91. Monetary Policy Objectives and Framework

Monetary policy is the process by which the  monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment. Monetary economics provides insight into how to craft optimal monetary policy.

The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee 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.”

• Goals: The goals in the mandate are “maximum employment, stable prices, and moderate long-term interest rates.” Achieving stable prices, keeping the inflation rate low, is the key. It is the source of maximum employment and moderate long-term interest rates. Low inflation rates mean that people make decisions without the confusion created by inflation. And, because the nominal interest rate equals the real interest plus the inflation rate, a low inflation rate means low long-term interest rates.

• Operational “Stable Prices” Goal: The Fed pays close attention to the core PCE deflator, the PCE deflator excluding food and fuel. The core inflation rate is the rate of increase of the core PCE deflator. Price stability can mean either a core inflation rate “low and stable enough so that it does not enter materially into the decisions of households and firms” (Alan Greenspan) or a core inflation rate of “1 or 2 percent” (Ben Bernanke).

• Operational “Maximum Employment” Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP. The Fed tries to minimize the output gap.

92. Monetary Policy Transmission

Ripple Effects of Changing the Interest Rate

Suppose the Fed lowers the federal funds rate using an open market sale. As a result:

• Other interest rates: Other short-term interest rate falls. Long-term bond interest rates also fall, but by a lesser amount.

• 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 exchange rate falls (the dollar depreciates).

• 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: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases.