CH9 - Chapter 18 Monetary Policy: Using Interest Rates to...

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Chapter 18 Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy Chapter Overview The purpose of this chapter is to study three different links: the link from the central bank’s balance sheet to its policy tools; the link from the policy tools to the policymakers’ objectives; and the link from monetary policy to the real economy. We’ll begin with the operational details that define the tools central bankers have at their disposal. Then we’ll turn to a discussion of the relationship between those tools and the policymakers’ objectives, to explain why modern monetary policy is equivalent to interest rate policy. Finally, we’ll look at how the level of the target interest rate is chosen. To keep the discussion manageable, we’ll focus on monetary policy in large economies like the United States and the Euro area. In the next chapter, we’ll discuss exchange rates and issues that are important to central banks in small, open economies. Reading this chapter will prepare students to: Analyze how the Fed conducts monetary policy; Compare the tools and processes of the Fed to those of the ECB in the conduct of policy; and Explain the Taylor Rule and its depiction of the tradeoffs in goals faced by modern central banks. Important Points of the Chapter Central bankers have a long list of goals and a short list of tools they can use to achieve them. They are supposed to stabilize prices, output, the financial system, exchange rates, and interest rates, yet the only real power they have comes from their control over their own balance sheet and their monopoly on the supply of currency and reserves. To achieve their goals, policymakers can change the size of the monetary base by buying and selling assets – primarily government securities – and by making loans to banks. But as we saw at the end of the last chapter, modern central bankers cannot use these tools to control the quantity of money. Instead, they use them to control interest rates – both the market rate for reserves and the rate they charge for discount loans. These are the primary tools of monetary policy. Indeed, modern monetary policy is equivalent to interest rate policy. Application of Core Principles Principle #4: Markets (page 430) If the Fed wanted to, it could force the market federal funds rate to equal the target rate all the time by participating directly in the market for overnight reserves, both as a borrower and as a lender. The Fed has never done this because it does not want the credit risk that would come with uncollateralized lending and because policymakers Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 253
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Chapter 18 Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy believe that the federal funds market provides valuable information about the health of specific banks.
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This note was uploaded on 02/12/2012 for the course ECON 101 taught by Professor Abrams during the Spring '11 term at Adams State University.

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CH9 - Chapter 18 Monetary Policy: Using Interest Rates to...

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