Transcript (a) The Fed buys securities from a commercial bank

ECONOMICS 5e
Michael Parkin
CHAPTER
15
Monetary Policy
Chapter 32 in Economics
Learning Objectives
• Describe the structure of the Federal
Reserve System (the Fed)
• Describe the tools used by the Fed to
conduct its monetary policy
• Explain what an open market operation is
and how it works
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Learning Objectives (cont.)
• Explain how an open market operation
changes the money supply
• Explain what determines the demand for
money
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Slide 15-‹#›
Learning Objectives (cont.)
• Explain how the Fed influences interest
rates
• Explain how interest rates influence the
economy
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Slide 15-‹#›
Learning Objectives
• Describe the structure of the Federal
Reserve System (the Fed)
• Describe the tools used by the Fed to
conduct its monetary policy
• Explain what an open market operation is
and how it works
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The Federal Reserve System
The Federal Reserve System serves as the
central bank for the United States.
A central bank is a bank’s bank and a public
authority that regulates a nation’s financial
institutions and markets.
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The Federal Reserve System
Monetary policy is conducted by the Fed.
Monetary policy is the adjustment of the
quantity of money in circulation to achieve
specific economic goals.
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The Federal Reserve System
These goals include:
1) Keeping inflation in check.
2) Maintaining full employment.
3) Moderating the business cycle.
4) Contributing toward achieving long-term
growth.
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The Federal Reserve System
The Structure of the Federal Reserve System
The primary elements in the Federal Reserve
System are:
1) The Board of Governors
2) The Regional Federal Reserve Banks
3) The Federal Open Market Committee
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The Federal Reserve System
The Board of Governors
• Seven members
• Appointed by the President
• Confirmed by the Senate
• Serve 14-year term
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The Federal Reserve System
The Board of Governors (cont.)
• Terms are staggered so that one comes vacant
every two years
• President appoints a member as Chairman to
serve a four-year term
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The Federal Reserve System
The Federal Reserve Banks
12 District banks
• Nine directors
• Three are appointed by the Board of Governors
• Six are elected by the commercial banks in the
district
• The directors appoint the district president
which is approved by the Board of Governors
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The Federal Reserve System
The Federal Reserve Banks
The New York Fed implements some of the
Fed’s most important policy decisions.
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The Federal Reserve System
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The Federal Reserve System
The Federal Open Market Committee
(FOMC)
• Serves as the main policy-making organ of the
Federal Reserve System
• Meets approximately every six weeks to review
the economy
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The Federal Reserve System
The Federal Open Market Committee
(FOMC)
Made up of the following voting members:
• The chairman and the other six members of
the Board of Governors
• The president of the Federal Reserve Bank
of New York
• The presidents of the other regional Federal
Reserve banks (four vote on a yearly rotating
basis)
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The Federal Reserve System
The Fed’s Power Center
The chairman of the Board of Governors has
the largest influence on the Fed’s monetary
policy actions.
• Paul Volcker
• Alan Greenspan
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The Federal Reserve System
The Fed’s Power Center (cont.)
The chairman’s power and influence stem from:
• First, the chairman controls the agenda and
dominates the meetings of the FOMC.
• Secondly, contact with a staff of economists
and other experts provides the chairman with
detailed briefings on monetary policy issues.
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The Federal Reserve System
The Fed’s Power Center (cont.)
The chairman’s power and influence stem from:
• Lastly, the chairman is the Fed’s
spokesperson and the point of contact with
the President and government and with
foreign central banks and governments.
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Learning Objectives
• Describe the structure of the Federal
Reserve System (the Fed)
• Describe the tools used by the Fed to
conduct its monetary policy
• Explain what an open market operation is
and how it works
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The Federal Reserve System
The Fed’s Policy Tools
• The Fed controls the money supply by
adjusting the reserves of the banking system.
• The Fed has three main tools it uses to achieve
this objective.
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The Federal Reserve System
The Fed’s Policy Tools
The three main policy tools are:
1) Required reserve ratios
2) Discount rate
3) Open market operations
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The Federal Reserve System
Required Reserve Ratios
The Fed determines a required reserve ratio for
each type of deposit.
• In 1997, banks were required to keep 3
percent of checking deposits up to $49
million and 10 percent of deposits in excess
of $49 million.
• Other deposits had no reserve requirement.
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The Federal Reserve System
Discount Rate
The discount rate is the interest rate at which
the Fed stands ready to lend reserves to
commercial banks.
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The Federal Reserve System
Open Market Operations
Open market operations are the purchase or sale
of government securities by the Federal
Reserve System on the open market.
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The Structure of the Fed
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The Federal Reserve System
The Fed’s Balance Sheet
The Fed’s three main assets are:
1) Gold and foreign exchange
2) U.S. government securities
3) Loans to banks
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The Federal Reserve System
The Fed’s Balance Sheet
The Fed’s two main liabilities are:
1) Federal Reserve notes in circulation
• Nonconvertible notes or “fiat money”
• Federal reserve notes are backed by the Fed’s
holdings of U.S. government securities
2) Bank’s deposits
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The Federal Reserve System
The Fed’s Balance Sheet
• The Fed’s liabilities along with the coins in
circulation make up the monetary base.
• Note: Coins are issued by the Treasury and not
liabilities of the Fed.
• The monetary base serves as the base for the
nation’s money supply.
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The Fed’s Balance Sheet,
December 1996
Assets
Liabilities
(billions of dollars)
(billions of dollars)
Gold and foreign exchange
21
U.S. government securities
460
Loans to banks
Total assets
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0
481
Federal Reserve notes
427
Bank’s deposits
25
Other liabilities (net)
29
Total liabilities (net)
481
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Learning Objectives
• Describe the structure of the Federal
Reserve System (the Fed)
• Describe the tools used by the Fed to
conduct its monetary policy
• Explain what an open market operation is
and how it works
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Controlling the Money Supply
How Required Reserve Ratios Work
When the Fed increases the required reserve
ratio:
• Banks must hold more reserves.
• To increase reserves, banks must decrease
lending.
• The decrease in lending decreases the
quantity of money.
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Controlling the Money Supply
How Required Reserve Ratios Work
When the Fed decreases the required reserve
ratio:
• Banks may hold less reserves.
• As a result of the decrease in reserves, banks
increase lending.
• The increase in lending increases the
quantity of money.
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Controlling the Money Supply
How the Discount Rate Works
When the Fed increases the discount rate:
• Banks must pay a higher price for any
reserves that they borrow from the Fed.
• Banks try to get by with smaller reserves.
• But given the required reserve ratio, banks
must decrease their lending.
• This decreases the quantity of money.
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Controlling the Money Supply
How the Discount Rate Works
When the Fed decreases the discount rate:
• Banks pay a lower price for any reserves that
they borrow from the Fed.
• Banks are willing to borrow more reserves
and increase their lending.
• This increases the quantity of money.
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Controlling the Money Supply
How an Open Market Operation Works
When the Fed buys securities in an open market
operation:
• The monetary base increases.
• Banks increase their lending.
• The quantity of money increases.
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Controlling the Money Supply
How an Open Market Operation Works
When the Fed sells securities in an open market
operation:
• The monetary base decreases.
• Banks decrease their lending.
• The quantity of money decreases.
Open market operations are used more often
than the other two options.
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Controlling the Money Supply
The Fed Buys Securities
The Fed can buy securities from either:
• A commercial bank
• The public
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Learning Objectives (cont.)
• Explain how an open market operation
changes the money supply
• Explain what determines the demand for
money
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Controlling the Money Supply
Two things occur when the Fed buys $100
million of securities from a Manhattan
Commercial Bank:
1) The bank has $100 million less
securities, and the Fed has $100 million
more securities.
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Controlling the Money Supply
Two things occur when the Fed buys $100
million of securities from a Manhattan
Commercial Bank:
2) The Fed pays for the securities by
crediting the bank’s deposit account at
the Fed with $100 million.
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The Fed Buys Securities
in the Open Market
(a) The Fed buys securities from a
commercial bank
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(a) The Fed buys securities from a commercial bank
The Federal Reserve Bank of New York
Assets
Liabilities
Reserves of
Securities +$100
Manhattan
The Fed buys
Commercial
securities from
+$100
Bank
a commercial
… and pays for the securities by increasing
bank ...
the reserves of the commercial bank.
The Manhattan Commercial Bank
Assets
Liabilities
Securities -$100
Reserves +$100
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Controlling the Money Supply
Three things occur when the Fed buys $100
million of securities from the Goldman
Sachs:
1) Goldman Sachs has $100 million less
securities, and the Fed has $100 million
more securities.
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Controlling the Money Supply
Three things occur when the Fed buys $100
million of securities from the Goldman
Sachs:
2) The Fed pays for the securities with a
check for $100 million drawn on itself,
which Goldman Sachs deposits in its
account at the Manhattan Commercial
Bank.
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Controlling the Money Supply
Three things occur when the Fed buys $100
million of securities from the Goldman
Sachs:
3) The Manhattan Commercial Bank
collects payment of this check from the
Fed, and $100 million is deposited in
Manhattan’s deposit account at the Fed.
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The Fed Buys Securities
in the Open Market
(b) The Fed buys securities from the public
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(b) The Fed buys securities from the public
The Federal Reserve Bank of New York
Assets
Liabilities
Securities +$100
The Fed buys securities
Goldman Sachs, a member
of the general public ...
Assets
Reserves of
Manhattan
Commercial
Bank
Goldman Sachs
+$100
Liabilities
Securities -$100
… and pays for the securities by
writing a check that is deposited
Deposits at
to Goldman Sachs’s account and
Manhattan
that increases the reserves of the
Commercial Bank
commercial banks.
+$100
The Manhattan Commercial Bank
Assets
Liabilities
Reserves +$100
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Goldman Sach’s Deposit +$100
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Controlling the Money Supply
When the Fed sells securities, the events are
the reverse of what was just presented.
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Controlling the Money Supply
The effects of an open market operation are
far reaching:
• Banks are able to make more loans, which
increases the quantity of money (multiplier
effect).
• It changes interest rates.
• It changes aggregate expenditure and real GDP.
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Controlling the Money Supply
Monetary Base and Bank Reserves
• The money multiplier is the amount by which a
change in the monetary base is multiplied to
determine the resulting change in the quantity
of money.
• It differs from the deposit multiplier.
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Controlling the Money Supply
Monetary Base and Bank Reserves
• A currency drain is an increase in currency held
outside the banks.
• This reduces the amount of additional money that
can be created.
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Controlling the Money Supply
The Multiplier Effect of an Open Market
Operation
• If the Fed purchases securities from banks a
series of events occur.
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Controlling the Money Supply
The purchase of securities from a bank leads
to:
1) An increase in the bank’s reserves (no
change in the quantity of money).
2) Banks lend excess reserves.
3) New deposits are used to make
payments.
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Controlling the Money Supply
The purchase of securities from a bank leads
to:
4) The money supply increases.
5) Some of the new money is held as
currency — a currency drain.
6) Some of the new money remains on
deposit in banks.
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Controlling the Money Supply
The purchase of securities from a bank leads
to:
7) Banks’ required reserves increase.
8) Excess reserves decrease, but remain
positive.
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A Round in the Multiplier Process
Following an Open Market Operation
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The Multiplier Effect of
an Open Market Operation
The Sequence
The Running Tally
Reserves
Deposits
Currency
Money
$33,333
$100,000
Open Market Operation
$100,000
Loan
$100,000
Currency
$33,333
Deposit
$66,667
Reserve
$6,667
Loan
$60,000
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$66,667
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The Multiplier Effect of
an Open Market Operation
The Sequence
Currency
$20,000
The Running Tally
Deposit
$40,000
Reserve
$4,000
Currency
$12,000
Reserves
Deposits
Currency
Money
$6,667
$106,667 $53,333
$160,000
$10,667
$130,667 $65,333
$196,000
$16,667
$166,667 $83,333
Loan
$36,000
Deposit
$24,000
and so
on...
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$250,000
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Learning Objectives (cont.)
• Explain how an open market operation
changes the money supply
• Explain what determines the demand for
money
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The Demand for Money
The Influences on Money Holding
The quantity of money people hold depends on:
1) The price level
2) The interest rate
3) Real GDP
4) Financial innovation
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The Demand for Money
The Price Level
Nominal money is the quantity of money
measured in dollars.
• The quantity of nominal money demanded is
proportional to the price level.
Real money is the quantity of money measured
in constant dollars.
• The quantity of real money demanded is
independent of the price level.
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The Demand for Money
The Interest Rate
The opportunity cost of holding money is the
interest rate a person could earn on assets they
could hold instead of money.
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The Demand for Money
Real GDP
• Money holdings depend upon planned
spending.
• The quantity of money demanded in the
economy as a whole depends on Real GDP.
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The Demand for Money
Financial Innovation
Changing technologies affect the quantity of
money held. These include:
• Daily interest checking deposits
• Automatic transfers between checking and
savings deposits
• Automatic teller machines
• Credit cards
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The Demand for Money
The Demand for Money Curve
The demand for money is the relationship
between the quantity of real money demanded
and the interest rate.
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Interest rate (percent per year)
The Demand for Money
Effect of an
increase in
the interest
rate
6
5
4
0
Effect of an
increase in
the interest
rate
2.9
MD
3.0
3.1
Real money (trillions of 1992 dollars)
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The Demand for Money
Shifts in the Demand Curve for Real Money
Changes in real GDP or financial innovation
changes the demand for money and shifts the
demand curve for real money.
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Interest rate (percent per year)
Changes in the Demand for Money
6
Effect of increase
in real GDP
5
4
MD2
Effect of decrease in
real GDP or financial
innovation
MD1
0
2.9
3.0
MD0
3.1
Real money (trillions of 1992 dollars)
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The Demand for Money
in the United States
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The Demand for Money
in the United States
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Learning Objectives (cont.)
• Explain How the Fed influences interest
rates
• Explain how interest rates influence the
economy
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Interest Rate Determination
• A percentage yield on a financial security is
the interest rate.
• The higher the price of a financial security,
other things remaining the same, the lower
is the interest rate.
• We will focus on the market for money,
since the Fed can influence the supply of
money.
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Interest Rate Determination
Money Market Equilibrium
• The interest rate is determined by the supply of
and demand for money.
• At any given moment in time, the quantity of
real money supplied is a fixed amount.
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Money Market Equilibrium
Interest rate (percent per year)
MS
6
Excess supply of
money. People buy
bonds and interest
rate falls
5
4
Excess demand for
money. People sell
bonds and interest
rate rises
MD
0
2.9
3.0
3.1
Real money (trillions of 1992 dollars)
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Learning Objectives (cont.)
• Explain How the Fed influences interest
rates
• Explain how interest rates influence the
economy
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Interest Rate Determination
Changing the Interest Rate
• Suppose the Fed begins to fear inflation.
• It decides to raise interest rates to discourage
borrowing and the purchase of goods and
services.
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Interest Rate Determination
Changing the Interest Rate
• To do so, the Fed sells securities in the open
market.
• Bank reserves decline.
• Less new loans are made.
• The money supply decreases.
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Interest rate (percent per year)
Interest Rate Changes
MS1
MS0 MS2
6
An increase in
the money
supply lowers
the interest rate
5
4
A decrease in
the money
supply raises
the interest rate
0
2.8
MD
2.9
3.0
3.1
3.2
Real money (trillions of 1992 dollars)
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Monetary Policy
Does the Fed actually change the money
supply and interest rates?
We will look at two different things:
• Short-term interest rates since 1970 and see
how the Fed influenced their fluctuations
• The period since the stock market crash of 1987
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Short-Term Interest Rates
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Money and Interest Rates
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Monetary Policy
Paul Volcker’s Fed
• When Volcker became chairman, in 1979, the
U.S. was experiencing double-digit inflation.
• Volcker ended the inflation.
• He did so by increasing interest rates sharply
between 1979 and 1981.
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Monetary Policy
Paul Volcker’s Fed (cont.)
• This was accomplished by open market
operations and increases in the discount rate.
• The interest rates increased not because Volcker
decreased the money supply, but because he
slowed the growth of the money supply.
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Monetary Policy
Paul Volcker’s Fed (cont.)
• T-bill rates increased form 10 to 14 percent.
• The prime increased from 9 to 14 percent.
• Mortgage rates increased from 11 to 15 percent.
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Monetary Policy
Paul Volcker’s Fed (cont.)
• The economy went into recession.
• Real GDP fell and the inflation rate slowed.
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Monetary Policy
Alan Greenspan’s Fed
• Greenspan became chairman in 1987.
• During the two preceding years, the money
supply had grown rapidly, and interest rates had
fallen.
• The stock market was recording record closings
regularly.
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Monetary Policy
Alan Greenspan’s Fed (cont.)
• Then, without warning, the stock market
crashed.
• The Fed immediately emphasized their
flexibility and sensitivity in the attempt to avoid
any fear of a banking crisis.
• It soon became clear that the economy was not
heading for a recession.
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Monetary Policy
Alan Greenspan’s Fed (cont.)
• Again, the economy began to grow.
• The Fed cut the growth of the money supply in
the attempt to avoid an increase in the inflation
rate.
• By 1989 the economy began to slow, and fears
of a recession became prominent.
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Monetary Policy
Alan Greenspan’s Fed (cont.)
• The money supply growth rate was increased
and interest rates were lowered.
• In 1990, the recession had become a reality.
• The Fed took actions that cut interest rates by 3
percentage points.
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Monetary Policy
Alan Greenspan’s Fed (cont.)
• By mid-1991, the economy had begun to
recover and real GDP expanded.
• The economy continued to grow, and by 1997
was threatening to set a record for the longest
peacetime expansion.
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Monetary Policy
Profiting by Predicting the Fed
• People try to anticipate what the Fed is about to
do buy and sell bonds in the hope of incurring a
profit.
• People who anticipate that the Fed is about to
increase the money supply buy bonds right
away, pushing their prices upward and pushing
interest rates downward before the Fed acts.
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The Ripple Effects of Monetary Policy
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The Fed buys securities
in the open market
The Fed sells securities
in the open market
Bank reserves increase,
and the quantity of
money increases
Bank reserves decrease,
and the quantity of
money increases
Interest rates fall
Interest rates rise
The dollar falls on
the foreign
exchange market
Net
exports
increase
Consumption
and investment
increases
The dollar rises on
the foreign
exchange market
Net
Consumption
exports and investment
decrease
decreases
Aggregate demand
increases
Aggregate demand
decreases
Real GDP and
inflation speed up
Real GDP and
inflation slow down
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Interest Rates and
Real GDP Growth
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The End
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