ECONOMICS

Twelfth Edition, Global Edition

Michael Parkin
11 MONETARY POLICY
After studying this chapter, you will be able to:
 Describe the objectives of U.S. monetary policy,
and the framework for setting an achieving them
 Explain how the Federal Reserve makes its
interest rate decision and achieves its interest
rate target
 Explain the transmission channels through
which the Federal Reserve influences real GDP,
jobs, and inflation
 Explain the Fed’s extraordinary policy actions

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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
Monetary policy refers to the actions undertaken by a nation's central
bank to control money supply to achieve sustainable economic
growth.
The Fed's overall goal is healthy economic growth. That's a 2% to 3%
annual increase in the nation's gross domestic product.
Monetary policy, the demand side of economic policy, refers to the
actions undertaken by a nation's central bank to control money supply
and achieve macroeconomic goals that promote sustainable
economic growth.

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Monetary policy is the policy adopted by the monetary authority of a
nation to control either the interest rate payable for
very short-term borrowing (borrowing by banks from each other to
meet their short-term needs) or the money supply, often as an attempt
to reduce inflation or the interest rate, to ensure price stability and
general trust of the value and stability of the nation's currency.
Monetary policy is a modification of the supply of money, i.e.
"printing" more money, or decreasing the money supply by changing
interest rates or removing excess reserves. This is in contrast to
fiscal policy, which relies on taxation, government spending, and
government borrowing as methods for a government to manage
business cycle phenomena such as recessions.

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Expansionary policy occurs when a monetary authority uses its procedures
to stimulate the economy. An expansionary policy maintains short-term interest
rates at a lower than usual rate or increases the total supply of money in the
economy more rapidly than usual.
It is traditionally used to try to reduce unemployment during a recession by
decreasing interest rates in the hope that less expensive credit will entice
businesses into borrowing more money and thereby expanding. This would
increase aggregate demand (the overall demand for all goods and services in
an economy), which would increase short-term growth as measured by
increase of gross domestic product (GDP).

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Contractionary policy maintains short-term interest rates
greater than usual, slows the rate of growth of the money
supply, or even decreases it to slow short-term economic
growth and lessen inflation. Contractionary policy can
result in increased unemployment and depressed
borrowing and spending by consumers and businesses,
which can eventually result in an economic recession if
implemented too vigorously

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All central banks have three tools of monetary policy in common. First, they all
use open market operations. They buy and sell government bonds and other
securities from member banks. This action changes the reserve amount the
banks have on hand. A higher reserve means banks can lend less. That's a
contractionary policy. In the United States, the Fed sells Treasurys to member
banks.
The second tool is the reserve requirement, in which the central banks tell
their members how much money they must keep on reserve each night. Not
everyone needs all their money each day, so it is safe for the banks to lend
most of it out. That way, they have enough cash on hand to meet most
demands for redemption. The current reserve ratio for U.S. banks is set at
10% by the Fed.

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The third tool is the discount rate. That's how much a central bank charges
members to borrow funds from its discount window. It raises the discount rate
to discourage banks from borrowing. That action reduces liquidity and slows
the economy. By lowering the discount rate, it encourages borrowing. That
increases liquidity and boosts growth.
Monetary policy can be broadly classified as either expansionary or
contractionary.
Tools include open market operations, direct lending to banks, bank reserve
requirements, unconventional emergency lending programs, and managing
market expectations—subject to the central bank's credibility.

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The Federal Reserve uses monetary policy to manage economic growth,
unemployment, and inflation.
It does this to influence production, prices, demand, and employment.
Expansionary monetary policy increases the growth of the economy, while
contractionary policy slows economic growth.
The three objectives of monetary policy are controlling inflation, managing
employment levels, and maintaining long term interest rates.
The Fed implements monetary policy through open market operations, reserve
requirements, discount rates, the federal funds rate, and inflation targeting.
The most important is to manage inflation. The secondary objective is to
reduce unemployment, but only after controlling inflation. The third objective is
to promote moderate long-term interest rates.

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 Monetary Policy Objectives and
Framework
Goals and Means
The Fed’s monetary policy objective 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
Goals are 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.
The key goal is price stability.
Price stability is the source of maximum employment and
moderate long-term interest rates.

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 The Conduct of Monetary Policy

How does the Fed conduct monetary policy?

This question has two parts:
 What is the Fed’s monetary policy instrument?
 How does the Fed make its policy decision?
The Monetary Policy Instrument
The monetary policy instrument is a variable that the
Fed can directly control or closely target.

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 The Conduct of Monetary Policy
The Fed has two possible instruments:
1. Monetary base: A monetary base is the total amount of a currency that is either in
general circulation in the hands of the public or in the commercial bank deposits held in
the central bank's reserves. This measure of the money supply typically only includes
the most liquid currencies; it is also known as the "money base
2. Federal funds rate—the interest rate at which banks borrow and lend overnight from
other banks.
Basics of Overnight Rate
The amount of money a bank has fluctuates daily based on its lending activities and its
customers' withdrawal and deposit activity. It may experience a shortage or surplus
of cash at the end of the business day. Those banks that experience a surplus often
lend money overnight to banks that experience a shortage of funds to maintain their
reserve requirements. The requirements ensure that the banking system remains
stable and liquid.

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 The Conduct of Monetary Policy

Figure 31.2 shows the

federal funds rate.
When the Fed wants to
avoid recession, it lowers
the Federal funds rate.
When the Fed wants to
check rising inflation, it
raises the Federal funds
rate.

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 The Conduct of Monetary Policy

The Fed’s Decision-Making Strategy

The Fed’s decision begins with an intensive assessment of
the current state of the economy.
Then the Fed forecasts three variables
 Inflation rate
 Unemployment rate
 Output gap

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Monetary Policy Transmission

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 Extraordinary Monetary Stimulus

Policy Strategies and Clarity

Two other approaches to monetary policy that other
countries have used are
 Inflation rate targeting
 Taylor rule

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 Extraordinary Monetary Stimulus

Inflation Rate Targeting

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.
Inflation targeting is a strategy that avoids serious inflation
and persistent deflation.

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 Extraordinary Monetary Stimulus
Taylor Rule
The Taylor rule is one kind of targeting monetary policy used by central banks. The
Taylor rule was proposed by the economist John B. Taylor. The Taylor rule is a formula
for setting the interest rate.
The Taylor Rule suggests that the Federal Reserve should raise rates when inflation
is above target or when gross domestic product (GDP) growth is too high and above
potential. It also suggests that the Fed should lower rates when inflation is below the
target level or when GDP growth is too slow and below potential.
By using a rule to set the interest rate, monetary policy contributes toward lessening
uncertainty.
With less uncertainty, financial markets, labor markets, and goods markets work better
as traders are more willing to make long-term commitments. The main aim of the Taylor
rule is to bring stability to the economy for the near term, while still sustaining long-term
expansion.

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The Taylor Rule Formula
The product of the Taylor Rule is three numbers:
an interest rate, an inflation rate and a GDP rate, all based
on an equilibrium rate to gauge the proper balance for an
interest rate forecast by monetary authorities.
This formula suggests that the difference between a
nominal interest rate and a real interest rate is inflation.
Real interest rates account for inflation while nominal rates
do not. To compare rates of inflation, one must look at the
factors that drive it.

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