Monetary Policy Tools

“It is well enough that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning.” Henry Ford

to G Taxes pay T NX S C Saving I Interest Rent Profits Wages Circular Flow Diagram Rest of World AE = C + I + G + NX G Firms Households Goods and Services Aggregate Expenditures

Monetary Policy • Changes in Monetary Policy Tools • In order to affect Aggregate Expenditures Expansionary Policy Increase AE Contractionary Policy Decrease AE

Monetary Policy Objectives • Maintain “stable prices” = inflation below 3%. • Maintain “sustainable economic growth” = Output Growth at least 3%

D=590 d1= 100 d2= 80 d3= 120 d4= 125 d5= 165 Banking System Deposits • Bank 1 has 100 • Bank 2 has 80 • Bank 3 has 120 • Bank 4 has 125 • Bank 5 has 165 Total deposits in the banking system are $590

All Banks Reserves R=59 Reserves = 10% of Deposits • Bank 1 has 100 (0.1) = 10 in reserves • Bank 2 has 80 (0.1) = 8in reserves. • Bank 3 has 120 (0.1) =12 in reserves • Bank 4 has 125(0.1)=12.5 in reserves • Bank 4 has 165(0.1)=16.5 in reserves Total reserves in the banking system are $59

All Banks Deposits D=590 All Banks Reserves d1= 100 d2= 80 d3= 120 R=59 d4= 125 d5= 165 Ms = Deposits + Currency outside banks. r = 0.1 R=59 D=590 L= 531 Assume currency outside banks is zero Ms = 590 531 are in loans.

Government Bonds • Treasury Bills • Mature in one yearor less (1,3 and 6 months) do not pay interest prior to maturity; instead they are sold at a discount to create a positive yield to maturity. The least risky investment available to U.S. investors. • Treasury Notes • Mature in two to ten years (2, 5 or 10 years). Pay interest every six months, and are commonly issued for denominations from $100 to $1,000,000. • The 10-year Treasury note commonly used as a proxy for long-term interest rates in general. • Treasury Bonds • Longest maturity, ten years to thirty years. Pay interest every six months like T-Notes.

Bank 1= 10 Bank 2 = 8 Bank 3= 12 R=59 Bank 4= 12.5 Bank 5= 16.5 The Fed’s T- Account Federal Reserve Bank Liabilities Assets Bonds The Fed holds Government bonds as part of their Assets. Bank’s reserves are liabilities to the Fed

Assets 1999 1998 Gold certificates $ 11,048 $11,046 Special drawing rights certificates 6,200 9,200 Coin 207 358 Items in process of collection 6,524 6,933 Loans to depository institutions 233 17 Securities purchased under agreements to resell (tri-party) 140,640 U.S. government and federal agency securities, net 483,902 488,911 Investments denominated in foreign currencies 16,140 19,768 Accrued interest receivable 5,314 4,680 Bank premises and equipment, net 1,861 1,787 Other assets 2,391 1,942 Total assets $674,460 $544,642 Liabilities and Capital Liabilities Federal Reserve notes outstanding, net $600,662 $491,657 Deposits Depository institutions 24,027 26,306 U.S. Treasury, general account 28,402 6,086 Other deposits 274 413 Deferred credit items 6,117 5,924 Surplus transfer due U.S. Treasury 1,066 1,373 Accrued benefit cost 816 780 Other liabilities 234 199 Total liabilities 661,598 532,738 Capital Capital paid-in 6,431 5,952 Surplus 6,431 5,952 Total capital 12,862 11,904 Total liabilities and capital $674,460 $544,642 THE FEDERAL RESERVE BANKS COMBINED STATEMENTS Dec. 31 in Millions

Bank 1= 10 Bank 2= 8 Bank 3= 12 R=59 Bank 4= 12.5 Bank 5= 16.5 The Fed Buys $10 in Bonds From Mr. Anderson Liabilities Assets FED 50 Bonds 60 Bonds 10 Bond Mr. Anderson Fed pays with a check which Anderson deposits at his bank

D=590 d1= 100 d2= 80 d3= 120 d4= 125 d5= 165 Mr. Anderson Deposits the Fed’s Check at Bank 1 All Banks Deposits New deposit At bank One +10

How did the fed pay for those bonds? Bank 1= 10 Bank 2= 8 Bank 3= 12 R=59 Bank 4= 12.5 Bank 5= 16.5 Fed manufactures the funds out of thin air! A Bond Purchase Increases Bank’s Reserves Liabilities Assets FED 50 Bonds 60 Bonds +10 Fed credits Bank One’s reserves Bank 1 presents Fed’s check to the Fed for clearing 10

When Bank One’s Reserves Increase • Bank One holds now more reserves than required: it has excess reserves • Bank One will make more loans • To other banks • To the public Until it holds only required reserves. • The loans generated become new deposits at other banks which keep 10% as reserves and loan the rest…

D R x 1 r 1 10 x 0.1 With $10 in extra reserves… D D = D D=100 D D = Deposits increase by 100 when reserves increase by 10. This 100 includes a 90 increase in loans.

At the end of the Money Multiplier Process… All Banks After All Banks Before r=10% r=10% D = 590 D = 690 R = 59 R = 69 L = 531 L = 621 D R=10;D D=100; D L = 90

All Banks Deposits D=590+100 All Banks Reserves d1= 100+10 d2= 80+20 d3= 120+15 R=59+10 d4= 125+25 d5= 165+30 Ms = Deposits + Currency outside banks. r = 0.1 R=59+10 D=590+100 L= 531+90 Ms = 590+100 531+90=621 are in loans.

r=10% D = 590 R = 59 L =531 In Summary • When the Fed Buys Bonds • New Reserves become available for banks to loan out • Money is created • The Money Supply increases. R=10% DD = DR(1/r) DR = Fed’s Purchase DL = DD - DR

Bank 1= 10 Bank 2= 8 Bank 3= 12 R=59 Bank 4= 12.5 Bank 5= 16.5 The Fed Sells $10 in Bonds to Mr. Brown Liabilities Assets FED 50 Bonds 40 Bonds 10 Bond Mr. Brown Brown pays with a check from his bank: Bank 3

Bank 1= 10 Bank 2= 8 Bank 3= 12 R=59 Bank 4= 12.5 Bank 5= 16.5 A Bond Sale Decreases Bank’s Reserves Liabilities Assets FED 50 Bonds 40 Bonds Fed erases Bank 3 reserves -10 Fed clears Brown’s check by reducing Bank 3 reserves -10

D=590 d1= 100 d2= 80 d3= 120 d4= 125 d5= 165 Bank 3 decreases Mr. Brown’s account by $10 All Banks Deposits Brown’s deposit account decreases by $10 -10

r=10% D = 590 R = 59 L =531 R=10% In Summary • When the Fed Sells Bonds • Fed clears payment by erasing bank reserves. • Reserves are no longer enough: bank must decrease loans outstanding. • Money is destroyed. • The Money Supply decreases. DD = DR(1/r) DR = Fed’s sale DR = -10 DD = -10(1/0.1) DD = -100 DL = DD - DR DL = -100 – (-10) = - 90

All Banks Deposits D=590-100 All Banks Reserves d1= 100-10 d2= 80-20 d3= 120-15 R=59-10 d4= 125-25 d5= 165-30 When the Fed Sells Bonds r = 0.1 R=59-10 D=590-100 L= 531-90 = 441 Ms = 590-100 531-90=441 are in loans.

The Federal Funds Rate Federal Funds Rate New Supply Supply Banks with excess reserves lend (Supply) funds in this market Fed buys bonds Federal Funds Rate io Banks short of reserves Borrow (Demand) funds in this market i1 Demand Quantity Bank Reserves

The Federal Funds Rate New Supply Federal Funds Rate Supply Fed sells bonds i1 io Demand Quantity Bank Reserves

Open Market Operations Fed buys/sells bonds from the public or banks Fed Injects/reduces banking system reserves Federal Funds Rate Decreases/Increases Investment Changes GDP Changes Long Term interest rates change Credit easier/harder to get All Short term interest rates change with the fed funds rate

Federal Funds Rate

1.81%

Banks are fully loaned up r=10% • The fed sells 2B in bonds, calculate: • The change in deposits: • The change in Loans: • The change in Reserves: • The change in the Money Supply: • Fill in the blanks with one of the choices provided in parenthesis. • If the Fed is selling bonds, we can conclude that the Fed is concerned with (inflation/unemployment)__________________. • The Fed sells bonds in order to (increase/decrease) ________________ the Federal Funds rate. • This change in the Federal funds rate will cause a (an) (increase/decrease) ____________________ in short term interest rates to consumers which will (slow down/increase) ___________________Aggregate Demand thus (slowing down/speeding up) ___________________ the (inflation/unemployment) _____________________________rate.

Tuesday September 16The central bank said it was keeping its target for the federal funds rate, at 2 percent. Fed said "strains in financial markets have increased significantly and labor markets have weakened further." However, the central bank also remained concerned about inflation pressures. "The downside risks to growth and the upside risks to inflation are both of significant concern to the committee," the Fed officials said.

Banks lend at this rate Federal Funds Rate Discount Rate Banks borrow at this rate from the Fed

Effective January 9, 2003 • Replaces discount rate, which was below-market rate, with a new type of discount window credit called primary credit. • Primary credit will be available for very shortterms as a backup source of liquidity to depository institutions that are in generally sound financial condition in the judgment of the lending Federal Reserve Bank. • Reserve Banks will extend primary credit at a rate above the federal funds rate, which should eliminate the incentive for institutions to borrow for the purpose of exploiting the positive spread of money market rates over the discount rate

Effective January 9, 2003 • By charging an above-marketrate and restricting eligibility to generally sound institutions, the primary credit program should considerably reduce the need for the Federal Reserve to review the funding situations of borrowers and monitor the use of borrowed funds. • This reduced administration in turn should make the discount window a more attractive funding source for depository institutions when money markets tighten.

Banks borrow at this rate from the Fed Primary Credit Rate Federal Funds Rate 2.25% 1.81% Banks lend at this rate

Where does the money for these loans come from? Lending rate Prime Rate Borrow from Fed Primary Credit Rate Borrow from Other banks Federal Funds Rate Fed manufactures the funds out of thin air!

Decreasing the Primary Credit Rate d • When funds from the Fed become “cheaper” banks find it less necessary to hold excess reserves… • In case of need, banks can borrow funds from the Fed. • Banks are induced to borrow from the fed rather than keep excess reserves to cover emergencies…

A decrease in d: two possible scenarios • Banks borrow more reserves from the Fed • Reserves in the banking system increase: the Fed injects new reserves which generate new loans and new deposits • Banks decrease Excess Reserves • Banks hold on to less excess reserves and thus make more loans generating new deposits. The Money Supply increases and interest rates drop

An increase in d With higher rates, banks will be less willing to borrowfrom the fed to cover emergency needs for reserves. Banks will beef up their reserves to avoid having to borrow at high rates: As loans are paid back, banks do not make new loans thus increasing excess reserves Loans and deposits through the banking system decrease. The Money Supply decreases and interest rates increase

Tuesday October 7, 2008 Fed now lends directly to Companies! • The central bank invoked emergency powers to lend money to companies outside the financial sector • Fed announced it would begin buying companies' short-term debt that firms use to pay for everyday expenses like salaries and supplies. • The powers were bestowed during the Depression as part of the Federal Reserve Act.

Changing the Discount Rate: d Fed lowers primary credit rate Banks borrow more from the fed Lower cost of borrowing is passed to consumers and firms Investment Increases GDP Increases Long Term interest rates drop Credit easier to get All Short term interest rates drop when the primary credit rate drops

Lower interest rates normally result in higher share prices Changing the Discount Rate: d Fed lowers primary credit rate Banks borrow more from the fed Lower cost of borrowing is passed to consumers and firms Stock Prices Increase Higher Profits More consumption and investment All Short term interest rates drop when the primary credit rate drops

Higher interest rates normally result in lower share prices Changing the Discount Rate: d Fed increases primary credit rate Banks borrow less from the fed higher cost of borrowing is passed to consumers and firms Stock Prices Decrease Lower Profits Less consumption and investment All Short term interest rates increase when the primary credit rate increases

3.Changing the Required Reserve Ratio. DD = DR(1/r) All Banks r=20% r = 10% DD = 10,000(1/0.1) R = 20,000 D = 100,000 DD = 100,000 AR = 20,000 RR = 10,000 ER = 10,000 D = 200,000 L = 80,000 Hold 10%=1,000 New loan = 10,000 New Deposit Hold 10%= 900 New loan = 9,000 New Deposit Hold 10%=810 New loan = 8100 New Deposit New loan …

All Banks After All Banks Before r=10% r=20% +100,000 180,000 +100,000 200,000 D = 100,000 R = 20,000 L = 80,000 Changing the Required Reserve Ratio. R = 20,000 D = 200,000 L = 180,000 Reserves do not change. The Fed Decreases r to 10% Now 20,000 in reserves must be 10% of total deposits 20,000= (0.1) D D = 20,000/0.1 D= 200,000 10,000 excess reserves leave the banks temporarily to multiply via loans: DD = DR(1/r) DD = 10,000(1/0.1) = 100,000 DL = DD - DR DL = 100,000 – 0 = 100,000

. Category Reserve Requirement (%) Net transaction accounts: $0 to $44.3 million 3 Over $44.3 million $1,329,000 (=3% of 44.3 million) + 10% of amount over $44.3 million Eurocurrency Liabilities 0% Reserve Required Ratio

Monetary Policy Tools