FMI - PART 4 - CHAP 10 - CONDUCT OF MONETARY POLICY.pptx.ppt

Editor's Notes

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• #2: Understanding the conduct of monetary policy is important because it affects not only the money supply and interest rates but also the level of economic activity and hence our well-being. To explore this subject, we look first at the Federal Reserve’s balance sheet and how the tools of monetary policy affect the money supply and interest rates. Then we examine in more detail how the Fed uses these tools and what goals the Fed and other countries’ central banks establish for monetary policy.
• #5: The cast of characters in the money supply story is as follows: 1. The central bank the government agency that oversees the banking system and is responsible for the conduct of monetary policy; in Canada, the Bank of Canada 2. Banks (depository institutions) the financial intermediaries that accept deposits from individuals and institutions and make loans: chartered banks and near banks 3. Depositors individuals and institutions that hold deposits in banks
• #6: Discount loans. The Fed can provide reserves to the banking system by making discount loans to banks. An increase in discount loans can also be the source of an increase in the money supply. The interest rate charged banks for these loans is called the discount rate. Government securities. This category of assets covers the Fed’s holdings of securities issued by the U.S. Treasury. As you will see, the Fed provides reserves to the banking system by purchasing securities, thereby increasing its holdings of these assets. An increase in government securities held by the Fed leads to an increase in the money supply.
• #8: When discussing the monetary base, we will focus only on the monetary liabilities of the Fed because the monetary liabilities of the Treasury account for less than 10% of the base. Currency in circulation is the amount of currency in the hands of the public (outside of banks)—an important component of the money supply. (Currency held by depository institutions is also a liability of the Fed but is counted as part of reserves.) Reserves. All banks have an account at the Fed in which they hold deposits. Reserves consist of deposits at the Fed plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Reserves are assets for the banks but liabilities for the Fed because the banks can demand payment on them at any time and the Fed is obliged to satisfy its obligation by paying Federal Reserve notes. As you will see, an increase in reserves leads to an increase in the level of deposits and hence in the money supply.
• #17: illustrates the monetary policy implementation process that we will be discussing in more detail below. Regardless of the tool the Federal Reserve uses to implement monetary policy, the major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves (required and excess reserves held as depository institution reserves balances in accounts at Federal Reserve Banks plus the vault cash on hand of commercial banks)
• #20: The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate , which is used in the United States to guide monetary policy. The fed funds rate is a function of the supply and demand for federal funds among banks and the effects of the Fed’s trading through the FOMC fed funds rate The interest rate on short-term funds transferred between financial institutions, usually for a period of one day.
• #22: When the Federal Reserve purchases securities, it pays for the securities by either writing a check on itself or directly transferring funds (by wire transfer) into the seller’s account. Either way, the Fed credits the reserve deposit account of the bank that sells it (the Fed) the securities. This transaction increases the bank’s excess reserve levels. When the Fed sells securities, it either collects checks received as payment or receives wire transfers of funds from these agents (such as banks) using funds from their accounts at the Federal Reserve Banks to purchase securities. This reduces the balance of the reserve account of a bank that purchases securities. Thus, when the Federal Reserve sells (purchases) securities in the open market, it decreases (increases) banks’ (reserve account) deposits at the Fed
• #23: To see how they work, let’s use T-accounts to examine what happens when the Fed conducts an open market purchase in which $100 of bonds are bought from the public. When the person or corporation that sells the $100 of bonds to the Fed deposits the Fed’s check in the local bank, the nonbank public’s T-account after this transaction is Assets Securities –$100 Checkable deposits +$100 When the bank receives the check, it credits the depositor’s account with the $100 and then deposits the check in its account with the Fed, thereby adding to its reserves. The banking system’s T-account becomes
• #24: Open market operations are not the only way the Federal Reserve can affect the amount of reserves. Reserves are also changed when the Fed makes a discount loan to a bank. For example, suppose that the Fed makes a $100 discount loan to the First National Bank. The Fed then credits $100 to the bank’s reserve account. The effects on the balance sheets of the banking system and the Fed are illustrated by the following T-accounts:
• #25: Open market operations are not the only way the Federal Reserve can affect the amount of reserves. Reserves are also changed when the Fed makes a discount loan to a bank. For example, suppose that the Fed makes a $100 discount loan to the First National Bank. The Fed then credits $100 to the bank’s reserve account. The effects on the balance sheets of the banking system and the Fed are illustrated by the following T-accounts: Similar reasoning indicates that when a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply
• #28: We derive a demand and supply curve for reserves. Then the market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the federal funds rate, the interest rate charged on the loans of these reserves Recall from the previous section that the amount of reserves can be split up into two components: (1) required reserves, which equal the required reserve ratio times the amount of deposits on which reserves are required, and (2) excess reserves, the additional reserves banks choose to hold.
• #29: When the federal funds rate is above the rate paid on excess reserves, ier, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls. Holding everything else constant, including the quantity of required reserves, the quantity of reserves demanded rises. Consequently, the demand curve for reserves, Rd, slopes downward in Figure 10.1 when the federal funds rate is above ier. If however, the federal funds rate begins to fall below the interest rate paid on excess reserves ier, banks would not lend in the overnight market at a lower interest rate. Instead, they would just keep on adding to their holdings of excess reserves indefinitely. The result is that the demand curve for reserves, Rd, becomes flat (infinitely elastic) at ier in Figure 10.1.
• #30: Thus, as long as iff remains below id, the supply of reserves will just equal the amount of nonborrowed reserves supplied by the Fed, NBR, and so the supply curve will be vertical, as shown in Figure 10.1. However, as the federal funds rate begins to rise above the discount rate, banks would want to keep borrowing more and more at id and then lending out the proceeds in the federal funds market at the higher rate, iff. The result is that the supply curve becomes flat (infinitely elastic) at id, as shown in Figure 10.1.
• #31: Market Equilibrium Market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied, Rs = Rd. Equilibrium therefore occurs at the intersection of the demand curve Rd and the supply curve Rs at point 1, with an equilibrium federal funds rate of . When the federal funds rate is above the equilibrium rate at , there are more reserves supplied than demanded (excess supply) and so the federal funds rate falls to as shown by the downward arrow. When the federal funds rate is below the equilibrium rate at , there are more reserves demanded than supplied (excess demand) and so the federal funds rate rises, as shown by the upward arrow. (Note that Figure 10.1 is drawn so that id is above because the Federal Reserve typically keeps the discount rate substantially above the target for the federal funds rate.)
• #32: The effect of an open market operation depends on whether the supply curve initially intersects the demand curve in its downwardsloped section versus its flat section. Panel (a) of Figure 10.2 shows what happens if the intersection initially occurs on the downward-sloped section of the demand curve. We have already seen that an open market purchase leads to a greater quantity of reserves supplied; this is true at any given federal funds rate because of the higher amount of nonborrowed reserves, which rises from NBR1 to NBR2. An open market purchase therefore shifts the supply curve to the right from Rs1 to Rs2 and moves the equilibrium from point 1 to point 2, lowering the federal funds rate from to Iff 1 to Iff 2.1 The same reasoning implies that an open market sale decreases the quantity of nonborrowed reserves supplied, shifts the supply curve to the left, and causes the federal funds rate to rise. Because this is the typical situation—since the Fed usually keeps the federal funds rate target above the interest rate paid on reserves—the conclusion is that an open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise However, if the supply curve initially intersects the demand curve on its flat section, as in panel (b) of Figure 10.2, open market operations have no effect on the federal funds rate. To see this, let’s again look at an open market purchase that raises the quantity of reserves supplied, which shifts the demand curve from to , but now where initially . The shift in the supply curve moves the equilibrium from point 1 to point 2, but the federal funds rate remains unchanged at ier because the interest rate paid on reserves, ier , sets a floor for the federal funds rate.
• #33: The effect of a discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section. Panel (a) of Figure 10.3 shows what happens if the intersection occurs in the vertical section of the supply curve so there is no discount lending and borrowed reserves, BR, are zero. In this case, when the discount rate is lowered by the Fed from to , the horizontal section of the supply curve falls, as in , but the intersection of the supply and demand curves remains at point 1. Thus, in this case, there is no change in the equilibrium federal funds rate, which remains at . Because this is the typical situation—since the Fed now usually keeps the discount rate above its target for the federal funds rate—the conclusion is that most changes in the discount rate have no effect on the federal funds rate. However, if the demand curve intersects the supply curve on its flat section, so there is some discount lending (i.e., BR > 0), as in panel (b) of Figure 10.3, changes in the discount rate do affect the federal funds rate. In this case, initially discount lending is positive and the equilibrium federal funds rate equals the discount rate, . When the discount rate is lowered by the Fed from to , the horizontal section of the supply curve falls, moving the equilibrium from point 1 to point 2, and the equilibrium federal funds rate falls from to in panel (b)
• #34: Reserve Requirements When the required reserve ratio increases, required reserves increase and hence the quantity of reserves demanded increases for any given interest rate. Thus, a rise in the required reserve ratio shifts the demand curve to the right from to in Figure 10.4, moves the equilibrium from point 1 to point 2, and in turn raises the federal funds rate from to . The result is that when the Fed raises reserve requirements, the federal funds rate rises. Conversely, a decline in the required reserve ratio lowers the quantity of reserves demanded, shifts the demand curve to the left, and causes the federal funds rate to fall. When the Fed decreases reserve requirements, the federal funds rate falls.
• #36: An important advantage of the Fed’s current procedures for operating the discount window and paying interest on reserves is that they limit fluctuations in the federal funds Rate If the demand for reserves has a large unexpected increase, the demand curve would shift to the right to where it now intersects the supply curve for reserves on the flat portion where the equilibrium federal funds rate, , equals the discount rate, id. No matter how far the demand curve shifts to the right, the equilibrium federal funds rate, , will just stay at id because borrowed reserves will just continue to increase, matching the increase in demand Similarly, if the demand for reserves has a large unexpected decrease, the demand curve would shift to the left to and the supply curve intersects the demand curve on its flat portion where the equilibrium federal funds rate, , equals the interest rate paid on reserves ier. No matter how far the demand curve shifts to the left, the equilibrium federal funds rate will stay at ier because excess reserves will just keep on increasing so that the quantity demanded of reserves equals the quantity of nonborrowed reserves supplied. Our analysis therefore shows that the Federal Reserve’s operating procedures limit the fluctuations of the federal funds rate to between ier and id. If the range between ier and id is kept narrow enough, then the fluctuations around the target rate will be small.
• #38: Open market operations are the primary tool used by the Fed to set interest rates Dynamic open market operations are intended to change the level of reserves and the monetary base, and defensive open market operations are intended to offset movements in other factors that affect reserves and the monetary base. It has the capacity to absorb the Fed’s substantial volume of transactions without experiencing excessive price fluctuations that would disrupt the market
• #40: At times, the Federal Reserve may want to temporarily increase (or decrease) the aggregate level of bank reserves for reasons other than directly impacting monetary targets or interest rates. For example, holiday deposit withdrawals can create temporary imbalances in the level of bank reserves. In this case, the Trading Desk often uses repurchase agreements or repos to offset such temporary shortfalls in bank reserves and liquidity. With a repo, the Fed purchases government securities from a dealer or a bank with an agreement that the seller will repurchase them within a stated period of time (generally 1 to 15 days) as specified in the repurchase agreement. When a repurchase agreement is used, the level of bank reserves rises as the securities are sold. They are then reduced when the dealers repurchase their securities a few days later. The return to the Fed for letting the dealer borrow funds in exchange for the securities (and the cost to the dealer for borrowing the funds) is the difference between the original prices and the repurchase price of the securities. When the Fed wants to conduct a temporary open market sale, it enters a reverse repurchase agreement (or a matched sale purchase transaction). In this case, the Fed sells securities to the dealer with the agreement to buy them back at a higher price later. The Fed uses repurchase agreements and reverse repurchase agreements to bring about a temporary change in the level of reserves in the system or to respond to some event that the Fed thinks could have a significant but shortlived effect on the economy. The objective of such repurchase agreements is to smooth out fluctuations in bank reserves and thus in the nation’s money supply and to avoid adverse impacts on interest rates.
• #41: The interest rate on these loans is the discount rate, and as we mentioned before, it is set higher than the federal funds rate target, usually by 100 basis points (one percentage point), and thus in most circumstances the amount of discount lending under the primary credit facility is very small. If the amount is so small, why does the Fed have this facility? The answer is that the facility is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above the federal funds target set by the FOMC. Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points (0.5 percentage point) above the discount rate. The interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers. Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates.
• #42: The interest rate on these loans is the discount rate, and as we mentioned before, it is set higher than the federal funds rate target, usually by 100 basis points (one percentage point), and thus in most circumstances the amount of discount lending under the primary credit facility is very small. If the amount is so small, why does the Fed have this facility? The answer is that the facility is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above the federal funds target set by the FOMC. Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points (0.5 percentage point) above the discount rate. The interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers. Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates.
• #43: Changes in reserve requirements affect the demand for reserves: A rise in reserve requirements means that banks must hold more reserves, and a reduction means that they are required to hold less. Reserve requirements have rarely been used as a monetary policy tool because raising them can cause immediate liquidity problems for banks with low excess reserves. When the Fed increased these requirements in the past, it usually softened the blow by conducting open market purchases or by making the discount loan window (borrowed reserves) more available, thereby providing reserves to banks that needed them. Continually fluctuating reserve requirements would also create more uncertainty for banks and make their liquidity management more difficult.
• #47: Like the Federal Reserve, the European System of Central Banks (which is usually referred to as the European Central Bank) signals the stance of its monetary policy by setting a target financing rate, which in turn sets a target for the overnight cash rate. Like the federal funds rate, the overnight cash rate is the interest rate for very short-term interbank loans. The monetary policy tools used by the European Central Bank are similar to those used by the Federal Reserve and involve open market operations, lending to banks, and reserve requirements.
• #48: There, banks can borrow (against eligible collateral) overnight loans from the national central banks at the marginal lending rate, which is set at 100 basis points above the target financing rate. The marginal lending rate provides a ceiling for the overnight market interest rate in the European Monetary Union, just as the discount rate does in the United States. Just as the Fed does, the Eurosystem has another standing facility, the deposit facility, in which banks are paid a fixed interest rate that is 100 basis points below the target financing rate. The prespecified interest rate on the deposit facility provides a floor for the overnight market interest rate, while the marginal lending rate sets a ceiling.
• #49: Like the Federal Reserve, the European Central Bank imposes reserve requirements such that all deposit-taking institutions are required to hold 2% of the total amount of checking deposits and other short-term deposits in reserve accounts with national central banks. All institutions that are subject to minimum reserve requirements have access to the European Central Bank’s standing lending facilities and participate in open market operations. Unlike the Federal Reserve, the European Central Bank pays interest on reserves. Consequently, the banks’ cost of complying with reserve requirements is low.
• #50: Price stability is desirable because a rising price level (inflation) creates uncertainty in the economy, and that uncertainty might hamper economic growth. For example, when the overall level of prices is changing, the information conveyed by the prices of goods and services is harder to interpret, which complicates decision making for consumers, businesses, and government, thereby leading to a less efficient financial system. Not only do public opinion surveys indicate that the public is hostile to inflation, but a growing body of evidence also suggests that inflation leads to lower economic growth.7 The most extreme example of unstable prices is hyperinflation, such as Argentina, Brazil, and Russia have experienced in the recent past. Hyperinflation has proved to be very damaging to the workings of the economy
• #51: in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes
• #52: The time-inconsistency problem is something we deal with continually in everyday life. We often have a plan that we know will produce a good outcome in the long run, but when tomorrow comes, we just can’t help ourselves and we renege on our plan because doing so has short-run gains. For example, we make a New Year’s resolution to go on a diet, but soon thereafter we can’t resist having one more bite of that rocky road ice cream—and then another bite, and then another bite—and the weight begins to pile back on. In other words, we find ourselves unable to consistently follow a good plan over time; the good plan is said to be time-inconsistent and will soon be abandoned Monetary policy makers also face the time-inconsistency problem. They are always tempted to pursue a discretionary monetary policy that is more expansionary than firms or people expect because such a policy would boost economic output (or lower unemployment) in the short run. The best policy, however, is not to pursue expansionary policy, because decisions about wages and prices reflect workers’ and firms’ expectations about policy; when they see a central bank pursuing expansionary policy, workers and firms will raise their expectations about inflation, driving wages and prices up. The rise in wages and prices will lead to higher inflation, but will not result in higher output on average.
• #53: High employment is a worthy goal for two main reasons: (1) the alternative situation—high unemployment—causes much human misery, and (2) when unemployment is high, the economy has both idle workers and idle resources (closed factories and unused equipment), resulting in a loss of output (lower GDP). Although it is clear that high employment is desirable, how high should it be? At what point can we say that the economy is at full employment? At first, it might seem that full employment is the point at which no worker is out of a job—that is, when unemployment is zero. But this definition ignores the fact that some unemployment, called frictional unemployment, which involves searches by workers and firms to find suitable matchups, is beneficial to the economy. For example, a worker who decides to look for a better job might be unemployed for a while during the job search. Workers often decide to leave work temporarily to pursue other activities (raising a family, travel, returning to school), and when they decide to reenter the job market, it may take some time for them to find the right job. Another reason that unemployment is not zero when the economy is at full employment is structural unemployment, a mismatch between job requirements and the skills or availability of local workers. Clearly, this kind of unemployment is undesirable. Nonetheless, it is something that monetary policy can do little about. This goal for high employment is not an unemployment level of zero but a level above zero consistent with full employment at which the demand for labor equals the supply of labor. This level is called the natural rate of unemployment. The goal of steady economic growth is closely related to the high-employment goal because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low Financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities and lead to a sharp contraction in economic activity. The promotion of a more stable financial system in which financial crises are avoided is thus an important goal for a central bank. Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. With the increasing importance of international trade to the U.S. economy, the value of the dollar relative to other currencies has become a major consideration for the Fed. A rise in the value of the dollar makes American industries less competitive with those abroad, and declines in the value of the dollar stimulate inflation in the United States.
• #54: In the long run, price stability promotes economic growth as well as financial and interest-rate stability. For example, when the economy is expanding and unemployment is falling, the economy may become overheated, leading to a rise in inflation. To pursue the price stability goal, a central bank would prevent this overheating by raising interest rates, an action that would initially lower employment and increase interest-rate instability
• #55: Mandates of this type, which put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued, are known as hierarchical mandates. They are the directives governing the behavior of central banks such as the Bank of England, the Bank of Canada, and the Reserve Bank of New Zealand, as well as for the European Central Bank. Thus, in practice, the Fed has a dual mandate to achieve two co-equal objectives: price stability and maximum employment.