Macroeconomics
Chapter 14 Assignments
\fW H AT I S E C O N O M I C S ? 457 C h a p t e r 1 4 MONETARY POLICY* * 457 Monetary Policy Objectives The Federal Reserve Act: there are 3 main goals of Monetary Policy: Goals: The goals in the mandate are \"of maximum employment, stable prices, and moderate long-term interest rates.\" The Fed pays attention to two measures of inflation: The Consumer Price Index (CPI) (which it monitors)and the Personal Consumption Expenditure (PCE) deflator which excludes food and fuel prices. The PCE deflator is the Fed's operational guide and the Fed defines the rate of increase in the core PCE deflator as the Core Inflation Rate. This measures changes in the prices of consumer goods except food and fuel. They use the core inflation rate because it is less volatile than the total CPI inflation rate and the Fed believes that it provides a better indication of whether price stability is being achieved. Responsibility for Monetary Policy The Fed has ultimate responsibility for monetary policy. The FOMC makes monetary policy decisions at eight scheduled meetings a year. Congress does not play a role in Monetary policy but the Fed reports to Congress twice a year. The President appoints members and the chair. The current chair is Jerome Powell. II. The Conduct of Monetary Policy Choosing a Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target. The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. Hitting the Federal Funds Rate Target: Open Market Operations The Fed uses open market operationsthe purchase or sale of government securities in the open marketto hit its federal funds target rate. An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank's reserves. o Bank reserves increase o Interest rate decreases An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank's reserves. o Bank reserves decrease o Interest rate increases 458 LECTURE NOTES CHAPTER 14 The Fed Fights Recession - Expansionary Monetary policy If the Fed believes that real GDP is less than potential GDP, the Fed will undertake expansionary monetary policy: Fed buys securities Reserves increase Federal funds rate decreases Other Interest rates decrease Consumption and Investment increase Interest rate differential decreases Exchange rate decreases (chapter 9 - interest rate differential) Exports increase Imports decrease Net exports increase Aggregate Demand increases Price Level increases Real GDP increases 458 M O N E TA RY P O L I C Y 459 The Fed Fights Inflation - Contractionary Monetary Policy If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem, the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale. Fed sells securities Reserves decrease Federal Funds Rate and Other Interest rates increase Consumption decreases Investment decreases Interest rate differential increases Exchange rate increases (chapter 9 - interest rate differential) Exports decrease Imports increase Net exports decrease Aggregate Demand decreases Price Level decreases Real GDP decreases Financial Crisis: During the financial crisis of 2007-08 and following recession, the Fed took extraordinary actions to limit damage and restore stability to the economy. A financial crisis is when a bank or financial institution can't make payments it promised to make. That will bleed over to other banks. Events that threaten a bank's solvency: Widespread fall in asset prices o The value of its assets (loans and securities) fall Large currency drain o Depositors withdraw funds and bank loses reserves. May not be able to meet its required reserves. Run on a bank o When depositors lose confidence and make massive withdrawals. What did Congress do to limit the scope of the financial crisis? Extended deposit insurance o It covered more institutions and raise the limit Authorized the Treasury to buy Troubled assets 459 460 LECTURE NOTES CHAPTER 14 o Established TARP (Troubled Asset Relief Program) - buying $700 billion of equity in troubled institutions which increased their reserves and equity. 460
