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Monetary Policy

Monetary Policy

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Monetary Policy

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  1. Monetary Policy Instruments, Targets, and Goals

  2. The Federal Reserve System • The Federal Reserve System was created in 1913. The Fed’s responsibilities include: • Controlling the supply of money • Monitoring & Regulating Commercial Banks • Facilitate Checks Clearing

  3. Who Owns the Federal Reserve System • The Federal Reserve System is a joint enterprise between the government and the private sector • The Fed’s operating budget is not part of the Federal budget • National banks are required by law to be members of the federal reserve system (membership is optional for state banks), but are also “owners” of the Fed.

  4. Leadership of the Federal Reserve • The Federal Reserve is divided into twelve districts. Each district has a Regional Federal Reserve Bank

  5. Federal Reserve Districts

  6. Leadership of the Federal Reserve • The Federal Reserve is divided into twelve districts. Each district has a Regional Federal Reserve Bank • Regional bank presidents are elected by member banks, local businesses, and the Board of Governors for 5 year terms (renewable) • The Board of Governors has seven members. Each is appointed by the president and confirmed by the senate for a 14 year non-renewable term • A member of the board is appointed chairman for a 4 year (renewable) term.

  7. The Federal Open Market Committee • The FOMC meets in New York City approximately 8 times per year to formulate monetary policy • The FOMC consists of: • The Board of Governors (7) • President of the New York Fed • Four Additional Regional Presidents (revolving) • Policy is decided by a majority vote

  8. Monetary Policy • Monetary policy is characterized by four criterion: • Goals: The desired result of monetary policy • Instruments: The methods used to influence the supply of money • Targets: Attempts to quantify the size of a policy decision • Discretion: The degree of flexibility in monetary policy

  9. Monetary Policy Goals • What are central banks trying to accomplish through monetary policy? • Low, stable rates of inflation (long run) • Full employment (short run) • Are these goals compatible with each other? (Phillips curve) • Internal objectives vs. external objectives

  10. Monetary Policy Instruments • How does the Federal Reserve “control” the supply of money? • Open Market Operations (M0 & M1) • Discount Rate (M0 & M1) • Reserve Requirement ( M1)

  11. Assets US Treasuries: $500B Other Assets: $60B Gold: $12B Loans to Commercial Banks (Discount Window): $.1B Total: $572.1B Liabilities Currency In Circulation: $500B Vault Cash: $40B Bank Deposits: $20B Net Worth: $12.1B Total: $572.1B The Fed’s Balance Sheet

  12. Open Market Operations • Recall that M0 (Monetary Base) is defined as liabilities of the central bank (currency plus bank reserves) • The Fed can control M0 through the purchase or sale of assets • Open Market Sale: Decreases M0 • Open Market Purchase: Increases M0

  13. Example • Suppose that the Fed wishes to increase the monetary base by $10B. This could be accomplished through an open market purchase of T-Bills

  14. Assets US Treasuries: $510B Other Assets: $60B Gold: $12B Loans to Commercial Banks (Discount Window): $.1B Total: $582.1B Liabilities Currency In Circulation: $500B Vault Cash: $40B Bank Deposits: $20B Net Worth: $12.1B Total: $572.1B The Fed’s Balance Sheet

  15. Example • Suppose that the Fed wishes to increase the monetary base by $10B. This could be accomplished through an open market purchase of T-Bills • The Fed pays for the securities by check which is redeemable in cash or can be deposited

  16. Assets US Treasuries: $510B Other Assets: $60B Gold: $12B Loans to Commercial Banks (Discount Window): $.1B Total: $582.1B Liabilities Currency In Circulation: $500B Vault Cash: $40B Bank Deposits: $30B Net Worth: $12.1B Total: $582.1B The Fed’s Balance Sheet

  17. Example • Suppose that the Fed wishes to increase the monetary base by $10B. This could be accomplished through an open market purchase of T-Bills • The Fed pays for the securities by check which is redeemable in cash or can be deposited • Suppose the Fed wishes to lower M0 by $5– it could accomplish this by selling some of its gold

  18. Assets US Treasuries: $510B Other Assets: $60B Gold: $7B Loans to Commercial Banks (Discount Window): $.1B Total: $577.1B Liabilities Currency In Circulation: $500B Vault Cash: $40B Bank Deposits: $30B Net Worth: $12.1B Total: $582.1B The Fed’s Balance Sheet

  19. Example • Suppose that the Fed wishes to increase the monetary base by $10B. This could be accomplished through an open market purchase of T-Bills • The Fed pays for the securities by check which is redeemable in cash or can be deposited • Suppose the Fed wishes to lower M0 by $5– it could accomplish this by selling some of its gold • The gold is paid for by check, which is drawn from either the bank’s reserve cash or its account at the Fed

  20. Assets US Treasuries: $510B Other Assets: $60B Gold: $7B Loans to Commercial Banks (Discount Window): $.1B Total: $577.1B Liabilities Currency In Circulation: $500B Vault Cash: $35B Bank Deposits: $30B Net Worth: $12.1B Total: $577.1B The Fed’s Balance Sheet

  21. Commercial Banking and M1 • Recall that M1 is composed of Currency in circulation and checking accounts. The Fed can control currency directly, but checking accounts are controlled by commercial banks

  22. Commercial Banking and M1 • Recall that M1 is composed of Currency in circulation and checking accounts. The Fed can control currency directly, but checking accounts are controlled by commercial banks • The fed can influence the creation of checking accounts through the reserve requirement and the discount rate

  23. Banks, like any other business, exist to earn profits • Banks accept deposits and then use those funds to create loans • Profit = Interest Collected on Loans – Interest Paid to Deposits

  24. Deposits represents a bank’s primary liability • When offering deposits a bank faces the tradeoff between liquidity and cost • Checkable deposits (included in M1) typically pay little or no interest, but must be paid on demand • Time deposits (included in M2) pay interest, but are less liquid

  25. Banks use their collected funds to create loans and buy securities • By law, commercial banks are required to keep a percentage of their deposits as vault cash (Reserve Requirement) – the reserve requirement is around 5% of checkable deposits (Monetary Control Act of 1980) • By law, commercial banks are restricted to only buying US treasury securities and some municipal bonds (Glass-Steagall Act)

  26. Assets Cash & Federal Reserve Deposits (5%) Marketable Securities (20%) Loans (Consumer, Commercial/Industrial, Real Estate) (70%) Liabilities Transaction (Demand) Deposits (11%) Non-Transaction Deposits (52%) Loans (Discount, Fed Funds) (20%) Balance Sheet

  27. Example: A $10,000 Open Market Purchase • Suppose the fed purchases a $10,000 from a bond dealer (M0 increases by $10,000). For simplicity, assume that the Fed pays in cash.

  28. Example: A $10,000 Open Market Purchase • Suppose the fed purchases a $10,000 from a bond dealer (M0 increases by $10,000). For simplicity, assume that the Fed pays in cash. • The bond dealer deposits the $10,000 at his local bank.

  29. Assets Cash: $10,000 Liabilities Demand Deposits: $10,000 Example: A $10,000 Open Market Purchase

  30. Example: A $10,000 Open Market Purchase • Suppose the fed purchases a $10,000 from a bond dealer (M0 increases by $10,000). For simplicity, assume that the Fed pays in cash. • The bond dealer deposits the $10,000 at his local bank. • The fed requires that 5% must remain in the bank’s vault as reserves. However, the bank is free to loan out the rest (assume it pays out the loan in cash)

  31. Assets Cash: $500 Loans: $9,500 Liabilities Demand Deposits: $10,000 Example: A $10,000 Open Market Purchase

  32. Example: A $10,000 Open Market Purchase • Suppose the fed purchases a $10,000 from a bond dealer (M0 increases by $10,000). For simplicity, assume that the Fed pays in cash. • The bond dealer deposits the $10,000 at his local bank. • The fed requires that 5% must remain in the bank’s vault as reserves. However, the bank is free to loan out the rest (assume it pays out the loan in cash) • Where does the $9,500 go?

  33. Example: A $10,000 Open Market Purchase • Suppose the fed purchases a $10,000 from a bond dealer (M0 increases by $10,000). For simplicity, assume that the Fed pays in cash. • The bond dealer deposits the $10,000 at his local bank. • The fed requires that 5% must remain in the bank’s vault as reserves. However, the bank is free to loan out the rest (assume it pays out the loan in cash) • Where does the $9,500 go? • It ends up in another bank!

  34. Assets Cash: $9,500 Liabilities Demand Deposits: $9,500 Example: A $10,000 Open Market Purchase

  35. Example: A $10,000 Open Market Purchase • Now the process is repeated. The bank that receives the $9,500 keeps 5% ($475) and can loan out the remaining $9,025.

  36. Assets Cash: $475 Loans: $9,025 Liabilities Demand Deposits: $9,500 Example: A $10,000 Open Market Purchase

  37. Example: A $10,000 Open Market Purchase • Now the process is repeated. The bank that receives the $9,500 keeps 5% ($475) and can loan out the remaining $9,025. • This $9,025 finds its way into another bank and the process continues. What will the final impact on M1 be?

  38. Example: A $10,000 Open Market Purchase • Now the process is repeated. The bank that receives the $9,500 keeps 5% ($475) and can loan out the remaining $9,025. • This $9,025 finds its way into another bank and the process continues. What will the final impact on M1 be? • M1 = $10,000 + $9,500 + $9,025 + …… = $200,000

  39. Example: A $10,000 Open Market Purchase • Now the process is repeated. The bank that receives the $9,500 keeps 5% ($475) and can loan out the remaining $9,025. • This $9,025 finds its way into another bank and the process continues. What will the final impact on M1 be? • M1 = $10,000 + $9,500 + $9,025 + …… = $200,000 • (Change in M1)/(Change in M0) = money multiplier = 20 = 1/Reserve Requirement

  40. Example: A $10,000 Open Market Purchase • Now the process is repeated. The bank that receives the $9,500 keeps 5% ($475) and can loan out the remaining $9,025. • This $9,025 finds its way into another bank and the process continues. What will the final impact on M1 be? • M1 = $10,000 + $9,500 + $9,025 + …… = $200,000 • (Change in M1)/(Change in M0) = money multiplier = 20 = 1/Reserve Requirement (1/.05) • Note that this scenario assumes that consumers never withdraw any cash. Suppose that the average consumer likes to keep 10% of their deposits as cash.

  41. Example: A $10,000 Open Market Purchase • Of the initial $10,000 bond purchase, only $9,000 finds its way into a bank. • The $9,000 deposit will generate $450 in reserves and $8,550 in new loans. • Of the $8,550 in loans, $7,695 is deposited, and so on • M1 = $9,000 + $8,550 + ….. = $73,000. • M1/M0 = multiplier = 7.3 = (1+cd)/(cd + rr) • cd (cash/deposits ratio) = .1 , rr (reserve req) = .05

  42. The Money Multiplier • The money multiplier is currently around 2.5 (a $1 increase in the monetary base increases M1 by $2.50) • The size of the multiplier is influenced by • Consumer behavior: If consumers hold onto more cash (cash to deposits ratio increases) the multiplier falls. • Commercial banks: Many banks choose to hold excess reserves (reserves above the 5% requirement). As excess reserves increase, the multiplier decreases. • The Federal Reserve: The federal reserve can restrict loan creation directly by raising the reserve requirement or indirectly by increasing the discount rate (this raises the bank’s cost of capital)

  43. Fed Instruments and Money Supply • If the federal reserve wishes to increase the M1 money supply, it has three choices: • An open market purchase of securities • A decrease in the reserve requirement • A decrease in the discount rate

  44. The Discount Rate vs. the Federal Funds Rate • The discount rate is the interest rate charged by the Fed on loans to commercial banks. • The discount rate is a non-market rate. It is a policy instrument determined by the Fed. • Current policy states that the discount rate is chosen to be approximately 100 basis points above the Federal Funds rate.

  45. The Discount Rate vs. the Federal Funds Rate • The discount rate is the interest rate charged by the Fed on loans to commercial banks. • The discount rate is a non-market rate. It is a policy instrument determined by the Fed. • Current policy states that the discount rate is chosen to be approximately 100 basis points above the Federal Funds rate. • The federal funds rate is the interest charged by commercial banks for very short term (usually overnight) loans to other commercial banks. • The Fed Funds rate is a market rate of interest. Therefore, it is determined by supply and demand, but is heavily influenced by the Fed.

  46. Interest Rates

  47. Intermediate Targets • An intermediate target is a variable not controlled by the fed, but heavily and predictably influenced by the Fed. Targets are used to quantify fed policy decisions (by how much will money supply be increased/decreased)

  48. Intermediate Targets • An intermediate target is a variable not controlled by the fed, but heavily and predictably influenced by the Fed. Targets are used to quantify fed policy decisions (by how much will money supply be increased/decreased) • We know that increasing the money supply lowers interest rates. Therefore, an expansionary policy can be stated two ways: • (Money target) We will increase the M1 money supply by 5%. • (Interest rate target) We will increase M1 by enough to lower the federal funds rate by 50 basis points.

  49. Price Targets • Suppose that you can perfectly control the supply of some commodity. Your goal is to maintain a constant price

  50. Price Targets • Suppose that you can perfectly control the supply of some commodity. Your goal is to maintain a constant price • How would you respond to an increase in demand?