Transcript Discount Rate

THE FED AND INTEREST RATES

Notes in circulation

Depository institution reserves
The FED used its power over the monetary base to
control the money supply.
Copyright© 2006 John Wiley &
Sons, Inc.
2





Up to this point, we used the term money
supply conceptually without providing a
specific definition.
There are various definitions of money
each focusing on a certain use of money.
M1 is the definition that focuses on money
as medium of exchange.
M2 focuses on money as store of value.
MZM includes all financial assets that can
be converted into cash immediately
(liquidity).
Copyright© 2006 John Wiley &
Sons, Inc.
3
Copyright© 2006 John Wiley &
Sons, Inc.
4




1.
2.
3.

By controlling the monetary base, the Fed
substantially influences the money supply.
The more is the excess reserves, the more interest
income they lose.(opportunity cost).
What creates the Excess reserves ?
Excess reserves appear as the Fed :
buys securities on the open market.
lowers the discount rate.
cuts reserve requirements.
As depository institutions lend or invest excess
reserves, they earn extra interest income.
Copyright© 2006 John Wiley &
Sons, Inc.
5
Copyright© 2006 John Wiley &
Sons, Inc.
6

When the Fed wants to increase the
money supply(using any of the three
tools),initially the reserves increases
creating excess reserves, that the banks
can invest or lend. Additionally, the
following things happen:
new loans created increases borrower’s
transactional balances.
 purchase of investment securities/assets increases
seller’s transactional balances.
 This helps in financing the purchases of the DSUs
of goods or services in real sector.
 Finally, this all contributes to economic growth .


By expanding or contracting monetary
base(increasing or decreasing the money supply),
Fed ◦ increases or decreases excess reserves, thus
◦ raising or lowering incentive to lend or invest, thus
◦ encouraging or discouraging expansion in real
sector.
7


The Fed Funds Market is a Fed-sponsored
system in which depository institutions lend
and borrow excess reserves overnight
among themselves. The interest rate on
these transactions—the Fed Funds
Rate(FFR)—is set by market forces.
The FFR is a “benchmark” rate in the financial
system—it normally represents the lowest
possible cost of loanable funds. In other
words, it is the inter-banking lending rate
and represents the primary cost of short
term loanable funds.
Copyright© 2006 John Wiley &
Sons, Inc.
8


1.
2.
3.
The Fed does not set the federal funds rate
but targets/influences it by controlling overall
availability of reserves.
FFR is important because:
It measures the return on the most liquid
financial assets (bank reserves).
It is closely related to the monetary policy.
It directly measures the available reserves in
the banking system.
Copyright© 2006 John Wiley &
Sons, Inc.
9
Market Equilibrium Interest Rate
1. Demand for the reserves by the depository
institutions (downward sloped)
2. Supply of the reserves by the Fed (upward sloped)
3. Equilibrium FF rate is when DRes = SRes
The FF
Rate
SRes
Equilibrium
Interest
DRes
Quantity of Reserves
Monetary Policy & The Fed Funds Rate
• OMO and its impact on FF rate
1.Purchasing Treasury securities leads to increase
reserves in the banking system then the supply curve
shifts rightward. As a result, the FF rate will decline.
The
FF
Rate
SRes1
SRes2
2.Selling Treasury securities
Quantity of reserves
•Discount rate and its impact on CB rate
1. Increase
discount
rate
means
increase
opportunity cost of holding reserves. So supply of
reserves will decline, the supply curve will shift
leftward, then the FFR increases.
The
FF
rate
SRes2
SRes1
DRes
2. Decrease discount rate
Quantity of Reserves
• RR and its impact on CB rate
1. Increase (RRR) leads to increase RR, decrease
ER i.e. the loans to the public, demand for
reserves from the FF increases, demand curve
shifts rightward, and FFR increases.
The
FF
rate
sRes
DRes2
DRes1
Quantity of Reserves
2. Decrease (RRR)

Open Market Operations: Buying pressures FFR

Discount Rate: Cutting discount rate pressures FFR
downward, selling pressures FFR upward
◦ Reserve effects are direct, immediate, dollar-fordollar.
◦ Ultimate effects on money supply are predictable.
downward, raising discount rate pressures FFR upward
◦
sensitivity of institutions to “Window scrutiny”
◦ The trend is always to keep the discount rate higher than the FFR to
encourage banks to borrow in the fed funds system rather than the
discount window.

Reserve Requirements: Cutting RR pulls FFR downward,
raising RR pushes FFR upward
◦ Reserve effects are direct, immediate, sustained, &
too dramatic for “fine tuning”
Copyright© 2006 John Wiley &
Sons, Inc.
14





The Fed can influence the FFR only in the short run
by using its monetary policy to expand or contract
the monetary base and hence affects the level of
reserves.
However, in the long run does not have the power to
set the FFR. Lets see why is that:
If the Fed tries to keep the FFR at low rate, people
will borrow and buy goods extensively, demand of
loans will be very high ,banks will be short of excess
reserves, the Fed will buy securities to increase the
money supply to prevent the FFR to increase. People
will fear inflation and continue to borrow and the
cycle continues.
On the other hand, if the Fed tries to keep the FFR at
high rate, few people will borrow, so FFR should
drop but the Fed will sell securities to reduce bank
reserves and contracts money supply. This can cause
depression.
Best Fed can ultimately do is try to promote stable
price levels.
Copyright© 2006 John Wiley &
Sons, Inc.
15



Changes in the fed funds rate provide a clue to
short term changes in the monetary policy.
When the FED wants to contract the economy
(decrease the money supply),we expect the FFR
to rise as more banks finds themselves short of
reserves and tend to borrow at fed funds
market.
When the FED wants to expand the economy
(increase the money supply),we expect the FFR
to decrease .
Copyright© 2006 John Wiley &
Sons, Inc.
16
Two school of thought about what affects the
level of economic activity:
1- Monetarist Economists
Monetarists assume propensity to consume—
•
•
rises as people perceive they have “more money”
drops as people perceive they have “less money”
The money supply is the key variable that
effect on economic activity.
adding reserves carefully should promote
economic growth
subtracting reserves carefully should slow the
economy
2- Keynesian Economists
John Maynard Keynes was influential British
economist of 1930s.
The interest rate is the key variable.



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.
Keynesian believe that monetary policy
always works unless the economy is in
liquidity trap.
Liquidity Trap:
When people already had a lot of money
relative to their needs that any extra money
will be hoarded and would no longer drive
down the interest rates.
Copyright© 2006 John Wiley &
Sons, Inc.
18

Increase in market interest rate leads to decrease
in the value of fixed – income securities.
Raising discount rate or / and raising reserve
requirements leads to a great fall in the stock
market.
•







Full employment
Economic growth
Price index stability
Interest rate stability
Stable financial system
Stable foreign exchange markets
Copyright© 2006 John Wiley &
Sons, Inc.
20


1.
2.
Full employment implies that every person of
working age who wishes to work can find
employment.
Types of unemployment
Frictional unemployment: people
unemployed in transition between jobs.
Structural unemployment: happens when
there is mismatch between a person’s skill
levels and available jobs or more jobs in one
region of the country but fewer in the
others.
Copyright© 2006 John Wiley &
Sons, Inc.
21



It is name given for a rising standard of living
,measured by output per unit of input.
Economic growth is made possible through
increased productivity of labour and capital.
For example: Productivity can be increased by
training the labour and applying new
technologies to the capital.
Copyright© 2006 John Wiley &
Sons, Inc.
22



Price Stability refers to the stability in the
average price of all goods and services in the
economy.
Inflation is defined as a continuous rise in the
average price level or a continuous decrease
in the purchasing power of money.
Inflation can be measured by price indexes
such as the Consumer Price Index(CPI).
Copyright© 2006 John Wiley &
Sons, Inc.
23



It refers to the swings or volatility of interest
rates over time.
Large interest rate fluctuations introduce
additional uncertainty into the economy and
make it harder to plan for the future.
For e.g. high interest rates , this prevents
consumer and business spending.
Copyright© 2006 John Wiley &
Sons, Inc.
24



Instability of the financial system can prevent
the efficient flow of funds between DSU and
SSU.
Any reduction in the flow of funds can reduce
consumer spending, business investment and
thus the economic growth.
For e.g. Role of the Central banks during the
Financial crisis.
Copyright© 2006 John Wiley &
Sons, Inc.
25



Exchange rates are the value of the local
currency relative to foreign currencies.
Fluctuations exchange rates introduce
uncertainty. What is the name of that risk?.
For e.g. When the value of dollars increases,
what does this mean in terms of exports and
imports?.
Copyright© 2006 John Wiley &
Sons, Inc.
26


1.
2.
3.
4.
Most of the goals of the Fed are consistent with
each other, except price stability and full
employment.
When economy is in expansion,
unemployment starts to decrease
More goods are produced and thus more
labour are needed.
Wages of labour starts to increase because
they became scarce and the same thing
applies to raw materials.
This increases the cost of production and thus
the prices of goods increased.(inflation).
Copyright© 2006 John Wiley &
Sons, Inc.
27


Philip’s Curve.
Stagflation.
Copyright© 2006 John Wiley &
Sons, Inc.
28