Monetary Policy

Money Multiplier

M1 = money multiplier x H

where H = high-powered money (aka monetary base) = currency + reserves

and

                     1 + CU/D money multiplier = -----------                     re + CU/D 

CU is currency, D is checking deposits, and re is the reserve requirement on checking deposits.

Tools of Monetary Policy

• 1. open market operations

  2. discount policy

  3. required reserve ratio

  4. margin requirements

  5. credit controls

Intermediate Targets

The Fed uses intermediate targets to guide policy as a step between its tools and the ultimate goals of price stability and economic growth.

Intermediate targets are variables the Fed cannot control directly but can influence predictably and are related to the Fed's goals. The most frequently used targets are monetary aggregates such as M1 and M2 and short-term interest rates such as the federal funds rate.

Interest Rate v. Monetary Targets

Political Environment

features designed to prevent undue political influence on the Fed

• • governora are appointed to 14 year terms, each of which expires every 2 years

  • chairman serves a 4 year term which expires more than halfway through the term of a U.S. president

  • Fed is completely self-financed

Rules v. Discretion

rules policy

policy settings are maintained regardless of short-term fluctuations in economic activity

discretionary policy

adjusted periodically in order to deal with changing conditions in the economy

case for rules

• • hostage example

  • monetary policy

time inconsistency

government has an incentive to renege on its promises

Ways to Achieve Central Bank Credibility

• 1. policy rule

  2. appointing a "tough" central banker

  3. changing central banker's incentives

  4. increasing central bank independence