Transcript Monetary Policy

16
Interest Rates and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Interest Rates
• Price paid for the use of money
• Many different interest rates
• Speak as if only one interest rate
• Determined by money supply and
money demand
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Monetary Policy
Monetary policy is the manipulation
of the money supply by changing
bank’s excess reserves.
LO1
Central Banks
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Definitions
• Total (Actual) Reserves: Amount of money a bank
holds (has available).
Total Reserves = Required Reserves + Excess Reserves
• Required Reserves: Fraction of Total (Actual)
Reserves a bank must keep (can’t be loaned).
• Reserve Ratio: Percentage of demand deposits bank
must maintain for required reserves.
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Definitions
• Excess Reserves: Amount of actual reserves the
bank has to loan.
Excess Reserves = Total Reserves – Required Reserves
• Monetary Multiplier (m) = 1/Reserve Ratio
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Tools of Monetary Policy
1. Open Market Operations
2. The Reserve Ratio
3. The Discount Rate
4. Interest on Reserves
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Tools of Monetary Policy
1. Open Market Operations
• Buying and selling of government
securities (or bonds) by the Fed
• Most important tool to change the
money supply
LO2
Tools of Monetary Policy
To increase Sm, Fed can buy securities
from bank or public.
Example:
Fed buys $1,000 security from
commercial bank and the reserve
ratio is 20%.
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Tools of Monetary Policy
• Fed pays for securities by increasing
bank’s actual reserves by $1,000.
• Since bank doesn’t have to maintain
required reserves for money from
Fed, excess reserves increase by
$1,000.
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Open Market Operations
• Money creating potential of single
bank is equivalent to its excess
reserves (amount it can loan).
• Bank’s money creating potential
increased by $1,000.
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Open Market Operations
• Monetary Multiplier (m) = 1/Reserve Ratio
m = 1/.2 = 5
Change in Sm = m x change in excess reserves.
•Money supply increases by $5,000
(5 x 1,000)due to monetary multiplier.
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Open Market Operations
Example #2:
•Fed buys $1,000 security from public,
reserve ratio is 20%
• Fed pays with $1,000 check,
• money supply is directly increased by
$1,000.
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Open Market Operations
• Check is deposited and bank’s actual
reserves rise by $1,000.
• Required reserves increase by $200.
(.2 x $1,000)
• Bank’s excess reserves rise by $800.
($1000 - $200)
• Bank’s lending ability increases by
$800.
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Open Market Operations
• Banking system’s money creating
potential increases by $4,000 (5 x
$800).
• Money supply increases by $5,000
$4,000 + $1,000 (initial check).
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Tools of Monetary Policy
The Reserve Ratio
Percentage of demand deposits bank
must maintain for required reserves.
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Tools of Monetary Policy
2. The Reserve Ratio
• Changes the money multiplier
• Reduce Reserve Ratio to increase
money supply
• Increase Reserve Ratio to reduce
money supply
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Tools of Monetary Policy
The Discount Rate
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Tools of Monetary Policy
3. The Discount Rate – Lender of Last
Resort
• Interest rate on loans from Fed to
banks
• Lower Discount Rate to increase
money supply
• Increase Discount Rate to reduce
money supply
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Tools of Monetary Policy
Interest on Reserves
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Tools of Monetary Policy
4. Interest on Reserves
• Increase interest rate on reserves
• Banks will leave more reserves with
Fed
• Decrease money supply
• Decrease interest rate on reserves
• Banks will leave fewer reserves with
Fed
• Increase money supply
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Tools of Monetary Policy
• Reserve Ratio changes bank’s
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•
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profitability
Discount Rate is a passive tool until
financial crisis
Interest on Reserves is too new
Fed Regulates Money Supply
Reduce Money Supply
Slow Down
• Increase Reserve
Requirement
• Sell Government Bonds
• Increase Discount Rate
Expand
Increase Money Supply
• Reduce Reserve
Requirement
• Buy Government Bonds
• Decrease Discount Rate
The Federal Funds Rate
• Member banks borrow
money from the Fed and
pass it on to their
customers – Prime Rate
• Fed also sets the rate that
banks charge each other –
Federal Funds Rate
The Federal Funds Rate
• Rate charged by banks on overnight
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loans made from temporary excess
funds
Targeted by the Federal Reserve when
changing the money supply
Prime interest rate is charged on loans
to most credit-worthy customers
Prime interest rate is directly related to
the Federal funds rate.
Monetary Policy
LO3
Monetary Policy
•
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Expansionary Monetary Policy
• Economy faces a recession
• Increase money supply, interest rates fall
• Lower target for federal funds rate
• Fed buys securities from banks and
public
• Lower reserve ratio
• Lower discount rate
• Decrease interest on reserves
Monetary Policy
•
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Restrictive Monetary Policy
• Periods of rising inflation
• Decreases money supply, interest rates
rise
• Increase target Federal funds rate
• Fed sells securities to banks and public
• Raise reserve ratio
• Raise discount rate
• Increase interest on reserves
Taylor Rule
• Rule of thumb for tracking actual
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monetary policy
Fed has 2% target inflation rate
Target FFR varies as inflation and
real GDP vary
Three basic rules when setting target
for Federal Funds Rate:
Taylor Rule
1.
2.
3.
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If real GDP = potential GDP and inflation is
2% then target federal funds rate is 4%
For each 1% increase of real GDP above
potential GDP, the Fed should raise the
real Federal Funds Rate by ½%
For each 1% increase in the inflation rate
above the 2% target rate, the Fed should
raise the Federal Funds Rate by ½%
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed buys bonds, lowers reserve ratio, lowers the
discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
LO5
Real GDP rises
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed sells bonds, increases reserve ratio, increases
the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
LO5
Inflation declines
Monetary Policy: Evaluation and Issues
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Evaluation and Issues
• Advantages over fiscal policy
• Speed and flexibility
• Isolation from political pressure
• Monetary policy more subtle than
fiscal policy
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Recent U.S. Monetary Policy
• Highly active in recent decades
• Quick and innovative actions during
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recent financial crisis and severe
recession
Critics contend Fed contributed to
crisis by keeping Federal funds rate
too low for too long
After the Great Recession
• Slow recovery, especially with
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employment
Zero Interest Rate Policy (ZIRP)
• Short-term rates near/at zero
• FFR = (zero – 0.25%)
• Zero-Lower-Bound Problem
• Economy didn’t expand, interest rates already
•
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at zero
Cannot have negative interest rates
After the Great Recession
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Quantitative Easing (QE, Mar 2009)
• Not intended to decrease interest rates
• Meant to increase reserves in bank system
• Purchased $1.75T
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Forward Commitment (QE2, Nov 2010)
• Fed preannounced purchase amount and for how long
• $600B @ $75B/month for 8 months
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Maturity Extension Program (Operation Twist)
• Fed announced: buy $677B long-term gov’t bonds while selling
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QE3 (Sep 2012)
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equivalent amount of short-term gov’t bonds
Spur investment and consumption with lower long-term rates
Open-ended policy commitment
Worries about ZIRP, QE, and Twist
• Government spending crowded out private
spending
• Large budget deficits by the Federal
government would lead to huge interest
costs
• Low interest rates punish savers, pension
plans, and retirement funds
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Problems and Complications
• Lags – Fiscal vs. Monetary
• Fiscal: Recognition, Administrative, Operational
• Monetary: Recognition and Operational
• Cyclical Asymmetry and the Liquidity
Trap
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