Transcript Chapter No. 9

Money, Banking, and Financial Markets
: Econ. 212
Stephen G. Cecchetti Monetary Policy:
Using Interest Rates to Stabilize the Domestic
Economy
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
The Federal Reserve’s Monetary Policy Toolbox
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The central bank can control the quantity of reserves that
commercial banks hold.
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Besides the quantity of reserves, the central bank can
control either the size of the monetary base or the price of its
components.
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The two prices it concentrates on are the interest rate at
which banks borrow and lend reserves overnight (the
federal funds rate) and the interest rate at which banks can
borrow reserves from the Fed (the discount rate).
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The central bank has three monetary policy tools, or
instruments: the target federal funds rate, the discount rate,
and the reserve requirement.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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The Target Federal Funds Rate and Open Market
Operations
The target federal funds rate is the FOMC’s primary policy
instrument. FOMC meetings always end with a decision on
the target level, and the statement that is released after the
meeting begins with an announcement of that decision.
The federal funds rate is determined in the market, rather
than being controlled by the Fed.
The name “federal funds” comes from the fact that the
funds banks trade are their deposit balances at the Fed.
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.
As a lender, the Fed would need to make unsecured loans to
commercial banks, and as a borrower, the Fed would in
effect be paying interest on excess reserves.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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The Fed has never done this because it does not want the
credit risk that would come with uncollateralized lending,
because policymakers believe that the federal funds market
provides valuable information about the health of specific
banks, and because the Fed has stated it will only pay
interest on reserves at the request of Congress.
The Fed chooses to control the federal funds rate by
manipulating the quantity of reserves through open market
operations: the Fed buys or sells securities to add or drain
reserves as required.
Day-to-day control of the supply of federal funds is the job
of the Open Market trading desk at the New York Federal
Reserve Bank.
Most days the market rate is close to the target rate,
although on occasion there have been spikes in the market
rate. These surprises have become less frequent as
information systems at banks and at the Fed have improved.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Discount Lending, the Lender of Last Resort and Crisis
Management
Lending to commercial banks is not an important part of the
Fed’s day-to-day monetary policy.
However, such lending is the Fed’s primary tool for ensuring
short-term financial stability, for eliminating bank panics,
and preventing the sudden collapse of institutions that are
experiencing financial difficulties.
The central bank is the lender of last resort, making loans to
banks when no one else can or will, but a bank must show
that it is sound to get a loan in a crisis.
The current discount lending procedures also help the Fed
meet its interest-rate stability objective.
The Fed makes three types of loans: primary credit,
secondary credit, and seasonal credit.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Primary credit is extended on a very short-term basis, usually
overnight, to sound institutions. It is designed to provide
additional reserves at times when the day’s reserve supply
falls short of the banking system’s demand. The system
provides liquidity in times of crisis, ensures financial stability,
and restricts the range over which the market federal funds
rate can move (helping to maintain interest-rate stability).
Secondary credit is available to institutions that are not
sufficiently sound to qualify for primary credit. Banks may
seek secondary credit due to a temporary shortfall in reserves
or because they have longer-term problems that they need to
work out.
Seasonal credit is used primarily by small agricultural banks
to help in managing the cyclical nature of farmers’ loans and
deposits.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Reserve Requirements
By adjusting the reserve requirement, the central bank can
influence economic activity because changes in the
requirement affect deposit expansion.
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Unfortunately, the reserve requirement turns out not to be
very useful because small changes in the reserve requirement
have large (really too large) impacts on the level of deposits.
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Today, the reserve requirement exists primarily to stabilize
the demand for reserves and help the Fed to maintain the
market federal funds rate close to target; it is not used as a
direct tool of monetary policy.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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Linking Tools to Objectives: Making Choices
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Desirable Features of a Policy Instrument
A good monetary policy instrument is easily observable by
everyone, is controllable and easily changed, and is tightly
linked to the policymakers’ objectives.
These requirements leave policymakers with few choices,
and over the years central banks have switched between
controlling the quantity and controlling the prices.
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Operating Instruments and Intermediate Targets
Operating instruments refer to actual tools of policy,
instruments that the central bank controls directly.
Intermediate target refers to instruments that are not
directly under the control of the central bank but that lie
between their policymaking tools and their objectives.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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A Guide to Central Bank Interest Rates: The Taylor Rule
A simple formula approximates what the FOMC does,
tracking the behavior of the target federal funds rate and
relating it to the real interest rate, inflation, and output.
The formula is:
Target Fed Funds rate = 2½ + current inflation + ½
(inflation gap) + ½ (output gap)
The 2½ term is the assumed long-term real interest rate. The
inflation gap is current inflation minus an inflation target,
and the output gap is current GDP minus its potential level.
When inflation rises about its target level, the response is to
raise interest rates; when output falls below the target level,
the response is to lower interest rates.
One interesting property of the Taylor Rule is that increases
in inflation raise the real interest rate.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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The “½” terms in the equation depend on how sensitive the
economy is to interest rate changes and on the preferences of
central bankers.
Some caveats: the Taylor Rule is too simple to take into
account sudden threats to financial stability. Also, the lack
of real-time data limits its usefulness in ongoing
policymaking.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Lessons of Chapter 18
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The Federal Reserve has three monetary policy tools.
The target federal funds rate is the primary instrument of monetary policy.
Open market operations are used to control the federal funds rate.
The Fed forecasts the demand for reserves each day and then supplies the amount
needed to meet the demand at the target rate.
The discount lending rate is used to supply funds to banks primarily during crises.
The Fed sets the primary lending rate 100 basis points above the target federal funds
rate.
In setting the primary lending rate above the target federal funds rate, the Fed is
attempting to stabilize the interest rate on overnight interbank lending.
The Fed also makes loans to banks in distress, through the secondary lending
facility, and to banks in need of seasonal liquidity.
Reserve requirements are used to stabilize the demand for reserves.
Banks are required to hold reserves against certain deposits.
Banks can hold either deposits at Federal Reserve Banks or vault cash, neither of
which earns interest.
Reserves are accounted for in such a way that everyone knows the level of reserves
that is required several weeks before banks must hold them.
The European Central Bank’s primary objective is price stability.
The ECB provides liquidity to the banking system through weekly auctions called
refinancing operations.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
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The minimum bid rate on the main refinancing operations, also know as the targetrefinancing rate, is the target interest rate controlled by the Governing Council.
The ECB allows banks to borrow from the marginal lending facility at an interest
rate that is 100 basis points above the target-refinancing rate.
Banks with excess reserves can deposit them at central bank and receive interest at
100 basis points below the target-refinancing rate.
European banks are required to hold reserves. They receive interest on their
balances at a rate that is equal to the average of the rate in recent refinancing
operations.
Monetary policymakers use several tools to meet their objectives.
The best tools are observable, controllable, and tightly linked to objectives.
Short-term interest rates are the best tools for monetary policymaking.
Modern central banks do not use intermediate targets like money growth.
The Taylor rule is a simple equation that describes movements in the federal funds
rate. It suggests that
When inflation rises, the FOMC raises the target interest rate by 1½ times the
increase.
When output rises above potential by 1 percent, the FOMC raises the target interest
rate ½ a percentage point.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University