Chapter-08-notes

Chapter-08-notes - Finance 3700 Financial Markets and...

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Finance 3700 Financial Markets and Institutions Fall 2007 Lecture Notes CHAPTER 8 Monetary policy: tools, goals, targets © Sven Thommesen
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2 TOOLS: HOW THE FED CONTROLS MONEY CREATION The Fed is charged with conducting monetary policy, which includes trying to manage the price level and/or interest rates, which requires manipulation of the money supply … Recall, the monetary base (“high-powered money”) = Banks’ deposits with the Fed + Currency held by banks (vault cash) + Currency held by the public (C) We see that the monetary base is equal to bank reserves plus cash held by the public (R+C). The Fed cannot control the amount of cash held by the public, so it will try to control bank reserves : by lending reserves to banks (against collateral, in the form of T-bills, at the discount rate ”) This increases the banks’ borrowed reserves . by purchasing securities in the bond markets from banks or from the public or from the Treasury; this is what is referred to as open market operations. They increase the banks’ non-borrowed reserves. NOTE that in both cases, the Fed lends, or pays with, new money which it makes up on the spot – it’s just a matter of changing electronic account balances! The Fed can also use these tools: Changing the legal reserve requirement r d - though note that increasing r d can have a devastating effect on the economy! Changing the rate at which it lends reserves to banks, the discount rate: - this affects how much money banks are willing to borrow from the Fed, and (depending on monetary policy) how much they are able to borrow - it also affects the rate at which banks lend to each other, the federal funds rate - it also affects the rate at which banks lend to their best customers, the prime rate .
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3 MONETIZING THE DEBT: the intersection of monetary and fiscal policy When the Federal government runs a budget deficit, the Treasury makes up the difference by borrowing (selling T-bills) at home or abroad. This act, by itself, has no effect on the money supply ! However, if the T-bills are purchased by the Fed , then bank reserves are increased and subsequently the money supply grows through the multiplier process. If the Treasury pays off bonds held by the Fed, the opposite happens: M shrinks. The Treasury borrows money by selling bonds (T-bills) in the bond markets . Anyone may purchase those bonds and thereby lend money to the government. The Fed purchases and sells bonds in the same bond markets. Hence the term, open market operations . Note that the Federal Reserve [current Chairman: Alan Greenspan] and the U.S. Treasury [current Treasury Secretary: John Snow] are separate institutions , which operate independently . They do not necessarily cooperate! In fact, the Fed is not allowed
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Chapter-08-notes - Finance 3700 Financial Markets and...

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