Transcript The Federal Reserve and Economic Goals

Chapter 13
The Tools and Goals of Central
Bank Monetary Policy
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Learning Objectives 
 To understand how the policy tools
available to central banks work in
carrying out money and credit policies.
 To discover how the Federal Reserve
System controls U.S. credit and interest
rate levels.
 To see how central bank policy actions
affect a nation’s economic goals.
 To learn about the difficulties that central
banks face in achieving policy goals.
13-3
Introduction
 Central banks are given the task of
regulating the money and credit system
in order to achieve the economic goals
of maximum employment, a stable
price level, and sustainable economic
growth.
 Although these objectives are not easy
to achieve and often conflict, the
central bank has powerful policy tools
at its disposal.
13-4
General versus
Selective Credit Controls
General credit controls affect the entire
banking and financial system
 Reserve requirements
 Discount rate
 Open market operations
Selective credit controls affect specific
groups or sectors of the financial system
 Moral suasion
 Margin requirements on the purchase of
listed securities
13-5
Open Market Operations
 Open market operations in the U.S. consist
of buying and selling of U.S. government
securities by the Federal Reserve System
 Affects the quantity and growth of legal
reserves
 Impacts general credit conditions
 Open market operations are a most flexible
policy tool
 Suitable for fine-tuning the financial
markets
 Primary policy tool of the Fed
13-6
Open Market Operations
 The open market tool has two major effects
 When the Fed is purchasing securities
 Additional market demand for the securities
 Tends to increase their prices
 Lower their yields and interest rates decline
 A Fed purchase of government securities
 Increases banking system reserves
 Expands its ability to make loans
 Create deposits
 Increasing the growth of money and credit
13-7
Open Market Operations
13-8
Open Market Operations
13-9
Open Market Operations
 Trading in securities by the Federal Reserve
System
 Carried out through the System’s Trading Desk
 Located at the Federal Reserve Bank of New York
 The Desk is supervised by the manager of the
System Open Market Account (SOMA)
 The manager is guided by policy directives from
Federal Open Market Committee (FOMC) meetings
 Checked through conference calls
13-10
Open Market Operations
Federal Open Market Committee Statement
13-11
Types of Federal Reserve
Open Market Transactions
Outright or Straight Open Market Transaction
(permanent change in the level of reserves
held by depository institutions)
Fed buys
securities
Fed sells
securities
Federal
Reserve
bank
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Securities
Dealer
Reserves
Dealer’s
bank
13-12
Types of Federal Reserve
Open Market Transactions
RP or Reverse RP Transaction
(temporary change in the level of reserves held by
depository institutions)
RP: Fed buys securities
temporarily
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Later:
Reserves
Securities returned
Reverse RP: Fed sells
securities temporarily
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Later:
Reserves
Securities returned
13-13
Types of Federal Reserve
Open Market Transactions
Run-Off Transaction
(permanent reduction in the level of reserves held
by depository institutions)
Federal
Reserve
bank
Maturing Treasury
securities
Treasury
Pays cash
Reserves
Sells more securities
to raise more cash
Dealer
Orders bank to pay
for the new securities
Dealer’s
bank
13-14
Types of Federal Reserve
Open Market Transactions
Agency Transaction (Type A)
(no change in the total level of reserves held by all
depository institutions)
Places order for securities
through a Federal Reserve bank
which then contacts dealer
Federal
Reserve
Dealer
customer
Delivers securities
Orders payment
to dealer
Customer’s
bank
Reserves
Dealer’s
bank
13-15
Types of Federal Reserve
Open Market Transactions
Agency Transaction (Type B)
(permanent reduction in the level of reserves held
by depository institutions)
Federal
Reserve
customer
Places order for securities
Securities delivered from
Orders Fed’s own portfolio
payment
to Fed
Reserves
Customer’s
bank
Federal
Reserve
bank
13-16
The Discount Rate
 The discount rate is the interest rate
that the Federal Reserve banks charge
on loans they grant to other institutions
(principally banks and security dealers)
 These loans are regarded as temporary
credit
 Are a backup source of funds to the
money market
 Credit is usually more expensive than in
the money market
13-17
The Discount Rate
 In 2003, the Fed redesigned the process
 Primary credit is extended only to sound
depository institutions
 Secondary credit
 Intended for those who do not qualify for
primary credit
 Cannot be used for asset expansion
 Seasonal credit
 For relatively small depository institutions
 Matching a pattern of seasonal fluctuations
in their deposits and loans
13-18
The Discount Rate
 Fed recently started setting the discount
rate on primary and secondary credit
above the target rate on federal funds
 Encourages depository institutions to borrow
in the fed funds market
 Makes the discount rate a passive policy tool
 The new policy ensures a “no hassle” supply
of primary credit to sound depository
institutions facing emergencies
 The primary credit rate also serves as a cap for
the prevailing market rate on federal funds
13-19
The Discount Rate
13-20
The Discount Rate
13-21
The Discount Rate
 An increase in the discount rate
 Reduces the volume of loans from the
discount window (cost effect)
 Makes borrowing from the Fed less attractive
(substitution effect)
 Signals that the Fed is pushing for tighter
credit conditions (announcement effect)
 Market participants may respond by
curtailing their spending plans
 Or may accelerate their borrowings (to
borrow before interest rates move even
higher)
13-22
Reserve Requirements
 In the U.S., all depository institutions are
required to conform to the deposit
reserve requirements set by the Fed
 Changes in reserve requirements are a
very potent, though little-used tool
 Recent legislation authorizes
 The Fed to pay interest on member balances
 Allow the Fed to adjust reserve requirements
downward as low as zero
 Scheduled for October 1, 2011
13-23
Reserve Requirements
 An increase in deposit reserve
requirements
 Decreases the deposit and money multipliers
 Slowing the growth of money, deposits and
loans
 Reduces the amount of excess legal reserves
 Institutions deficient in required legal
reserves will have to sell securities, cut back
on loans, or borrow reserves
 Increases interest rates as depository
institutions scramble to cover any reserve
deficiencies
13-24
Effect of Changes in Reserve Requirements
on Deposits, Loans, and Investments
13-25
Effect of Changes in Reserve Requirements
on Deposits, Loans, and Investments
13-26
Current Levels of
Reserve Requirements
The required reserves are a function
of the type of account
 Transaction accounts
 Deposits to make payments by
negotiable or transferable instruments
 Checking accounts and NOW
 Nonpersonal time deposits
 Interest-bearing time deposits
 Savings deposits and MMDAs
 Eurocurrency liabilities
13-27
Current Levels of
Reserve Requirements
13-28
Selective Credit Controls
Used by the Fed
 Moral suasion
 Use of “arm-twisting” or “jawboning” by
central bank officials
 Encourage lending institutions and the
public to conform with the spirit of its
policies
13-29
Selective Credit Controls
Used by the Fed
 Margin requirements
 Limit the amount of credit that can be used
as collateral for a loan
 Since 1974, the U.S. margin requirement
has been 50% of the market value of the
securities
 Stocks
 Convertible bonds
 Short sales
13-30
Selective Credit Controls
Used by the Fed
13-31
Interest Rate Targeting
 In recent years, central banks have given
increasing weight to targeting the cost and
availability of credit in the money market
 Charged with stabilizing market conditions
 Assure a smooth flow of funds from savers to
borrowers
 Ensure the government security market
functions smoothly
 Adequate supplies of credit are available to
security dealers
 Federal government can easily market debt
13-32
Interest Rate Targeting
The Fed adopted a federal funds interest
rate targeting procedure in 1989
In 1994 the Fed adopted a new policy
 Openness
 Informing the public immediately of changes
Fed adjusts target rate incrementally
 Over an extended period of time
 Typically 25 to 50 basis points at a time
(policy inertia)
 Also provide indicator of bias
13-33
Interest Rate Targeting
13-34
Interest Rate Targeting
 Borrowed reserves are loans made to
depository institutions by the Federal
Reserve banks
 Nonborrowed reserves are legal reserves
that belong to depository institutions
 The Fed achieves its target through open
market operations that impact primarily the
nonborrowed reserves (and hence the total
reserves) available to the banking system
13-35
Interest Rate Targeting
13-36
Interest Rate Targeting
 Fed’s activities may differentially
impact long-term and short-term
interest rates
 For example, a decision that lowers
short term rates but generates higher
inflationary expectations
 May push long-term interest rates upward
 Capital market investors seek
compensation for the fear of greater
inflation
13-37
The Federal Reserve and
Economic Goals
The goal of controlling inflation
 Inflation creates undesirable distortions in
the allocation of scarce resources
 In the 1990s, several central banks (such as
New Zealand, Canada, and U.K.) began
setting target inflation rates or rate ranges.
 The U.S. has not set an explicit target,
though it seeks to drive inflation so low that
it does not affect business and consumer
decisions
13-38
The Federal Reserve and
Economic Goals
13 - 39
13-39
The Federal Reserve and
Economic Goals
Jury is out on central bank inflation
targeting
 Central bank most likely institution to follow
strategy
 Some central bankers hesitant to set
specific numerical inflation-rate targets
 Fear a loss of flexibility
 Fear adverse consequences of public
learns target has been missed
Room for more evidence of benefits and
costs of inflation targeting
13-40
The Federal Reserve and
Economic Goals
Deflation is a decline in the overall
price level
 Can be disruptive to price stability
 Quantitative easing is one potential
solution
 Rapid injection of reserves into
financial system
 Very low interest rates
 Japan tried this with mixed success
13-41
The Federal Reserve and
Economic Goals
Hyperinflation is very high inflation
 Many economies have had bouts of
hyperinflation in recent years
 Brazil, Argentina, Israel, etc.
 In some cases inflation exceeded 1000%
per year
 Difficult to live in environment
 Prices change daily
 Currency loses value quite fast
 Significant change in behavior to protect
wealth
13-42
The Federal Reserve and
Economic Goals
Economies suffering from
hyperinflation typically perform
poorly
 Eliminating hyperinflation is painful to
the economy
 Higher unemployment
 Lower or negative economic growth
 Once hyperinflation is eliminated,
employment and growth recover
13-43
The Federal Reserve and
Economic Goals
The Goals of full employment and stable
economic growth
 For over fifty years
 The Fed has also been committed to
achieving the highest level of employment
 Consistent with sustainable long-run
economic growth
13-44
The Federal Reserve and
Economic Goals
Natural rate of unemployment
Some unemployment is inevitable
 The unemployment rate is the percentage
of the workforce actively seeking
employment but are not currently working
 Frictional unemployment
 Temporary unemployment of job seekers
 If all unemployment is frictional, the
unemployment rate is referred to as the
natural rate of unemployment
13-45
The Federal Reserve and
Economic Goals
What is the natural rate of
unemployment?
 During the 1950s and 1960s it was believed to
be 5-5.25%
 During the 1970s and 1980s the expectation
changed to be 6-6.25%
 However during the 1980s there was a
reversal
 Unemployment started to trend down
 Today the expected natural rate of
unemployment is back down to about 5%
13-46
The Federal Reserve and
Economic Goals
13-47
The Federal Reserve and
Economic Goals
Challenges of predicting the future
natural rate of unemployment
 Technology has altered demand for highskilled workers
 Educational and technical training impact
future natural rates of unemployment
13-48
The Federal Reserve and
Economic Goals
Potential GDP
 Alternate method of determining
economic potential
 Measures what GDP would be if the
economy were at full employment
 Then measure GDP gap
 Difference between potential GDP and
actual GDP
 A negative GDP gap is a sign that the
economy is underperforming
13-49
The Federal Reserve and
Economic Goals
13-50
The Conflicting Goals and
Limitations of Monetary Policy
 Challenge to assess economic
performance
 Difficult to identify imbalances
 Monetary policy has implications for both
current and future imbalances
 The uncertainty of assessing the economy
might explain monetary policy inertia
 A slow approach may be the best strategy
 Minimize the implications of a mistake
 Even more, the economy is dynamic
13-51
The Conflicting Goals and
Limitations of Monetary Policy
 This uncertainty has led to a great deal
of caution by central bankers
 Further policy goals can sometimes
conflict with one another
 Any action might negatively impact one of
the factors they are trying to control
 Central banks have typically been tasked
principally to control inflation
 Monetary policy can be effective at
fighting inflation
13-52
The Limitations of Monetary Policy
 Central banks cannot completely control
financial conditions or the money supply
 There seems to be a tradeoff between
variability in inflation versus variability in
output and employment
 Other problems exist as well
 Economic changes feed back on the
money supply and the financial markets
 The structure of the economy is changing
 Central banks have limited ability to impact
long-term rates and the economy
13-53
Markets on the Net
Answers.com at answers.com
Bank of Canada at
www.bankofcanada.ca/en
Bank of England at
www.bankofengland.co.uk/
Bank of Japan at www.boj.or.jp
Chicago Board of Trade at
www.cbot.com
Complianceheadquarters at
www.complianceheadquarters.com
13-54
Markets on the Net
Economagic.com at www.economagic.com
Electronic Code of the Federal Regulations
at ecfr.gpoaccess.gov
European Central Bank www.ecb.int
Fed 101 at
www.federalreserveeducation.org/Fed101
Federal Open Market Committee at
www.federalreserve.gov/fomc
Federal Reserve Bank of Cleveland at
www.clevelandfed.org
13-55
Markets on the Net
 Federal Reserve Bank of New York at
newyorkfed.org
 Federal Reserve Bank of San Francisco
at frbsf.org
 Federal Reserve System at
www.federalreserve.gov
 Finra at www.finra.org
 Interest-Rate Targeting at
www.federalreserve.gov/fomc
13-56
Markets on the Net
 Investopedia.com at
www.investopedia.com
 Investorwords.com at
www.investorwords.com
 Howstuffworks at
money.howstuffworks.com
 Money-rates.com at www.money-rates.com
 Morgan Lewis at www.morganlewis.com
 NBER at www.nber.org
 NYSE Euronext at www.nyse.com
13-57
Markets on the Net
RePEc at ideas.repec.org
Reserve Bank of New Zealand at
www.rbnz.govt.nz
The Discount Window at
www.frbdiscountwindow.org
The Free Dictionary at
www.thefreedictionary.com
Wikipedia at en.wikipedia.org
13-58
Chapter Review
 Introduction to the tools and goals of
monetary policy
 General versus selective credit controls
 General credit controls of the Fed
 Open market operations
 The Federal Reserve’s discount rate
 Reserve requirements
13-59
Chapter Review
 Selective credit controls used by the
Fed
 Moral suasion by central bank officials
 Margin requirements
 Interest rate targeting
 The federal funds rate
 Fed funds targeting and long-term interest
rates
13-60
Chapter Review
 The Federal Reserve and economic goals
 The goal of controlling inflation
 The goal of maximum employment
 The goal of sustainable economic growth
 Monitor unemployment
 The natural rate of unemployment
 The potential GDP
 The trade-offs among central bank goals
 The limitations of monetary policy
13-61