Monetary Policy:
Deliberation and Implementation
Week 12 – November 9, 2005
J. K. Dietrich - FBE 524 - Fall, 2005
Roles of Central Banks
 List
–
–
–
–
–
of central bank roles in Rose (p. 354)
Market stabilization
Control of money supply
Lender of last resort
Supervisor of the banking system
Protecting and improveing the flow of
payments
 Last
two are independent of others, and first
three all relate to money supply
J. K. Dietrich - FBE 524 - Fall, 2005
Control of money supply
 Promote
economic goals
– Full employment
– Price stability
– Economic growth through improvements in
productivity with investment
 How
good must central banks be?
 Theory of optimal currency areas weighs
costs of multiple currencies versus local
control of money supply to promote above
J. K. Dietrich - FBE 524 - Fall, 2005
Robert Mundell
“…Many of the political changes in the century have
been caused by little-understood perturbations in the
international monetary system, while these in turn have
been a consequence of the rise of the United States and
mistakes of its financial arm, the Federal Reserve
System. The twentieth century began with a highly
efficient international monetary system that was
destroyed in World War I, and its bungled recreation in
the interwar period brought on the Great Depression,
Hitler, and World War II.”
”A Reconstruction of the Twentieth Century” (Nobel Prize Lecture,
December 10, 2002) in American Economic Review, June 2002, p. 327
J. K. Dietrich - FBE 524 - Fall, 2005
Roles of Federal Reserve
Control of money supply - to be discussed
 Market stabilization
– Fed open market operations
– Statements of officials
 Lender of last resort
– Incentive problems
 Maintaining and improvement of payments
mechanism
– Private competitors, pre-Fed arrangements
 Supervisor of the banking system
– Performed by other agencies

J. K. Dietrich - FBE 524 - Fall, 2005
Monetary Policy
 Deliberation
 Implementation
 Prediction
 Evaluation
 Criticism
J. K. Dietrich - FBE 524 - Fall, 2005
Deliberation
 Since
1935, monetary policy is the
responsibility of the Federal Open Market
Committee (FOMC)
 FOMC consists of 7 Federal Reserve
Governors (Washington based) and five
voting Federal Reserve Bank presidents
– New York FRB president
– Chicago/Cleveland FRB presidents alternate
– Three of remaining nine FRB presidents rotate
J. K. Dietrich - FBE 524 - Fall, 2005
What is Money?
 Fed
tracks three money measures
– M1 = Currency + checkable accounts + others
– M2 = M1 + small savings accounts (including
IRAs and Keoghs at banks) + others
– M3 = M2 + large CDs + Eurodollars + others
 Which
is relevant to level of economic
activity -- actively debated issues
 Which can Fed control?
J. K. Dietrich - FBE 524 - Fall, 2005
The Money Multiplier
 Fed
controls its balance sheet, including the
monetary base = currency + reserves
 Money multiplier derives relation between
supply of money (whichever definition) and
the monetary base. Rose (p. 521) has M1
multiplier:
1  CASH
M1 Multiplier 
RR D  CASH  EXR  ( RR T  TIME )
 Note
factors affecting money supply
J. K. Dietrich - FBE 524 - Fall, 2005
Money Multiplier
M1 Multiplier 1959 to Present
4.0
3.6
3.2
2.8
2.4
2.0
1.6
60
65
70
75
80
85
90
M1MULTIPLIER
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
95
00
Currency Ratio
Currency Ratio 1959 to Present
.60
.55
.50
.45
.40
.35
.30
.25
.20
60
65
70
75
80
85
CRATIO
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
90
95
00
FOMC meetings
 Eight
scheduled meetings per year: one today
 Next meeting is December 13, 2005
 Last scheduled meeting was November 1, 2005
 Last meeting for which minutes were released was
September 20, 2005 (available on Internet)
 Format of meetings routine
– Discuss financial markets and economy
– Adopt formal instructions to the manager of the
System Open Market Account (directive)
J. K. Dietrich - FBE 524 - Fall, 2005
Input to FOMC Deliberations

Staff projections
– Green book
– Blue book
– Beige book

Conceptual framework
– Non-accelerating inflation rate of employment (NAIRU)
– Taylor’s rule i    .5    *  .5 y
t
t

t

t
where i is Fed funds rate and π is inflation and y is output gap (difference between actual and potential GDP)
– Econometric models and projections
J. K. Dietrich - FBE 524 - Fall, 2005
Implementation
 Fed
can only control its own balance sheet,
or high-powered money consisting of
currency and bank reserves
 Since 1970, Fed targets growth rates in
money supply
– Initially two month growth targets
– 1975 started announcing six month target and
cone
 Humphrey-Hawkins
J. K. Dietrich - FBE 524 - Fall, 2005
required annual target
Fed Balance Sheet: Oct. 30, 2003
Assets
Liabilities
U.S. Government Securities $658.0 Federal Reserve Notes
Gold stock
$11.0 Deposits
Depository institutions
U.S. Treasury
Total Assets
$748.2 Total Liabilities
Equity
J. K. Dietrich - FBE 524 - Fall, 2005
$669.4
$26.6
$5.7
$ 730.4
$17.8
Fed Balance Sheet: Oct.28, 2004
Assets
Liabilities
U.S. Government Securities $706.7 Federal Reserve Notes
Gold stock
$11.0 Deposits
Depository institutions
U.S. Treasury
Total Assets
$792.7 Total Liabilities
Equity
$707.2
$24.9
$4.6
$ 771.9
$20.8
(U.S. Securities up 7.4%, FR Notes up 5.6%, reserves down 6.4%)
J. K. Dietrich - FBE 524 - Fall, 2005
Fed Balance Sheet: Oct.26, 2005
U.S. Government Securities $739.5 Federal Reserve Notes
Gold stock
$11.0 Deposits
Depository institutions
U.S. Treasury
Total Assets
$821.6 Total Liabilities
Equity
$767.9
$21.5
$4.7
$ 794.1
$27.5
(U.S. Securities up 4.6%, FR Notes up 8.6%, reserves down 13.6%)
J. K. Dietrich - FBE 524 - Fall, 2005
FOMC and Board of Governors
 FOMC
sets monetary policy
 Board of Governors rules on issues
concerning regulatory changes, acquisitions
under Gramm-Leach-Bliley Act of 1999
 Board reports twice annually to Congress
under requirements of Full Employment and
Balanced Growth Act of 1978 (HumphreyHawkins)
 Testimony to Congress
J. K. Dietrich - FBE 524 - Fall, 2005
Problems in Implementation
 Monetary
statistics reported late and are
subject to revision (described as driving by
looking in rear-view mirror)
 Market rates are instantaneously observable
and Fed Funds rate immediately impacted
by changes in high-powered money
(reserves)
 Fed traditionally focussed on rates or credit
market conditions
J. K. Dietrich - FBE 524 - Fall, 2005
Fed Targets and Base Growth
f=Fed Funds rate
Demand for Reserves
and Funds
}
Narrow
range
}
Wide
range
Non-Borrowed Reserves
J. K. Dietrich - FBE 524 - Fall, 2005
Reserves
Borrowed Reserves
= Discounts at Fed
Required reserves
 Reserve
requirements depend on which
banks (3% for smaller banks) and level of
transactions versus other accounts
 Calculation period runs 14 days from a
Tuesday to Monday
 Maintenance period is 14 days, ending on
Wednesday 16 days after calculation period
 Vault cash based on previous maintenance
period applied to required reserves
J. K. Dietrich - FBE 524 - Fall, 2005
Lagged Reserves
Tuesday
Monday
Monday
Wednesday Wednesday
Calculation
Period
 Reserve
Monday
Monday
Thursday Wednesday Wednesday
Maintenance
Period
calculated on a dollar days basis
 Penalties for shortfalls, limited advantage
(carry-forward) for excess
 Clearing balances affected by Fed wire and
Treasury transactions
J. K. Dietrich - FBE 524 - Fall, 2005
Growth Monthly and Smoothed
Monthly Base Growth and 12-Month Moving Average
6
4
2
0
-2
-4
60
65
70
75
80
BASEGROWTH
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
85
90
95
00
BGROWSMOOTH
Monetary Base and Money
Monetary Growth: Base, Currency, and M1
1400
1200
1000
800
600
400
200
0
60
65
70
75
80
BASE
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
85
90
CURRENCY
95
00
M1
“Base Drift”
M 1 Gr owth C ones at 2% and 4% Annual Gr owth
360
340
320
Base Drift 1/1974 to 1/1976
300
280
260
1974
1975
1976
M1
M 1H IGH G
M 1H IGH G2
J. K. Dietrich - FBE 524 - Fall, 2005
1977
1978
M 1LOWG
M 1LOWG2
Fed Funds and M1 Growth in ‘70s
Fed Funds and Base Growth in the 1970's
14
20
12
15
10
10
8
5
6
0
4
-5
2
-10
70
71
72
73
74
75
FEDFUNDSRATE
J. K. Dietrich - FBE 524 - Fall, 2005
76
77
78
M1GROWTH
79
Volcker - October 6, 1979
 Focus
on growth of aggregates
 Widen Fed Funds trading range to 400 basis
points
 Focus on non-borrowed reserves
 Experience
– Interest rates
– Monetary growth
J. K. Dietrich - FBE 524 - Fall, 2005
The Early ‘80s under Volcker
M 1 Growth and Fed Funds Rate 1979-1982
20
40
18
30
16
20
14
12
10
10
0
8
-10
6
4
-20
80
81
82
83
FEDFUNDSRATE
J. K. Dietrich - FBE 524 - Fall, 2005
84
85
86
M1GROWTH
Fed Funds and M1 Growth Now
Fed Funds Rate and Base Growth
10
8
6
4
2
0
-2
-4
88
90
92
94
M1GROWSMOOTH
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
96
98
00
M1GROWTH
02
04
FEDFUNDS
Prediction (“Fed Watching”)
 Importance
of Fed actions is less than in
1970’s, but still matter to market observers
 Fed watching is still common on the street
 Fed watching consists of
– Observing what they say they are doing
» Speeches, testimony, interviews, remarks
– Assessing what they have done
» Statistical releases
– Tracking the market’s reaction
J. K. Dietrich - FBE 524 - Fall, 2005
Evaluation
 Humphrey-Hawkins
specifies monetary
policy objectives to be low inflation and
economic growth
 Last eight years have been a period of low
inflation and rapid growth
 Basic evaluation is that Greenspan has been
a great chairman and his re-appointment by
Clinton de-politicized the Fed
J. K. Dietrich - FBE 524 - Fall, 2005
Criticism
 Theoretical
argument by monetarists
– “Inflation is always and everywhere a monetary
phenomenon” - Milton Friedman
 Fed
is a giant player and its actions have an
immense effect on markets, producing
uncertainty
 A base growth rule, gold standard, or
comprehensible price rule would eliminate
uncertainty about Fed policy
J. K. Dietrich - FBE 524 - Fall, 2005
Theoretical/Philosophical Issues
 The
econometric models used for policy are
fundamentally flawed (the Lucas critique)
– Participants in efficient markets try to anticipate
changes and alter behavior accordingly
– Parameters of estimated response functions will
change constantly, hence are unstable
– Data too limited to assess changes on models
 Unanticipated
J. K. Dietrich - FBE 524 - Fall, 2005
changes in policy are risks
Greenspan revisited
 What
are his (or the FOMC’s under his
leadership) guiding principles, or rules?
 How do asset prices, representing future
value of cash flows, and goods inflation
relate to each other and monetary policy?
 Fed has increased its transparency with
post-FOMC meeting announcements, but
what else is being discussed?
J. K. Dietrich - FBE 524 - Fall, 2005
Central Banks
 European
monetary system
– The Euro - January, 1999, and beyond
– Brief history of European monetary union
– Challenges facing the European Central Bank
 Bank
of Japan
 People’s Bank of China
 Central banks elsewhere - independence or
political domination are the issues
J. K. Dietrich - FBE 524 - Fall, 2005
Next Week: November 16
 Read
Chapter 18 in text concerning
government and consumer debt markets
 Bring a Wall Street Journal for next
Tuesday to class
 Plan team meeting and consultation with me
concerning group semester project
J. K. Dietrich - FBE 524 - Fall, 2005