Transcript Monetary Policy

FIN 30220: Macroeconomic
Analysis
The Federal Reserve and Monetary
Policy
The National Banking Act of 1863 allowed Nationally chartered banks to
distribute bank notes
National Banks controlled
the supply of currency in
the US through their
lending policies
National Banks were the
primary source of credit
Money center banks
were the “root source”
of credit
National banks who were short of funds
would borrow from money center banks
Larger State banks who were short of funds
would borrow from National banks
Small State banks who were short of funds would borrow
from larger state banks
Credit Channels under the
National/State Banking
System

The Federal Reserve System was created in
1913 by Woodrow Wilson.





Regulate the banking industry
“Lender of Last Resort”
Control the money supply
Provide banking services for the federal
government
Check Clearing
Note: The Federal Reserve System is a private bank. It is actually owned by
the banks within the Federal Reserve System
Credit Channels
under the
Federal Reserve
System
Federal Reserve
= Federal Funds Market
= Discount Window
The Federal Reserve System Divides the country into
12 Districts numbered 1 - 12 from east to west
Each district has a Federal Reserve Bank with a bank president
elected by the bank’s board of directors for 4 year renewable terms
Bank President
Board of Directors
Class A (4)
Member Banks
Class B (4)
Local Business
Class C (4)
Federal Reserve
Board
The Chairman is elected from the Board for a renewable 4 year term
Sarah
Raskin
Daniel
Tarullo
Jerome
Powell
(2010)
(2009)
(2012)
Janice
Elizabeth
Yellen (Vice Duke
Chairman)
(2008)
(2010)
Ben
Bernanke
Jeremy
Stein
(2003)
(2012)
The Federal Reserve board is headquartered in Washington DC. The Board
Consists of 7 “Governors” appointed by the President and confirmed by the Senate
for 14 Year Non-Renewable terms
The Federal Open Market Committee (FOMC) is the policymaking
group of the Federal Reserve System. They meet approximately 8
times per year. Policies are determined by majority vote
Board of
NY Fed
Governors (7) President (1)
Regional Fed
Presidents (4)
Generally, all 12 bank presidents are present at the meeting, but only 5 can
vote. The NY Fed president has a permanent vote while the remaining
presidents vote on a revolving basis.
Instruments refer to the policy options the Fed
has to control the supply of money…
Discount Window Loans
Open Market Operations
By purchasing or selling
US Treasuries, the Fed can
alter the supply of bank
reserves (MB)
The Fed can also influence
reserves by altering the
interest rate charged on
loans to commercial
banks. (MB)
Reserve Requirements
This is the most
often used
instrument!
Reserve Requirements
influence the ability of
banks to create new loans
which affects the broader
aggregates (M1,M2)
The Reserve Requirement is the least used of the Fed’s
policy tools. A Bank is required to keep a minimum
percentage of its deposits either as cash or on deposit at
the federal reserve (reserve deposits pay no interest)
Federal Reserve
Assets
Liabilities
$ 2,500 (Reserves)
Acme National Bank
Assets
$ 2,500 (Cash)
Liabilities
$50,000 (Deposits)
$ 2,500 (Reserves)
$45,000 (T-Bills)
$100,000(Loans)
$100,000 (Equity)
Reserve Accounts are
liabilities of the Fed
Acme currently has 10% of its
deposit liabilities on Reserve
(Cash + Reserves)/Deposits
Suppose Acme Bank wanted to create a $30,000 loan.
This is done by establishing a line of credit (i.e. creating
a new checkable deposit)
Acme National Bank
Assets
$ 2,500 (Cash)
Liabilities
$50,000 (Deposits)
The loan shows up on
both sides of the
balance sheet
$ 2,500 (Reserves) $30,000 (Deposit)
$45,000 (T-Bills)
$100,000(Loans)
$30,000 (Loan)
$100,000 (Equity)
Acme’s reserve ratio drops
to 6.25% (5/80)
Type of Liability
Reserve Requirement
Transaction Account
$0 - $7M
0%
$7M - $47.6M
3%
More than $47.6M
10%
Time Deposits
0%
Eurocurrencies
0%
The Reserve Requirement has no impact on the monetary base,
but it restricts the ability of banks to create loans – this influences
the broader aggregates.
The discount window was the primary policy tool of the federal
reserve when it was first established in 1913. Discount window
loans are collateralized by the assets of the bank (equal to around
90% of the loan)
Federal Reserve
Assets
$ 2,500 (Loan)
Liabilities
$ 2,500 (Reserves)
$ 2,500 (Reserves)
Acme National Bank
Assets
Liabilities
$ 2,500 (Cash)
$80,000 (Deposits)
$ 2,500 (Reserves)
$ 2,500 (Reserves) $ 2,500 (Disc. Loan)
$45,000 (T-Bills)
$130,000(Loans)
Res. Req. = 5%
A $2,500 loan from the discount
window would raise reserves to the
required 5%
$50,000 (Equity)
This bank would like to create a
$70,000 loan, but doesn’t have the
reserves to back it up
The Fed actually has several discount lending programs
Type of Credit
Interest Rate Policy
Primary (No Questions Asked)
Fed Funds + .5%
Secondary (Additional
Financial Information
Required)
Fed Funds + 1.0%
Seasonal (Must demonstrate
reoccurring seasonal liquidity
needs, <$500M in Deposits)
Fed Funds + .2%
Discount Lending (1959-2005)
Discount Lending (1959-Present)
By purchasing and/or selling securities, the Fed can directly control the
quantity of non-borrowed reserves in the banking sector.
The Fed
debits/credits the
reserve account of
the dealer’s bank
Federal Reserve
Dealers Buy/Sell
bonds from the Fed
Bond Dealer
Most transactions are done with repurchase agreements (Repos). These
are purchases/sales along with an agreement to reverse the transaction
at a later date
Currently, open market operations are the primary policy
tool of the Fed. Trading takes place in NYC
Federal Reserve
Assets
Liabilities
$ 2,500 (T- Bills) $ 2,500 (Reserves)
$ 2,500 (Reserves)
Acme National Bank
Assets
$ 2,500 (Cash)
$ 2,500 (Reserves)
$ 2,500 (Reserves)
- $ 2,500 (T- Bills)
$45,000 (T-Bills)
$130,000(Loans)
Res. Req. = 5%
Liabilities
$80,000 (Deposits)
$50,000 (Equity)
An open market purchase increases the reserves of the banking
sector – this raises M0
The Money multipliers describe the relationship between a change in the
monetary base (controlled by the Fed) and the broader aggregates
$ Change in M1 = mm1 * $ Change in MB
Cash
1 + Deposits
mm =
Cash
Reserves
+
Deposits
Deposits
$ Change in M2 = mm2 * $ Change in MB
Cash
+ M2-M1
1 + Deposits
Deposits
mm2 =
Cash
Reserves
+
Deposits
Deposits
The Fed can influence total bank reserves, which affects the multipliers!
Fed Policy from start to finish….
Staff economists at each
federal reserve bank brief
the president of
local/national economic
conditions
Trading desk calls
bond dealers and asks
for bids
Bank Presidents/Governors
present policy
recommendations to the
FOMC – A vote is taken.
The monetary base is to be
increased by $100M
This order is passed to
the trading desk in NYC
Fed Policy from start to finish….
Acme National Bank
Assets
+$100M (Reserves)
Liabilities
+ $100M (Deposits)
The dealers with the winning
bids deliver the bonds. Their
bank’s reserve accounts are
credited
The bank must keep approximately 5% (reserve requirement) of the new deposit on
reserve, but is free to loan out the remaining $95M. Some of this will be loaned to
business customers, some finds its way into the Federal Funds market
FF Rate
Excess supply of
reserves pushes down
the Fed Funds Rate
Supply
5%
Reserves
Fed Policy from start to finish….
Through the Fed Funds
Market, the reserves are
distributed throughout
the banking sector
Fed Funds Market
Each bank uses its new reserves to create additional loans
As banks increase the supplies of the various aggregates, their
rates drop as well
M1 Rate
M2 Rate
Supply
Supply
6%
7%
M1
$ Change
= mm1 * $100M
in M1
M2
$ Change
= mm2 * $100M
in M2
2
These newly created loans are used to purchase labor,
materials, consumer goods, etc.
8
Eventually, this newly created demand will influence prices…
Wages
Prices
Demand
Demand
Hours
GDP
Higher demand for goods and services drive up their prices
(wages and prices)
Increases in
inflation raise
the nominal
interest rate
Nominal
Interest =
Rate
Real
Interest
Rate
+
Expected
Inflation
Monetary Policy goals address the central bank’s agenda
in general terms
The Bank of England Follows an explicit Inflation Target.
Specifically, the goal is to maintain 2% annual inflation.
The ECB (European Central Bank) and the Federal
Reserve follow policies of stable prices and
maintenance of full employment
Intermediate Targets address the question: “How will I meet my goals?”.
Targets are variables that the central bank can more directly control.
Goals vs. Targets
For Tiger Woods, the
goal is to win the golf
tournament
The target is to score
18 under par (the
number he thinks he
needs to win)
The Federal Reserve is currently targeting the Federal
Funds Rate at 0.00%
The Bank of England is currently targeting the repo rate at
0.50%
The European Central Bank is currently targeting the
lending rate at 1.50%
Targets can be broadly classified into either “Price
Targets” or “Quantity Targets”
Suppose that the Federal Government could influence
the supply of oranges and wanted to regulate the orange
market
Price
Lowering the price to
$4 (price target) and
Raising the quantity to
1,500 (quantity target)
are both describing the
same policy
(expanding the orange
market)
Supply
$5/Lb
$4/Lb
Demand
1,000 1,500
Quantity of
Oranges
Your response to demand changes will differ
across policies
Price
If demand for oranges
increases and the Fed
is following a price
target, they must
respond by increasing
supply
Supply
Target
Range
$5/Lb
Demand
Quantity of
Oranges
However, your response to demand changes
will differ across policies
Target
Range
Price
If demand for oranges
increases and the Fed
is following a quantity
target, they must
respond by decreasing
supply
Supply
Demand
1000Lbs
Quantity of
Oranges
Suppose that the Fed wants to lower its target to 4% (expansionary
monetary policy)
i
M2
A $250 purchase of
Treasuries would be
required
2,000
= $250
8
5%
4%
Md
Change in M2 = $2,000
M
P
M2
Multiplier
Suppose that the Fed is Targeting the Interest Rate at
5%
i
Suppose an increase in
GDP raises Money
Demand
M2
The Fed needs to
increase the
monetary base by
5%
Md
Change in M2 = $1,000
M
P
1,000
= $125
8
(An Open Market
Purchase of
Treasuries)
During the late 70’s, the federal reserve changed its policy
from an interest rate target to a money target. The money
target was abandoned in the mid eighties.
25
20
15
10
5
0
Jan-70
Jan-74
Jan-78
Fed Funds
Discount
Jan-82
Prime
Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular course of
action?
The British have pre-committed to a fixed inflation
rate.
The ECB (European Central Bank) and the Federal
Reserve both follow discretionary policies (i.e.
policy is decided at the FOMC meeting)
For most of its history, the US has followed a
gold standard
US Treasury
A Gold Standard has two rules:
The government sets an
official price of gold ($35/oz)
The government guarantees
convertibility of currency into
gold at a fixed price
Assets
$7,000 (Gold)
Liabilities
$10,000 (Currency)
(200 oz. @ $35/oz)
$3,000 (T-Bills)
Reserve Ratio = 70%
Value of Gold Reserves
Reserve Ratio = Currency Outstanding
=
$7,000
$10,000
During most of the gold standard era, the Government had a reserve
ratio of around 12%
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
US Treasury (P = $35)
Assets
$7,000 (Gold)
Liabilities
Price
Supply
$10,000 (Currency)
(200 oz. @ $35/oz)
$3,000 (T-Bills)
100 oz. Gold
@ $35/oz
$35
$3,500 (Currency)
Reserve Ratio = 70%
Suppose that the Treasury purchased gold to increase the supply of
currency outstanding (i.e. increase the money supply)
Demand
Q
By committing to convertibility at $35 an ounce, the government
restricted its ability to increase/decrease the money supply
US Treasury (P = $35)
Assets
$7,000 (Gold)
Liabilities
Price
Supply
$10,000 (Currency)
(200 oz. @ $35/oz)
$3,000 (T-Bills)
$35
Demand
Reserve Ratio = 70%
As the market price rises above $35 (due to increased demand),
households start buying gold from the Treasure @ $35/oz and sell it in
the open market. This reverses the original transaction
Q
The gold standard and prices:
Recall that in the long run, the price level is directly
proportional to the ratio of money to output:
(Gold Reserves)
M=
Reserve Ratio
s
M
 k (i, t ) y
P
With a (relatively) fixed supply of money, prices remained stable in the
long run
The gold standard and the supply of gold:
US Treasury (P = $35)
Assets
$7,000 (Gold)
Liabilities
Price
Supply
$10,000 (Currency)
(200 oz. @ $35/oz)
$35
$3,000 (T-Bills)
100 oz. Gold
@ $35/oz
$3,500 (Currency)
Demand
Reserve Ratio = 70%
From time to time, new gold deposits were discovered. This increased
supply would push down the market price. In response, households
would buy the cheap gold and sell it to the Treasury for $35. This would
increase the money supply.
Q
The gold standard and the business cycle:
US Treasury (P = $35)
Assets
$7,000 (Gold)
Liabilities
Price
Supply
$10,000 (Currency)
(200 oz. @ $35/oz)
$35
$3,000 (T-Bills)
(-) Gold
(-) Currency
Demand
Reserve Ratio = 70%
Typically, during recessions, the price of gold would rise (flight to quality).
High gold prices would cause households to buy gold from the Treasury to
sell in the market. This would force the treasury to lose reserves and
contract the money supply.
Q
Gold Standard: Long Run vs. Short Run
Long Run: By restricting the long run supply of
money, the gold standard produced constant, low
average rates of inflation (bankers are happy)
Short Run: By forcing monetary policy to be
subject to fluctuating gold prices, the gold standard
exacerbated the business cycle (farmers are
unhappy)
Currently, the Fed follows an interest rate target. The target
interest rate (Fed Funds Rate) is adjusted according to a
‘Taylor Rule”
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)
Long Run: When the economy is at full employment ( Unemployment = 5%)
and inflation is at its long run target (2%), the Fed targets the Fed Funds
Rate (Nominal) at
FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4%
Short Run: During recessions (when inflation is low and unemployment is
high), the Fed lowers its target. During expansions, when inflation is high
and unemployment is low), the Fed raises its target.
Case study: Productivity Growth during the late 90’s
i
FE
LM
A contraction of the money
supply raises interest rates
and pushes the economy
back to capacity
4%
IS
y
Even with higher capacity,
rapidly expanding
investment demand pushed
the economy beyond
capacity – this causes
rising prices
Productivity growth expanded US production capacity
End of 1992 Recession
Asian Financial Crisis
Late 90’s Expansion
Stock Market Bubble
7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
Jan-94
Fed Funds
Discount
Nov-94
Sep-95
Jul-96
May-97
Mar-98
Jan-99
Nov-99
Case study: Stock Market Crash and Liquidity Shocks
i
FE
An increase in the money
supply lowers interest rates
and pushes the economy
back to capacity
LM
4%
IS
y
Rapidly declining investment demand pushed the
economy below capacity – this causes falling prices
Stock Market Crash
Recession of 2001
Beginning of Recovery
7
6
5
4
Fed Funds
Discount Rate
3
2
1
0
Jan-00
Sep-00
May-01
Jan-02
Sep-02
Problems
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Obviously, we can’t observe supply/demand
curves. Instead, we have to look at the data
and guess at the underlying cause.
The outside lag (the amount of time for a
policy to impact the economy) is “long and
variable”