
Monetary Policy Objectives
The objectives of monetary policy stems from the mandate
of the Board of Governors of the federal Reserve System
as set out in the Federal Reserve Act of 1913 and its
amendments. The law states:
The Fed and the FOMC shall maintain long-term growth of
the monetary and credit aggregates commensurate with
the economy’s long-run potential to increase production,
so as to promote effectively the goals of maximum
employment, stable prices, and moderate long-term
interest rates.
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 Monetary Policy Objectives and
Framework
Goals and Means
Fed’s monetary policy objectives has two distinct parts:
1. A statement of the goals or ultimate objectives
2. A prescription of the means by which the Fed should
pursue its goals

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 Monetary Policy Objectives and
Framework
Goals of Monetary Policy
Maximum employment, stable prices, and moderate long-
term interest rates
In the long run, these goals are in harmony and reinforce
each other, but in the short run, they might be in conflict.
Key goal is price stability.
Price stability is the source of maximum employment and
moderate long-term interest rates.

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 Monetary Policy Objectives and
Framework
Means of Achieving the Goals
By keeping the growth rate of the quantity of money in line
with the growth rate of potential GDP, the Fed is expected
to be able to maintain full employment and keep the price
level stable.
How does the Fed operate to achieve its goals?

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 Monetary Policy Objectives and
Framework
Operational “Stables Prices” Goal
The Fed also pays close attention to the CPI excluding
fuel and food—the core CPI.
The rate if increase in the core CPI is the core inflation
rate.
The Fed believes that the core inflation rate provides a
better measure of the underlying inflation trend and a
better prediction of future CPI inflation.

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 Monetary Policy Objectives and
Framework

Figure 31.1 shows

the core inflation rate
and the CPI inflation
rate.
You can see that the
CPI inflation rate is
volatile and that the
core inflation rate is a
better indicator of
price stability.

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 Monetary Policy Objectives and
Framework
Operational “Maximum Employment” Goal
Stable price is the primary goal but the Fed pays attention
to the business cycle.
To gauge the overall state of the economy, the Fed uses
the output gap—the percentage deviation of real GDP
from potential GDP.
A positive output gap indicates an increase in inflation.
A negative output gap indicates unemployment above the
natural rate.
The Fed tries to minimize the output gap.
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 Monetary Policy Objectives and
Framework
Responsibility for Monetary Policy
What is the role of the Fed, the Congress, and the
President?
The FOMC makes monetary policy decisions.
The Congress makes no role in making monetary policy
decisions. The Fed makes two reports a year and the
Chairman testifies before Congress (February and June).
The formal role of the President is limited to appointing the
members and Chairman of the Board of Governors.

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 The Conduct of Monetary Policy
Choosing a Policy Instrument
The monetary policy instrument is a variable that the
Fed can directly control or closely target.
As the sole issuer of the monetary base, the Fed is a
monopoly.
1. Should the Fed fix the price of U.S. money on the
foreign exchange market (the exchange rate)?
2. Should the Fed let the exchange rate be flexible and
target the short-term interest rate?
The Fed must decide which variable to target.
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 The Conduct of Monetary Policy

The Federal Funds Rate

The Fed’s choice of policy instrument (which is the same
choice as that made by most other major central banks) is
a short-term interest rate.
Given this choice, the exchange rate and the quantity of
money find their own equilibrium values.
The specific interest rate that the Fed targets is the
federal funds rate, which is the interest rate on overnight
loans that banks make to each other.

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 The Conduct of Monetary Policy

Figure 31.2 shows the

federal funds rate.
When the Fed wants
to slow inflation, it
raises the Federal
funds rate.
When inflation is low
and the Fed wants to
avoid recession, it
lowers the Federal
funds rate.

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 The Conduct of Monetary Policy

Although the Fed can change the federal funds rate by any
(reasonable) amount that it chooses, it normally changes
the rate by only a quarter of a percentage point.
How does the Fed decide the appropriate level for the
federal funds rate?
And how, having made that decision, does the Fed get the
federal funds rate to move to the target level?

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 The Conduct of Monetary Policy

The Fed’s Decision-Making Process

The Fed could adopt either
 An instrument rule
 A targeting rule

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 The Conduct of Monetary Policy

Instrument Rule
An instrument rule sets the policy instrument at a level
based on the current state of the economy.
The best known instrument rule is the Taylor rule:
Set the federal funds rate at a level that depends on
 The deviation of the inflation rate from target
 The size and direction of the output gap.

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 The Conduct of Monetary Policy

Targeting Rule
A targeting rule sets the policy instrument at a level that
makes the forecast of the ultimate policy target equal to
the target.
If the ultimate policy goal is a 2 percent inflation rate and
the instrument is the federal funds rate, …
then the targeting rule sets the federal funds rate at a level
that makes the forecast of the inflation rate equal to 2
percent a year.

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 The Conduct of Monetary Policy

To implement such a targeting rule, the FOMC must

gather and process a large amount of information about
the economy, the way it responds to shocks, and the way
it responds to policy.
The FOMC must then process all this data and come to a
judgment about the best level for the policy instrument.
The FOMC minutes suggest that the Fed follows a
targeting rule strategy.
Some economists think that the interest rate settings
decided by FOMC are well described by the Taylor Rule.

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 The Conduct of Monetary Policy

Hitting the Federal Funds Rate Target: Open Market

Operations
An open market operation is the purchase or sale of
government securities by the Fed from or to a commercial
bank or the public.
When the Fed buys securities, it pays for them with newly
created reserves held by the banks.
When the Fed sells securities, they are paid for with
reserves held by banks.
So open market operations influence banks’ reserves.

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 The Conduct of Monetary Policy

Figure 31.3 shows the

effects of an open market
purchase on the balance
sheets of the Fed and the
Bank of America.
The open market purchase
increases bank reserves.

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 The Conduct of Monetary Policy

Figure 31.4 shows the

effects of an open market
sale on the balance sheets
of the Fed and Bank of
America.
The open market sale
decreases bank reserves.

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 The Conduct of Monetary Policy

Equilibrium in the Market

for Reserves
Figure 31.5 illustrates the
market for reserves.
The x-axis measures the
quantity of reserves held.
The y-axis measures the
federal funds rate.

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 The Conduct of Monetary Policy

The banks’ demand for

reserves is the curve RD.
The federal funds rate is
the opportunity cost of
holding reserves, so the
higher the federal funds
rate, the fewer are the
reserves demanded.
The demand for reserves
slopes downward.

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 The Conduct of Monetary Policy

The red line shows the

Fed’s target for the
federal funds rate.
The Fed’s open market
operations determine
the actual quantity of
reserves in banking
system.

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 The Conduct of Monetary Policy

Equilibrium in the market

for reserves determines
the federal funds rate.
So the Fed uses open
market operations to keep
the federal funds rate on
target.

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 Monetary Policy Transmission

Quick Overview
When the Fed lowers the federal funds rate:
1. Other short-term interest rates and the exchange rate
fall.
2. The quantity of money and the supply of loanable funds
increase.
3. The long-term real interest rate falls.
4. Consumption expenditure, investment, and net exports
increase.

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 Monetary Policy Transmission

5. Aggregate demand increases.

6. Real GDP growth and the inflation rate increase.
When the Fed raises the federal funds rate, the ripple
effects go in the opposite direction.
Figure 31.6 provides a schematic summary of these ripple
effects, which stretch out over a period of between one
and two years.

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 Monetary Policy Transmission

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 Monetary Policy Transmission

Interest Rate Changes

Figure 31.7 shows the
fluctuations in three
interest rates:
 The short-term bill rate
 The long-term bond rate
 The federal funds rate

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 Monetary Policy Transmission

Short-term rates move

closely together and
follow the federal funds
rate.
Long-term rates move
in the same direction as
the federal funds rate
but are only loosely
connected to the federal
funds rate.

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 Monetary Policy Transmission

Exchange Rate Fluctuations

The exchange rate responds to changes in the interest
rate in the United States relative to the interest rates in
other countries—the U.S. interest rate differential.
But other factors are also at work, which make the
exchange rate hard to predict.

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 Monetary Policy Transmission

Money and Loans

When the Fed lowers the federal funds rate, the quantity
of money and the quantity of loans increase.
Consumption and investment plans change.
Long-Term Real Interest Rate
Equilibrium in the market for loanable funds determines
the long-term real interest rate, which equals the nominal
interest rate minus the expected inflation rate.
The long-term real interest rate influences expenditure
plans.
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 Monetary Policy Transmission

Expenditure Plans
The ripple effects that follow a change in the federal funds
rate change three components of aggregate expenditure:
 Consumption expenditure
 Investment
 Net exports
The change in aggregate expenditure plans changes
aggregate demand, real GDP, and the price level, which in
turn influence the goal of inflation rate and output gap.

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 Monetary Policy Transmission
The Fed Fights Recession
If inflation is low and the output gap is negative, the
FOMC lowers the federal funds rate target.

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 Monetary Policy Transmission

The increase in the supply of money increases the

supply of loanable funds in the short-term.

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 Monetary Policy Transmission
The Fed Fights Inflation
If inflation is too high and the output gap is positive, the
FOMC raises the federal funds rate target.

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 Monetary Policy Transmission

The decrease in the supply of money decreases the

supply of loanable funds in the short-term.

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 Monetary Policy Transmission

Loose Links and Long and Variable Lags

Long-term interest rates that influence spending plans are
linked loosely to the federal funds rate.
The response of the real long-term interest rate to a
change in the nominal rate depends on how inflation
expectations change.
The response of expenditure plans to changes in the real
interest rate depends on many factors that make the
response hard to predict.
The monetary policy transmission process is long and
drawn out and doesn’t always respond in the same way.

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 Alternative Monetary Policy Strategies

The Fed might have chosen any of four alternative

monetary policy strategies: One of them is an instrument
rule and three are alternative targeting rules.
The four alternatives are
 Monetary base instrument rule
 Monetary targeting rule
 Exchange rate targeting rule
 Inflation targeting rule

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 Alternative Monetary Policy Strategies
Monetary Base Instrument Rule
The McCallum rule makes the growth rate of the
monetary base respond to the long-term average growth
rate of real GDP and medium-term changes in the velocity
of circulation of the monetary base.
The rule is based on the quantity theory of money.
The McCallum rule does not need an estimate of either the
real interest rate or the output gap.
The McCallum rule relies on the demand for money and
the demand for monetary base being reasonably stable.
The Fed believes that these are too unstable to allow a
McCallum rule work well.
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 Alternative Monetary Policy Strategies

Money Targeting Rule

Friedman’s k-percent rule makes the quantity of money
grow at a rate of k percent a year, where k equals the
growth rate of potential GDP.
Friedman’s idea was tried but abandoned during the
1970s and 1980s.
The Fed believes that the demand for money is too
unstable to make the use of monetary targeting reliable.

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 Alternative Monetary Policy Strategies

Exchange Rate Targeting Rule

With a fixed exchange rate, a country has no control over
its inflation rate.
The Fed could use a crawling peg exchange.
The disadvantage rate of a crawling peg to target the
inflation rate is that the real exchange rate often changes
in unpredictable ways.
With crawling peg targeting the inflation rate, the Fed
would need to identify changes in the real exchange rate
and offset them.

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 Alternative Monetary Policy Strategies

Inflation Targeting Rule

Inflation rate targeting is a monetary policy strategy in
which the central bank makes a public commitment
1. To achieve an explicit inflation target
2. To explain how its policy actions will achieve that target
Several central banks practice inflation targeting and have
done so since the mid-1990s.
It is not clear whether inflation targeting would deliver a
better outcome than the Fed’s current implicit targeting.

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 Alternative Monetary Policy Strategies

Why Rules?
Why do all the monetary policy strategies involve rules?
Why doesn’t the Fed use discretion?
The answer is that monetary policy is about managing
inflation expectations.
A well-understood monetary policy rule helps to create an
environment in which inflation is easier to forecast and
manage.

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