Monetary Policy

How the Fed Conducts Monetary Policy: Monetary Policy Objectives

The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production , so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates .”(24)

The goals are often described as a “dual mandate” to achieve stable prices and maximum employment (full employment).

  • In the short run , the Fed can face a tradeoff between policy that lowers the inflation rate but raises the unemployment rate, and policy that lowers the unemployment rate but raises the inflation rate.
  • In the long run , the Fed’s goals are in harmony. Achieving stable prices, and keeping the inflation rate low and predictable is the source of maximum employment and moderate long-term interest rates. (10)

Low inflation rates mean that people make decisions without the confusion created by inflation. A low inflation rate also means low long-term interest rates ( nominal interest rate is real interest rate plus inflation rate).

Fed’s Operational Goals and FOMC:

  • Operational “Maximum Employment” Goal: The Fed tracks the output gap , which is the percentage deviation of real GDP from potential GDP. A positive output gap leads to inflation; a negative output gap results in unemployment. The Fed tries to minimize the output gap.
  • Operational “Stable Prices” Goal: The Fed pays attention to the core inflation rate , which is the annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) excluding the prices of food and fuel. (19)

Price stability can mean a core inflation rate between one and two percent. (25)

Responsibility for Monetary Policy

The FOMC makes monetary policy decisions at eight scheduled meetings a year. The Fed ( not the Congress or the President) has ultimate responsibility for monetary policy.

Marriner S. Eccles Federal Reserve Headquarters, Washington D.C.
Figure 7-3: Marriner S. Eccles Federal Reserve Headquarters, Washingtonby Wikipedia is licensed under CC BY-SA 3.0

The Fed’s Decision-Making Strategy: Policy Instruments

A monetary policy instrument is a variable that the Fed can directly control or closely target and that influences the economy in desirable ways. 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, which is the interest rate at which banks can borrow and lend reserves in the federal funds market (that is, the market for overnight loans of reserves). Although the Fed can change the federal funds rate by any amount, it normally changes the federal funds rate one quarter of a percentage point at a time. (19)

The Fed can use two alternative decision-making strategies:

  • Instrument rule : A decision rule, which sets the policy instrument at a level that is based on the current state of the economy.
  • Targeting rule : A decision rule, which sets the policy instrument at a level that makes the forecast of the ultimate policy goal equal to its target.

FOMC minutes suggest that the Fed follow a targeting rule that sets the federal funds rate at a level that it forecasts will set the inflation rate equal to its targeted value. (19)

Hitting the Federal Funds Rate Target

The Fed uses open market operations—the purchase or sale of government securities in the open market—to 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.
  • An Open Market Sale : The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves.

The federal funds rate is determined in the market for reserves. The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. The higher the federal funds rate, the smaller the quantity of reserves demanded. The Fed’s open market operations determine the supply of reserves.

If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The quantity of reserves increases and the federal funds rate falls. If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities. The quantity of reserves decreases and the federal funds rate rises. (19)

Monetary Policy Transmission: An Overview

Suppose the Fed uses an open market operations purchase of government securities to lower the federal funds rate. The transmission mechanism for this expansionary monetary policy is then:

Other interest rates : Other short-term interest rate falls. Long-term bond interest rates fall, but by less.

Exchange rate : The fall in the U.S. interest rate lowers the U.S. interest rate differential. The demand for U.S. dollars decreases and the supply of U.S. dollars increases. The U.S. dollar depreciates, which means that the exchange rate falls.

Money and bank loans : Banks’ reserves have increased so they have excess reserves. Banks loan the excess reserves, so loans and the quantity of money increases.

Long-term real interest rate : The real interest rate is determined in the loanable funds market. In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate.

Expenditure plans : Consumption expenditure and investment increase as a result of the lower real interest rate. Net exports increase as a result of the fall in the exchange rate.

Aggregate demand : Because aggregate expenditure increases, aggregate demand increases. A multiplier effect increases aggregate demand by more than the initial increase in aggregate expenditure. As a result of the increase in aggregate demand, the equilibrium price level rises and equilibrium real GDP increases. (19)

The diagram summarizes steps 1 through 8, outlining the contractionary monetary policy. The Contractionary Monetary Policy Transmission include the following eight steps: step 1, The Fed raises the federal funds rate (after the FOMC Meeting Date), step 2, Other short-term interest rates rise and the exchange rate rises (after the FOMC Meeting Date), step 3, The quantity of money and supply of loanable funds decrease (after 1 to 3 Months), step 4, The long-term real interest rate rises (after 1 to 3 Months), step 5, Consumption expenditure, investment, and net exports decrease (after 1 Year), step 6, Aggregate demand decreases (after 1 Year), step 7, Real GDP growth rate decreases (after 1 Year) — which represents the cost associated with this policy, and step 8, Inflation rate decreases (after 2 Years) — which represents the gain associated with this policy.
Figure 7-4: Contractionary Monetary Policy by FSCJ is licensed under CC-BY-4.0.
The diagram summarizes steps 1 through 8, outlining the expansionary monetary policy. The Expansionary Monetary Policy Transmission include the following eight steps: step 1, The Fed lowers the federal funds rate (after the FOMC Meeting Date), step 2, Other short-term interest rates fall and the exchange rate falls (after the FOMC Meeting Date), step 3, The quantity of money and supply of loanable funds increase (after 1 to 3 Months), step 4, The long-term real interest rate falls (after 1 to 3 Months), step 5, Consumption expenditure, investment, and net exports increase (after 1 Year), step 6, Aggregate demand increases (after 1 Year), step 7, Real GDP growth rate increases (after 1 Year) — which represents the gain associated with this policy, and step 8, Inflation rate decreases (after 2 Years) — which represents the cost associated with this policy.
Figure 7-5: Expansionary Monetary Policy by FSCJ is licensed under CC-BY-4.0
The diagram shows how the Fed combats inflationary pressures via contractionary monetary policy.
Figure 7-6: The Fed Combats Inflationary Pressures by FSCJ is licensed under CC-BY-4.0.