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FIN 30220: Macroeconomic Analysis

FIN 30220: Macroeconomic Analysis. The Federal Reserve and Monetary Policy. The Federal Reserve System was created in 1913 by Woodrow Wilson. Regulate the banking industry “Lender of Last Resort” Control the money supply Provide banking services for the federal government Check Clearing.

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FIN 30220: Macroeconomic Analysis

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  1. FIN 30220: Macroeconomic Analysis The Federal Reserve and Monetary Policy

  2. The Federal Reserve System was created in 1913 by Woodrow Wilson. • Regulate the banking industry • “Lender of Last Resort” • Control the money supply • Provide banking services for the federal government • Check Clearing Note: The Federal Reserve System is a private bank. It is actually owned by the banks within the Federal Reserve System

  3. The Federal Reserve System Divides the country into 12 Districts numbered 1 - 12 from east to west

  4. Each district has a Federal Reserve Bank with a bank president elected by the bank’s board of directors for 4 year renewable terms Bank President Board of Directors Class A (4) Class B (4) Class C (4) Member Banks Local Business Federal Reserve Board

  5. The Chairman is elected from the Board for a renewable 4 year term Stanley Fischer (Vice Chairman) (2014) Daniel Tarullo (2009) Jerome Powell (2012) Janice Yellen (Chairman) (2014) Lael Brainard (2014) The Federal Reserve board is headquartered in Washington DC. The Board Consists of 7 “Governors” appointed by the President and confirmed by the Senate for 14 Year Non-Renewable terms

  6. The Federal Open Market Committee (FOMC) is the policymaking group of the Federal Reserve System. They meet approximately 8 times per year. Policies are determined by majority vote Board of Governors (7) NY Fed President (1) Regional Fed Presidents (4) Generally, all 12 bank presidents are present at the meeting, but only 5 can vote. The NY Fed president has a permanent vote while the remaining presidents vote on a revolving basis.

  7. The Fed has three tools at its disposal… Discount Window Loans The Fed can also influence reserves by altering the interest rate charged on loans to commercial banks. (MB) Open Market Operations By purchasing or selling US Treasuries, the Fed can alter the supply of bank reserves (MB) Reserve Requirements Reserve Requirements influence the ability of banks to create new loans which affects the broader aggregates (M1,M2) This is the most often used instrument!

  8. Lending under the Federal Reserve System Federal Reserve = Federal Funds Market (Market rate) = Discount Window (Non-Market)

  9. Discount window loans are usually very short term and for relatively small dollar amounts…unless there is a problem in the economy

  10. Our most recent financial crash caused a huge spike in federal reserve lending.

  11. The Fed can control either M0 through open market operations or discount lending or the broader aggregates through altering the reserve requirement. Open Market Operations Discount Window Lending $ Change in M1 = mm1 * $ Change in MB Cash 1 + Deposits mm = Cash Reserves + Deposits Deposits Reserve Requirement

  12. Fed Policy from start to finish…. Staff economists at each federal reserve bank brief the president of local/national economic conditions Bank Presidents/Governors present policy recommendations to the FOMC – A vote is taken. The monetary base is to be increased by $100M Trading desk calls bond dealers and asks for bids This order is passed to the trading desk in NYC

  13. Fed Policy from start to finish…. Acme National Bank The dealers with the winning bids deliver the bonds. Their bank’s reserve accounts are credited Assets Liabilities +$100M (Reserves) + $100M (Deposits) The bank must keep approximately 5% (reserve requirement) of the new deposit on reserve, but is free to loan out the remaining $95M. Some of this will be loaned to business customers, some finds its way into the Federal Funds market FF Rate Excess supply of reserves pushes down the Fed Funds Rate Supply 5% Reserves

  14. Fed Policy from start to finish…. Through the Fed Funds Market, the reserves are distributed throughout the banking sector Fed Funds Market Each bank uses its new reserves to create additional loans

  15. As banks increase the supplies of the various aggregates, their rates drop as well M1 Rate M2 Rate Supply Supply 6% 7% M1 M2 $ Change in M1 $ Change in M2 = mm2 * $100M = mm1 * $100M 8 2 These newly created loans are used to purchase labor, materials, consumer goods, etc.

  16. Eventually, this newly created demand will influence prices… Wages Prices Demand Demand Hours GDP Higher demand for goods and services drive up their prices (wages and prices) Increases in inflation raise the nominal interest rate Nominal Interest Rate Real Interest Rate Expected Inflation = +

  17. Monetary Policy goals address the central bank’s agenda in general terms The Bank of England Follows an explicit Inflation Target. Specifically, the goal is to maintain 2% annual inflation. The ECB (European Central Bank) and the Federal Reserve follow policies of stable prices and maintenance of full employment

  18. Intermediate Targets address the question: “How will I meet my goals?”. Targets are variables that the central bank can more directly control. Goals vs. Targets The targetis to score 18 under par (the number he thinks he needs to win) For Tiger Woods, the goalis to win the golf tournament The Federal Reserve is currently targeting the Federal Funds Rate at 0.00% The Bank of England is currently targeting the repo rate at 0.50% The European Central Bank is currently targeting the lending rate at 1.50%

  19. Targets can be broadly classified into either “Price Targets” or “Quantity Targets” Suppose that the Federal Government could influence the supply of oranges and wanted to regulate the orange market Price Supply Lowering the price to $4 (price target) and Raising the quantity to 1,500 (quantity target) are both describing the same policy (expanding the orange market) $5/Lb $4/Lb Demand Quantity of Oranges 1,000 1,500

  20. Your response to demand changes will differ across policies Price Supply If demand for oranges increases and the Fed is following a price target, they must respond by increasing supply Target Range $5/Lb Demand Quantity of Oranges

  21. However, your response to demand changes will differ across policies Target Range Price Supply If demand for oranges increases and the Fed is following a quantity target, they must respond by decreasing supply Demand Quantity of Oranges 1000Lbs

  22. Suppose that the Fed wants to lower its target interest rate to 4% (expansionary monetary policy) A $250 purchase of Treasuries would be required 2,000 = $250 5% 8 4% M2 Multiplier Change in M2 = $2,000

  23. Suppose that the Fed wants to maintain its 5% target. Suppose an increase in GDP raises Money Demand The Fed needs to increase the monetary base by 5% 1,000 = $125 8 (An Open Market Purchase of Treasuries) Change in M2 = $1,000

  24. During the late 70’s, the federal reserve changed its policy from an interest rate target to a money target. The money target was abandoned in the mid eighties.

  25. For most of its history, the US has followed a gold standard US Treasury • A Gold Standard has two rules: • The government sets an official price of gold ($35/oz) • The government guarantees convertibility of currency into gold at a fixed price Assets Liabilities $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) $3,000 (T-Bills) Reserve Ratio = 70% Value of Gold Reserves $7,000 = Reserve Ratio = Currency Outstanding $10,000 During most of the gold standard era, the Government had a reserve ratio of around 12%

  26. By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply US Treasury (P = $35) Price Assets Liabilities Supply $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) $3,000 (T-Bills) $35 100 oz. Gold @ $35/oz $3,500 (Currency) Demand Q Reserve Ratio = 70% Suppose that the Treasury purchased gold to increase the supply of currency outstanding (i.e. increase the money supply)

  27. By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply US Treasury (P = $35) Price Assets Liabilities Supply $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) $3,000 (T-Bills) $35 Demand Q Reserve Ratio = 70% As the market price rises above $35 (due to increased demand), households start buying gold from the Treasure @ $35/oz and sell it in the open market. This reverses the original transaction

  28. The gold standard and the supply of gold: US Treasury (P = $35) Price Assets Liabilities Supply $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) $35 $3,000 (T-Bills) 100 oz. Gold @ $35/oz $3,500 (Currency) Demand Q Reserve Ratio = 70% From time to time, new gold deposits were discovered. This increased supply would push down the market price. In response, households would buy the cheap gold and sell it to the Treasury for $35. This would increase the money supply.

  29. The gold standard and the business cycle: US Treasury (P = $35) Price Assets Liabilities Supply $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) $35 $3,000 (T-Bills) (-) Gold (-) Currency Demand Q Reserve Ratio = 70% Typically, during recessions, the price of gold would rise (flight to quality). High gold prices would cause households to buy gold from the Treasury to sell in the market. This would force the treasury to lose reserves and contract the money supply.

  30. Gold Standard: Long Run vs. Short Run Long Run: By restricting the long run supply of money, the gold standard produced constant, low average rates of inflation (bankers are happy) Short Run: By forcing monetary policy to be subject to fluctuating gold prices, the gold standard exacerbated the business cycle (farmers are unhappy)

  31. Currently, the Fed follows an interest rate target. The target interest rate (Fed Funds Rate) is adjusted according to a ‘Taylor Rule” FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%) Long Run: When the economy is at full employment ( Unemployment = 5%) and inflation is at its long run target (2%), the Fed targets the Fed Funds Rate (Nominal) at FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4% Short Run: During recessions (when inflation is low and unemployment is high), the Fed lowers its target. During expansions, when inflation is high and unemployment is low), the Fed raises its target.

  32. Case study: Productivity Growth during the late 90’s A contraction of the money supply raises interest rates and pushes the economy back to capacity Even with higher capacity, rapidly expanding investment demand pushed the economy beyond capacity – this causes rising prices 4% Productivity growth expanded US production capacity

  33. End of 1992 Recession Asian Financial Crisis Late 90’s Expansion Stock Market Bubble

  34. Case study: Stock Market Crash and Liquidity Shocks An increase in the money supply lowers interest rates and pushes the economy back to capacity 4% Rapidly declining investment demand pushed the economy below capacity – this causes falling prices

  35. Stock Market Crash Beginning of Recovery Recession of 2001

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