characteristics, agenda, Targets, Rules vs. Discretion, gold standard, Case study

1. Monetary Policy

2. Monetary policy can be categorized by four characteristics
Monetary
Policy
Goals
InstrumentsIntermediate
Targets
Discretion

3. Instruments refer to the policy options the
Fed has to control the supply of money…
Open Market Operations
By purchasing or selling US
Treasuries, the Fed can alter
the supply of bank reserves
(MB)
Discount Window Loans
The Fed can also influence
reserves by altering the
interest rate charged on
loans to commercial banks.
(MB)
Reserve Requirements
Reserve Requirements
influence the ability of banks
to create new loans which
affects the broader
aggregates (M1,M2,M3)
This is the most
often used
instrument!

4. Monetary Policy goals address the central bank’s
agenda in general terms
The Bank of England Follows an explicit Inflation Target.
Specifically, the goal is to maintain 2% annual inflation.
The Bank of China appears to have export driven growth
as their primary objective
The ECB (European Central Bank) and the Federal
Reserve follow policies of stable prices and
maintenance of full employment

5. Intermediate Targets address the question: “How will I meet my goals?”.
Targets are variables that the central bank can more directly control.
For Tiger Woods, the
goal is to win the golf
tournament
The target is to score
18 under par (the
number he thinks he
needs to win)
The Bank of China is currently targeting the exchange rate
at 8.28 Yuan per dollar
The Federal Reserve is currently targeting the Federal
Funds Rate at 2.75%
The Bank of England is currently targeting the repo rate at
4.75%
Goals vs. Targets

6. Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
Suppose that the Federal Government could
influence the supply of oranges and wanted to
regulate the orange market
Quantity of
Oranges
Price
Demand
Supply
$5/Lb
Lowering the price to
$4 (price target) and
Raising the quantity to
1,500 (quantity target)
are both describing the
same policy
(expanding the orange
market)
1,000 1,500
$4/Lb

7. Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
Quantity of
Oranges
Price
Demand
Supply
$5/Lb
If demand for oranges
increases and the Fed
is following a price
target, they must
respond by increasing
supply
Target
Range
However, your response to demand changes
will differ across policies

8. Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
Quantity of
Oranges
Price
Demand
Supply
If demand for oranges
increases and the Fed
is following a quantity
target, they must
respond by decreasing
supply
1000Lbs
Target
Range
However, your response to demand changes
will differ across policies

9. Suppose that the Fed wants to lower its
target to 4% (expansionary monetary policy)
Interest Rate (i)
M2 = mm(MB)
M
P
Md(y,t)
5%
M2 Multiplier = 8
Change in M2 = $2,000
4%
2,000
8
= $250
A $250 purchase of
Treasuries would be
required

10. Suppose that the Fed is Targeting the
Interest Rate at 5%
Interest Rate (i)
M2 = mm(MB)
M
P
Md(y,t)
5%
M2 Multiplier = 8
Suppose an increase in
GDP raises Money
Demand
Change in M2 = $1,000
The Fed needs to
increase the
monetary base by
1,000
8
= $125
(An Open Market
Purchase of
Treasuries)

11. During the late 70’s, the federal reserve changed its policy from an interest rate
target to a money target. The money target was abandoned in the mid eighties.
0
5
10
15
20
25
Jan-70
Jan-72
Jan-74
Jan-76
Jan-78
Jan-80
Jan-82
Jan-84
Fed Funds
Discount
Prime

12. Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular
course of action?
The Chinese have pre-committed to maintaining a
fixed exchange rate while the British have pre-
committed to a fixed inflation rate.
The ECB (European Central Bank) and the Federal
Reserve both follow discretionary policies (i.e.
policy is decided at the FOMC meeting)

13. Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular course of
action?
Benefits of Rules
A states monetary
policy rule is easy
top forecast (i.e. it
has less
uncertainty)
Costs of Rules
A fixed policy rule
allows the
possibility of
speculative attacks
(i.e. exploiting the
monetary policy
rule for profit)

14. For most of its history, the US has followed a
gold standard
A Gold Standard has two rules:
The government sets an
official price of gold ($35/oz)
The government guarantees
convertibility of currency into
gold at a fixed price
Assets Liabilities
200 oz. Gold
@ $35/oz
$7,000 (Gold)
$10,000 (Currency)
US Treasury
$3,000 (T-Bills)
Reserve Ratio = 70%
Reserve Ratio =
Value of Gold Reserves
Currency Outstanding
=
$7,000
$10,000
During most of the gold standard era, the Government had a reserve
ratio of around 12%

15. Price
Demand
Supply
$35
Assets Liabilities
200 oz. Gold
@ $35/oz
$7,000 (Gold)
$10,000 (Currency)
US Treasury (P = $35%)
$3,000 (T-Bills)
Reserve Ratio = 70% Q
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
Suppose that the Treasury purchased gold to increase the supply of
currency outstanding (i.e. increase the money supply)
100 oz. Gold
@ $35/oz $3,500 (Currency)

16. Price
Demand
Supply
$35
Assets Liabilities
200 oz. Gold
@ $35/oz
$7,000 (Gold)
$10,000 (Currency)
US Treasury (P = $35%)
$3,000 (T-Bills)
Reserve Ratio = 70%
Q
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
As the market price rises above $35 (due to increased demand),
households start buying gold from the Treasure @ $35.oz and sell it in
the open market. This reverses the original transaction

17. The gold standard and prices:
Recall that in the long run, the price level
is directly proportional to the ratio of
money to output:
M
s
P
=k( i,t) y
M =
$35(Gold Reserves)
Reserve Ratio
With a (relatively) fixed supply of money, prices remained stable in the
long run

18. Price
Demand
Supply
$35
Assets Liabilities
200 oz. Gold
@ $35/oz
$7,000 (Gold)
$10,000 (Currency)
US Treasury (P = $35%)
$3,000 (T-Bills)
Reserve Ratio = 70%
Q
The gold standard and the supply of gold:
From time to time, new gold deposits were discovered. This increased
supply would push down the market price. In response, households
would buy the cheap gold and sell it to the Treasury for $35. This would
increase the money supply.
100 oz. Gold
@ $35/oz $3,500 (Currency)

19. Price
Demand
Supply
$35
Assets Liabilities
200 oz. Gold
@ $35/oz
$7,000 (Gold)
$10,000 (Currency)
US Treasury (P = $35%)
$3,000 (T-Bills)
Reserve Ratio = 70%
Q
The gold standard and the business cycle:
Typically, during recessions, the price of gold would rise (flight to
quality). High gold prices would cause households to buy gold from
the Treasury to sell in the market. This would force the treasury to lose
reserves and contract the money supply.
(-) Gold (-) Currency

20. Gold Standard: Long Run vs. Short Run
Long Run: By restricting the long run supply
of money, the gold standard produced
constant, low average rates of inflation
(bankers are happy)
Short Run: By forcing monetary policy to be
subject to fluctuating gold prices, the gold
standard exacerbated the business cycle
(farmers are unhappy)

21. FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation – 2%)
Currently, the Fed follows an interest rate target. The target interest
rate (Fed Funds Rate) is adjusted according to a ‘Taylor Rule”
1% Cyclical Unemployment = 2.5% Output Gap
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)

22. Currently, the Fed follows an interest rate target. The target interest rate
(Fed Funds Rate) is adjusted according to a ‘Taylor Rule”
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)
Long Run: When the economy is at full employment ( Unemployment = 5%)
and inflation is at its long run target (2%), the Fed targets the Fed Funds
Rate (Nominal) at
FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4%
Short Run: During recessions (when inflation is low and unemployment is
high), the Fed lowers its target. During expansions, when inflation is high
and unemployment is low), the Fed raises its target.

23. Case study: Productivity Growth during the late 90’s
i S
I + (G-T)
4%
i
Ms
4%
Md
M
P
Loanable
Funds
During the late 90’s, rapid income growth and productivity raised
consumer spending (savings falls) and raised investment spending.
Higher spending raised the demand for money. As unemployment
dropped to 4.5% (above capacity), prices began to rise.

24. Case study: Productivity Growth during the late 90’s
i
S
I + (G-T)
4%
i
Ms
4%
Md
M
P
Loanable
Funds
The Fed responded by raising interest rates (contracting the money
supply). The Fed was able to “slow down” the economy before
inflation became a problem.

25. End of 1992 Recession
Late 90’s Expansion
Asian Financial Crisis
Stock Market Bubble
2
2.5
3
3.5
4
4.5
5
5.5
6
6.5
7
Jan-94
May-94
Sep-94
Jan-95
May-95
Sep-95
Jan-96
May-96
Sep-96
Jan-97
May-97
Sep-97
Jan-98
May-98
Sep-98
Jan-99
May-99
Sep-99
Jan-00
May-00
Fed Funds
Discount

26. Case study: Stock Market Crash and Liquidity Shocks
i
S
I + (G-T)
4%
i
Ms
4%
Md
M
P
Loanable
Funds
After the market crash, demand (primarily investment) slowed down
and interest rates started falling. Further, the economy was operating
well below capacity (Unemployment hit 6%) and inflation was hovering
around zero.

27. Case study: Stock Market Crash and Liquidity Shocks
i
S
I + (G-T)
4%
i
Ms
4%
Md
M
P
Loanable
Funds
Lowering the Fed funds target allowed the fed to increase the money
supply and stimulate spending.

28. 0
1
2
3
4
5
6
7
Jan-00
Apr-00
Jul-00
Oct-00
Jan-01
Apr-01
Jul-01
Oct-01
Jan-02
Apr-02
Jul-02
Oct-02
Fed Funds
Discount Rate
Stock Market Crash
Recession of 2001
Beginning of Recovery?

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www.TheStockker.co
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