Who Controls Monetary Policy in the U.S.?

Summary

This segment delves into the Federal Reserve's monetary policy, highlighting its tools like open market operations, discount rates, and reserve requirements to influence economic activity. It distinguishes between expansionary and contractionary policies, explaining how bond buying and selling affect interest rates and economic growth. The script also touches on the challenges of setting and meeting targets for inflation and unemployment, the importance of the federal funds rate, and the complexities of inflation targeting in the face of supply shocks and economic fluctuations.

Takeaways

• 💼 The Federal Reserve (FED) uses monetary policy tools such as open market operations, discount rate adjustments, reserve requirements, and interest rates on bank reserves to influence economic activity and maintain steady growth.
• 🔍 The FED's goal is to manage economic swings and maintain a constant growth rate, which is challenging due to the complexity of economic variables and the data lag involved in policy decisions.
• 📈 Expansionary monetary policy is used to close recessionary gaps by shifting the aggregate demand curve to the right or up, typically through open market operations where the FED buys bonds, reducing interest rates and stimulating investment and consumption.
• 📉 Contractionary monetary policy is pursued when inflation is a threat, involving the selling of bonds to increase interest rates, reducing the money supply, and curbing investment and consumption spending.
• 💡 The FED's actions are guided by the understanding of the relationship between bond prices and interest rates, where an increase in bond prices leads to a decrease in interest rates and vice versa.
• 🏦 The independence of the FED from political institutions allows it to make decisions in the best interest of the nation without being influenced by prevailing political winds.
• 🎯 The FED sets targets for inflation and unemployment rates and uses monetary policy to adjust the economy towards these targets, with the federal funds rate being a key target.
• 📊 Historically, the FED has targeted monetary growth rates, but current policy focuses on controlling the federal funds rate to influence the money supply and price level.
• 🌐 The FED's inflation targeting strategy aims for a systematic 2% rate, reflecting a balance between contractionary and stimulative strategies to maintain economic stability.
• 🚧 Difficulties with inflation targeting policies include adverse supply shocks, which can lead to both inflation and recession, complicating the FED's efforts to control economic gaps.
• 🔮 Central banks focus on expected rates of inflation, using economic models to predict and get ahead of potential inflationary or recessionary trends to minimize economic impact.

Q & A

What is the primary goal of the Federal Reserve's monetary policy?

The primary goal of the Federal Reserve's monetary policy is to influence economic activity to maintain a steady and constant growth rate.

What are the main tools in the Federal Reserve's toolbox to influence economic activity?

The main tools include open market operations, changing the discount rate, adjusting reserve requirements, and altering the interest rate payable to banks on their reserve holdings.

How does the Federal Reserve use open market operations to influence interest rates?

The Federal Reserve influences interest rates by buying and selling government bonds in the open market, which in turn affects the bond prices and consequently the interest rates.

What is the purpose of expansionary monetary policy?

The purpose of expansionary monetary policy is to shift the aggregate demand curve to close a recessionary gap, restore full employment, and stimulate investment and interest-sensitive consumption.

How does the Federal Reserve implement expansionary monetary policy?

The Federal Reserve implements expansionary monetary policy by buying bonds in the open market, which increases the money supply and causes interest rates to decrease.

What is the opposite of expansionary monetary policy?

The opposite of expansionary monetary policy is contractionary monetary policy, which is used when inflation is perceived to be a threat.

How does the Federal Reserve implement contractionary monetary policy?

The Federal Reserve implements contractionary monetary policy by selling bonds, which decreases the money supply and raises interest rates, reducing investment and consumption spending.

What is the role of the Federal Reserve's interest rate targets in monetary policy?

The interest rate targets, particularly the federal funds rate, play a key role in driving the flow of credit to households, firms, and government units, impacting short-term lending rates and the overall economy.

What are the challenges faced by the Federal Reserve in setting and achieving its policy targets?

Challenges include the difficulty in forecasting employment and inflation rates, the lag in data, and the complexity of managing economic swings to align with the set targets.

What is the current target for the inflation rate set by the Federal Reserve?

The current target for the inflation rate set by the Federal Reserve is a systematic 2% rate.

How do adverse supply shocks impact the effectiveness of monetary policy?

Adverse supply shocks can put monetary policy at odds with controlling inflation and recession, making it difficult for central banks to manage inflationary and recessionary gaps effectively.

What is the difference between explicit and flexible inflation targeting policies?

Explicit inflation targeting policies are more rigid and set clear numerical targets for inflation, while flexible inflation targeting policies allow for more adaptability and adjustments in response to economic conditions.

Outlines

00:00

💼 Monetary Policy Tools and Economic Influence

This paragraph discusses the Federal Reserve's (FED) role in influencing economic activity through monetary policy. The FED aims to maintain a steady and constant growth rate using various tools, such as open market operations, adjusting the discount rate, reserve requirements, and interest rates payable to banks. The goal is to balance aggregate demand and supply to keep the economy moving upward at a controlled growth rate. The paragraph also explains the concepts of expansionary and contractionary monetary policies, detailing how the FED uses bond purchases to lower interest rates and stimulate investment and consumption, thereby closing recessionary gaps. Conversely, contractionary policy is employed when inflation is a threat, with the FED selling bonds to raise interest rates and reduce investment and spending.

05:00

📉 Challenges in Forecasting and Implementing Monetary Policy

The second paragraph delves into the difficulties faced by entities like the FED in forecasting employment and inflation rates. Given the complexity of the data and the timelines involved in evaluating it, making accurate predictions is challenging. The paragraph explains the FED's contractionary policy actions, such as selling bonds to increase interest rates, which can reduce investment and consumption spending. It also touches on the independence of the FED from political influences, emphasizing the importance of making decisions in the best interest of the nation without being swayed by political climates. Additionally, the paragraph discusses the FED's policy targets, including the federal funds rate and monetary growth rate, and the challenges of inflation targeting, especially in the face of adverse supply shocks.

10:00

🎯 The Fed's Policy Targets and Inflation Control

This paragraph focuses on the FED's policy targets, particularly the interest rate and monetary growth rate. It highlights the importance of the federal funds rate in impacting short-term lending rates and the flow of credit to various economic sectors. The paragraph also discusses the historical efforts of the FED under Paul Volcker to control inflation through strict monetary growth targeting, which led to a recession. It mentions that while monetary growth rates are no longer a specific target, the FED still uses money supply to influence the federal funds rate. Additionally, the paragraph covers the FED's current approach to targeting a systematic 2% inflation rate and the challenges of inflation targeting policies, especially in response to historical policy attempts and adverse supply shocks.

15:03

🛠️ Central Banks' Approaches to Inflation and Economic Stability

The final paragraph examines the strategies of central banks, including the FED, in focusing on the expected rate of inflation to manage economic stability. It discusses the challenges of dealing with past, current, and expected inflation rates and the use of economic models to predict and manage these rates. The paragraph also touches on the impact of adverse supply shocks, such as those caused by OPEC's decisions on oil prices, which can significantly affect the economy. It concludes by contrasting explicit and flexible inflation targeting policies, highlighting the need for central banks to develop flexible strategies that can be adjusted in response to economic conditions.

Keywords

💡Monetary Policy

Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve (the Fed), to control the supply of money and interest rates in order to stabilize the economy. It is a key tool used by the Fed to influence economic activity. In the script, monetary policy is discussed as the means by which the Fed can either stimulate or contract the economy, depending on economic conditions, with the goal of steady and constant growth.

💡Macroeconomic Variables

Macroeconomic variables are broad economic indicators that reflect the overall performance of an economy, such as GDP, inflation, and unemployment rates. These variables are crucial for the Fed to monitor and influence through monetary policy. The script emphasizes the importance of understanding these variables in the context of the Fed's actions and their impact on the economy.

💡Open Market Operations

Open market operations are the buying and selling of government securities, such as bonds, by the central bank in the open market to control the money supply and interest rates. The script explains how the Fed uses open market operations to implement its monetary policy, either by purchasing bonds to lower interest rates or selling them to raise them.

💡Discount Rate

The discount rate is the interest rate at which commercial banks can borrow money from the central bank, typically on a short-term basis. The script mentions the discount rate as one of the tools the Fed can change to influence the economy, with adjustments potentially affecting the borrowing costs for banks and, by extension, the economy.

💡Reserve Requirements

Reserve requirements are the minimum amount of funds that banks must hold in reserve, either as cash or as deposits with the central bank. The script discusses how the Fed can change these requirements to control the money supply, with higher reserves potentially limiting the amount of money banks can lend out.

💡Expansionary Monetary Policy

Expansionary monetary policy is a strategy used by the Fed to stimulate economic growth by increasing the money supply and lowering interest rates. The script describes how this policy can be implemented through open market operations, such as buying bonds to lower interest rates and encourage investment and consumption.

💡Contractionary Monetary Policy

Contractionary monetary policy is the opposite of expansionary policy, where the Fed aims to reduce inflation by decreasing the money supply and raising interest rates. The script explains how the Fed might sell bonds in this scenario, which would increase interest rates and potentially reduce investment and consumption.

💡Aggregate Demand

Aggregate demand represents the total demand for all goods and services in an economy at a given period. The script discusses how the Fed's monetary policy can influence aggregate demand, with expansionary policy aiming to increase it and contractionary policy aiming to decrease it, in order to achieve economic stability.

💡Federal Funds Rate

The federal funds rate is the interest rate at which banks lend reserves to each other overnight. It is a critical target for the Fed's monetary policy, as it influences short-term lending rates and the flow of credit in the economy. The script highlights the importance of the federal funds rate in the Fed's efforts to control inflation and promote economic growth.

💡Inflation Targeting

Inflation targeting is a monetary policy strategy where the central bank sets a specific target for inflation and adjusts monetary policy to achieve that target. The script mentions the Fed's current approach to targeting a 2% inflation rate, illustrating how this strategy can help stabilize the economy by providing a clear goal for monetary policy.

💡Adverse Supply Shocks

Adverse supply shocks occur when there is a sudden decrease in the supply of goods or services, leading to higher prices and potentially causing inflation and recession. The script references OPEC's impact on oil prices as an example of an adverse supply shock, highlighting the challenges for monetary policy when dealing with such external factors.

Highlights

The Federal Reserve's goal is to influence economic activity to maintain a steady and constant growth rate.

The Fed uses tools such as open market operations, discount rate adjustments, reserve requirements, and interest rates on bank reserves to influence the economy.

Expansionary monetary policy aims to close recessionary gaps by shifting the aggregate demand curve to the right or up.

The Fed implements expansionary policy by buying bonds in the open market, which increases the money supply and reduces interest rates.

Lowering interest rates stimulates investment and interest-sensitive consumption purchases.

Contractionary monetary policy is used when inflation is perceived as a threat, involving selling bonds to increase interest rates.

Raising interest rates can reduce investment and consumption spending, as consumers may choose to save instead.

The Fed's independence from political institutions allows it to make decisions in the best interest of the nation without political influence.

The Fed sets targets for inflation and unemployment and uses monetary policy to steer the economy towards these targets.

The Federal Reserve fund rate is a key target, with the FOMC directing the New York Federal Reserve to adjust it through open market operations.

Monetary growth rate was a target under Paul Volcker's leadership, but it led to a double-dip recession.

The Fed currently focuses on the money supply and federal funds rate rather than strict monetary growth rate targets.

Controlling the price level or expected changes in the price level is a target for central banks, with the Fed aiming for a 2% inflation rate.

Difficulties with inflation targeting policies include adverse supply shocks that can lead to both inflation and recession.

Central banks focus on the expected rate of inflation, using models to predict and get ahead of inflationary trends.

There is a distinction between explicit and flexible inflation targeting policies, with the latter allowing for more adaptability.

The challenges of monetary policy include the difficulty of forecasting and the impact of external factors like OPEC decisions on oil prices.

Transcripts

welcome back to segment two class and

tonight we're going to talk about

monetary policy and M macroeconomic

variables and when we talk about what

the FED can do especially on monetary

policy there are some tools in the in

the fed's toolbox uh that they can use

to influence economic activity that's

that's the goal of the FED is to is to

influence economic activity so that it

keeps the growth

rate as steady and

constant

um as they have the capability to manage

so it again it's it's extremely

difficult to manage it you've got swings

we've talked about a roller coaster

route on the FED but some of the um some

of the tools that they can use is uh

through open market operation ations

they can buy and sell government bonds

they can change the discount rate we

talked about that they can change

reserve requirements again talked about

discount rate and reserve requirements

in chapter 11 and they can change

interest rate payable to Banks own

Reserve Holdings again that goes back to

I think it was chapter 11 and what

they're trying to do is they're trying

to drive the economic model for

aggregate demand and aggregate supply in

such way is to keep the economy moving

um hopefully in an upward position and

also at a um as a steady control growth

rate one thing that that the FED does

and the text want you to understand the

difference between expansionary monetary

policy and contractionary monetary

policy so expansionary monetary policy

the shed the the fed

shifts the aggregate demand curve uh in

trying to close recessionary Gap so

let's say they've identified a

recessionary gap and they're trying to

put together an expansionary monetary

policy that's going to shift that a

theand curve out to the right or up to

the right depending on how you want to

look at it and it's going to have close

that recessionary Gap and restore full

employment and the way the FED goes

about this is the Fed buys Bonds in the

open market again they're open market

operations strategy and as they as they

buy bonds it bids up the price of the

bond and remember what we talked about

the interest rate is the face value of

the bond minus the bond price divided by

the bond price and is the Fed bids up

those bond prices so the numerator of

that fraction or the numerator of that

ratio show is going to start getting

smaller because the bond price is

increasing also the denominator is going

to get larger because they're bidding up

the price on that Bond and what's going

to happen interest rates are going to

come

down the FED prints money to buy bonds

it increases the money supply and it

causes interest rates to come down again

they're bidding up the price of the

bonds competitive market bidding up

price of bonds and as those price those

bonds go up interest rates going to come

down and as the interest rates come down

it stimulates investment and the

interest sensitive consumption purchases

so again go back to um and I mentioned

it I don't want to say ad nauseum but

multiple times when you start to get

into these economic discussions and

especially on a test if there are

questions that you're having trouble

getting your arms around just go back to

the formulas and look at the formulas if

it's talking about monetary policy and

talking about the bond prices and what

it does to interest rates just think

about that formula it's a really easy

formula interest rates equal the face

value of the bond minus the bond price

divided by the bond price and as bond

prices go up and

down remember up and down on the bond

prices think about what that does to

your ratio and that will answer the

question on what it's going to do to the

interest

rate so conversely to the expansionary

policy you've got the contractionary

policy or the contractionary monetary

policy and the FED pursues

contractionary policy when the inflation

is perceived to be a threat well

sometimes inflation is a threat but um

and I'm not sure that any government

agency and and I don't include the fed

and the government agency but

um I think it's difficult

for any entity let's say that is trying

to forecast employment rates trying to

forecast inflation rates um it is just

really difficult given the data that not

only they have available to them but the

timelines that they have to evaluate

that data and how much of a lag is there

on the data that they're trying to use

to drive these policy decisions

and so on the contractionary policy what

the FED does is the Fed selles bonds

okay sales bonds lowers the price of the

bond because you're selling the bonds so

they're lowering the price of them and

it does what it increases the interest

rate remember lowers the price right so

numerator gets

bigger denominator gets

smaller and the ratio goes

up in the monetary Market Bond sales

reduce the money supply and raise the

interest rates reduces some investment

and some consumption spending remember

so as interest rates go up firms are

less likely maybe to

um be aggressive in investing and and

increasing their Capital stock and think

about the you know the consumer what's

the consumer going to do is interest

rates start to go up maybe the consumer

forego some current

consumption of goods and services pushes

it out to the Future takes some of that

transaction money some of that

precautionary money even some of their

specula money and invest it in interest

bearing accounts or interest bearing

assets to make some money on it so they

will forego a consumption now on the

consumer side in lie of um some

consumption in the future when the

interest rates head back in another

Direction problems and controversies

with monetary policy so you've got the

Board of Governors setting up here

making decisions you've got the fomc

making decisions um fortunately they're

independent of political instit you know

institutions and they reach decisions

they Implement quickly based on the

information that they have they

Implement quickly and they make

decisions quickly the best interest of

the nation without regards to prevailing

political winds that's extremely

important they're not the the FED is not

um I guess in the South you'll say

beholding but the FED is not beholding

to the political climate unless the

political climate for some reason

threatens to change the mandate that is

set up for the

fed and the FED as far as controversies

and and problems a lot of the fed's

problems stem from um the targets that

they set up the targets of policies

targets a monetary policy in this case

and it develops a set of targets to

achieve and the FED inter intervenes and

Eon in the economy pushes objectives

away from the target so they set a

target for inflation rate they set a

target for unemployment and as the

economy starts to push the metrics that

the information is giving them away from

these objectives or away from these

targets then at that point the FED

starts working their magic with monetary

policy to try to get uh the metrics back

closer to

targets andan as far as the the target

when we're talking about targets U let's

look at the interest rate um the key

role especially the Federal Reserve fund

rate that's that's on the interest rate

side the fomc directs New York Federal

Reserve to buy or sell bonds until the

federal funds rate hits whatever that

Target that the FED has set up so again

open market operations buying and

selling bonds until um they are going to

to at least hopefully hit that Federal

fund

rate um the FED buys bonds again here

we're talking about stimulation policy

fed buys bonds pumps new reserves into

the banking system Banks generate new

loans with you know new reserves the

interest rates on the loans go down and

it gets you know and they eventually hit

the federal funds rate which is the

Target that they've set up again

stimulation contraction fed sales bonds

again we've talked about that funds

received from the sale of the bonds are

drained from the money supply and you

know quote locked away in the federal

reserve's Vault and with fewer funds

available the funds rate Rises currently

the most important Target objective is

the interest rate from a feds

perspective and probably from the

economic perspective also

impact short-term lending rates drives

the flow of credit to households firms

and units of government so it's

impacting the it's impacting not only

the loan rates but it's driving the flow

of credit and money in and out of

households firms and even some

government

agencies second target so the interest

rates the first one the second target as

far as the fed's targets is a monetary

growth rate and then Paul vuler they go

back to Paul voker who was um one of the

chairs and in 1979 vuler targets strict

monetary growth to drive down

inflation he reduced

inflation but it led to a double dip

recession so again buer kind of you know

was it what they what they're referring

to now or what the economists are

referring to now it was the United

States

monetarist experiment um didn't go very

well for buker I mean he got to control

interest rates but um the recession um

that was driven um as a result of his

monetary policy um that didn't bod too

well for voo and his his approach to U

controlling the monetary policy and

inflation and now um monetary growth

rates are are no longer a specifically

reported Target the FED only focuses on

the money supplies and means to drive

federal funds rates so they still look

at at the monetary growth rates or the

monetary or the money supply as long as

they use it to drive the federal funds

rate so that's why they're they're

playing in in the money supply

Market the price level or expected

changes in the price level so now we've

got the third target 1980s and 1990s

countries struggled with inflation they

tried to emulate Germany and Japan

because they seem to have inflation

under control the target of policy in

many countries was trying to control the

price level the central banks especially

the efforts have reduced inflation

promoted and to some extent promoted

economic

stability currently the fed and and pal

who's you know the the current head of

the FED they target a systematic 2%

contraction or C Target a 2% rate and

they talk about contraction versus

stimulation so so they're looking at

contractionary method strategies they're

looking at stimulative strategies so

you've got you've got pal and think

about what pal has just been doing you

know trying to control price level you

know he's been you know bumping up the

interest rates so um I'm not sure even

though the inflation rate see 23 I I

can't remember what can't remember what

the expected yearly inflation rate's

going to be when 23 ends and what few

days

today's today is the eth yesterday was

Pearl Harbor day so today is the eth and

we've got another I don't know 23 days

to go

in this in this annual year or for till

the year is over so I'm not sure what

maybe the maybe the inflation rate for

this year is going to finish up at I

don't know 3% maybe

4% um still not great inflation rate but

better than the inflation rate that we

had in

2022 um there are some difficulties with

you know inflation targeting policies

and unfortunately um respond to

historical policy attempts we there

adverse Supply shocks and can incur both

inflation and in recession especially

what we saw in the Great Recession of

2008 um and if you want to talk about

adverse Supply shocks um think about our

our buddies in OPEC we talked about um

oil

prices I think they were talking about

it maybe in chapter three or chapter 4 I

can't remember one of the earlier

chapters in the text about the uh

historical oscillation or or wild swings

and fluctuations and oil prices OPEC

trying to control it um and the partners

are I don't even call them Partners uh

the individuals that participate in OPEC

um they have a hard time staying true to

U the desires of OPAC where they try to

use the supply to control and keep the

price of oil up so um those are those

are you know OPEC decisions um sometimes

significantly um impact um the economy

not only United States but in other

countries and you know with adverse

Supply shocks monetary policy at odds

with inflation and recession and and so

you do have a problem controlling

inflation and controlling recession

inflationary gaps recessionary gaps um

Central Bank Banks try to focus on the

expected rate of inflation and there's

kind of the past rate of inflation

there's the current rate of inflation

and then there's the expected rate of

inflation and it's a guessing game um

again economists develop these very

complicated intricate models and some

work some don't and um policy makers are

using these models to try to determine

the expected inflation rate and they're

basically what they're trying to do

they're trying to get out ahead of it

trying to get out of front of in front

of it to U even if it even if it goes

inflationary or recessionary Gap trying

to stay out far enough ahead of it so

that the swings and and the depths or

the the breadth of those gaps is not as

significantly damaging to the economy as

it would ordinarily

be um you've got explicit and you you

know versus flexible um inflation Target

policies and explicit you're looking at

you know developing um you know

inflation targeted policies and on the

flexible side you know they've already

developed and they want something that's

flexible and something that's not like

trying to turn the Titanic something

that you can um you develop and be

flexible and Implement and be able to

tweak as you go along and with that

we're going to stop again and when we

come back we're going to take uh up the

challenges of monetary policy so see by

back in a few

minutes