Monetary Policy

Monetary Policy

Monetary Policy – The actions the Fed takes to influence the money supply to target interest rates in order to pursue macroeconomic objectives of:

1. Price stability

2. Full employment

3. Economic growth

4. Stability of financial markets and institutions

Price Stability

Inflation undermines money’s function as a store of value.

During 1979-1981, inflation rates were the highest the U.S. has ever experienced during peacetime.

When Paul Volcker become chairman of the Fed in 1979, he made fighting inflation his top priority. Since then, both Greenspan and Bernanke made price stability a priority.

Full Employment

Under law, the Fed is mandated to promote high employment. This goal falls upon the other branches of the government; the President and Congress, but the Fed is mandated by law to promote monetary conditions that are conducive to employment.

Fed’s Dual Mandate

In 1977, Congress amended The Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

http://www.chicagofed.org/webpages/publications/speeches/our_dual_mandate.cfm

Dual Mandate

“[M]onetary policy aims to minimize the deviations of inflation from 2 percent and the deviations of the unemployment rate from 6 percent, with equal weight on both objectives.”

Yellen November 13, 2012 http://www.federalreserve.gov/newsevents/speech/yellen20121113a.htm

Short-run tradeoff between Inflation and Unemployment

The Fed can expand aggregate demand which will lower unemployment, but this comes at a cost of higher price levels.

Remember, in the short-run wages tend to be sticky while output prices are flexible. An increase in output price due to an increase in demand, raises the firm’s profit margin, allowing them to hire more workers.

Economic Growth

Outside of price stability, promoting high employment, and promoting the stability of financial markets and institutions, there is little the Fed can do to promote economic growth through spending and saving.

The Fed can manipulate interest rates which will change incentives to spend and save, but Congress and the President have much more power over spending and saving through taxation.

Stability of Financial Market and Institutions

A well-functioning financial system is vital to economic well-being.

During the financial crisis of 2008, large investment banks suffered a liquidity problem and the Fed offered them trillions of dollars in discount loans, previously only available to commercial banks, in order to ease the catastrophe and stabilize the financial industry. Commercial banks – borrow from HHs and firms.

Investment banks – borrow from other investment banks, mutual funds, hedge funds – which are like mutual funds, but require a much more complex and riskier investment strategy.

Monetary Policy Targets

To achieve its macroeconomic objectives, the Fed has only two monetary policy targets in which it can focus on; the money supply and the interest rate.

The Fed typically focuses on the interest rate to achieve low prices, high employment, and economic growth.

However, the interest rate and money supply are closely related.

The Demand for Money

The demand for money is an inverse relationship between the interest rate the quantity of money demanded.

Why is it downward sloping?

HHs and firms have the option of either holding money or other financial assets, such as U.S. T-bills, that bear interest.

As the interest rate increases, financial assets become much more attractive.

As the interest rate decreases, money become more attractive. Money bears no interest, but can easily buy goods and services, unlike financial assets that must be converted.

Shifts in Money Demand

Changes in variables other than interest rates have the ability to shift the demand for money, such as a ΔGDP and a ΔP.

ΔGDP: as GDP increases, the amount of buying and selling will increase, increasing the demand for money and raising interest rate.

ΔP: higher price levels increase the demand for money since more money is required for buying and selling and this raises the interest rate.

The Supply of Money and the Fed’s Monetary Tools

The supply of money is fixed during a given time, but the Fed can influence it by using three main monetary tools.

1. Open market operations – buying and selling government securities.

2. Changing the discount rate – the interest rate in which banks can borrow from the Fed.

3. Changing the reserve requirement.

Open Market Operations

The FOMC normally meets 8 times a year to conduct open market operations (i.e. the buying and selling of government securities)

Expansionary Monetary Policy: Purchase of securities from banks. Banks reserves increase, which increase the money supply as they make loans.

Contractionary Monetary Policy: Selling of securities to banks. Banks reserves decrease, which decreases the money supply.

Changing the Discount Rate

The discount rate is the rate of interest the Fed charges to member banks to meet their reserve requirement.

Expansionary Monetary Policy: decreasing the discount rate since banks borrow more.

Contractionary Monetary Policy: increasing the discount rate since banks borrow less.

The discount rate is usually front page news. As of 11/19/2014, it is 0.75%

http://www.frbdiscountwindow.org/index.cfm

Changing the Reserve Requirement

Expansionary Monetary Policy – decreasing the reserve requirement since it increases the money multiplier.

Contractionary Monetary Policy – increasing the reserve requirement since it decreases the money multiplier. Notice that altering the reserve requirement affects both reserves and

the money multiplier.

This tool is hardly used. It easy to lower the reserve requirement, but difficult to raise it since banks with insufficient reserves would be forced to sell securities and call in loans. This would be a disruption to banks and their customers. That last time it was changed (lowered) was in 1992.

Other Monetary Tools

Moral Suasion – Presidents of banks getting a call from the BoGs who try to goad them on what to do. This is rarely practiced nowadays. Some examples of moral suasion are Smokey the Bear and the Scarlett

Letter.

Quantitative Easing – unconventional monetary policy to increase the supply of money in an economy when the federal funds rate is either at, or close to, zero. The Fed essentially creates money electronically by adding a number to an account, increasing the excessive reserves that a banks has to stimulate lending through the money multiplier process. "Quantitative" refers to the fact that a specific quantity of money is being

created “Easing" refers to reducing the pressure on banks

Equilibrium in the Money Market

Equilibrium in the money market occurs where the demand for money intersects the supply of money, resulting in the equilibrium interest rate.

Expansionary monetary policy increases the money supply and reduces interest rates

Contractionary monetary policy decreases the money supply and increases the interest rate

The Tale of Two Interest Rates

Long term real interest rate – the rate of interest determined in the loanable funds model which is relevant for purchasing long term financial assets (i.e. corporate bond, financing factories or building, or HHs buying new homes).

Short term nominal interest rate – the rate of interest determined in the money market model

Does the Fed target the Money Supply or Interest Rates?

Before the early 1980’s the Fed focused on M1, but deregulation and financial innovations (paying interest on savings accounts and money market mutual funds) made M1 a less relevant measure and the Fed relied more on M2.

During the 1990’s the relationship between M2 and economic growth started to break down.

July 1993, Greenspan told Congress that the Fed would increase it reliance to obtain their macroeconomic objectives by focusing on interest rates, primarily the federal funds rate.

Federal Funds Rate

FFR – the interest rate banks charge each other for overnight loans to meet their reserve requirements.

Remember, banks have no incentive to hold excessive reserves and sometimes come up short when deposits exceed loans and have to borrow to meet their reserve requirements.

The Fed does not set the FFR. Rather it is determined by the supply of reserves relative to the demand for them. The Fed can target the FFR by increasing or decreasing the supply of

bank reserves through OMO.

The Fed targets the FFR.

Targeting the Federal Funds Rate

Graph

http://www.newyorkfed.org/charts/ff/

Tables

http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm

Federal Funds Rate

The Federal Funds Rate is not directly relevant to HHs and firms, but only relevant to banks who borrow and lend from each other.

However, the FFR rate and the prime rate move very closely together. Prime rate – rate the bank charges its most credit worthy businesses. Prime rate is the basis for other rates that HHs face - auto loans,

credit cards, personal loans, and home equity loans. The terms of such loans typically are expressed as prime plus a certain percentage, depending on the borrower's credit rating and other factors.

Changes in the FFR often result in changes in interest rate on short term assets (T-bills and CD) and changes in interest rates on long-term financial assets (corporate bonds and mortgages).

FFR vs. Prime Rate

Zero Lower Bound (ZLB)

Notice that the federal fund rate is essentially 0% (0.9% as of 4/11/2014).

This creates a problem for monetary policy during depressed economies since they cannot lower interest rates further.

Monetary policy becomes less effective and unconventional tools (QE) are used.

Also known as a liquidity trap.

How Monetary Policy affects Aggregate Demand

The Fed targets short-term interest rates and interest rates affect Aggregate Demand. Consumption – interest rates particularly effect the

consumption of durable goods, spending, and savings.

Investment – Firms finance some of their investment (capital) through borrowing and consumers borrow to purchase new homes.

Net Exports – As U.S. interest rates rise relative to world interest rates, investment of U.S. financial assets is more desirable, increasing the demand for U.S. dollars, which increases the value of the dollar. A stronger dollar reduces Nx.

Notice that there is an inverse relationship between C, I, and Nx and the interest rate.

Two Types of Monetary Policy

Expansionary Monetary Policy- A decrease in the interest rate, leading to an increase in C, I, and Nx. This increases Aggregate Demand, resulting in:

Increase in GDP, Price levels, and employment

Contractionary Monetary Policy – An increase in the interest rate, leading to a decrease in C, I, and Nx. This decreases Aggregate Demand, resulting in:

Decrease in GDP, Price levels, and employment.

Limitations of Monetary Policy

Conducting Monetary Policy requires information about GDP. If GDP is falling, the Fed wants to implement expansionary monetary policy.

Data on GDP is published by the BEA and advanced reports are not available to about a month after the quarter ended. Then they are subject to numerous revisions.

The first quarter of 2001 showed modest increase in GDP of 2%, but was revised to 1.3%. Action was not as pressing until the revised data came out.

Monetary Policy in Summary:

Contractionary Monetary Policy(Tight Money Policy)

Expansionary Monetary Policy(Easy Money Policy)

Open market sales of securities Open market purchase of securities

Increase in the discount rate Decrease in the discount rate

Increase in reserve requirement Decrease in reserve requirement

Monetary Policy in Summary:

A tight money policy reduces the money supply which increases interest rates. Higher interest rates decrease C, I, and Nx, shifting AD to the left and resulting in:

Decreases in GDP, employment, and prices.

An easy money policy increases the money supply which decreases interest rates. Lower interest rates increase C, I, and Nx, shifting AD to the right and resulting in:

Increases in GDP, employment, and prices.

Addendum: The Fed’s new Tools

The Fed’s tools may become outdated in the near future (the reserve requirement is already) as the Fed adopts new tools.

The traditional tools rely on banks being fairly close to their required reserves.

However, as part of quantitative easing in response to the financial crisis, banks found themselves holding onto excess reserves. To be specific, U.S. banks were legally required to be holding

$101 billion in reserves as of October 29, but they were actually holding $2,557 billion in reserves--about 25 times the required amount.

Addendum: The Fed’s new Tools

Banks holding onto excess reserves may persists for years to come.

Addendum: The Fed’s new Tools

Addendum: The Fed’s new Tools

The Fed’s new main tool is likely to be paying interest rates on excess reserves (began on Oct 1, 2008 and currently 0.25%).

By changing the interest rate on excess reserves, the Fed can affect how much banks want to hold onto reserves and how much they are willing to lend and at what interest rates.

If the Fed increases this rate, banks will hold onto more reserves and lend less (including to each other), and vice versa.

This will push up the ffr and other interest rates throughout the economy.

Addendum: The Fed’s new Tools

Their backup tool is the "overnight reverse repurchase agreement facility” or reverse repo or RRP.

A reverse repurchase agreement, also called a “reverse repo” or “RRP,” is an open market operation in which the Desk [the New York Fed trading desk] sells a security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Federal Reserve on the cash invested by the RRP counterparty.

Addendum: The Fed’s new Tools

For policy purposes, the RRP is a form of short term lending and borrowing.

When the Fed conducts a RRP, it is essentially setting the level of interest of overnight borrowing.

Addendum: The Fed’s new Tools

In summary, the interest paid on reserves will establish a ceiling for the federal funds rates, and when the RRP is used, it will establish a floor.

For example, suppose the RRP rate is 5 basis points and it’s creating a pretty tight floor at five. Meanwhile the interest on reserves is 25 basis points, so the federal funds rate is going to be between 5 and 25.

Source: The Two New Tools of Monetary Policy