Transcript tighten monetary policy

Monetary policy
Creation of the Fed
In 1913 Congress authorized the Federal Reserve as the U.S. central
bank
The third time it had created one—the charters of the previous
central banks were allowed to expire, largely because Americans
expressed suspicion about the East Coast financial establishment
controlling credit and currency.
Prior to 1913 the country suffered several recessions (panics) in the
19th century and a severe one in 1907; one that was worsened by
the inability of private banks to produce the currency demanded by
depositors.
The 1907 Panic prodded Congress to create our present central bank.
Creation of
the Fed
Populist aversion to the concept remained, however—thus, Congress established 12 central banks, supervised by a relatively
weak Federal Reserve Board in Washington.
Within this Federal Reserve System existed 12 independent Regional banks and 25 branch offices.
The private banks that the Fed was to serve provided the Fed’s seed money, but they have virtually no control over central
bank.
Evolution of the Fed
As the importance of a national monetary policy increased, power to conduct it was eventually concentrated in
Washington. Because monetary actions can be unpopular, Congress has insulated the Fed from day-to-day political
pressures by staggering the 14 year terms of the seven governors who serve on the Board of Governors. In addition,
the Fed does not need appropriations from Congress to operate.
Evolution of the Fed
The 12 regional banks still exist, but
they largely coordinate their actions
through the board of governors.
Job of the Fed (the end)
• The Fed’s job involves being alert for signs of
recession or accelerating inflation and conducting
monetary policy aimed at preventing either.
• The twin goals of the Fed: price stability (i.e.
curbing inflation) and full employment (i.e.
promoting economic growth.
• These twin goals, if/when met result in continued
and sustainable economic prosperity.
• Achieving these goals requires quite a balancing
act.
The Fed’s balancing act:
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There are times when money is difficult to obtain, loans become expensive and
individuals and businesses don’t spend. People lose jobs because such items as cars
and airline tickets are not purchased or new buildings are not built. If not enough
money is available and loans are expensive and hard to obtain, people spend less.
Businesses then produce fewer goods and services than they are capable of
producing. They lay off workers and slow investments. If production declines for
many months, in what is called a recession, people can lose jobs.
At other times, lots of people have jobs, money seems easy to obtain and people and
businesses spend freely. Sometimes the good times get out of hand. Too many
dollars chase too few goods, and prices rise. Loans can be obtained so easily that free
spending becomes frivolous spending as investors pay too much for assets such as
real estate and stocks. If too much money is available, the major consequence is
inflation—a general increase in prices. If businesses are near the limit of their
production capacity, any increase in the money supply means that consumers and
businesses will spend more dollars on the same amount of goods and services, driving
up their average cost. Inflation strikes especially hard at those on fixed incomes or
whose incomes do not rise as fast as inflation, as well as those who save and lend
because their dollars may be worth less in the future.
The Fed’s balancing act
• The Fed tries to make sure that dollars are
plentiful enough so consumers and businesses
can buy all the goods and services produced
by the economy, even while investing in new
facilities and technology to supply a growing
population and provide a higher standard of
living.
Job of the Fed (the means)
• The ultimate aim of Fed policy is to
increase/decrease demand (the quantity of goods
and services that consumers and businesses are
willing and able to purchase).
• The Fed can affect the environment in which
economic decisions are made by manipulating
the money supply (i.e. cash and credit
conditions).
• The Fed does not work directly on consumers or
businesses, rather, it accomplishes its policy
through banks by changing monetary policies.
$ $ Monetary Policy $ $
• Involves the manipulation of the amount of funds that banks have
available to lend.
• As the central decision-making body in charge of monetary policy, the
Fed can take actions almost daily to help determine how much money is
available, how easily it may be borrowed, and how costly it will be (i.e.
interest rates).
• This in turn affects how many people will have a job, whether prices will
be stable, and how many goods and services will be produced and sold.
• With an eye on today and tomorrow, the Fed regulates the supply of
credit and money.
• In short, the Fed has the authority to change the level of bank reserves in
a way it thinks will provide the amount of money and credit that will
lead to full employment, stable prices, and economic growth.
FOMC: The vehicle of the Fed’s monetary policies
• The Federal Open Market Committee (FOMC)
• A twelve member group consisting of the 7 governors who
serve on the board and the President of the Federal
Reserve bank of New York (all permanent members) as well
as the Presidents of 3 other Federal Reserve banks who
serve staggered terms that meets 8 times annually to
review the economy and devise monetary policy.
• This monetary policy is carried out by the Federal Reserve
Bank of New York.
• 1978: the FOMC was ordered by Congress to conduct
policy to achieve twin goals: price stability and full
employment.
The three tools of monetary policy
• The discount rate
• Reserve Requirements
• Open Market Operations
The Discount Rate
• The interest rate that the Fed charges to banks that need to borrow from
the Fed to meet their reserve requirements. Banks borrow from the Fed
at the so-called “discount window”. Decades ago, this was a key tool of
monetary policy. By changing the rate it charges at its “discount
window,” for these loans, the Fed can encourage or discourage lending.
The discount rate is a passive tool. For it to work, banks must come to
the Fed to borrow. For about 25 years, healthy banks have virtually
ceased borrowing at the discount window, so the Fed cannot affect
lending much by raising or lowering the discount rate.
Reserve Requirements
•
A percentage of checking deposits commercial banks and other deposit-taking
institutions (e.g. savings and loan associations) are required by the Fed to keep on
“reserve” (out of circulation) as cash in their vaults or as deposits in special “reserve
balance” Fed accounts that resemble standard checking accounts. These “reserves”
must be non-interest bearing accounts—otherwise, banks might be encouraged to
enlarge deposits since the money would be accruing interest. The amount of money
the banking system can create from a deposit ultimately is limited by the reserve
requirement. A bank cannot lend these required reserves. The Fed can induce banks
to lend more or less by changing the reserve requirements. At most large banks
today, the reserve requirement is ten percent. Because banks earn no interest on
reserve deposits, they prefer to keep them close to the required minimum. Those
holding more than is required lend the excess (usually overnight) to banks that are
short of reserves and otherwise would pay a sizable penalty to the Fed. The interest
rate paid by a bank to borrow excess reserves from another bank is called the federal
funds rate. The federal funds rate is determined by supply and demand. The Fed
seldom changes reserve requirements to affect monetary policy because frequent
changes in reserve requirements would be disruptive to banks and would be likely to
change reserves in far bigger increments than the Fed usually seeks.
Open Market Operations
• Currently, the monetary policy tool carried out almost exclusively by the
Fed; it involves buying and selling government securities from private
sources. The New York Federal Reserve Bank is the main actor.
Securities that the New York Federal Reserve Bank buys and sells are
basically IOU’s issued by the federal government for various periods of
time as Treasury bills, notes, and bonds. These transactions occur in socalled government securities markets. The New York Fed open market
desk does business with securities firms, called dealers, which are in
business to trade Treasury securities for customers and themselves.
About 30 of these “dealers” are designated by the Fed as “primary”
dealers and those are the firms with which the Fed buys and sells
securities.
“Tightening” monetary policy
• If/when FOMC members determine that
demand for goods and services is increasing
faster than businesses can supply them, they
tighten monetary policy to fight inflation.
“Tightening” monetary policy
•
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FOMC reduces the funds available to banks for loans and raises interest rates in hopes of
discouraging the willingness of businesses and consumers from borrowing and buying.
The Discount Rate:
If, for example, the economy heats up, The Fed can decide to cool off the national economy
by raising the discount rate. The “discount window” at which banks borrow from the Fed, is
narrowed, banks generate less loans at higher rates because it is more costly for them to
borrow from the Fed, and less available money lowers business investment, employment,
consumer spending, and borrowing.
The Reserve Requirement:
If, for example, the economy heats up, the Fed can decide to cool off the national economy
by increasing the reserve requirement ratio. This action would mean less money is available
for banks to lend and more money would be kept out of circulation in “reserves”. The
demand for a smaller amount of available money raises interest rates for consumers and
businesses and would result in a decline in employment, salaries, prices, and business
spending.
Example: If the Fed raises the requirement from ten percent to eleven percent, banks
would have one percent less of their checking deposits available to lend. The higher the
requirement, the less money can be created by a bank because it requires the bank to set
aside a larger part of accepted deposits leaving less available for relending.
“Easing” Monetary Policy
• If/when businesses aren’t selling as many
goods and services as they can produce and
fewer people have jobs than want them, or if
the Fed thinks that the economy is headed in
that direction, it eases monetary policy.
Limits of the Fed
• Whereas the Fed has more control over the interest rates
of short-term loans, it has much less control over the
interest rates of long-term loans such as home mortgages.
• The Fed cannot make people spend or borrow more than
they want to, and it cannot force banks and other lenders
to provide loans. Moreover, the Fed cannot control what
particular goods and services consumers want to buy and
what investments businesses are willing to make.
• Although the Fed can affect the environment in which
economic decisions are made, it cannot force anyone to
respond. It can increase the money supply, but people do
not have to spend more. It can make credit more
expensive (i.e. raise interest rates), but people still might
spend money faster and pay the higher interest rates.
Limits of the FED
• Monetary policy does not address important
issues such as growing income inequality.