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Monetary policy in the short run

Understand the structure of the Federal Reserve.

Describe the goals of monetary policy.

Explain the Federal Reserve’s monetary policy tools.

Use the IS–MP model to understand how monetary policy affects the economy in the short run.

Explain the challenges in using monetary policy effectively.

Evaluate the arguments for and against central bank independence.

Explain how monetary policy operates in an open economy.

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Learning Objectives
After studying this chapter, you should be able to:
12.1
12.2
12.3
12.4

12.5
12.6
12.7

Why didn’t the Fed avoid the recession of 2007-2009?

Fed chairman Ben Bernanke studied the causes of the Great Depression of the 1930s as a professor at Princeton.

Vowed the Fed would never allow such a disaster again.

Yet 2007-2009 recession was worst since Great Depression.

Fed was more aggressive than it had been during the Great Depression:

Saved Bear Stearns by arranging for purchase by JP Morgan Chase.

Despite concerns about moral hazard.

But initial actions were slow, as Fed was slow to recognize the threat the housing and financial crisis posed.

Drew criticism both for action and inaction.

Bernanke received fewest Senate votes for confirmation any Fed chairman had received for second term.

Monetary policy actions taken by Fed remain controversial.

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The Federal Reserve undertook unprecedented policy actions in response to the recession of 2007–2009.

Why were traditional Federal Reserve policies ineffective during the 2007–2009 recession?

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Key Issue and Question

Issue:

Question:

Central banks

The Federal Reserve, or “Fed”, is the central bank of the United States.

Central banks conduct monetary policy in order to:

Stabilize the economy and the financial system.

Reduce the severity of economic fluctuations.

Monetary policy The actions the Federal Reserve takes to manage interest rates and the money supply to pursue macroeconomic goals.

We will use the IS-MP model to explain how the Fed conducts monetary policy.

We will also discuss how in practice it can be difficult for the Fed and other central banks to implement effective policies.

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Understand the structure of the Federal Reserve.

12.1

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Learning Objective

Creation of the Federal Reserve system

Until 1913, U.S. went without a central bank.

No lender of last resort, so bank runs were common.

Bank run The process by which depositors who have lost confidence in a bank simultaneously withdraw enough funds to force the bank to close.

The bank runs would often set off financial panics, as occurred in 1873, 1884, 1893, and 1907.

The frequency of financial panics—and the accompanying economic downturns—convinced Congress that a central bank was necessary.

In 1913 President Wilson and Congress established the Federal Reserve System.

Federal Reserve System The central bank of the United States; commonly referred to as “the Fed.”

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The structure of the Federal Reserve System

The Fed has a Board of Governors, appointed by the president.

Board of Governors The governing board of the Federal Reserve System, consisting of seven members appointed by the president of the United States.

The seven governors serve nonrenewable terms of 14 years that are staggered, so one term expires every two years.

The president appoints one member of the Board to serve as the chairman for a renewable four-year term.

Ben Bernanke was appointed in 2006 by George W. Bush and reappointed by Barack Obama in 2010.

Chairman acts as public face of the Fed.

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Federal Reserve districts and banks

The Federal Reserve Act divided the U.S. into 12 Federal Reserve districts.

Each district has a Federal Reserve Bank.

District banks are somewhat independent from the government:

Federal Reserve districts and banks

Figure 12.1

Owned by commercial banks within the district.

Select their own presidents.

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The Federal Open Market Committee

Federal Open Market Committee (FOMC) The 12-member Federal Reserve committee that directs open market operations.

The 12-member FOMC is at the center of Fed policymaking.

7 governors, including the chair of the Board of Governors.

New York Fed president.

4 of the remaining 11 Fed presidents, serve on a rotating basis.

All 12 presidents attend FOMC meetings, but only 4 vote.

The FOMC conducts open market operations.

Meets eight times a year, but can meet more frequently.

The FOMC typically decides how to set the federal funds rate.

Open market operations The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets.

Federal funds rate The interest rate that banks charge each other on short-term loans.

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Describe the goals of monetary policy.

12.2

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Learning Objective

Goals of monetary policy

The main goal of monetary policy is to advance the economic well-being of the population.

Efficient employment of labor and capital

Steady growth in output

Stable economic conditions

More specifically, the Fed’s goals to promote a well-functioning economy are:

Price stability

High employment

Financial market stability

Interest rate stability

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Fed goal 1: Price stability

Inflation erodes the value of money.

Most industrial countries have price stability as a policy goal.

Inflation makes prices less useful as signals for resource allocation.

Firms with uncertain future prices hesitate to enter into contracts.

Families have difficulty deciding on savings.

Fluctuations in inflation redistribute income.

Fed’s goal of price stability is low and stable inflation, not zero inflation.

Low and stable inflation allows prices to efficiently allocate resources.

Fed has no official target for inflation.

Unofficial target rate of inflation is around 2% annually.

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Fed goal 2: High employment

High employment or a low unemployment rate.

Unemployed workers and unused factories lower output.

Cause of financial distress.

Congress and the president share responsibility with Fed for employment.

Fed tries to keep unemployment at or near the natural rate of unemployment.

Not zero unemployment: that would be negative cyclical unemployment, and (per the Phillips curve) would cause high inflation.

In 2012, FOMC announced it believed natural rate of unemployment is between 5.2% and 6.0%.

Consistent with CBO estimates

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Fed goal 3: Financial market stability

Inefficiency in matching savers and borrowers results in lost resources.

Firms need to obtain financing to develop products and services.

Stability of financial markets promotes efficient matching of savers and borrowers.

Fed created as a response to financial market turmoil of 1907.

Banks prone to liquidity problems because of maturity mismatch.

Borrow short-term from depositors and lend long term.

Failure of one bank may result in contagion to other banks.

Multiple bank closings result in bank panics.

Central bank acts as lender of last resort to help prevent panics.

As recession of 2007-2009 showed, any financial firm that borrows short term and lends long term can be subject to runs.

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Fed goal 4: Interest rate stability

Interest rate fluctuations make planning difficult.

Firms: investment in plants and equipment

Households: investment in houses

Partially motivated by political pressure and desire for stable saving and investment environment.

Sharp fluctuations cause hardship for banks and financial firms with maturity mismatches (i.e., borrow short-term and lend long-term).

Therefore stability in interest rates helps stabilize financial system.

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The Fed’s dual mandate

Congress has authorized the Fed to pursue the goals of price stability, maximum employment, and moderate long-term interest rates.

How can the Fed pursue all these goals at once?

Really only two goals: price stability and maximum employment.

Low, stable inflation will result in moderate long-term interest rates.

So many commentators refer to these two goals as the Fed’s dual mandate.

Open question: Is the Fed’s dual mandate necessarily consistent with financial market stability?

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Explain the Fed’s monetary policy tools.

12.3

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Learning Objective

Monetary policy tools

The Fed has a variety of policy tools at its disposal.

Three traditional tools:

Open market operations

Discount loans

Reserve requirements

New policies introduced in 2007-2009 recession:

Interest on bank reserves.

Interest on funds deposited at the Fed for more than one day.

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Traditional Fed tool 1: Open market operations

The FOMC conducts open market operations (“OMOs”): the purchase and sale of government securities to affect the federal funds rate.

Federal funds rate is determined in the federal funds market.

Demand controlled by banks, to hold required reserves and (possibly) to hold excess reserves to meet short-run needs.

Also if no other good lending opportunities are available

Supply controlled by Fed.

Open market sales decrease reserves, open market purchases increase reserves.

After meetings, FOMC issues statement including its target for the federal funds rate.

Issues policy directive to Fed account manager to perform OMOs via the Open Market Trading Desk in New York.

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Does the Federal Reserve hit its target funds rate?

The FOMC conducts monetary policy by setting a target for the federal funds rate.

Fed controls supply of funds, but rate is determined by interaction of demand and supply.

Fed has generally been successful at keeping the market rate close to the target rate.

In December 2008 Fed “temporarily” abandoned a single target in favor of a target range of 0.00% to 0.25%.

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Macro Data

Traditional Fed tool 2: Discount loans

Banks can borrow directly from the Fed through the discount window at a regional Federal Reserve Bank. In so doing, the Fed acts as the lender of last resort.

Typically very short in duration (usually overnight, always ≤90 days).

Rate on loans is the discount rate.

Discount rate The interest rate that the Federal Reserve charges on discount loans.

Discount loans are provided by increasing banks’ reserves, increasing the monetary base.

Help to provide liquidity to financial institutions.

Usually set at a rate higher than the federal funds rate—so only banks that cannot borrow from other banks use discount loans.

From January 2000 through July 2007, discount loans averaged just $219 million per month.

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Traditional Fed tool 3: Reserve requirements

Banks are required to hold a certain percentage of checking account deposits as either vault cash or deposits with the Fed; these are reserve requirements.

Reserve requirements Regulations that require banks to hold a fraction of checking account deposits as vault cash or deposits with the Fed.

The ratio of reserves checking account deposits that banks must hold is the required reserve ratio.

Banks may choose to hold excess reserves.

Changing the reserve requirement is done infrequently; banks find it disruptive for business.

Fed has not changed reserve requirements since 1992.

Other central banks use this tool frequently; People’s Bank of China reduced required reserve ratio several times in late 2011, early 2012.

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New Fed tool 1: Interest on bank reserves

Since reserves held did not earn a return, banks objected to their requirement as being a hidden tax.

In 2006, Congress authorized the Fed to start paying interest on reserve deposits in 2011.

Moved up to October 2008 due to financial crisis.

This gives the Fed another tool to use to influence bank reserve levels, and hence lending:

Raising the rate restrains bank lending

Lowering the rate encourages lending

In principle, the Fed could offer different rates on required and excess reserves; in practice, it offers the same rate (0.25% as of September 2012) on each.

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New Fed tool 2: Interest on other Fed deposits

The Fed offers banks term deposits (similar to certificates of deposit at commercial banks) through the new Term Deposit Facility (TDF).

Term deposits are offered in periodic auctions, where interest rates are determined.

July 2012: Interest rate on auction of $3 billion in 28-day deposits was 0.26%, just above the 0.25% paid on reserve deposits.

Term deposit funds are removed from reserve holdings.

So firms have fewer reserves available to expand loans and the money supply.

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Other nontraditional Fed policy actions

Until 1980, with very few exceptions, the Fed made loans only to commercial banks that were members of the Federal Reserve System.

In 1980, Congress authorized Fed to make loans to all depository institutions.

By 2007, shadow banking system of investment banks, money market mutual funds, hedge funds, and other nonbank financial firms had grown.

These were involved in initial stages of financial crisis.

Such firms were not eligible for discount loans, handicapping the Fed.

But “unusual and exigent circumstances” clause of Federal Reserve Act authorized lending to entities that could not borrow from commercial banks.

Fed set up several temporary lending programs for these firms.

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Fed lending during the financial crisis

The Fed dramatically increased the availability of funds under the “unusual and exigent circumstances” clause during the financial crisis.

Lending by the Fed during the financial market shock

Figure 12.2

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On the Board of Governors, four can be a crowd

Prior to the beginning of the financial crisis, key monetary policy debates took place during FOMC meetings.

Analysts watch outcomes of meetings for clues about Fed actions.

Government in the Sunshine Act (1976): Public notice must be given before a meeting of most federal agencies.

Rapidly unfolding events made giving public notice inconvenient.

“Meeting” defined as >3 members of committee meeting.

So Bernanke met with “informal group of advisors”: Board of Governors members Donald Kohn and Kevin Warsh and NY Fed president Timothy Geithner.

Geithner was not a member of the Board of Governors, so didn’t trigger the “public notice” requirement.

Unintended consequence of “Sunshine Act” was to limit input from other members of the Board of Governors in monetary policy.

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Making the Connection

Use the IS–MP model to understand how monetary policy affects the economy in the short run.

12.4

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Learning Objective

Monetary policy and aggregate expenditure

Fed can keep short-term rates such as the federal funds rate near their target.

Goal is to affect consumption and investment behavior, which respond to long-term rates.

Long term interest rate determined by:

TSE is the term structure effect

DP is the default-risk premium

These are assumed to remain unchanged, meaning changes to i impact iLT

The nominal interest rate is the stated rate on a loan or a bond.

Assume that e is formed using adaptive expectations.

Then increases in nominal rates also increase real interest rates, as:

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Relationship among various interest rates

The federal funds rate is closely linked to long-term interest rates such as the mortgage rate and corporate borrowing rates.

Federal funds rates moves more than long-term rates.

The federal funds rate and the interest rates on corporate bonds and mortgages

Figure 12.3

Between 2000 and 2005 mortgage and bond rates did not fall, meaning investors may have thought future short-term rates would be higher, increasing the TSE.

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In early prints of this book, the labels for the 30-year mortgage and corporate Aaa bonds are reversed; let your students know.

Open market operations and real GDP

Increasing the federal funds rate target is a contractionary monetary policy.

The Fed does this by selling more bonds; a decrease in the price of a bond is an increase in the interest rate.

Decreasing the federal funds rate target is an expansionary monetary policy.

The Fed does this by buying back bonds; the price of the bonds will rise, effectively a decrease in the interest rate that holding bonds offers.

The table describes the effects of these open market operations on real GDP.

Open market operations and real GDP

Table 12.1

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Using monetary policy to fight a recession

The goal of high employment is equivalent to keeping cyclical unemployment close to zero.

During a recession, the cyclical unemployment rate rises.

We assume a demand shock here, moving IS1 left to IS2, creating a negative output gap and reducing the inflation rate from π1 to π2.

The Fed lowers the long-term real rate, shifting MP1 down to MP2, eliminating the output gap and increasing the inflation rate.

Expansionary monetary policy

Figure 12.4

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Using monetary policy to fight inflation

Suppose a positive demand shock has increased the IS curve to IS1. The inflation rate would rise to π1 as a result.

The Fed would take action, raising the long-term real rate from r1 to r2, reducing the output gap back to zero and reducing inflation to π2, which equals πe.

Contractionary monetary policy

Figure 12.5

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Using monetary policy to deal with a supply shock

Supply shocks, such as an oil price increase, shift the Phillips curve up from PC1 to PC2. At the same zero output gap we had at point A, there is simply a higher inflation rate at point B.

In order to reign in inflation, the Fed can raise the real interest rate from r1 to r2, such that MP1 rises to MP2, where inflation goes back to πe at point C.

The result is to create a negative output gap in order to keep inflation at πe.

Monetary policy and an increase in oil prices

Figure 12.6

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Did the Fed make the Great Depression worse?

The Great Depression was the most severe economic contraction that the United States has ever experienced.

During the first years of the Great Depression in the early 1930s, the Fed thought that its monetary policy was expansionary because interest rates were low and stable. For example, the nominal interest rate on the safest corporate bonds varied from 4.4% to 5.4%. The Fed thought that these low interest rates represented an expansionary policy, so that there was no need to change policy.

Because the United States experienced deflation during these years, however, the real interest rate on the safest corporate bonds increased from 4.8% in October 1929 when the stock market crashed to 15.8% in May 1932!

Use the IS–MP model to show the effect of a monetary policy that allowed the real interest rate to increase from 4.8% to 15.8%.

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Solved Problem

Did the Fed make the Great Depression worse?

Step 1 Review the chapter material.

Step 2 Draw the relevant IS-MP and Phillips curve Graphs. The Fed did not target interest rates during the Great Depression. The initial MP curve is at 4.8%, with equilibrium at point A. The new MP curve was at a real rate of 15.8%, with equilibrium at point B. A negative output gap opens, and inflation falls.

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Solved Problem

Did the Fed make the Great Depression worse?

Step 3 Discuss the effects of a rising real rate on the economy. The real rate rose, resulting in a declining level of output and inflation. It became more expensive for firms and households to borrow. Aggregate expenditure declined between 1929 and 1932, with the U.S. economy experiencing deflation.

Milton Friedman argued that the Fed’s policies were partly responsible for the severity of the Great Depression, emphasizing that the Fed failed to stop bank panics and the decline in the supply of money and also failed to distinguish real rates from nominal rates.

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Solved Problem

The liquidity trap and the zero lower bound

The ways in which monetary policy can affect real GDP and prices are known in general as channels of monetary policy.

In IS-MP model, Fed controls the short-term real interest rate: the interest rate channel.

But in two important instances, the interest rate channel may not be effective:

When short-term nominal interest rate gets low enough, households might prefer to hold money rather than short-term bonds. So the interest rate cannot be pushed lower: a liquidity trap.

The short-term nominal interest rate cannot logically go below zero; no-one would buy such a bond. This is the zero bound constraint.

Economists debate whether the liquidity trap is a real phenomenon; but the zero bound constraint must exist.

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Alternative channels of monetary policy

Suppose the interest rate channel is not effective; what other channels of monetary policy are available to the Fed?

Credit channels

The bank lending channel

The balance sheet channel

Quantitative easing

We will discuss each of these in turn.

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Credit channels: the bank lending channel

This channel emphasizes the behavior of borrowers who depend on bank loans. It exists due to asymmetric information.

Asymmetric information The situation in which one party to a transaction has better information than the other party.

Bank lending channel works by making more money available for loans.

Who borrows from banks?

Smaller firms, which have better knowledge about their true financial condition than would investors.

Households looking to finance consumption, housing investment

Open market purchases increase reserves, which banks use to make loans.

With sufficient excess reserves, banks become willing to take risks.

New loans increase consumption and investment expenditures and output.

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Credit channels: the balance sheet channel

Expansionary monetary policy often increases stock prices and value of other assets.

Lower return to bonds drives up value of alternative assets.

When these assets are more valuable, firms and households can use them as collateral to obtain loans.

Hence more loans will be made, expanding consumption and investment.

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Quantitative easing

If short-term nominal interest rates are close to zero, the central bank can still add reserves by purchasing long-term securities; this is known as quantitative easing.

Quantitative easing A central bank policy that attempts to stimulate the economy by buying long-term securities.

In December 2008, the federal funds rate was nearly zero.

Fed purchased nearly $1.7 trillion in mortgage-backed securities and longer-term Treasury securities in early 2009 and 2010.

Objective is to directly lower long-term interest rates to induce consumers and firms to borrow more.

November 2010, Fed began a second round of quantitative easing (QE2).

An additional $600 billion in long-term Treasuries.

September 2012, Fed began a third round (QE3).

Purchasing mortgage-backed securities, until economy recovers.

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How does quantitative easing work?

Recall the expression for the long-run real interest rate:

Conventionally, the Fed attempts to reduce r by lowering the federal funds rate, i.

Using quantitative easing, the Fed reduced the term premium in the term structure effect.

By purchasing 10-year Treasury notes.

In reality, the market for 10-year Treasury notes is very large; unclear whether quantitative easing really had much real effect.

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Is quantitative easing new?

Bank of Japan engaged in quantitative easing during early 2000s.

Bank of Japan set targets for the volume of bank reserves, and bought long-term government securities to try to achieve that level.

Required reserves: ~ 6 trillion yen

Bank of Japan’s target reserves: 30-35 trillion yen

Idea was to create huge excess reserves, so that Japanese banks would lend to firms and households.

Unclear whether Japan’s experiment with quantitative easing worked either.

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Federal Reserve assets

The Fed’s balance sheet expanded dramatically from $959 billion before the Lehman bankruptcy to $2.2 trillion on November 12, 2008.

Federal Reserve assets, 2007-2012

Figure 12.7

Increase came from new credit facilities such as the commercial paper market.

Access to commercial paper market is critical for day-to-day operation of many large firms.

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Operation twist

In September 2011, Fed announced it would purchase $400 billion of long-term securities while also selling $400 billion of short-term securities.

This was known as Operation Twist: an attempt to “twist” the yield curve.

Increase short-term interest rates while simultaneously lowering long-term interest rates.

Reduce term premium in the TSE.

Operation Twist did not increase monetary base, or threat of future inflation—a significant potential drawback of quantitative easing.

Most economists believe Operation Twist had only modest success in raising real GDP and employment.

Ben Bernanke in mid-2012: effect of the policy “still working its way through the system”.

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Explain the challenges to using monetary policy effectively.

12.5

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Learning Objective

Policy lags

Several important policy lags prevent monetary policy from being as effective as the IS-MP model makes it appear:

Recognition lag The period of time between when a shock occurs and when policymakers recognize that the shock has affected the economy.

Economic data become available to policymakers only after several months.

Difficult to determine if response is necessary.

Implementation lag The period of time between when policymakers recognize that a shock has occurred and when they adjust policy to the shock.

Takes time to determine how to respond—relatively short for monetary policy, since FOMC meets regularly.

Impact lag The period of time between a policy change and the effect of that policy change.

Friedman: impact lags are “long and variable”; takes time for corporate and household behavior to adjust.

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Economic forecasts

Fed responds not to current state of economy, but to expected state of the economy when policies will actually take effect.

Effect of a cut in federal funds rate will be felt over next several years.

Good policy requires good forecasts; the table below helps to explain why the Fed didn’t act early in order to head off the recession of 2007-2009: it didn’t see it coming.

Federal Reserve forecasts for real GDP growth during 2007 and 2008

Table 10.2

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Model uncertainty

Economists use models to approximate reality.

Uncertain how events will change real GDP and inflation.

Uncertain how changes in short-term nominal rates will affect long-term real interest rates and how much consumption changes.

We know consumption responds to changes in wealth.

Question remains: How much does consumption change?

Recent CBO estimate: $100 in real estate wealth changes consumption between $1.70 and $21.00.

Between the policy lags, forecast uncertainty, and model uncertainty, it is not surprising that the Fed is generally relatively cautious in making significant policy changes.

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Consequences of policy limitations

Policy lags and forecast uncertainty can lead to errors by policymakers.

Suppose the economy is in a recession (point A).

The Fed implements an expansionary monetary policy intended to shift the economy back to full employment (point B).

However before the policy takes effect, the economy recovers (to point C).

Now the policy takes effect, and the economy moves to point D.

Positive output gap

Increased inflation

Monetary policy that is poorly timed

Figure 12.8

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Did the Fed cause the 2001 recession?

In mid-2000, the Fed believed the economy was operating at 3.5% above potential GDP.

CPI inflation had risen from 1.4% in September 1998 to 3.7% in June 2000.

Fed responded by increasing the target federal funds rate, from 5.0% in September 1998 to 6.5% in May 2000.

The bursting of the dot-com bubble and the September 11, 2001 terrorist attacks resulted in a recession.

Recession was short, but recovery was slow.

Did the Fed’s decision to increase the federal funds rate contribute to the recession and the slow recovery? Use the IS–MP model to show the effect of the Fed’s policy.

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Solved Problem

Did the Fed cause the 2001 recession?

Step 1 Review the chapter material.

Step 2 Draw the initial equilibrium using an IS-MP graph. In the second quarter of 2000, the Phillips curve should show inflation at 3.7%, and the output gap should be 3.5% on both the Phillips curve graph and the IS-MP graph.

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Solved Problem

Did the Fed cause the 2001 recession?

Step 3 Show the effect of the increase in interest rates. The Fed increased the federal funds rate, which should increase long-term real rates. If the Fed knows exactly how much to increase rates, it can eliminate the positive output gap and bring inflation down.

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Solved Problem

Did the Fed cause the 2001 recession?

Step 4 Show the effect of the collapse in stock prices and the terrorist attacks.Stock market collapses reduce wealth, and therefore consumption. Both the stock market collapse and the terrorist attacks in 2001 increased uncertainty about the future. The result is the IS curve shifting to the left, moving from equilibrium from point B to point C. There should then be a negative output gap and lower inflation.

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Solved Problem

Moral hazard

Financial investments are inherently risky.

Potentially large profits, but also potentially large losses.

Ordinarily, managers have a strong financial incentive to balanced potential reward and risk.

What if the manager believes the government will not allow the firm to fail: a too-big-to-fail policy?

May increase moral hazard, as manager/firm insured against downside risk.

Too-big-to-fail policy A policy in which the federal government does not allow large financial firms to fail for fear of damaging the financial system.

The cost of the Fed’s commitment to short-run financial market stability may be the potential for moral hazard in the long run.

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“Too big to fail”—the legacy of Continental Illinois

Continental Illinois Bank suffered large losses in 1984.

Smaller banks had deposits at Continental Illinois.

Belief was that multiple banks would fail if Continental Illinois failed.

FDIC seized the assets of Continental Illinois.

Bondholders, who are usually paid less than face value when an institutions fails, received full payment.

Creditors of Continental Illinois paid no penalty for the failure of Continental Illinois.

Government’s response by rescuing bondholders at Continental Illinois set the precedent that policymakers would rescue them in the event of a future crisis.

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Making the Connection

“Too big to fail”—the legacy of Continental Illinois

Neil McLeish, a Morgan Stanley analyst said “Prior to Lehman, there was almost an unshakeable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default.”

There remain many financial firms that are “too big to fail”, like JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs.

Gary Stern, former president of Minneapolis Fed: “Market participants believe that nothing has changed, that too-big-to-fail is fully intact.”

Some analysts suggest large institutions ought to be reduced in size, so government can more credibly say it will allow them to fail.

Alternative: more heavily regulate such institutions.

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Making the Connection

Evaluate the arguments for and against central bank independence.

12.6

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Learning Objective

The independence of the U.S. Federal Reserve

Fed’s mandate has been price stability, high employment, and financial market stability.

While the Fed acts within boundaries established by Congress and the president, its structure has been designed to insulate it from political pressure.

14-year overlapping terms for governors.

Independently funded through interest paid on U.S. Treasury holdings.

FOMC decides target federal funds rate without direct input from the president or Congress.

Fed developed new tools without approval of president or Congress during the 2007-2009 financial crisis.

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The case for and against independence

The case for independence

Monetary policy is too important and technical to be determined by politicians.

Politicians have short-term focus, with concern about future elections.

Short-term focus may clash with long-term interests like low and stable rates of inflation.

Political pressures might increase the likelihood of fluctuations in the money supply based on election cycles.

The case against independence

Elected officials should make public policy.

No way to hold appointed officials accountable for their actions.

Benefits may exist between coordinating monetary policy and fiscal policy.

Fed has not always used independence well:

Fed’s concerns about inflation prevented it from assisting in the Great Depression.

Overly inflationary policy in the 1960s and 1970s.

Possibly left interest rates too low after the 2001 recession.

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Central bank independence and inflation

In a 1993 study, Alberto Alesina and Larry Summers showed that more independent central banks had lower average inflation rates.

This is consistent with the view that independent central banks resist political pressure to stimulate the economy in the short run, at the cost of higher long-run inflation.

Central bank independence and the average inflation rate

Figure 12.9

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Explain how monetary policy works in an open economy.

12.7

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Learning Objective

Monetary policy in an open economy

Now more than ever, most economies are open and experience extensive trade and flows of financial investment with other countries.

Our IS-MP model has so far ignored how these interactions affect monetary policy.

In this section, we will consider:

How monetary policy relates to international trade and international monetary flows.

How monetary policy is affected by different exchange rate policies.

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Monetary policy with floating exchange rates

An expansionary policy lowers the real interest rate.

U.S. assets look less attractive, so net capital outflows/net exports increase and the U.S. dollar depreciates.

The increase in net exports provides another reason why output increases.

An expansionary monetary policy with floating exchange rates

Figure 12.10

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Monetary policy with a fixed exchange rate

With fixed exchange rates, there is a limit to how low the central bank can push the real interest rate. Why?

Domestic assets become less attractive, so foreigners sell them, demanding foreign currency reserves, which eventually run out.

An expansionary monetary policy with fixed exchange rates

Figure 12.11

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Fixed exchange rate alternative: currency devaluation

Fixed exchange rate systems given policymakers another expansionary tool: currency devaluation.

Devalued currency increases net exports, hence IS curve.

This would result in higher inflation, which the central bank would need to offset with an increase in the real interest rate.

A currency devaluation

Figure 12.12

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Desirable goals in an open economy

Exchange-rate stability

Reduces uncertainty of buying, selling, and investing across borders.

Households and firms find it easier to decide how to invest and save.

Monetary policy independence

Effective monetary policy can reduce the severity of business cycles.

Flexible exchange rates give freedom to central banks, while fixed exchange rates cannot be used to achieve both price stability and high employment.

Free capital flows

Households and firms finance gross private investment expenditures through capital inflows.

Capital inflows can finance government budget deficits.

Not universally desired; capital controls can limit nominal exchange rate fluctuations.

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The policy trilemma

Policy trilemma The hypothesis that it is impossible for a country to have exchange-rate stability, monetary policy independence, and free capital flows at the same time.

The policy trilemma

Figure 12.13

Example: If capital can flow freely and the central bank is independent, as in the U.S., the central bank will try to keep inflation low. But then the currency will appreciate or depreciate according to the monetary policies of other countries, creating undesirable exchange-rate risk.

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Answering the key question

“Why were traditional Federal Reserve policies ineffective during the 2007–2009 recession?”

The traditional Fed response to a recession is to reduce the short-term nominal interest rate; normally this will decrease the long-term real interest rate.

This traditional interest rate channel could not operate during the recession, because the federal funds rate was pushed nearly to zero.

Hence the Fed was forced to craft new policies in an attempt to increase real GDP and employment.

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