The Conduct of Monetary Policy FNCE 4070 – Financial Markets and Institutions
The Federal Reserve’s Balance Sheet The conduct of monetary policy by the Federal Reserve involves actions that affect its balance sheet. This is a simplified version of its balance sheet, which we will use to illustrate the effects of Fed actions.
The Federal Reserve’s Balance Sheet: Liabilities • The monetary liabilities of the Fed include: • Currency in circulation: the physical currency in the hands of the public, which is accepted as a medium of exchange worldwide. • Reserves: All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves.
The Federal Reserve’s Balance Sheet: Assets • The monetary assets of the Fed include: • Government Securities: These are the U.S. Treasury bills and bonds that the Federal Reserve has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply. • Discount Loans: These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply. • Mortgage Backed Securities – These are securities guaranteed by Freddie Mac, Fannie Mae and Ginnie Mae.
Fed Balance Sheet – Current and 2006 Assets Assets Liabilities Liabilities
Supply and Demand in theMarket for Reserves • Demand curve slopes down because iff, ER and Rd up • Supply curve slopes down because iff, DL , Rs • Equilibrium iffwhere Rs = Rd
Discount Policy • The Fed’s discount loans are primarily of three types: • Primary Credit: Policy whereby healthy banks are permitted to borrow as they wish from the primary credit facility. • Secondary Credit: Given to troubled banks experiencing liquidity problems. • Seasonal Credit: Designed for small, regional banks that have seasonal patterns of deposits.
Response to Change in Discount Rate: Case 1—no intersection • The Fed lowers id, and does not cross the demand curve • Rs shifts down • iff is unchanged
Response to Change in Discount Rate: Case 2—demand intersected • The Fed lowers id, and does cross the demand curve • Rs shifts down • iff falls
Supply and Demand in theMarket for Reserves • RR , Rd shifts to right, iff
Tools of Monetary Policy: Open Market Operations • Open Market Operations • Dynamic: Meant to change Reserves • Defensive: Meant to offset other factors affecting Reserves, typically uses repos • Advantages of Open Market Operations • Fed has complete control • Flexible and precise • Easily reversed • Implemented quickly Information about the FOMC http://www.federalreserve.gov/fomc
Example 1 • Let’s walk through an asset/liability view of what happens when the Fed buys a security from the public. • Assume the Fed buys $100 of assets from the public
Member of Public • Before the Fed buys the asset • After the Fed buys the asset
Banking System • Before the Fed buys the asset • After the Fed buys the asset – as the check is from the Fed the deposit will end up as reserves
Federal Reserve System • Before the Fed buys the asset • After the Fed buys the asset – as the check is from the Fed the deposit will end up as reserves
Response to Open Market Operations:Case 1—downward sloping demand • Open market purchase shifts supply curve to the right (NBR1 to NBR2). • Rs shifts down, fed funds rate falls. • Reverse for sale.
Response to Open Market Operations: Case 2—flat demand • Open market purchase shifts supply curve to the right (NBR1 to NBR2). • Rs parallel, fed funds rate unchanged. • Reverse for sale.
Required vs. Excess Reserves • The previous example had the bank with enough deposits so that the $100 of addition deposit had required reserves of $10. • The bank has excess reserves of $90.
No Interest on Deposits • Throughout most of the Fed’s history interest was not paid on reserves. • A bank would thus be incentivized to lend at any positive interest rate. • A bank has two choices • Lend the excess reserves to another bank at Fed Funds or • Lend the funds out to someone else.
Monetary Base and Money Supply • The monetary base is equal to • Currency in circulation • Reserves • Treasury monetary liabilities (<10%) • The money supply can be defined either as • M1 – The total amount of cash outside the banking industry plus all demand deposits (checkable deposits) • M2 = M1 + most savings accounts, money market accounts and small size time deposits.
Example 2 • Let’s assume that the bank lends its excess reserves of $90 to an individual
Banking System • After lending the excess reserves the banking system’s balance sheet will look as follows. • The Loan will be credited into a bank account as a checkable deposit and • the loan will appear as an asset
Federal Reserve System • Finally the Federal Reserve System will be unchanged. • Required reserves will be 10+9=19 • Excess reserves will be 81.
The Money Multiplier • Over time the Fed might expect that all excess reserves be converted into required reserves and the final banking system balance sheet would be
The Money Multiplier • This is defined to be M1/(Monetary Base). The current money multiplier is roughly 0.9. • As seen by the previous example one could expect that an increase in reserves through an open market purchase could lead to an increase in the money supply of 10 times the amount of the increase.
The Age of Deleveraging • Before the Fed buys the asset an individual has the following balance sheet • After the Fed buys the asset
Banking System • Before the Fed buys the asset • After the Fed buys the asset
Federal Reserve System • Before the Fed buys the asset • After the Fed buys the asset • Required Reserves $11.11 • Excess Reserves $100
Goals of Monetary Policy • The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of • maximum employment, • stable prices, and • moderate long-term interest rates.
Inflation Targeting Inflation targeting involves: • Announcing a medium-term inflation target • Commitment to monetary policy to achieve the target • Increasing transparency through public communication of objectives • Increasing accountability for missed targets
Inflation Targeting:Pros and Cons • Advantages • Easily understood by the public • Increases accountability of the central bank and places an emphasis on transparency by the Fed. • Helps avoid the time-inconsistency problem since public can hold central bank accountable to a clear goal
Inflation Targeting:Pros and Cons • Advantages (continued) • Allows for better private sector planning since the central bank must communicate • Inflation goals • Regular measures of inflation • How to achieve the goals given current conditions • Explanation of deviations from targets • Performance has been good!
Inflation Targeting:Pros and Cons • Disadvantages • Signal of progress is delayed • Affects of policy may not be realized for several quarters. • Policy tends to promote too much rigidity • Limits policymakers ability to react to unforeseen events • Usually “flexible targeting” is implemented, focusing on several key variables and targets modified as needed
Lender of Last Resort • Financial panics are extremely damaging to an economy. • Bank runs can cause serious damage. As a depositor in an institution which is rumored to be insolvent you are better off being first in line to take your money out. • Reserve Banking depends on all depositors not attempting to take their money out at the same time. • When there are rumors of a bank insolvency it can actually cause insolvency because of the run.
FDIC • The FDIC can alleviate some risk of bank runs but • The insurance fund only covers around 1% of all outstanding deposits • Large deposits are not covered • In a serious banking crisis the system might need further support. The Federal Reserve provides this
2007 Crisis • The Federal Reserve sees itself as the lender of last resort to the financial system as a whole not just banks • During the crisis it • Significantly reduced the discount rate • Extended the length of discount loans from overnight to 90 days • Created a term auction facility to remove the stigma from discount loans • Extended currency swap lines to foreign central banks who in turn were able to make loans of US dollars to their banks • Facilitated the purchase of Bear Stearns by JP Morgan