Introduction
1. Monetary Policy
The term "monetary policy" refers to the actions undertaken by a central bank,
such as the Federal Reserve Board in the States, to influence the availability and
cost of money and credit to help promote national economic goals. The Federal
Reserve Act of 1913 gave the Federal Reserve responsibility for setting
monetary policy.
2. Monetary Policy Goals (Single or Dual)
 Maintain price stability
 Maintain full employment growth
U.S. is in the dual group, New Zealand is in the single group, for example.
 Some thoughts
 Regression
3. Current Consensus
 Low, stable inflation is important for market-driven growth
 Monetary policy is the most direct determinant of inflation
 Monetary policy is the most flexible instrument for achieving median term
stabilization objectives.
4. Tools
The Federal Reserve controls the three tools of monetary policy—
 Open market operations – interest rate target
 The discount rate
 Reserve requirements.
Plus one unconventional tool (QE)
The Board of Governors of the Federal Reserve System is responsible for the
discount rate and reserve requirements, and the Federal Open Market
Committee is responsible for open market operations. Using the three tools, the
Federal Reserve influences the demand for, and supply of, balances that
depository institutions hold at Federal Reserve Banks and in this way alters the
federal funds rate. The federal funds rate is the interest rate at which depository
institutions lend balances at the Federal Reserve to other depository institutions
overnight.
Changes in the federal funds rate trigger a chain of events that affect other shortterm interest rates, foreign exchange rates, long-term interest rates, the amount
of money and credit, and, ultimately, a range of economic variables, including
employment, output, and prices of goods and services.
Open Market Operations
Open market operations--purchases and sales of U.S. Treasury and federal
agency securities--are the Federal Reserve's principal tool for implementing
monetary policy. The short-term objective for open market operations is specified
by the Federal Open Market Committee (FOMC). This objective can be a desired
quantity of reserves or a desired price (the federal funds rate). The federal funds
rate is the interest rate at which depository institutions lend balances at the
Federal Reserve to other depository institutions overnight. See the Excel File
The Discount Rate
The discount rate is the interest rate charged to commercial banks and other
depository institutions on loans they receive from their regional Federal Reserve
Bank's lending facility--the discount window. The Federal Reserve Banks offer
three discount window programs to depository institutions: primary credit,
secondary credit, and seasonal credit, each with its own interest rate. All discount
window loans are fully secured. New Development: because of the stigma, the
discount window is rarely used. Currently, however, the central bank allows
primary brokerage banks to borrow from its discount window.
Reserve Requirements
Reserve requirements are the amount of funds that a depository institution must
hold in reserve against specified deposit liabilities. Within limits specified by law,
the Board of Governors has sole authority over changes in reserve requirements.
Depository institutions must hold reserves in the form of vault cash or deposits
with Federal Reserve Banks.
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Of less than $12.4 million have no minimum reserve requirement;
Between $12.4 million and $79.5 million must have a liquidity ratio of 3%;
Exceeding $79.5 million must have a liquidity ratio of 10%
Quantitative Easing (QE)
Quantitative easing is an unconventional monetary policy used by central banks
to stimulate the national economy when standard monetary policy has become
ineffective. A central bank implements quantitative easing by buying financial
assets from commercial banks and other private institutions, thus creating money
and injecting a pre-determined quantity of money into the economy. This is
distinguished from the more usual policy of buying or selling government bonds
to change money supply, in order to keep market interest rates at a specified
target value.
Expansionary monetary policy typically involves the central bank buying shortterm government bonds in order to lower short-term market interest rates.
However, when short-term interest rates are either at, or close to, zero, normal
monetary policy can no longer lower interest rates. Quantitative easing may then
be used by the monetary authorities to further stimulate the economy by
purchasing assets of longer maturity than only short-term government bonds,
and thereby lowering longer-term interest rates further out on the yield curve.
Quantitative easing raises the prices of the financial assets bought, which lowers
their yield.
Quantitative easing can be used to help ensure that inflation does not fall below
target. Risks include the policy being more effective than intended in acting
against deflation – leading to higher inflation, or of not being effective enough if
banks do not lend out the additional reserves. According to the IMF and various
other economists, quantitative easing undertaken since the global financial crisis
has mitigated the adverse.
5. Rule-based Monetary Policy
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
Credibility Issue.
Example: Taylor’s Rule
rt   t  rt*  0.5*( t   t* )  0.5*[(
yt  yt*
)*100]
yt*
Where rt is the Fed Fund rate, rt* is the real rate,  t is inflation,  t* is the targeted
inflation, yt is the output, and yt* is the potential output.
Three variables are unobserved: rt* ,  t* , and yt* . For the real rate, we usually take
the ex post difference between nominal rate and inflation. However, for  t* and
yt* we need to estimate.
Estimate  t*
What is the target? Is it around 1.5%?
The problem here is that if people take an average over a long period time, it
may not fit the most recent period that well.
We may be able to figure it out by using the basic concept so-called NAIRU
(Non-Accelerate-Inflation-Rate-of-Unemployment), based on the following
relationship, to figure it out.
Inflation = f(lagged inflation, lagged unemployment, change of productivity,
shocks)
Estimation (CBO’s)
CPIt  2.87  lag (CPI )  0.77(runempt )  0.43*(CPIft 1 )  0.06( prodt )  1.84(Wage _ dummy)
R 2  0.77
Where lag (CPI ) is polynomial-distributed-lags; runempt is unemployment rate;
CPIft 1 is lagged food and energy prices change; and prodt is productivity
deviations.
People now can solve the equation for runempt by keeping CPI t constant.
Unemployment Rate vs. NAIRU
12
10
8
6
4
2
0
1949Q1
1958Q1
1967Q1
1976Q1
1985Q1
1994Q1
2003Q1
Source: Economy.com, CBO.
If we think the NAIRU is around 5%, then we derived the inflation associated with
it.
Estimate yt*
Importance of yt* : Benchmark of the economy’s performance at the optimal level.
Starting from the production function
y  f ( L, K , TFP )
Total Factor Productivity is the residuals.
If people can smooth the individual components, they might be able to get the
output level net of the cyclical component.
How to smooth:
HP Filter (NOT)
Regression (CBO’s method):
log( L)   *(ut  ut* )  f (T1953 , T1957 , T1960 , T1969 , T1973 , T1980 , T1990 , T2001 )
Here Tyear is a trend variable whose trend value starting at the beginning of a
business cycle, while (ut  ut* ) is the difference between the actual unemployment
rate and NAIRU.
Other components are estimated by using the same method.
See SAS Example.
6. FRB Macro Structural Model
The FRB/US model is a large-scale model of the U.S. economy featuring
optimizing behavior by households and firms as well as detailed descriptions of
monetary policy and the fiscal sector. It has 60 stochastic equations, 320
identities and 125 exogenous variables.
The model's large number of endogenous variables permits the study of the
effects of a broad range of macroeconomic policies and exogenous shocks on
real GDP and its major spending components
 the unemployment rate and other key labor market indicators
 several measures of inflation and relative prices
 the main categories of national income
 a detailed treatment of the government's account
 various interest rates, asset prices, and components of wealth
FRB/US has a neoclassical core that combines a production function with
endogenous and exogenous supplies of production factors and key aspects of
household preferences such as impatience.
To account for cyclical fluctuations, the model features rigidities that apply to
many decisions made by households and firms -- these rigidities enable the
model to generate gradual responses of macroeconomic variables to a wide
range of exogenous shocks that are consistent with the economic data.
Here we provide only an overview of the main specifications of the various
agents' behavior and how they compare to other models currently used in policy
analysis, and then focus on illustrating some properties of the model.
More Detailed Discussion
7. Uncertainty of Monetary Policy
Monetary Policy tends to have lags, which creates uncertainties of the policy
impacts. For example, while a central bank tries to stimulate an economy by
cutting interest rates, it has to anticipate what will happen in the near term.
Any forecast involves risks. Bank of England has a very famous way to evaluate
the forecast risk: Bloody red fan chart for inflation, and lately, green river fan
chart for output. (See Presentation).
8. Summary
Taylor’s Rule/Uncertainties related to monetary policy changes
NAIRU
HP Filter
FRB/US Model
Fan Chart/Forecast Risk