Module 31 monetary policy and the interest rate


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Module 31 monetary policy and the interest rate

  1. 1.  In the short run, the interest rate is determined in the money market and the loanable funds market adjusts in response to changes in the money market. However, in the long run, the interest rate is determined by matching supply and demand of loanable funds that arise when real GDP equals potential output.
  2. 2.  The Federal Reserve can use changes in the money supply to change the interest rate. An increase in the money supply drives the interest rate down, and a decrease in the money supply drives the interest rate up. So, by adjusting the money supply up or down, the Fed can set the interest rate.
  3. 3.  The Federal Open Market Committee meets every six weeks to decide on the interest rate by targeting a target federal funds rate, which is a desired level for the federal funds rate. This target is then enforced by the Open Market Desk of the Federal Reserve Bank of New York, which adjusts the money supply through open-market operations. Open market operations are purchase or sale of Treasury bills on the open market.
  4. 4.  The Fed purchases or sells Treasury bills until the actual federal funds rate equals the target rate. The other tools of monetary policy, lending through the discount window or changes in the reserve requirements, are not used regularly.
  5. 5.  Monetary policy, as with fiscal policy, can be used to stabilize the economy. Monetary policy shifts the aggregate demand curve through the effect of monetary policy on the interest rate.
  6. 6.  When the Fed expands the money supply, this leads to a lower interest rate. A lower interest rate leads to more investment spending, which leads to a higher real GDP, which leads to higher consumer spending, and so on through the multiplier process. The total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right. This is called expansionary monetary policy.
  7. 7.  When the Fed contracts the money supply, this leads to a higher interest rate. A lower interest rate leads to lower investment spending, which leads to a lower real GDP, which leads to lower consumer spending, and so on. The total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left. This is called contractionary monetary policy.
  8. 8.  Policy makers try to fight recessions; they also try to ensure price stability, with low (but not zero) inflation. In general, central banks engage in expansionary monetary policy when the actual GDP is below potential output. The output gap is the percentage difference between actual real GDP and potential output; it is positive when actual real GDP exceeds potential output, and negative when actual real GDP lies below potential output.
  9. 9.  The Fed has tended to raise interest rates when the output gap is rising (inflationary gap) and cut rates when the output gap is falling (recessionary gap). One exception was in the late 1990s when the Fed left rates steady for several years even as a positive output gap developed, which went along with a low unemployment rate. This was because the inflation rate was low. Low inflation during the mid-1990s helped encourage loose monetary policy both in late 1990s and in 2002-2003.
  10. 10.  In 1993, Stanford economist John Taylor suggested that monetary policy should follow a rule that takes into account concerns about both the business cycle and inflation. The Taylor Rule for monetary policy is a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap.
  11. 11.  Taylor suggested that the actual monetary policy often looks as if the Fed was following this rule. The rule Taylor suggested was: Federal Funds Rate =1 + (1.5 * inflation rate) + (0.5 * output gap) Taylor’s rule does a pretty good job at predicting the Fed’s actual behavior.
  12. 12.  However, in 2009, a combination of low inflation and a large and negative output gap put Taylor’s rule of prediction of the federal funds rate into the negative numbers, which is impossible to target. The Fed responded by cutting rates aggressively and the federal funds rate fell to almost zero.
  13. 13.  Monetary policy, rather then fiscal policy, is the main tool of stabilization policy. Like fiscal policy, it is subject to lags: it may take time for the Fed to recognize economic problems and time for monetary policy to affect the economy. However, the Fed can move more quickly than Congress, so monetary policy is the preferred tool.
  14. 14.  The Fed tries to keep inflation low, but positive. Although the Fed does not target any specific rate of inflation, it is widely believed to prefer inflation at about 2% per year. However, other central banks do have explicit inflation targets, so they don’t use any rule to set monetary policy. Instead, they announce the inflation rate that they want to achieve (the inflation target), and set policy in an attempt to hit that target; this is called inflation targeting.
  15. 15.  The central bank of New Zealand was the first to adopt inflation targeting, for a range between 1-3%. Central banks with a target range for inflation seem to aim for the middle of a range between 1-3%, and central banks with a fixed target tend to give themselves considerable wiggle room.
  16. 16.  The difference between inflation targeting and the Taylor rule is that inflation targeting is forward-looking and the Talylor rul is backward-looking. The Taylor rule adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.
  17. 17.  Inflation targeting has two key advantages:1. Transparency: the public knows the objective of an inflation-targeting central bank.2. Accountability: the success of a central bank can be judged by seeing how closely actual inflation rates have matched the inflation target, so central bankers are accountable.
  18. 18.  Inflation-targeting is criticized as being too restrictive; there are times when other concerns should take priority over any particular inflation rate, when the stability of the financial system is at risk. For example, in 2007-8 the Fed cut rates more than either the Taylor rule or inflation targeting would dictate because of the fear of turmoil in the financial markets leading to a major recession (which it did).