How Does Monetary Policy Impact Macroeconomic Variables?

Summary

This segment delves into the Federal Reserve's monetary policy tools, such as open market operations, discount rate adjustments, and reserve requirements, aimed at stabilizing economic growth. It explains the concepts of expansionary and contractionary policies, their effects on interest rates, investment, and consumption, and the challenges of setting and meeting policy targets like inflation and unemployment rates. The script also touches on the Fed's independence and the complexities of forecasting economic variables.

Takeaways

• 🏛️ The Federal Reserve (FED) uses monetary policy tools such as open market operations, discount rate adjustments, reserve requirement changes, and interest rate adjustments on bank reserve holdings to influence economic activity.
• 📈 The goal of the FED is to manage economic growth by influencing aggregate demand and supply to maintain a steady and constant growth rate, which is challenging due to economic swings.
• 💹 Expansionary monetary policy is used to close a recessionary gap by shifting the aggregate demand curve to the right or up, which involves the FED buying bonds to decrease interest rates and stimulate investment and consumption.
• 📉 Contractionary monetary policy is pursued when inflation is a threat, involving the FED selling bonds to increase interest rates, reduce money supply, and decrease investment and consumption spending.
• 🤔 The FED faces difficulties in forecasting and managing employment and inflation rates due to the complexity of data analysis and the lag in economic data.
• 🎯 The FED sets targets for monetary policy, including inflation and unemployment rates, and uses monetary policy to adjust when actual metrics deviate from these targets.
• 📊 The Federal Reserve fund rate is a key target, with the FED using open market operations to adjust the federal funds rate to influence short-term lending rates and the flow of credit.
• 💰 Monetary growth rate used to be a specific target, but now the FED focuses on controlling the money supply to influence the federal funds rate.
• 📈 The FED currently targets a systematic 2% inflation rate, using both contractionary and stimulative strategies to manage price levels and economic stability.
• 🛠️ Central banks, including the FED, face challenges in controlling inflation and recession, especially in response to adverse supply shocks, which can complicate monetary policy decisions.
• 🔮 Policymakers use economic models to predict expected inflation rates, aiming to implement monetary policy proactively to minimize the impact of inflationary or recessionary gaps.

Q & A

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

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

What are the main tools the FED uses to influence economic activity?

The main tools the FED uses 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 FED use open market operations to implement expansionary monetary policy?

The FED implements expansionary monetary policy by buying government bonds in the open market, which increases the money supply and decreases interest rates, stimulating investment and consumption.

What is the relationship between bond prices and interest rates?

As bond prices increase, the numerator of the interest rate formula decreases, and the denominator increases, resulting in lower interest rates. Conversely, when bond prices decrease, interest rates increase.

How does the FED's contractionary monetary policy differ from its expansionary policy?

In contractionary monetary policy, the FED sells bonds, which decreases the money supply and increases interest rates, reducing investment and consumption to combat inflation.

What is the significance of the Federal Reserve's independence from political institutions?

The FED's independence allows it to make decisions in the best interest of the nation's economy without being influenced by prevailing political winds or agendas.

What are the targets of the FED's monetary policy?

The targets of the FED's monetary policy include interest rates, monetary growth rate, and the price level or expected changes in the price level.

Why did the FED shift from targeting monetary growth rates to focusing on the federal funds rate?

After the monetarist experiment led by Paul Volcker in the 1970s, which reduced inflation but also led to a recession, the FED shifted its focus to controlling the federal funds rate as a more effective means of managing the economy.

What is the current inflation target set by the FED?

The current inflation target set by the FED is a systematic 2% rate.

What are the challenges faced by the FED in controlling inflation and managing recessionary gaps?

Challenges include the difficulty in forecasting inflation and employment rates, the lag in economic data, and the impact of adverse supply shocks, such as fluctuations in oil prices.

How does the FED approach inflation targeting policies?

The FED targets a systematic inflation rate and uses various strategies, including expansionary and contractionary monetary policies, to manage price levels and control inflation.

Outlines

00:00

💼 Federal Reserve's Monetary Policy Tools

This paragraph discusses the Federal Reserve's (FED) role in influencing economic activity through monetary policy. The FED uses various tools, such as open market operations, changing the discount rate, and adjusting reserve requirements, to manage the economy's growth rate. The goal is to maintain a steady and constant growth rate, despite the inherent difficulty due to economic swings. The paragraph also explains the difference between expansionary and contractionary monetary policies, detailing how the FED uses bond purchases to lower interest rates and stimulate the economy during a recessionary gap. The process involves an increase in the money supply, which leads to a decrease in interest rates, encouraging investment and consumption.

05:00

📉 Challenges in Forecasting and Implementing Monetary Policy

The second paragraph delves into the challenges faced by the FED in forecasting employment and inflation rates, given the complexity of the data and the time lag in its availability. It explains how the FED implements contractionary policy by selling bonds to increase interest rates, which in turn reduces the money supply and curbs investment and consumption spending. The paragraph also touches on the FED's independence from political institutions and its mandate to make decisions in the nation's best interest, irrespective of political climates. The focus then shifts to the FED's policy targets, such as the federal funds rate and monetary growth rate, and the historical context of Paul Volcker's efforts to control inflation, which led to a recession.

10:00

🎯 The Fed's Policy Targets and Inflation Control

This paragraph examines the FED's policy targets, emphasizing the importance of the federal funds rate in influencing short-term lending rates and the flow of credit to various economic sectors. It also discusses the FED's past focus on monetary growth rates and the shift in recent years to concentrate on the money supply to affect the federal funds rate. The paragraph further explores the FED's targeting of the price level or expected changes in the price level, referencing the efforts in the 1980s and 1990s to control inflation by emulating the successful policies of Germany and Japan. The current approach of the FED, under the leadership of Jerome Powell, is highlighted, with a focus on achieving a systematic 2% inflation rate, and the challenges of inflation targeting policies, especially in response to adverse supply shocks.

15:03

🛠️ Strategies for Inflation Control and Policy Flexibility

The final paragraph discusses the strategies for controlling inflation, including the focus on expected inflation rates by central banks. It outlines the challenges of predicting inflation and the use of economic models by policymakers to forecast and mitigate potential economic gaps. The paragraph also contrasts explicit inflation targeting policies with more flexible approaches, emphasizing the need for adaptable strategies that can be adjusted in response to changing economic conditions. The discussion concludes with a mention of the difficulties posed by organizations like OPEC in controlling oil prices, which can significantly impact the global economy and complicate efforts to manage inflation and recession.

Keywords

💡Monetary Policy

Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve in the U.S., to manage the economy by adjusting the money supply and interest rates. In the video, it is the primary tool discussed for influencing economic activity, with the goal of maintaining steady and constant growth rates. The script mentions how the Federal Reserve uses various instruments within its toolbox to implement monetary policy.

💡Macroeconomic Variables

Macroeconomic variables are broad economic indicators that reflect the overall performance of an economy, such as GDP, inflation, and unemployment rates. The script discusses these variables in the context of how they are influenced by the Federal Reserve's monetary policy decisions, aiming to stabilize and steer the economy towards desired outcomes.

💡Federal Reserve (FED)

The Federal Reserve, often referred to as the FED, is the central banking system of the United States. It plays a crucial role in the video's discussion on monetary policy, as it is the institution responsible for implementing such policies to influence economic conditions. The script highlights the FED's independence from political pressures and its mandate to manage economic stability.

💡Open Market Operations

Open market operations are the buying and selling of government bonds by the central bank to adjust the money supply and influence interest rates. The script explains how the FED uses this tool to implement monetary policy, either by purchasing bonds to lower interest rates (expansionary policy) or selling bonds to raise them (contractionary policy).

💡Discount Rate

The discount rate is the interest rate at which commercial banks can borrow money from the central bank. In the script, it is mentioned as one of the tools the FED can adjust to influence the economy. A change in the discount rate can affect the borrowing costs for banks, which in turn can impact the money supply and economic activity.

💡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 amount of money banks have available to lend, thereby affecting the money supply and economic activity.

💡Interest Rate

Interest rates are the cost of borrowing money and are a key component of monetary policy. The script explains how the FED manipulates interest rates through open market operations to stimulate or restrain the economy. Lower interest rates encourage borrowing and spending, while higher rates can cool down an overheating economy.

💡Expansionary Monetary Policy

Expansionary monetary policy is a strategy employed by the central bank to stimulate economic growth by increasing the money supply and lowering interest rates. The script describes how the FED uses this policy to close a recessionary gap, aiming to restore full employment by shifting the aggregate demand curve.

💡Contractionary Monetary Policy

Contractionary monetary policy is the opposite of expansionary policy, where the central bank aims to reduce inflation by decreasing the money supply and raising interest rates. The script mentions this policy as a response to perceived inflation threats, with the FED selling bonds to increase interest rates and reduce economic activity.

💡Aggregate Demand and Supply

Aggregate demand and supply are economic concepts that refer to the total quantity of goods and services demanded and supplied in an economy. The script discusses how the FED's monetary policy tools are used to influence these aggregates in a way that promotes steady economic growth and avoids large fluctuations.

💡Inflation Targeting

Inflation targeting is a monetary policy strategy where the central bank sets a specific inflation rate and adjusts monetary policy to achieve that target. The script talks about the challenges and controversies of this approach, including the difficulty of forecasting inflation and the potential for adverse supply shocks.

Highlights

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

The Fed uses tools like open market operations, discount rate adjustments, and reserve requirements changes to manage the economy.

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

The Fed can stimulate the economy by buying bonds, which increases the money supply and decreases interest rates.

Interest rate changes affect investment and consumption by influencing the cost of borrowing.

Contractionary monetary policy is used when inflation is perceived as a threat, involving bond sales to reduce the money supply and increase interest rates.

The challenges of forecasting employment and inflation rates are highlighted, emphasizing the difficulty in managing economic policy.

The independence of the Federal Reserve from political institutions is crucial for making unbiased policy decisions.

The Fed's targets include interest rates, monetary growth rate, and the price level or expected changes in the price level.

The Federal Reserve fund rate is a key target, influencing short-term lending rates and the flow of credit.

Monetary growth rates are no longer a specifically reported target, with the Fed focusing on money supply to drive federal funds rates.

Inflation targeting policies have been implemented, aiming for a systematic 2% inflation rate.

Difficulties with inflation targeting include adverse supply shocks that can cause both inflation and recession.

Central banks focus on the expected rate of inflation, using models to predict and manage economic swings.

The distinction between explicit and flexible inflation targeting policies is discussed, with a preference for adaptable strategies.

The challenges of monetary policy include the need for quick decision-making and implementation based on available information.

The transcript concludes with a teaser for the next segment, which will discuss the challenges of monetary policy in more detail.

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

demand 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 reducing 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 invests 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 Bode 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 meth 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 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 C by

back in a few

minutes