Transcript McGraw-Hill/Irwin Chapter 18 Monetary Policy: Using Interest Rates

Chapter 18
Monetary Policy:
Using Interest Rates to
Stabilize the Domestic
Economy
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Monetary Policy & Interest Rates:
The Big Questions
1. What are the tools used by central
bankers to meet their stabilization
objectives?
2. How are the tools linked to the central
bank’s balance sheet?
3. How is the interest rate target
chosen?
18-2
Monetary Policy & Interest Rates:
Roadmap
•
•
•
•
Federal Reserve’s Toolbox
Operational Policy at the ECB
Linking Tools to Objectives
A Guide to Setting Interest Rates
18-3
Federal Reserve’s
Monetary Policy Toolbox
• Federal Funds Rate
• Discount Rate
• Reserve Requirement
18-4
The Target Federal Funds Rate
and Open Market Operations
• Interest rate on overnight interbank loans
• It is a market rate, the Fed
doesn’t control it precisely.
• Since they are the monopoly supplier of
reserves, they influence the market by
controlling supply.
18-5
The Target Federal Funds Rate
and Open Market Operations
• Could simply participate in the market
as a borrower and a lender
• Don’t lend because the market is
unsecured Fed won’t accept credit risk
• They don’t borrow, because that would
mean paying interest on reserves
18-6
The Target Federal Funds Rate:
and the Market for Bank Reserves
• Use Open Market Operations
• Estimate the demand for reserves each
morning, and then supply the amount
they expect to meet the demand at the
target interest rate.
18-7
The Target Federal Funds Rate:
and the Market for Bank Reserves
• Reserve Demand
Slopes Down
• For levels of reserves
less than the discount
rate, supply is vertical
• For levels of reserves
more than the discount
rate, supply is
horizontal
18-8
The Target Federal Funds Rate:
and the Market for Bank Reserves
• An increase in reserve
demand is met by an
open market purchase
• The vertical portion of
reserve supply shifts to
the left to keep the
federal funds rate at the
target level
18-9
Target and Effective
Federal Funds Rate
18-10
• Federal Funds Rate is overnight
lending rate
• Long-term interest rates = average of
expected short-term interest rates plus
risk premium
• When expected future path of the
federal funds rate changes, long-term
interest rates we all care about change.
18-11
• Work is done by the Markets Group at
the Federal Reserve Bank of New York
• Job is to stabilize the fed funds rate
• Use both temporary and permanent
open market operations
– Permanent are about once a week
– Temporary are every day
18-12
• Temporary Open Market Operations
use repurchase agreements
18-13
18-14
• Deciding the level of reserves is
complicated and uses information from
– Treasury about their balance
– Reserve managers at commercial banks
– Fed funds dealers
18-15
Discount Lending
• Not an important part of day-to-day
monetary policy.
• Primarily to avert crises:
Central bank is the lender of last resort
18-16
Discount Lending
The Details
• Primary credit
– Fed funds target + 100 basis Points
– Banks qualify by having good supervisory ratings
and by having posted acceptable collateral
– Hope is that it will cap the funds rate
• Secondary credit
– Fed funds target + 150 basis points
– Banks who don’t qualify for primary credit and
can’t get the funds more cheaply in the market
• Seasonal credit
– Purpose is to address seasonal liquidity needs.
18-17
Reserve Requirements
• Not really a policy tool any more.
• Details
– Banks must hold a minimum level of reserves
based on two-week average of balances in
certain accounts.
– Reserve computation period ends every 2nd Mon
– Reserve maintenance period:
2 weeks ending the 3rd Thurs following the end of
the computation period.
– Rules make reserve demand predictable.
18-18
The Fed’s Monetary Policy Toolbox
18-19
Operational Policy at
the European Central Bank
• Targets the main refinancing rate:
Rate on a weekly auction of 2-week maturity
loans from the central banks to the
commercial banks.
• Marginal Lending Facility
ECB makes loans at target +100 bps
• Deposit Facility
ECB pays interest at target –100 bps
on excess reserves
18-20
Operational Policy at
the European Central Bank
18-21
• Central banks set a
target overnight rate
plus
– A lending rate
– A deposit rate
• The purpose is to keep
the market overnight
rate inside the channel
18-22
Linking Tools to Objectives:
Desirable Features of Instrument
• Easily observable by everyone
• Controllable and quickly changed
• Tightly linked to the policymakers’
objectives
18-23
What if the Fed Targeted
the Quantity of Reserves?
• A shift in reserve demand
would move the market
federal funds rate
• Reserve targets make
interest rates volatile
• The federal funds rate is the
link from the financial sector
to the real economy
• Targeting reserves could
destabilize the real economy
18-24
Linking Tools to Objectives:
Targets and Instruments
• Operating Instruments
• Interest rates or Monetary base
• Intermediate targets
• Monetary Aggregates (M1 , M2)
• Objectives
• Low Inflation, Growth, stable interest rates
18-25
Linking Tools to Objectives:
Targets and Instruments
18-26
• Bypasses intermediate targets and
focuses on final objective
• Components:
– Public announcement of numerical target
– Commitment to price stability as primary
objective
– Frequent public communication
18-27
Setting the Interest Rate Target:
The Taylor Rule
The Taylor Rule tracks the actual behavior of
the target federal funds rate and relates it to
the real interest rate, inflation, and output.
Target Fed Funds rate =
2½ + Current Inflation
+ ½ (Inflation gap)
+ ½ (Output gap)
18-28
Setting the Interest Rate Target:
The Taylor Rule
•When inflation rises above target:
respond by raising the interest rate
•When output falls below target:
respond by lowering the interest rate
18-29
Setting the Interest Rate Target:
The Taylor Rule
If inflation = target and
output = potential output, then
target federal funds rate
= 2½ + inflation target
18-30
Setting the Interest Rate Target:
The Taylor Rule
18-31
• Economic data is revised relatively
often and the revisions can be large
• Real GDP data is
– Initially released at the end of a quarter
– Revised 6 times over the next 3 years
– Continues to be revised after that
18-32
18-33
Chapter 18
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008