Transcript Chapter 3 PowerPoint

CHAPTER 3
THE FED AND
INTEREST RATES
The monetary base comprises the Fed’s 2 largest
liabilities:
Federal Reserve Notes in circulation
Depository institution reserves
(reserve account balances and vault cash)
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The money supply involves the Monetary Aggregates
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The Fed controls the monetary base….
To meet reserve requirements, depository institutions must
transact with Fed in monetary base assets. They either deposit adequate reserves at FRB or
maintain adequate cash in vault
Either way, reserves - required or excess - earn no interest.
The more cash or reserves an institution holds above its
requirements with the Fed, the more it wants to make new
loans or investments to avoid lost interest income.
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…Thus the Fed controls the money supply….
Excess reserves appear as Fed buys securities on open market,
lends at Discount Window, or
lowers reserve requirements
As depository institutions lend or invest excess
reserves, M1 increases
new loan of excess reserves increases borrower’s
transactional balances
purchase of investment securities increases seller’s
transactional balances
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…and the Money Supply affects the economy.
Proceeds of new loans or investments not only
increase M1 but finance purchases by DSUs of
goods or services in real sector, contributing to
economic growth.
By expanding or contracting monetary base, Fed increases or decreases excess reserves, thus
raising or lowering incentive to lend or invest, thus
encouraging or discouraging expansion in real sector.
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To influence interest rates, Fed targets but does not set
Fed Funds Rate
Fed Funds market is Fed-sponsored system in
which depository institutions lend and borrow
excess reserves among themselves
Fed Funds Rate, set by market forces as
institutions bargain with each other, is benchmark
rate, measuring return on bank reserves (most liquid of all assets)
availability of reserves to finance credit demand
intent and effect of monetary policy
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As Fed adjusts tools of monetary policy, reserve effects influence Fed Funds
rate significantly in short run
Open Market Operations: Buying pressures FFR downward,
selling pressures FFR upward
Reserve effects are direct, immediate, dollar-for-dollar
Ultimate M1 effects are substantially predictable
Discount Rate: Cutting discount rate pressures FFR
downward, raising discount rate pressures FFR upward
Reserve effects depend on—
• sensitivity of institutions to “Window scrutiny”
• differential between Discount Rate & FFR
Reserve Requirements: Cutting RR pulls FFR downward,
raising RR pushes FFR upward
Reserve effects are direct, immediate, sustained, & too
dramatic for “fine tuning”
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Fed cannot set Fed Funds rate in long run
Ultimately, factors in real sector determine credit demand:
Fed cannot artificially sustain FFR too low or high
Borrowing costs too low—
• M1 may grow too rapidly
• Real investment decisions may be distorted
(e.g., borrowing may just finance hoarding of assets)
Borrowing costs too high—
• M1 may not “keep up with” real sector
• Economy may falter as real investment declines
Best Fed can ultimately do is try to promote stable price
levels
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Why central banks manipulate reserves or rates: 2 schools of thought
Monetarists
Keynesians
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Monetarists: Key financial variable for changing economic activity is
the money supply.
Monetarists assume propensity to consume—
rises as people perceive they have “more money”
drops as people perceive they have “less money”
is distorted by volatility in prices
Thus money supply can be used to influence aggregate
demand
adding reserves carefully should promote economic growth
subtracting reserves carefully should slow the economy
central bank can distort price levels by over-adjusting either
way
Short-term interest rates merely indicate monetary
policy’s effects
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Keynesians: Key financial variable for changing economic activity is
interest rates.
John Maynard Keynes was influential British economist of
1930s
Keynesians discount or disregard direct money supply
effects
Real sector economic growth is—
Stimulated by falling rates as economic activity costs less to finance
Slowed by rising rates as economic activity costs more to finance
Always and significantly susceptible to influence of monetary
policy
To Keynesians, money supply changes reflect reactions to
interest rates
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6 basic goals of monetary policy, set by the Humphrey-Hawkins Act of
1978
Full employment
Economic growth
Price index stability
Interest rate stability
Stable financial system
Stable foreign exchange markets
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EXHIBIT 3.6
Ten-Year Treasury Rates (1960–2006)
Source: Federal Reserve Board of
Governors, H.15 Statistical Release.
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3 channels of the transmission process for monetary policy
Business investment in real assets
Consumer spending for durable goods and housing
Net exports
(Gross exports less gross imports)
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Business investment in real assets
Present values of future cash flows from real assets
depend significantly on general level of interest rates
Rates fall, PVFCF rises
Rates rise, PVFCF drops
Most capital expenditures are debt-financed; interest
expense is thus material in profitability of most
businesses
Monetary policy thus always involves material incentives
or disincentives for business investment
Fed can manipulate incentives but not compel results
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Consumer spending for durable goods & housing
Much consumer spending is on credit, so it tends to
vary directly with credit conditions
Falling interest rates tend to encourage spending
Rising interest rates tend to discourage spending
Monetary policy can thus often affect aggregate
demand to some extent
Fed can encourage/discourage but not necessarily
compel; Consumers don’t necessarily make
financial decisions the way businesses do Businesses are mostly rational and profit-maximizing
Consumers are partly rational and partly emotional
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Net exports
Interest rates affect exchange rates
Falling interest rates in a country tend to “weaken” its currency
Rising interest rates in a country tend to “strengthen” its currency
Exchange rates affect imports and exports
As domestic currency weakens—
• Domestic demand for imports drops as they become more costly but
• Foreign demand for exports rises as they become less costly
As domestic currency strengthens—
• Domestic demand for imports rises as they become less costly and
• Foreign demand for exports drops as they become more costly
Monetary policy thus usually affects net exports.
Fed can weaken or strengthen dollar, but may do so
for any of numerous reasons, related or unrelated to
export effects
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Monetary Policy and Economic Variables (Exhibit 3.8)
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Complications of monetary policy: controlling the money supply is
not easy.
Technical factors demand constant adjustment
Velocity of money is difficult to predict
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Technical factors demand constant adjustment
Cash drains
Cash holdings by public “use up” monetary base
Fed must try to offset with carefully calibrated open
market purchases
The float
DACI – CIPC = Float, net extension of credit by Fed
Fed must try to offset float with carefully calibrated
open market sales
US Treasury deposits
Treasury payments cause large shifts in reserves
Fed and Treasury try to coordinate any large fluctuations
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Velocity of money is difficult to predict
Ratio of gross domestic product to money supply
(turnover rate of unit of money in economy)
For given change in money supply, Fed—
can expect general direction of change in economy
cannot ensure particular degree of change in economy
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