Monetary Policy

Report
Monetary Policy and the Fed
A central bank is a type of banker’s bank
whose financial obligations underlie an
economy’s money supply
0The central bank in the U.S is the Fed
0If commercial banks need to borrow money, they
go to the central bank
0If there’s a financial panic and a run on banks, the
central bank is there to make loans
The ability to create money gives the central
bank the power to control monetary policy
The Federal Reserve System
0 The Federal Reserve Act of 1913 created the
Federal Reserve System
0 To provide for the establishment of Federal reserve
banks, to furnish an elastic currency, to afford means of
rediscounting commercial paper, to establish a more
effective supervision of banking in the United States,
and for other purposes
0 First United States Bank [ 1791 - 1811]
0 Second United States Bank [ 1816 - 1836]
0 The charters of both were allowed to lapse
0 The 1907 bank crises caused the public to demand the
government do something to keep this from happening
again
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Federal Reserve District
Banks
0 Each Federal Reserve District Bank is owned
by the several hundred member banks in that
district
0 A commercial bank becomes a member by buying
stock in the Federal Reserve District Bank
0 So, the Fed is a quasi public-private enterprise, not
controlled by the president or Congress
0 Effective control is really exercised by the Federal
Reserve Board of Governors in Washington, D.C.
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Federal Reserve System
• Board of Governors
– 7 appointed members
– Appointed by President
– Confirmed by Senate
• Sets reserve requirements
• Supervises & regulates
member banks
• Establishes and
administers regulations
• Oversees Federal Reserve
Banks
• 12 District Banks
• Propose discount rates
• Hold reserve balances
for member institutions
• Lends reserves
• Furnish currency
• Collects & clears checks
• Handle U.S. government
debt & cash balances
Federal Open Market Committee (Board of Governors plus 5 Reserve
Bank Presidents. This committee directs open market operations which
is the primary instrument of monetary policy
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The Federal Reserve System
Federal Reserve Districts are shaded.
Board of Governors of the Federal Reserve System
Federal Reserve Bank cities
Federal Reserve Branch cities
Boundaries of Federal Reserve Branch territories
12
Alaska
Seattle
1
9
Helena
Portland
Buf falo
2
Boston
Minneapolis
7
12
Chicago
Detroit
3
Cleveland
Omaha
Salt
Lake
City
San
Francisco
Kansas
10
Richmond
5
Charlotte
Nashville
Oklahoma
City
El
Paso
Little
Rock
Atlanta
Birmingham
Dallas
San
Antonio
Baltimore
Washington
St.
Louis
8
11
New York
Philadelphia
4
Denver
Los
Angeles
Pittsburgh
6
Jacksonville
Houston
New Orleans
12
Hawaii
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Miami
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The Federal Reserve System
Structure of the Fed
Board of Governors
7 members appointed by the
president and confirmed by the
senate
Oversees
Regional Reserve Banks
and Branches
12 regional Federal Reserve
banks and 25 branches
Federal Open Market Committee
(FOMC)
Board of Governors plus 5 Federal
Reserve bank presidents
Open Market Operations
FINANCIAL SECTOR
Provides Services
GOVERNMENT
Duties of the Fed
Conducts monetary policy (influencing the supply
of money and credit in the economy)
Supervises and regulates financial institutions
Lender of last resort to financial institutions
Provides banking services to the U.S. government
Issues coin and currency
Provides financial services to commercial banks,
savings and loan associations, savings banks, and
credit unions
The Tools of Conventional Monetary
Policy
The Fed influences the amount of money in
the economy by controlling the monetary base
0Monetary base is vault cash, deposits of the Fed,
and currency in circulation
Monetary policy affects the amount of
reserves in the banking system
0Reserves are vault cash or deposits at the Fed
0Reserves and interest rates are inversely related
Open Market Operations*
Open market operations are the primary way
in which the Fed changes the amount of
reserves in the system
0Open market operations are the Fed’s buying
and selling of Treasury bills and Treasury bonds
0To expand the money supply, the Fed buys
bonds
0To contract the money supply, the Fed sells
bonds
Open Market Operations*
An open market purchase is
expansionary monetary policy that tends
to reduce interest rates and increase
income
0When the Fed buys bonds, it deposits
money in its accounts at a bank
0Bank reserves are increased, and when
banks loan out the excess reserves, the
money supply increases
Open Market Operations*
An open market sale is a
contractionary monetary policy that
tends to raise interest rates and lower
income
0When the Fed sells bonds, it receives
checks drawn against banks
0The bank’s reserves are reduced and the
money supply decreases
The Federal Open-Market Committee (FOMC)
Boiling it down!
0 To fight recessions, the FOMC buys
securities
0This increases the rate of growth of the
money supply
0 To fight inflation, the FOMC sells securities
0This decreases the rate of growth of the
money supply
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Executing Open Market
Operations**
0To expand money supply, the Fed
buys bonds.
• To contract money supply, the Fed
sells bonds.
An Open Market Purchase
0 When the Fed buys bonds, it deposits the
money in federal government accounts at
a bank.
• Bank cash reserves rise, encouraging
banks to lend out the excess.
• The money supply rises.
An Open Market Sale
0 When the Fed sells bonds,
• In return for the bond, the Fed receives a
check drawn against a bank.
• The bank’s reserve assets are reduced and
money supply falls.
The Reserve Requirement and the
Money Supply
The reserve requirement is the percentage the Fed
sets as the minimum amount of reserves a bank must
have
 There are other ways the Fed can impact the banks’ reserves
• The Fed can directly add to the banks’ reserves
• The Fed can change the interest rate it pays banks’ on their
reserves
• The Fed can change the Fed funds rate, the rate of interest at
which banks borrow the excess reserves of other banks
Changing Reserve
Requirements
0 The Federal Reserve Board has the power to change
reserve requirements within the legal limits of 8 and
14% for checkable deposits
0 Changing reserve requirements is the ultimate weapon
and is rarely used
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-43
Borrowing from the Fed and the
Discount Rate
In case of a shortage of reserves, a bank can borrow
reserves directly from the Fed
The discount rate is the interest rate the Fed charges
for those loans it makes to banks
0 An increase in the discount rate makes it more expensive to
borrow from the Fed and may decrease the money supply
0 A decrease in the discount rate makes it less expensive to
borrow from the Fed and may increase the money supply
The Fed Funds Market
Banks with surplus reserves loan these
reserves to banks with a shortage in reserves
0Fed funds are loans of excess reserves banks
make to each other
0Fed funds rate is the interest rate banks charge
each other for Fed funds
By selling bonds, the Fed decreases reserves,
causing the Fed funds rate to increase
By buying bonds, the Fed increases reserves,
causing the Fed funds rate to decrease
Changing the Discount Rate*
0 An increase in the discount rate makes it
more expensive for banks to borrow from
the Fed.
• A decrease in the discount rate makes it
less expensive for banks to borrow from
the Fed.
The Fed Funds Rate
and the Discount Rate since 1990
The Federal Reserve Bank follows
expansionary or contractionary
monetary policy by targeting a lower
or higher Fed funds rate
9%
8%
7%
Fed funds rate
6%
5%
4%
Discount rate
3%
2%
1%
0%
1990
1994
1998
2002
2006
2010
2014
Offensive and Defensive Actions
Defensive actions are designed to maintain
the current monetary policy
0The Fed buys bonds during emergencies
0Reserves would otherwise decrease because
individuals and businesses don’t get to the bank
with their cash
Offensive actions are designed to have
expansionary or contractionary effects on the
economy
The Fed Funds Rate as an Operating Target
Monetary policy affects interest rates
The Fed looks at the Federal funds rate and
other targets to determine whether monetary
policy is tight or loose
If the Fed funds rate is above the Fed’s target
range, it buys bonds to increase reserves and
lower the Fed funds rate
If the Fed funds rate is below the Fed’s target
range, it sells bonds to decrease reserves and
raise the Fed funds rate
The Complex Nature of Monetary Policy
While the Fed focuses on the Fed funds rate as its
operating target, it also has its eye on its ultimate
targets: stable prices, acceptable employment,
sustainable growth, and moderate long-term interest
rates
Fed tools
Open market
operations,
Discount rate,
and Reserve
requirement
Operating target
Fed funds rate
Intermediate targets
Consumer confidence
Stock prices
Interest rate spreads
Housing starts
Ultimate targets
Stable prices
Sustainable growth
Acceptable
employment
Moderate i rates
The Taylor Rule
The Taylor rule is a useful approximation for
predicting Fed policy
Formally the Taylor rule is:
Fed funds rate = 2% + Current inflation
+ 0.5 x (actual inflation less desired
inflation)
+ 0.5 x (percent deviation of aggregate
output from potential)
Limits to the Fed’s Control of the Interest Rate
 The Fed may not be able to shift the entire yield curve up or
down, but may make it steeper, flatter or inverted
 A yield curve is a curve that shows the relationship between
interest rates and bonds’ time to maturity
 An inverted yield curve is one in which the short-term rate
is higher than the long-term rate
 As financial markets become more liquid, and technological
changes occur, the Fed’s ability to control the long-term
rate through conventional monetary policy lessens
8
8
7
7
Yield (interest rate)
Yield (interest rate)
The Yield Curve
6
5
4
3
6
5
4
3
2
2
1
1
1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr.
Time to maturity
Yield Curve
1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr.
Time to maturity
Inverted Yield Curve
Summary: The Tools of
Monetary Policy
0 To fight recession, the Fed will
0 Lower the discount rate
0 Buy securities on the open market
0 Lower reserve requirements
0 This would be done only as a last resort
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-46
Summary: The Tools of
Monetary Policy
0 To fight inflation, the Fed will
0 Raise the discount rate
0 Sell securities on the open market
0 Raise reserve requirements
0 This would be done only as a last resort
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
14-47

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