Monetary PolicyPart 2

Who does it? How they do it?

Monetary Policy and the Fed A central bank is a type of banker’s bank

whose financial obligations underlie an economy’s money supply

0The central bank in the U.S is the Fed

0If commercial banks need to borrow money, they go to the central bank

0If there’s a financial panic and a run on banks, the central bank is there to make loans

The ability to create money gives the central bank the power to control monetary policy

0The Federal Reserve Act of 1913 created the Federal Reserve System0 To provide for the establishment of Federal reserve

banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes

0 First United States Bank [ 1791 - 1811]0 Second United States Bank [ 1816 - 1836]

0The charters of both were allowed to lapse0 The 1907 bank crises caused the public to demand the

government do something to keep this from happening again

The Federal Reserve System

14-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve District Banks

0Each Federal Reserve District Bank is owned by the several hundred member banks in that district0 A commercial bank becomes a member by buying

stock in the Federal Reserve District Bank0 So, the Fed is a quasi public-private enterprise, not

controlled by the president or Congress0Effective control is really exercised by the Federal

Reserve Board of Governors in Washington, D.C.

14-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Federal Reserve System• Board of Governors

– 7 appointed members– Appointed by President– Confirmed by Senate

• Sets reserve requirements• Supervises & regulates

member banks• Establishes and

administers regulations• Oversees Federal Reserve

Banks

• 12 District Banks• Propose discount rates• Hold reserve balances

for member institutions• Lends reserves• Furnish currency• Collects & clears checks• Handle U.S. government

debt & cash balances

Federal Open Market Committee (Board of Governors plus 5 Reserve Bank Presidents. This committee directs open market operations which is the primary instrument of monetary policy 14-7

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Federal Reserve Districts are shaded.Board of Governors of the Federal Reserve SystemFederal Reserve Bank citiesFederal Reserve Branch citiesBoundaries of Federal Reserve Branch territories

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Alaska

Seattle

PortlandHelena

12

LosAngeles

SaltLakeCity

Denver

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Omaha

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OklahomaCity

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Kansas

Dallas

LittleRock

New OrleansHouston

ElPaso

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Boston

Detroit

St.Louis

Nashville

Atlanta

Miami

Jacksonville

Charlotte

Buffalo

NewYork

PhiladelphiaBaltimore

Washington

Cleveland

Birmingham

Chicago

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Hawaii

SanFrancisco

SanAntonio

Richmond

Minneapolis

Pittsburgh

The Federal Reserve System

The Federal Reserve System

Structure of the FedBoard of Governors

7 members appointed by the president and confirmed by the

senate

FINANCIAL SECTOR GOVERNMENT

Regional Reserve Banks and Branches

12 regional Federal Reserve banks and 25 branches

Oversees

Federal Open Market Committee (FOMC)

Board of Governors plus 5 Federal Reserve bank presidents

Provides ServicesOpen Market Operations

Duties of the FedConducts monetary policy (influencing the supply

of money and credit in the economy)

Supervises and regulates financial institutions

Lender of last resort to financial institutions

Provides banking services to the U.S. government

Issues coin and currency

Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions

The Tools of Conventional Monetary Policy

The Fed influences the amount of money in the economy by controlling the monetary base

0Monetary base is vault cash, deposits of the Fed, and currency in circulation

Monetary policy affects the amount of reserves in the banking system

0Reserves are vault cash or deposits at the Fed

0Reserves and interest rates are inversely related

Open Market Operations*Open market operations are the primary way

in which the Fed changes the amount of reserves in the system

0Open market operations are the Fed’s buying and selling of Treasury bills and Treasury bonds

0To expand the money supply, the Fed buys bonds

0To contract the money supply, the Fed sells bonds

Open Market Operations*

An open market purchase is expansionary monetary policy that tends to reduce interest rates and increase income

0When the Fed buys bonds, it deposits money in its accounts at a bank

0Bank reserves are increased, and when banks loan out the excess reserves, the money supply increases

Open Market Operations*

An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income

0When the Fed sells bonds, it receives checks drawn against banks

0The bank’s reserves are reduced and the money supply decreases

The Federal Open-Market Committee (FOMC)Boiling it down!

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0To fight recessions, the FOMC buys securities

0This increases the rate of growth of the money supply

0To fight inflation, the FOMC sells securities0This decreases the rate of growth of the

money supply

Executing Open Market Operations**

0To expand money supply, the Fed buys bonds.

• To contract money supply, the Fed sells bonds.

An Important Slid

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An Open Market Purchase0When the Fed buys bonds, it deposits the

money in federal government accounts at a bank.

• Bank cash reserves rise, encouraging banks to lend out the excess.

• The money supply rises.

An Open Market Sale0When the Fed sells bonds,

• In return for the bond, the Fed receives a check drawn against a bank.

• The bank’s reserve assets are reduced and money supply falls.

The Reserve Requirement and the Money Supply

The reserve requirement is the percentage the Fed sets as the minimum amount of reserves a bank must have

There are other ways the Fed can impact the banks’ reserves

• The Fed can directly add to the banks’ reserves

• The Fed can change the interest rate it pays banks’ on their reserves

• The Fed can change the Fed funds rate, the rate of interest at which banks borrow the excess reserves of other banks

Changing Reserve Requirements

0 The Federal Reserve Board has the power to change reserve requirements within the legal limits of 8 and 14% for checkable deposits0 Changing reserve requirements is the ultimate weapon

and is rarely used

14-43Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Borrowing from the Fed and the Discount Rate

In case of a shortage of reserves, a bank can borrow reserves directly from the Fed

The discount rate is the interest rate the Fed charges for those loans it makes to banks

0An increase in the discount rate makes it more expensive to borrow from the Fed and may decrease the money supply

0A decrease in the discount rate makes it less expensive to borrow from the Fed and may increase the money supply

The Fed Funds MarketBanks with surplus reserves loan these

reserves to banks with a shortage in reserves0Fed funds are loans of excess reserves banks

make to each other0Fed funds rate is the interest rate banks charge

each other for Fed funds

By selling bonds, the Fed decreases reserves, causing the Fed funds rate to increase

By buying bonds, the Fed increases reserves, causing the Fed funds rate to decrease

Changing the Discount Rate*

0An increase in the discount rate makes it more expensive for banks to borrow from the Fed.

• A decrease in the discount rate makes it less expensive for banks to borrow from the Fed.

The Fed Funds Rate and the Discount Rate since 1990

1990 1994 1998 2002 2006 2010 2014

9%

8%

7%

6%

5%

4%

3%

2%

1%

0%

Fed funds rate

Discount rate

The Federal Reserve Bank follows expansionary or contractionary monetary policy by targeting a lower or higher Fed funds rate

Offensive and Defensive ActionsDefensive actions are designed to maintain

the current monetary policy0The Fed buys bonds during emergencies

0Reserves would otherwise decrease because individuals and businesses don’t get to the bank with their cash

Offensive actions are designed to have expansionary or contractionary effects on the economy

The Fed Funds Rate as an Operating Target

Monetary policy affects interest rates

The Fed looks at the Federal funds rate and other targets to determine whether monetary policy is tight or loose

If the Fed funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate

If the Fed funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate

The Complex Nature of Monetary Policy

Fed tools Operating target Intermediate targets Ultimate targets

Open market operations, Discount rate, and Reserve requirement

Fed funds rate

Consumer confidenceStock pricesInterest rate spreadsHousing starts

Stable pricesSustainable growthAcceptable employmentModerate i rates

While the Fed focuses on the Fed funds rate as its operating target, it also has its eye on its ultimate targets: stable prices, acceptable employment, sustainable growth, and moderate long-term interest rates

The Taylor RuleThe Taylor rule is a useful approximation for

predicting Fed policy

Formally the Taylor rule is:

Fed funds rate = 2% + Current inflation + 0.5 x (actual inflation less desired inflation) + 0.5 x (percent deviation of aggregate

output from potential)

Limits to the Fed’s Control of the Interest Rate

The Fed may not be able to shift the entire yield curve up or down, but may make it steeper, flatter or inverted

A yield curve is a curve that shows the relationship between interest rates and bonds’ time to maturity

An inverted yield curve is one in which the short-term rate is higher than the long-term rate

As financial markets become more liquid, and technological

changes occur, the Fed’s ability to control the long-term rate through conventional monetary policy lessens

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1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr. 1 yr. 5 yr. 10 yr. 15 yr. 20 yr. 25 yr. 30 yr.

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Yiel

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Yiel

d (i

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The Yield Curve

Time to maturity Time to maturity

Yield Curve Inverted Yield Curve

Summary: The Tools of Monetary Policy

0 To fight recession, the Fed will0 Lower the discount rate0 Buy securities on the open market0 Lower reserve requirements

0This would be done only as a last resort

14-46Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

An Important Slid

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Summary: The Tools of Monetary Policy

0 To fight inflation, the Fed will0 Raise the discount rate0 Sell securities on the open market0 Raise reserve requirements

0This would be done only as a last resort

14-47Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

An Important Slid

e