This document provides an overview of monetary policy tools and how they are used by central banks. It discusses conventional tools like open market operations, reserve requirements, and the discount rate. It also covers unconventional tools used in the financial crisis like large-scale asset purchases and forward guidance. The document explains how these tools impact monetary policy objectives like inflation and economic growth. It analyzes features of desirable policy instruments and why most central banks target interest rates rather than monetary aggregates.
It talks about the stability of the financial system in India. How a financial system can be stable and how it will be a positive thing for the economy.
central bank is the father of all banks, main regulatory body of the nation which control and regulate all the banks of the country. central bank is the financial advisor to the government.
This presentations chalks out in detail information about ALM in Indian Bank. It starts with the basics of Balance sheet; applicability of ALM in real life; Evolution and then starts with main topics of ALM like structured statement; Liquidity risk, its management; currency risk and finally ends with Interest Risk management.
Links to Video’s in the ppt
Balance Sheet
http://www.investopedia.com/terms/b/balancesheet.asp
NII/NIM
http://www.investopedia.com/terms/n/netinterestmargin.asp
www.abhijeetdeshmukh.com
I’m a young Pakistani Blogger, Academic Writer, Freelancer, Quaidian & MPhil Scholar, Quote Lover, Co-Founder at Essar Student Fund & Blueprism Academia, belonging from Mehdiabad, Skardu, Gilgit Baltistan, Pakistan.
I am an academic writer & freelancer! I can work on Research Paper, Thesis Writing, Academic Research, Research Project, Proposals, Assignments, Business Plans, and Case study research.
Expertise:
Management Sciences, Business Management, Marketing, HRM, Banking, Business Marketing, Corporate Finance, International Business Management
For Order Online:
Whatsapp: +923452502478
Portfolio Link: https://blueprismacademia.wordpress.com/
Email: arguni.hasnain@gmail.com
Follow Me:
Linkedin: arguni_hasnain
Instagram : arguni.hasnain
Facebook: arguni.hasnain
It talks about the stability of the financial system in India. How a financial system can be stable and how it will be a positive thing for the economy.
central bank is the father of all banks, main regulatory body of the nation which control and regulate all the banks of the country. central bank is the financial advisor to the government.
This presentations chalks out in detail information about ALM in Indian Bank. It starts with the basics of Balance sheet; applicability of ALM in real life; Evolution and then starts with main topics of ALM like structured statement; Liquidity risk, its management; currency risk and finally ends with Interest Risk management.
Links to Video’s in the ppt
Balance Sheet
http://www.investopedia.com/terms/b/balancesheet.asp
NII/NIM
http://www.investopedia.com/terms/n/netinterestmargin.asp
www.abhijeetdeshmukh.com
I’m a young Pakistani Blogger, Academic Writer, Freelancer, Quaidian & MPhil Scholar, Quote Lover, Co-Founder at Essar Student Fund & Blueprism Academia, belonging from Mehdiabad, Skardu, Gilgit Baltistan, Pakistan.
I am an academic writer & freelancer! I can work on Research Paper, Thesis Writing, Academic Research, Research Project, Proposals, Assignments, Business Plans, and Case study research.
Expertise:
Management Sciences, Business Management, Marketing, HRM, Banking, Business Marketing, Corporate Finance, International Business Management
For Order Online:
Whatsapp: +923452502478
Portfolio Link: https://blueprismacademia.wordpress.com/
Email: arguni.hasnain@gmail.com
Follow Me:
Linkedin: arguni_hasnain
Instagram : arguni.hasnain
Facebook: arguni.hasnain
This presentation explains various monetary instruments being adopted by the Reserve Bank of India. It also shows their impact on stock market. It also show the statistic trend of inflation, repo rate, reverse repo rate, etc in India.
includes objectives of monetary policy and its importance and discussed different monetary instruments like bank rate, cash reserve ratio, statutary liquidity ratio, rationing of credit , moral suasion, repo rate, marginal requirement
.Monetary policy is the macroeconomic policy laid down by the central bank. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity.
OBJECTIVES OF MONETARY POLICY
Full Employment
• Price Stability
• Economic Growth
• Balance of Payments
• Exchange Rate Stability
• Neutrality of Money
• Equal Income Distribution
Model Attribute Check Company Auto PropertyCeline George
In Odoo, the multi-company feature allows you to manage multiple companies within a single Odoo database instance. Each company can have its own configurations while still sharing common resources such as products, customers, and suppliers.
The French Revolution, which began in 1789, was a period of radical social and political upheaval in France. It marked the decline of absolute monarchies, the rise of secular and democratic republics, and the eventual rise of Napoleon Bonaparte. This revolutionary period is crucial in understanding the transition from feudalism to modernity in Europe.
For more information, visit-www.vavaclasses.com
Read| The latest issue of The Challenger is here! We are thrilled to announce that our school paper has qualified for the NATIONAL SCHOOLS PRESS CONFERENCE (NSPC) 2024. Thank you for your unwavering support and trust. Dive into the stories that made us stand out!
This is a presentation by Dada Robert in a Your Skill Boost masterclass organised by the Excellence Foundation for South Sudan (EFSS) on Saturday, the 25th and Sunday, the 26th of May 2024.
He discussed the concept of quality improvement, emphasizing its applicability to various aspects of life, including personal, project, and program improvements. He defined quality as doing the right thing at the right time in the right way to achieve the best possible results and discussed the concept of the "gap" between what we know and what we do, and how this gap represents the areas we need to improve. He explained the scientific approach to quality improvement, which involves systematic performance analysis, testing and learning, and implementing change ideas. He also highlighted the importance of client focus and a team approach to quality improvement.
How to Split Bills in the Odoo 17 POS ModuleCeline George
Bills have a main role in point of sale procedure. It will help to track sales, handling payments and giving receipts to customers. Bill splitting also has an important role in POS. For example, If some friends come together for dinner and if they want to divide the bill then it is possible by POS bill splitting. This slide will show how to split bills in odoo 17 POS.
Ethnobotany and Ethnopharmacology:
Ethnobotany in herbal drug evaluation,
Impact of Ethnobotany in traditional medicine,
New development in herbals,
Bio-prospecting tools for drug discovery,
Role of Ethnopharmacology in drug evaluation,
Reverse Pharmacology.
How to Make a Field invisible in Odoo 17Celine George
It is possible to hide or invisible some fields in odoo. Commonly using “invisible” attribute in the field definition to invisible the fields. This slide will show how to make a field invisible in odoo 17.
2. Learning Objectives
• Illustrate the market for reserves and demonstrate how
changes in monetary policy can affect the federal funds
rate.
• Summarize how conventional monetary policy tools
are implemented and the advantages and limitations of
each tool.
• Explain the key monetary policy tools that are used
when conventional policy is no longer effective.
• Identify the distinctions and similarities between the
monetary policy tools of the Federal Reserve and those
of the European Central Bank.
3. Conventional Toolbox
GONZAGA UNIVERSITY 3
What is it How is it Controlled? What is its Impact?
Target
Federal
Funds Rate
Interest rate charged on
overnight loans between
banks.
Supply of reserves
adjusted through omo
to meet expected
demand at target rate.
Changes interest rates
throughout the economy
Discount Rate Interest rate charged by
the Fed on loans to
commercial banks.
Set at a premium over
the target ff rate.
Ceiling on market ff rate.
Means to provide
liquidity to banks in
times of crisis
Deposit Rate Interest rate paid by Fed
on reserves held by
banks.
Set at a spread below
the target ff rates.
Sets a floor under the
market ff rate
Reserve
Requirement
Fraction of deposits that
banks must keep either
on deposit at the Fed or
as cash in their value.
Set by the Fed Board
within a legally
imposed range.
Stabilizes the demand for
reserves. Not used to
alter monetary policy
4. The Market for Reserves and
the Federal Funds Rate
• Demand and Supply in the Market for Reserves
• What happens to the quantity of reserves
demanded by banks, holding everything else
constant, as the federal funds rate changes?
• 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
5. Demand in the Market for
Reserves
• Since the fall of 2008, the Fed has paid interest on
reserves at a level that is set at a fixed amount
below the federal funds rate 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
flat (infinitely elastic) at ior
6. Supply in the Market for
Reserves
• Two components: nonborrowed and borrowed reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing from
other banks
• If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow more and more at id,
and relend at iff
• The supply curve is horizontal (perfectly elastic) at id
8. How Changes in the Tools of
Monetary Policy Affect the
Federal Funds Rate
• Effects of open an market operation depends on
whether the supply curve initially intersects the
demand curve in its downward sloped section versus
its 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).
• Open market operations have no effect on the federal
funds rate when intersection occurs at the flat section
of the demand curve.
9. How Changes in the Tools of
Monetary Policy Affect the
Federal Funds Rate
• If the intersection of supply and demand occurs on the
vertical section of the supply 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 supply curve, a change in the
discount rate shifts that portion of the supply curve and the
federal funds rate may either rise or fall depending on the
change in the discount rate.
• When the Fed raises reserve requirement, the federal funds
rate rises and when the Fed decreases reserve
requirement, the federal funds rate falls.
13. The Need for Reserve
Requirements
• Numerous factors are altering the demand for
the monetary base.
• As the demand for the reserves disappears,
will monetary policy go with it?
• There are other countries who have
eliminated reserve requirements entirely, but
retain monetary policy control.
– Australia, Canada, and New Zealand, for example.
GONZAGA UNIVERSITY 13
14. The Need for Reserve
Requirements
• They do it through a “channel” or “corridor” system
that involves setting not only a target interest rate, but
also a lending and deposit rate: just as the Fed and the
ECB do.
• Banks in need of funds will never be willing to pay
more than the central bank’s lending rate, and
• Those that have excess funds will never be willing to
lend at a rate below the central bank’s deposit rate.
• This will continue to give monetary policymakers a tool
to influence the economy.
GONZAGA UNIVERSITY 14
15. Response to a Change in the
Interest Rate on Reserves
16. Federal Funds to Long-term
• The Federal Funds Rate is the overnight
lending rate.
• Long-term interest rates = average of expected
short-term interest rates + the risk premium.
• When the expected future path of the federal
funds rate changes, long-term interest rates
we all care about change.
GONZAGA UNIVERSITY 16
17. Operating Procedures Limit
Fluctuations in the Federal
Funds Rate
• Supply and demand analysis of the market for
reserves illustrates how an important
advantage of the Fed’s current procedures for
operating the discount window and paying
interest on reserves is that they limit
fluctuations in the federal funds rate.
19. Conventional Monetary Policy
Tools
• During normal times, the Federal Reserve uses
three tools of monetary policy—open market
operations, discount lending, and reserve
requirements—to control the money supply
and interest rates, and these are referred to as
conventional monetary policy tools.
20. Discount Policy and the
Lender of Last Resort
• Discount window
• Primary credit: standing lending facility
– Lombard facility
• Secondary credit
• Seasonal credit
• Lender of last resort to prevent financial
panics
– Creates moral hazard problem
21. Primary Credit
• Primary credit is extended on a very short-term
basis, usually overnight, to institutions that the
Fed’s bank supervisors deem to be sound.
• Banks seeking to borrow must post acceptable
collateral.
• The interest rate on primary credit is set at a
spread above the federal fund target rate called
the primary discount rate.
GONZAGA UNIVERSITY 21
22. Primary Credit
• Primary credit is designed to provide
additional reserves at times when the open
market staff’s forecasts are off and so that the
day’s reserve supply falls short.
– The market federal funds rate will rise above the
FOMC’s target.
• Providing a facility through which banks can
borrow at a penalty rate above the target puts
a cap on the market federal funds rate.
GONZAGA UNIVERSITY 22
23. Primary Credit
• The system is designed both:
– To provide liquidity in times of crisis, ensuring
financial stability, and
– To keep reserve shortages from causing spikes in
the market federal funds rate.
• By restricting the range over which the market
federal funds rate can move, this system helps
to maintain interest-rate stability.
GONZAGA UNIVERSITY 23
24. Secondary Credit
• Secondary credit is available to institutions that
are not sufficiently sound to qualify for primary
credit.
• The secondary discount rate is set about the
primary discount rate.
• There are two reason a bank might seek
secondary credit:
– A temporary shortfall of reserves, or
– They cannot borrow from anyone else.
GONZAGA UNIVERSITY 24
25. Secondary Credit
• By borrowing in the secondary credit market,
a bank signals that it is in trouble.
• Secondary credit is for banks that are
experiencing longer-term problems that they
need some time to work out.
• Before the Fed makes the loan, it has to
believe that there is a good chance the bank
will be able to survive.
GONZAGA UNIVERSITY 25
26. Seasonal Credit
• Seasonal credit is used primarily by small agricultural
banks in the Midwest to help in managing the cyclical
nature of farmers’ loans and deposits.
• Historically, these banks had poor access to national
money markets.
• In recent years, however, there has been a move to
eliminate seasonal credit.
• There seems little justification for the practice as they
now have easy access to longer-term loans from large
commercial banks.
GONZAGA UNIVERSITY 26
27. Reserve Requirements
• Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the reserve
requirement the same for all depository
institutions.
• Reserve requirements are equal to zero for the
first $15.5 million of a bank’s checkable deposits,
3% on checkable deposits from $15.5 to $115.1
million, and 10% on checkable deposits over
$115.1 million. The Fed can vary the 10%
requirement between 8% and 14%.
28. Interest on Excess Reserves
• The Fed started paying interest on excess
reserves only in 2008
• The interest-on-excess-reserves tool came to
the rescue during the crash as banks were
accumulating huge quantities of excess
because it can be used to raise the federal
funds rate
29. Using Discount Policy to
Prevent a Financial Panic
• To prevent the collapse of the financial sector, the
Chairman of the Board of Governors announced
before the market opened on Tuesday, October
20, the Federal Reserve System’s “readiness to
serve as a source of liquidity to support the
economic and financial system.” In addition to
this extraordinary announcement, the Fed made
it clear that it would provide discount loans to
any bank that would make loans to the securities
industry. The outcome of the Fed’s timely action
was that a financial panic was averted
30. Relative Advantages of the
Different Monetary Policy
Tools
• Open market operations are the dominant policy tool
of the Fed since it has complete control over the
volume of transactions, these operations are flexible
and precise, easily reversed, and can be quickly
implemented.
• The discount rate is less well used since it is no longer
binding for most banks, can cause liquidity problems,
and increases uncertainty for banks. The discount
window remains of tremendous value given its ability
to allow the Fed to act as a lender of last resort.
31. On the Failure of
Conventional Monetary Policy
Tools in a Financial Panic
• When the economy experiences a full-scale
financial crisis, conventional monetary policy
tools cannot do the job, for two reasons.
• First, the financial system seizes up to such an
extent that it becomes unable to allocate capital
to productive uses, and so investment spending
and the economy collapse.
• Second, the negative shock to the economy can
lead to the zero-lower-bound problem.
32. Nonconventional Monetary
Policy Tools During the Global
Financial Crisis
• Liquidity provision: The Federal Reserve implemented
unprecedented increases in its lending facilities to provide
liquidity to the financial markets
– Discount Window Expansion
– Term Auction Facility
– New Lending Programs
• Large-scale asset purchases: During the crisis, the Fed
started three new asset purchase programs to lower
interest rates for particular types of credit:
– Government Sponsored Entities Purchase Program
– QE2
– QE3
34. Nonconventional Monetary
Policy Tools During the Global
Financial Crisis
• Quantitative Easing Versus Credit Easing
– During the global financial crisis, the Federal Reserve
became very creative in assembling a host of new
lending facilities to help restore liquidity to different
parts of the financial system.
• Forward Guidance
– By committing to the future policy action of keeping
the federal funds rate at zero for an extended period,
the Fed could lower the market’s expectations of
future short-term interest rates, thereby causing the
long-term interest rate to fall.
35. Nonconventional Monetary
Policy Tools During the Global
Financial Crisis
• Negative Interest Rates on Banks’ Deposits
– Setting negative interest rates on banks’ deposits
is supposed to work to stimulate the economy by
encouraging banks to lend out the deposits they
were keeping at the central bank, thereby
encouraging households and businesses to spend
more. However, there are doubts that negative
interest rates on deposits will have the intended,
expansionary effect.
36. Linking Tools to Objectives:
Making Choices
• Monetary policymakers’ goals are:
– Low and stable inflation,
– High and stable growth,
– A stable financial system, and
– Stable interest and exchange rates.
• These are given to them by their elected
officials.
• But day-to-day policy is left to the technicians.
GONZAGA UNIVERSITY 36
37. Linking Tools to Objectives:
Making Choices
• A consensus has developed among monetary
policy experts that:
– The reserve requirement is not useful as an
operational instrument,
– Central bank lending is necessary to ensure
financial stability, and
– Short-term interest rates are the tool to use to
stabilize short-term fluctuations in prices and
output.
GONZAGA UNIVERSITY 37
38. Desirable Features of a Policy
Instrument
• A good monetary policy instrument has three
features:
• It is easily observable by everyone.
• It is controllable and quickly changed.
• It is tightly linked to the policymakers’
objectives.
GONZAGA UNIVERSITY 38
39. Desirable Features of a Policy
Instrument
• It is important that a policy instrument be
observable to ensure transparency in
policymaking, which enhances accountability.
• An instrument that can be adjusted quickly in the
face of a sudden change in economic conditions
is clearly more useful than one that cannot.
• And the more predictable the impact of an
instrument, the easier it will be for policymakers
to meet their objectives.
GONZAGA UNIVERSITY 39
40. Desirable Features of a Policy
Instrument
• The reserve requirement does not meet these
criteria because banks cannot adjust their
balance sheets quickly.
• So what other options do we have?
– Well there are the other components of the
central bank’s balance sheet.
• But how do we choose between controlling
quantities and controlling prices?
GONZAGA UNIVERSITY 40
41. Desirable Features of a Policy
Instrument
• From 1979 to 1982, the Fed targeted reserves
rather than interest rates.
– We saw interest rates that would not have been
politically acceptable if they had been announced as
targets.
– Since they said they were targeting reserves, the Fed
escaped responsibility for the high interest rates.
• When inflation had fallen and interest rates came
back down, the FOMC reverted to targeting the
federal funds rate.
GONZAGA UNIVERSITY 41
42. Desirable Features of a Policy
Instrument
• There is a very good reason the vast majority of
central banks in the world today choose to target
an interest rate rather than some quantity on
their balance sheet.
• With reserve supply fixed, a shift in reserve
demand changes the federal funds rate.
• If the fed chooses to target the quantity of
reserves, it gives up control of the federal funds
rate.
• Targeting reserves creates interest rate volatility.
GONZAGA UNIVERSITY 42
43. Desirable Features of a Policy
Instrument
• A shift in reserve
demand would move the
market federal funds
rate.
• Reserve targets make
interest rates volatile.
• The federal funds rate is
the link from the
financial sector to the
real economy.
• Targeting reserves could
destabilize the real
economy. GONZAGA UNIVERSITY 43
44. Desirable Features of a Policy
Instrument
• Interest rates are the primary linkage between
the financial system and the real economy.
– Stabilizing growth means keeping interest rates
from being overly volatile.
• This means keeping unpredictable changes in
the reserve demand from influencing interest
rates and feeding into the real economy.
– The best way to do this is to target interest rates.
GONZAGA UNIVERSITY 44
45. Inflation Targeting
• Inflation targeting bypasses intermediate targets and
focuses on the final objective.
• Components:
– Public announcement of numerical target,
– Commitment to price stability as primary objective, and
– Frequent public communication.
• Inflation targeting increases policymakers’
accountability and helps to establish their credibility.
• The result is not just lower and more stable inflation
but usually higher and more stable growth as well.
GONZAGA UNIVERSITY 45
46. Operating Instruments and
Intermediate Targets
• Central bankers sometimes use the terms
operating instrument and intermediate target.
• Operating instruments refer to actual tools of
policy.
– These are instruments that the central bank controls
directly.
• The term intermediate targets refers to
instruments that are not directly under their
control, but lie somewhere between their
policymaking tools and their objectives.
GONZAGA UNIVERSITY 46
48. Operating Instruments and
Intermediate Targets
• The monetary aggregates are a prime example of
intermediate targets.
• The idea behind targeting M2, for example, is
that changes in the monetary base affect the
monetary aggregates before they influence
inflation or output.
– So targeting M2, central bankers can more effectively
met their objectives.
• Money growth is just an indicator easily
monitored by the public.
GONZAGA UNIVERSITY 48
49. Operating Instruments and
Intermediate Targets
• Central bankers have largely abandoned
intermediate targets.
• So while people still do discuss intermediate
targets, it is hard to justify using them.
– Policymakers instead focus on how their actions
directly affect their target objectives.
• The most common of these objectives is the
practice of inflation targeting.
GONZAGA UNIVERSITY 49
50. A Guide to Central Bank
Interest Rates: The Taylor Rule
• Interest rate setting is all about numbers.
• The FOMC sets the target federal funds rate.
• The Government Council of the ECB chooses a
specific level for the main refinancing rate.
• The policymakers not only pick the numbers, but
the day on which to make changes.
• Each group has a large staff of people who
provide the research used to make these
decisions.
GONZAGA UNIVERSITY 50
51. A Guide to Central Bank
Interest Rates: The Taylor Rule
• The Taylor Rule tracks the actual behavior of
the target federal funds rate and relates it to
the real interest rate, inflation, and output.
• Target Fed Funds rate =
2 + Current Inflation + ½ (Inflation gap) + ½ (Output gap)
GONZAGA UNIVERSITY 51
52. A Guide to Central Bank
Interest Rates: The Taylor Rule
• This assumes a long-term real interest rate of
2 percent.
• The inflation gap is current inflation minus an
inflation target.
• The output gap is current GDP minus its
potential level:
– The percentage deviation of current output from
potential output.
GONZAGA UNIVERSITY 52
53. A Guide to Central Bank
Interest Rates: The Taylor Rule
• For example, if
– Inflation is currently 3 percent, and
– GDP equals its potential level so there is no output
gap, then
– The target federal funds rate should be set at
= 2 + 3 + ½ = 5 ½ percent.
GONZAGA UNIVERSITY 53
54. A Guide to Central Bank
Interest Rates: The Taylor Rule
• When inflation rises above its target level,
– The response is to raise interest rates.
• When output falls below the target level,
– The response is to lower interest rates.
• If inflation is currently on target and there is
no output gap,
– The target federal funds rate should be set at its
neutral rate of target inflation plus 2.
GONZAGA UNIVERSITY 54
55. A Guide to Central Bank
Interest Rates: The Taylor Rule
• The Taylor rule has some interesting
properties.
– The increase in current inflation feeds one for one
into the target federal funds rate; however,
– The increase in the inflation cap is halved.
• A 1 percentage point increase in the inflation
rate raises the target federal funds rate 1½
percentage points.
GONZAGA UNIVERSITY 55
56. A Guide to Central Bank
Interest Rates: The Taylor Rule
• The Taylor rule tells us that for each percentage
point increase in inflation,
– The real interest rate, equal to the nominal interest
rate minus expected inflation, goes up half a
percentage point.
• This means that higher inflation leads
policymakers to raise the inflation-adjusted cost
of borrowing.
– This then slows the economy and ultimately reduces
inflation.
GONZAGA UNIVERSITY 56
57. A Guide to Central Bank
Interest Rates: The Taylor Rule
• The Taylor rule also states that for each
percentage point output is above potential:
– Interest rates will go up half a percentage point.
• The halves in the equation depend on both:
– How sensitive the economy is to interest-rate
changes, and
– The preferences of central bankers.
• The more bankers care about inflation:
– The bigger the multiplier for the inflation gap, and
– The lower the multiplier for the output gap.
GONZAGA UNIVERSITY 57
58. A Guide to Central Bank
Interest Rates: The Taylor Rule
• The implementation of the Taylor rule requires
four inputs:
– The constant term, set at 2;
– A measure of inflation;
– A measure of the inflation gap; and
– A measure of the output gap.
• The constant is a measure of the average risk-free
real interest rate over the long run.
– Since 1980, the inflation-adjusted one-year treasury
yield has averaged about 2%.
GONZAGA UNIVERSITY 58
59. A Guide to Central Bank
Interest Rates: The Taylor Rule
• Economists and central bankers believe that the
personal consumption expenditure (PCE) index is
a more accurate measure of inflation.
– In 2012, the Fed set its inflation target in terms of the
annual rise in the PCE.
• The PCE comes from the national income
accounts.
• Using the Fed’s inflation target of 2%
– The neutral target federal funds rate is 4 percent = (2
+ 2).
GONZAGA UNIVERSITY 59
60. A Guide to Central Bank
Interest Rates: The Taylor Rule
• For the output gap, the natural choice is the
percentage by which GDP deviates from a
measure of its trend, or potential.
• Figure 18.9 plots the FOMC’s actual target federal
funds rate, together with the rate predicted by
the Taylor rule.
– The two lines are reasonably close to each other.
– The FOMC usually changed the target federal funds
rate when the Taylor rule predicted it should.
GONZAGA UNIVERSITY 60
61. A Guide to Central Bank
Interest Rates: The Taylor Rule
GONZAGA UNIVERSITY 61
62. A Guide to Central Bank
Interest Rates: The Taylor Rule
• We should recognize some caveats.
• At times the target rate does deviate from the
Taylor rule, and with good reason.
– It is too simple to take account of sudden threats to
financial stability.
– The federal funds rate will be below the Taylor rule in
periods characterized by at least one of two factors:
• Unusually stringent conditions across an array of financial
markets; or
• Deflationary worries that arose as nominal interest rates
approached their zero bound.
GONZAGA UNIVERSITY 62
63. A Guide to Central Bank
Interest Rates: The Taylor Rule
• If the economy is weak and inflation is both low
and falling below the central bank’s objective,
policymakers might set their target rate
temporarily below the one implied by the Taylor
rule.
– This is a risk management approach to policy.
– We saw this in 2002-2005 when the target federal
funds rate was below that implied by the Taylor rule.
– Some economists believe that this amplified the
housing bubble and contributed to the crisis that
followed.
GONZAGA UNIVERSITY 63
64. A Guide to Central Bank
Interest Rates: The Taylor Rule
• There is a lack of real time data.
– While we might be able to make good monetary
policy for 1995 using the Taylor rule and the data
available to us today, that isn’t of much practical
use.
– Policymakers have no choice but to make good
decisions based on information that is less than
completely accurate.
GONZAGA UNIVERSITY 64
65. Forward Guidance
• Communication is a powerful tool of a
credible central bank.
• Forward guidance about monetary policy
affects markets and behavior.
• Central banks can halt potential runs on banks
maintaining some stability.
• However, central banks must follow through
when tested if they are to remain credible.
GONZAGA UNIVERSITY 65
66. Forward Guidance
• The simplest unconventional approach is for
the central bank to provide forward guidance.
• They might express the intent to keep the
policy target low for an extended period of
time.
– This could have a specific termination date, or
duration could be dependent on some future
change in economic conditions.
GONZAGA UNIVERSITY 66
67. Forward Guidance
• To stimulate economic activity, forward
guidance aims at lowering the long-term
interest rates that affect private spending.
• However, to be effective, forward guidance
needs to be credible.
• If not, markets may not respond as the central
bank hopes.
GONZAGA UNIVERSITY 67
68. Forward Guidance
• Between 2002 and 2004, the FOMC issued an
unconditional commitment indicating that its
target funds rate would stay low for the
“foreseeable future” or for a “considerable
period.”
• In 2004, it assured markets that the
withdrawal of accommodation would occur at
a “measured pace” to avoid fears of sharp rate
hikes.
GONZAGA UNIVERSITY 68
69. Forward Guidance
• In 2008, the FOMC adopted a conditional
approach as the financial crisis deepened.
– They announced that “weak economic conditions are
likely to warrant exceptionally low levels of the federal
funds rate for some time.”
• Although forward guidance can be effective, the
Fed’s experience suggests that they are difficult
to calibrate and can have disturbing side effects.
– They, therefore, remain tools for exceptional
circumstances.
GONZAGA UNIVERSITY 69