Bond Fundamentals – Monetary Policy and Fiscal Policy

It’s the Federal Reserve Bank that influences the money supply. Three tools are used to implement monetary policy:

  1. Open Market Operations
  2. Discount Rates
  3. Reserve Requirements

Since open market operations is the tool used most, we will cover it. Here’s how it works: When the economy is growing too fast and the Fed is worried about the inflation rate, it will sell government securities from its portfolio to the open market. This decreases bank reserves, which means the money supply decreases. When there are less bank and businesses have to pay the bank more in order to borrow. This discourages consumers and businesses from borrowing. Less borrowing means less spending, which slows the economy and eventually can reduce price pressures.

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Uncertainty and monetary policy rules in the United States

“Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape” (Greenspan 2003).

Uncertainty is a central issue in monetary policy, as the quote from Alan Greenspan above illustrates. Empirical models, however, rarely take account of this, effectively assuming that policymakers ignore uncertainty. The evident focus of policymakers on uncertainty suggests that this assumption is invalid and therefore that empirical models of monetary policy must account for uncertainty. This article considers the effects of uncertainty about the true state of the economy on monetary policy, estimating a monetary policy rule that allows for this.

Our empirical model combines elements of Svensson’s (1997) model of inflation forecast targeting with models drawn from the theoretical literature on optimal monetary policy when there is uncertainty about the true state of the economy, most prominently Svensson and Woodford (2003, 2004) and Swanson (2004). In existing models of monetary policy under certainty, monetary policy affects inflation and the output gap directly, so it is optimal for policymakers to use these variables in forming monetary policy. This is the basis for the Taylor rule (Taylor 1993) model of monetary policy and its subsequent refinements (e.g., Woodford 2003).

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Has Monetary Policy Been So Bad That It Is Better to Get Rid of It? The Case of Mexico

MANY LATIN AMERICAN COUNTRIES are considering adopting the U.S. dollar as legal currency, and some, like Ecuador, have taken concrete steps in that direction. Proponents of dollarization generally hold the view that domestic monetary policy has been the primary cause for the economic instability experienced by these countries in the past three decades. Yet, at least for Mexico, very few empirical studies have tried to identify the role of monetary policy.

The existing empirical literature on Mexican monetary policy consists mainly of single equation estimations (see Calvo and Mendoza 1996 and Kamin and Rogers 1996), or of reduced-form vector autoregressions (see Copelman and Werner 1995 and Hernandez 1999).(1) The first class of models is silent on the impact of monetary policy on the rest of the economy. The second class of models, by definition, cannot identify monetary policy. In addition, all previous literature has either ignored the issue of changes in regime, or has confined itself to the study of monetary policy within regimes. This despite the fact that some of Mexico’s major crises occurred during the passage from one regime to another. A proper evaluation of the impact of monetary policy on the Mexican economy requires that these critical transition periods are considered.

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