Monetary Policy Actions in the Short run

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  Capitalism and Privatization (Concepts and Theories)

  • (Author)
  • 2014(Publication Date)
  • College Publishing House

    (Publisher)

  The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. All of these purchases or sales result in more or less base currency entering or leaving market circulation. Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) Open mouth operations (talking monetary policy with the market). Theory Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money.

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  Principles of Economics 3e

  • Steven A. Greenlaw, David Shapiro, Daniel MacDonald(Authors)
  • 2022(Publication Date)
  • Openstax

    (Publisher)

  If tight 28.4 • Monetary Policy and Economic Outcomes 679 monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 28.9 (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level. FIGURE 28.9 The Pathways of Monetary Policy (a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP. Federal Reserve Actions Over Last Four Decades For the period from 1970 through 2020, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations. Of course, telling the story of the U.S. economy since 1970 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The ten episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson. Figure 28.10 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades.

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  Principles of Macroeconomics 3e

  • David Shapiro, Daniel MacDonald, Steven A. Greenlaw(Authors)
  • 2022(Publication Date)
  • Openstax

    (Publisher)

  If tight 15.4 • Monetary Policy and Economic Outcomes 369 monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. Figure 15.9 (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level. FIGURE 15.9 The Pathways of Monetary Policy (a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP. Federal Reserve Actions Over Last Four Decades For the period from 1970 through 2020, we can summarize Federal Reserve monetary policy by looking at how it targeted the federal funds interest rate using open market operations. Of course, telling the story of the U.S. economy since 1970 in terms of Federal Reserve actions leaves out many other macroeconomic factors that were influencing unemployment, recession, economic growth, and inflation over this time. The ten episodes of Federal Reserve action outlined in the sections below also demonstrate that we should consider the central bank as one of the leading actors influencing the macro economy. As we noted earlier, the single person with the greatest power to influence the U.S. economy is probably the Federal Reserve chairperson. Figure 15.10 shows how the Federal Reserve has carried out monetary policy by targeting the federal funds interest rate in the last few decades.

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  Applied Intermediate Macroeconomics

  • Kevin D. Hoover(Author)
  • 2011(Publication Date)
  • Cambridge University Press

    (Publisher)

  9. Monetary policy may be guided either by discretion (always adjust policy to new circumstances to reach the best outcome) or by policy rules. Four factors support rules: (i) ignorance about the true state of the economy at the time of the decision; (ii) lags in recognizing and implementing policy; (iii) rules provide Key Concepts 679 a more stable background for private economic decisions; and (iv) rules over-come the problem of dynamic consistency. Complex rules that account for many contingencies are, in fact, hard to distinguish from discretion. 10. The actual behavior of the Federal Reserve is reasonably well described by the Taylor rule, which sets the Federal-funds rate to the rate of inflation plus posi-tive factors for inflation above target and output above potential (as measured using a concept of potential output for which exceeding potential is possible). 11. Governments may influence the exchange rate directly through buying and sell-ing foreign currencies or indirectly through monetary policies that affect interest rates or rates of inflation. 12. Interventions in foreign-exchange markets affect monetary policy because pur-chases and sales of foreign exchange act like other open-market operations to change the stock of central-bank reserves. The Fed may “sterilize” such changes to the reserve base through offsetting open-market operations in government bonds. 13. Exchange-rate movements in response to policy affect the relative prices of domestic and foreign goods and, therefore, net exports, which offer another channel from monetary policy to the real economy. 14. In earlier times, the foreign-exchange values of national currencies were deter-mined by their prices in terms of gold. From the end of World War II until 1973, their values were determined by international agreement – a system of fixed exchange rates.

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  The Chinese Macroeconomy and Financial System

  A U.S. Perspective

  • Ronald M Schramm(Author)
  • 2015(Publication Date)
  • Routledge

    (Publisher)

  8 Monetary Policy in Action

  慈不掌兵, 义不掌财

  Neither Controlling an Army nor Controlling Finances is for the Timid

  The tools mentioned in the last chapter are used to impact economic performance in a positive direction. Figure 8.1 provides the traditional mechanism by which monetary policy works—what is known as the transmissions mechanism. It also depicts the enhanced set of tools and goals included in China’s monetary policy (note that enhancements are shaded). Clearly, the transmission mechanism in China is even more complex than the traditional one since it includes multiple tools and goals. In this chapter, we will explain why. The transmissions mechanism represents a chain of actions and outcomes, starting with the central bank trying to either stimulate or slow the economy using policy tools.

  Figure 8.1

   The traditional transmission mechanism in the United States and the more complex mechanism in China (shaded text indicates additional tools/targets in China).

  Source: Author created.

  The initial policy action typically impacts bank reserves, which in turn impact the short-term interest rates that banks charge each other (the interbank market rate), as well as longer-term interest rates—and end users. China’s transmission system also affects the availability of credit—influencing the size of the loan or even the possibility that a loan application is turned down. As these types of lending constraints are passed on to companies and consumers within the economy, their decisions to purchase investment goods or consumer goods are affected. This in turn impacts overall economic activity.

  The transmission mechanism can be shown graphically by using the investment–savings/liquidity–money demand (IS/LM) framework found in Chapter 9 and described in Figure 8.2

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  The Financial System, Financial Regulation and Central Bank Policy

  • Thomas F. Cargill(Author)
  • 2017(Publication Date)
  • Cambridge University Press

    (Publisher)

  Third – control issues: Central banks have less control over the money supply than they did in the past as a result of variation in the money multiplier, which many attribute to the wider range of financial assets available to the public as the result of deregulation and financial liberalization. In contrast, central banks do have significant influence over short-term interest rates. At the same time, this advantage has a caveat. While central banks can influence very short-term interest rates, their influence over medium-and long-term interest rates is much less certain. The longer the term of the interest rate, the more important inflationary expectations. Fourth – relationship to economic activity issues: At various times there has been a close and direct relationship between money and economic activity; however, the relationship between money and economic activity during the past several decades has become unstable for ongoing monetary policy. Central banks have turned to the interest rate channel in the belief it provides a better foundation connecting the tools of monetary policy with the final policy targets. 13.5 The Monetary Policy Instruments 293 Despite arguments in favor of interest rates as the policy instrument, the money supply remains fundamentally important, because, over the longer run, inflation and deflation are inherently related to the growth rate of the money supply. A central bank that puts the money supply on the back burner and focuses only on interest rates is a central bank that will finds its policy to be one of “trouble in River City”. Chapter 14 Step 4: The Central Bank Model of the Economy 14.1 Introduction Step 1 of the sequence of central bank policy focused on the institutional design of the central bank in general and the institutional design of the Federal Reserve in par-ticular. The actual formulation and execution of monetary policy are concentrated in a central committee in most central banks.

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  Explaining and Forecasting the US Federal Funds Rate

  A Monetary Policy Model for the US

  • M. Clements(Author)
  • 2003(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  INTRODUCTION The Fed describes monetary policy as ‘actions undertaken ... to influ- ence the availability and cost of money and credit to help promote national economic goals’. The Federal Reserve Act specifies that in conducting monetary policy, the Federal Open Market Committee (FOMC) should seek ‘to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates’. The Fed controls the three main tools of monetary policy: open market operations (the FFR), the discount rate, and reserve require- ments. This book examines only the FFR, which is influenced by open market operations, the buying and selling of securities, which is the Fed’s primary instrument for controlling monetary policy. The FOMC is responsible for open market operations and setting the FFR. The committee comprises 12 voting members and meets at eight scheduled meetings a year. The FFR is the interest rate at which depository institutions (banks) lend balances at the Fed to each other overnight. Changes in the FFR in turn affect other interest rates, both long and short term, such as government and corporate bonds, mort- gage and credit rates. The exchange rate of the dollar is also sensi- tive to changes in the FFR. Using this rate, the Fed can affect the price of money and credit. In this way it influences employment, output and inflation. Strictly speaking, the Fed’s mandate of ‘price stability’ is a misnomer. Price stability means, by definition, zero inflation. Also, CHAPTER 2 Monetary Policy at the US Federal Reserve 27 the mandate does not specify which inflation measure should be targeted. In reality, the Fed looks to achieve inflation stability using an inflation measure that it considers to best represent price move- ments across the economy. In February 2000, the Fed ostensibly signalled a preference for the Commerce Department’s Personal Consumption Expenditure (PCE) price index as its chosen inflation measure.

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  Japanese Monetary Policy

  • Kenneth J. Singleton(Author)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  Irrespective of its objectives, when the BOJ changes its policy stance, how does this affect the economy? Table 5.5 shows that innovations in the call rate very strongly drive down output, with the peak effect coming after twelve to fifteen months. Since it has already been observed that innovations in the call rate mainly reflect changes in the BOJ’s policy stance, one can conclude that monetary policy does affect real output.8 Accordingly, it is possible to reject the real business cycle theorist’s view, which holds that money is always noth- ing but a+mirror image of real shocks and plays no role in the business cycle (King and Plosser 1984; Plosser 1990). This point can also be confirmed, though more casually, just by looking at figure 5.6. Inflation also negatively responds to call rate shocks, but its response is much weaker than the response of output, and the lags are longer. By focusing on the periods of interest rate smoothing, I have argued that real shocks are important in the business cycle. When the BOJ changes its policy stance, however, it also affects the real economy. 5.4 The Ransmission of Monetary Policy Monetary policy affects the real economy. What is the transmission mecha- nism of monetary policy? As a preliminary step to answering this question, table 5.6 summarizes, for the postwar business cycle, the extent to which 8. Romer and Romer (1989) put a dummy variable (which identifies the six months when the Federal Reserve made the decision to seek to induce a recession in order to reduce inflation) into the univariate autoregressive equation for industrial production. They found that this dummy var- iable has a significantly negative effect on industrial production. The dummy variable constructed from Federal Reserve records, however, does not indicate the length of the shocks caused by the Fed, nor does it differentiate the shocks by size.

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  Reforms in China's Monetary Policy

  A Frontbencher's Perspective

  • Sun Guofeng(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  142 ● Reforms in China’s Monetary Policy long-term interest rates of the bond market and the short-term interest rates of paper market. Therefore, if the central bank can control the interest rate in the money market, it can almost control the whole market interest rate sys- tem. And third, stable interest rate in the money market is an important precondition for the smooth operation of financial system, and yet, violent fluctuations of money market rates are detrimental to the expected stability of financial institutions and will affect their sound operation; therefore, from the perspective of the stability of the financial system, the central bank should maintain the stable performance of the interest rates in the money market. 2. The central bank should closely monitor the mid- and long-term inter- est rate level to avoid systematic interest rate risks. This is determined by the specific situation in China. In real practice, the open market operations of the PBC will not only pay attention to the short-term interest rate in the money market but also are subject to unavoidable influence on long-term interest rate under the circumstances of practical restricts. Monetary poli- cies are aggregate demand management policies, in essence, they are short- term management policies. The central bank’s open market operations as the major tool for monetary policy implementation are in essence short-term demand management policy tools, which mainly focus on short-term market interest rate instead of long-term market interest rate. However, the practical situation in China is that treasury bonds and policy financial bonds circu- lated on the market are basically long-term bonds with maturities of no less than five years, and there are rarely any short-term bonds with maturities of less than one year.

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  Monetary Economics

  Theories, Evidence and Policy

  • David G. Pierce, Peter J. Tysome(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  11 Monetary policy: targets, indicators, rules and discretion This is the first of three chapters in which we shall consider a number of issues relating to monetary policy. In this chapter we will be discussing two of them: (1) What is the best target of monetary pohcy and what variable(s) provides the best indication of whether the policy is on course? (2) Should policy be conducted at the discretion of the authorities or should it be based on a pre-determined rule? In Chapter 12 we describe and briefly assess the major techniques of policy available to the authorities, while in the final chapter we survey the targets and methods of monetary policy as it has been applied in the UK since the end of the Second World War. Before considering the question of targets and indicators we will first outline the broad nature of monetary policy. Monetary policy may be used by the authorities as one of several different ways of trying to achieve certain macroeconomic goals: (1) A high level of employment. (2) A low rate of inflation. (3) Balance of payments equilibrium. (4) A satisfactory rate of economic growth. These goals are sometimes called the ultimate targets of policy, but as we shall be using the term target to mean something else, we shall refer to them simply as the goals of policy. The monetary authorities do not have direct control over these goals, but instead can act only on certain instruments of policy, or instrumental variables as they are usually called, which are under their direct influence. These instruments include open-market operations, special deposits and possibly the discount rate of the central bank. The instrumental variables do not however exert any direct influence on the goals of policy. Instead they work through intermediate variables, a category which embraces such things as bank reserves, the level of short and long-term interest rates and the total money supply. Many of the intermediate variables are hnked together.

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