Session 5: The Fed, More on Banking, and Stocks

I. The Fed– Structure, Functions and Priorities– Take-aways– Its workings in money markets.

II. Central Banking and Monetary Policy Monetary Transmission Mechanism

• Effects of Money on Output and Prices• The Money Market• The Mechanism• Tie-in with the AD-AS Framework

III. The Stock Market 1/What are stocks?How are stocks and bonds related?Helpful Tips and Rules of Thumb.

The Fed• The Fed’s structure – Who’s in charge?

– Does it act independently from politics?

• A bit of History (1913 Act)

• Functions:– (1) Conducing monetary policy

• OMO

• Discount rate

• Reserve requirement

– (2) Supervising banks– (3) Providing financial services

The Major Players at the Fed

12

The Make-up of the Fed• Board of Governors

– 7 nominated by the President, confirmed by Senate– 14-year overlapping terms

• Federal Open Market Committee (FOMC)– 12 voting members

• 7 Governors (6 plus the Chairman of the Board)• 5 Presidents of the regional Federal Reserve Banks

– NY Reserve Bank President, plus– Four Reserve Bank Presidents which rotate each year

• There are 12 Reserve Bank Presidents– Each represent important districts in the US.

The FOMC

• When will they meet (8 times/year)?– http://www.federalreserve.gov/fomc/#calendars

• Who will meet?– http://www.federalreserve.gov/fomc/#members

• 2007 – NY, Chicago, Boston, St. Louis, Kansas City.

• 2008 – NY, Cleveland, Philadelphia, Dallas, Minneapolis.

• 2009 – Chicago, Richmond, Atlanta, San Francisco.

Fed Inside Workings on Governorship

Board of Governors:

7 members appointed

by the President

and confirmed

by the Senate

Federal Open Market Committee

12 members: Board of Governors and 5 FR Bank Presidents

Federal Reserve Banks

12 Banks operating 25 branches and 9

additional offices for processing checks

Each Bank with 9 directors

3 Class-A (Banking)

3-Class B (Business)

3- Class C (Public)

Directors appoint: President, First VP, other officers and

employees

Member banks

About 5400

Large about 400

Medium about 1600

Small about 3400

Each group elects one Class A and

one Class B director in each

FR District

Federal Advisory Council

12 members

Approves salaries

Approves appt. and salaries

Elect

Elect

AppointsContributes Capital

Functions, Tools, and Instruments

A Bit of History

• States had control of money in many cases

• Money supply was very erratic

• Bank panics were not uncommon

• In face of increased interstate commerce, obvious need arose for centralized, coordinated money supply

• Most developed countries have centralized bank system and money system – some, like in the EU, have recently moved to more widespread currency, etc. (the EURO)

The Fed’s Monetary Tools

Tool Expansionary Policy

Contractionary Policy

OMO Buy bonds. Sell bonds.

Discount rate (or federal funds rate)

↓ rates ↑ rates

Reserve requirement

↓ ratio ↑ ratio

The Mechanics on the OMO’s• Government issues Treasury bills and notes.• The Fed has a “sweet deal” with the Treasury• When the Fed buys bonds.

– Buys securities with money that it creates, money that didn’t exist before.

– Earns interest on them and receives income on these holdings.

• When the Fed sells bonds.– Fed receives money:– Bank reserves go down– Tightens over-all money supply and credit.

Why is it called open market?

• (1) When Fed wants to buy Government securities, it asks all the dealers (it does business with) at what prices would you be willing to sell securities that they own. Fed buys securities from the firms that are willing to accept the lowest prices.

• (2) When the Fed sells, it asks the group of dealers for bids: the highest bid is accepted by the Fed.

• Open because the Government doesn’t decide which dealers it will do business with: the choice emerges from an “open market”.

• The dealers in the open market are competing to do business with the Fed on the basis of price.

Other Fed Tools• Discount and Federal Fund Rate

– Discount rate - rate at which the Fed lends money to banks over-night if banks think they may be short on required reserves

– Federal Funds rate – rate at which banks are allowed to charge each other for over-night loans

• Reserve requirement– Long-term parameter (hasn’t been changed in

probably 20 years)

Federal Reserve Determines Federal Funds Rate

The Fed’s Priorities

• (1) Combat inflation

• (2) Preserve integrity of financial institutions

• (3) Prevent excessive unemployment

• (4) Defend the exchange rate of the dollar

• Most countries have central banks: their objectives may be ranked differently than in the US

Some “Take Aways”

• (1) No single variable triggers monetary tightening or loosening

• (2) Ultimate objective: Price stability• (3) FED earns money on its holdings• (4) Discount rate policy formally was the major

tool; more recently, OMO has been.• (5) Monetary policy is directed to affect AD

which takes about 6 to 12 months. Not lasting effect: prices and wages tend to adjust.

• (6) FED affects short-term interest rates: not long-term rates.

Central Banking and Monetary Policy

• Effects of Money on Output and Prices– Monetary Transmission Mechanism– The Money Market– The Mechanism– Tie-in with the AD-AS Framework

Monetary Policy and AD-AS FrameworkContractionary Policy

• (1) Fed sells bonds– Public pays $$$

– Bank reserves (R)↓

• (2) As R↓, demand deposits↓, MS ↓

• (3) MS↓, i↑• (4) i↑, I↓, C↓, AD↓• (5) AD↓, GDP↓,

inflation pressure↓

Expansionary Policy

• (1) Fed buys bonds– Public receives $$$

– Bank reserves (R)↑

• (2) As R↑, demand deposits↑, MS↑

• (3) MS↑, i↓• (4) i↓, I↑, C↑, AD↑• (5) AD↑, GDP↑,

inflation pressure↑

The Money Market

Changes in Monetary Policy or Prices Affect Interest Rates

Central Bank determines the Money Supply, Changing Interest Rates and Investment, Thereby Affecting GDP

An Expansionary Monetary Policy Shifts AD Curve to the Right, Raising Output and Prices

III. The Stock Market

• (1) Constant “digester” of information: gives an up-dated appraisal of worth of companies.

• (2) Calculates the valuation (ROR) versus risk and other factors.

• (3) If all information is available to everybody: markets should be efficient.

Inaction between Stocks and Bonds

• Stock Value = f (revenue, costs, expectations)– Revenue = f (price, etc.) ------- Inflation– Costs = f (interest rate, etc.) --- Interest rate– Expectations = f (ROR, etc.) -- Interest rate

• Bond Value = f (ROR relative to interest rate)

• As i↑ ~ ROR↑ -- fixed “I” instruments, value ↓

• Thus as stock prices↑, bond prices ↓

Another look at stocks and bonds relationship

• Keep in mind that interest rates CONTROL the market value of bonds.

• A bond’s price moves in the opposite direction of interest rates. Why?– Suppose you have a $100 bond yielding 7% and interest rate

goes up to 8%. Now old bond is worth $99.07.

– Suppose now you have the same bond, but interest rate goes to 3%. What is your bond worth now? ($103.88)

• Even the fear of inflation (or rise in interest rate) can drive bond prices down. Usually on average, 30-year T-bonds yields 3% + inflation.

Some General Conclusions

• Stock Market = person with a yo-yo going up an escalator.

• It generally pays to take risks.

• Diversifying works.

• If you choose stocks,– Start early– Asses your risk coefficient– Take time to select investments/mutual funds– Try to go “long-term”– Minimize expenses and watch out for tax implications

Formulae for the Session 5:Money-Supply Multiplier and the Rule of 70

• Money-supply multiplier =MSM

• MSM = change in money/change in reserves

• MSM = 1/required reserve ratio

• Rule of 70 = number of years to double your initial amount at a given rate of growth (i)

• N= 70/i (i = whole number growth, not percentage)