If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The Fed’s open market operations determine the supply of reserves. The higher the federal funds rate, the smaller the quantity of reserves demanded. The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. The federal funds rate is determined in the market for reserves. An Open Market Sale : The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves.An Open Market Purchase : The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves.The Fed uses open market operations-the purchase or sale of government securities in the open market-to hit its federal funds target rate. Targeting rule : A decision rule, which sets the policy instrument at a level that makes the forecast of the ultimate policy goal equal to its target.įOMC minutes suggest that the Fed follow a targeting rule that sets the federal funds rate at a level that it forecasts will set the inflation rate equal to its targeted value.Instrument rule : A decision rule, which sets the policy instrument at a level that is based on the current state of the economy.The Fed can use two alternative decision-making strategies: Although the Fed can change the federal funds rate by any amount, it normally changes the federal funds rate one quarter of a percentage point at a time. The interest rate the Fed targets is the federal funds rate, which is the interest rate at which banks can borrow and lend reserves in the federal funds market (that is, the market for overnight loans of reserves). The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The Fed’s Decision-Making Strategy: Policy InstrumentsĪ monetary policy instrument is a variable that the Fed can directly control or closely target and that influences the economy in desirable ways. Price stability can mean a core inflation rate between one and two percent. Operational “Stable Prices” Goal: The Fed pays attention to the core inflation rate , which is the annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) excluding the prices of food and fuel.The Fed tries to minimize the output gap. A positive output gap leads to inflation a negative output gap results in unemployment. Operational “Maximum Employment” Goal: The Fed tracks the output gap , which is the percentage deviation of real GDP from potential GDP.A low inflation rate also means low long-term interest rates ( nominal interest rate is real interest rate plus inflation rate). Low inflation rates mean that people make decisions without the confusion created by inflation. Achieving stable prices, and keeping the inflation rate low and predictable is the source of maximum employment and moderate long-term interest rates.
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