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October 31 notes - Monetary Policy and the Economy Required...

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Unformatted text preview: Monetary Policy and the Economy Required Reading Chapter 13 Basic Questions • What is the Fed? Institution in US that conducts Monetary Policy • How does it conduct Monetary Policy? • Procedure: Discuss the Fed & Monetary Policy first under “Normal” circumstances Later, discuss Fed & Monetary Policy in the last three years Hint • Deposit Expansion Example: Initiated by an Injection of Reserves into the Banking System via a Currency Deposit • More Common Procedure: Fed Injects or Removes Reserves from the Banking System via Monetary Policy • How? Federal Reserve System • Federal Reserve System, or the “Fed”, is U.S. Central Bank European Union came together to form Central Bank, as well • Established in 1914 • Consists of 12 Federal Reserve Banks Intent: Avoid concentration of financial power in NY Not Government Agencies Private Corporations owned by Member Banks In most countries, Central Bank is just one bank, but in US it is 12. Congress carved US into 12 districts and established central bank in each. The fear was that financial power would be concentrated in NY (ironic, because it was anyways) Fed Power Centers • Board of Governors of the Federal Reserve System (“The Board”) 7 Members appointed by President 14 Year Terms 4 Year Term for the Chairman • Federal Open Market Committee (FOMC) Board of Governors Plus 5 Reserve Bank Presidents Independence of Fed • Formally Independent of the Government • Subject to political pressure • Central Bank Independence is crucial to controlling inflation Didn't want candidates up for re-election to make short-term decisions in order to get re-elected which would not be beneficial in the long-run Instruments of Monetary Policy of the Fed • Open Market Operations: Buys and sells Government Securities • Discount Policy: Lends Reserves to Banks at the “Discount Rate” • Reserve Requirements Policy: Sets Legal Reserve Requirement Ratio Current RR has been set since 1992 Federal Reserve Balance Sheet Fed Government Securities (GS) Reserve Deposits (RD) Feds pay very small interest rate. Very small. Loans to Banks (LN-DW) Other Assets Other Liabilities • Key Assets Government Securities (GS): To conduct Open Market Operations, Fed buys & sells Government Securities Loans to Banks (LN-DW): Fed lends Reserves to Banks at the “Discount Window”. Interest Rate paid on Loans is the “Discount Rate”. • Key Liability Reserve Deposits (RD): Banks hold Reserve Deposits mainly to satisfy legal reserve requirements Open Market Operations Overview • Key Instrument of Monetary policy • Broad Effects Effects on Financial Markets Deposits and the Money Supply Interest Rates Effects on Markets for Goods & Services Aggregate Expenditures Output and the Price Level Open Market Purchase Fed GovSec +1000 RD-A +1000 Feds buy government securities from a dealer, pays for them by writing a check on itself. Dealer deposits check in its bank, so that DD increases by 1000. Bank A sends check back to Feds. Increases Reserve Deposit Account by 1000 (form of reserve deposits). Bank A R +1000 DD *Pay for securities through reserve deposits +1000 Bank A has increase in deposits of 1000, and increase in reserves of 1000. If Required Reserves is 10%, can save $100 and set off deposit expansion process. • Fed buys Government Securities from a dealer with a check drawn upon itself • Dealer deposits check at Bank A • Bank A receives an increase in RD at Fed • NB: Position of Bank A is Identical to that of Bank A in Deposit of Currency example • Bank A: Required Reserves (RR) = +100 Excess Reserves (ER) = +900 • Bank A can acquire Earning Assets (EA) • Sets off Deposit Expansion process and Increases the Money Supply Principle Open Market Purchase • An Open Market Purchase of Government Securities by the Fed of $X Injects an equivalent amount of Reserves into the Banking System. • Expands Demand Deposits and thus increases the Money Supply Principle Open Market Sale • An Open Market Sale of Government Securities by the Fed of $X Drains an equivalent amount of Reserves from the Banking System. • Contracts Demand Deposits and thus reduces the Money Supply Interest Rates What is an Interest Rate? Some Interest Rates are Set by Financial Institutions Examples: iSD Interest Rate on Saving Deposits iMort Interest Rate on Mortgages iBus Interest Rate on Business Loans Other Interest Rates Must be Calculated A n E xample: Interest R ates on Bonds B ond C ontract Specifies: InP Interest Payment or C oupon Payment in $ PM P rice of Bond at M aturity M aturity D ate: Assume O ne Y ear M arket Specifies: PB = C urrent Price of the Bond C alculate: iB Interest R ate or Y ield to M aturity on the Bond iB InP PB Interest R eturn PM PB PB C apital G ain InP PB PM PB 1 Numerical Example From Bond Contract, assume: InP Interest Payment or Coupon Payment = $40 per year PM Price of Bond at Maturity = $1000 Maturity Date: One Year From the Market, assume: PB Current Price of the Bond = $975 iB Interest Rate or Yield on a One-Year Bond 40 1000 975 975 975 Interest Return 40 25 975 975 Capital Gain 0.041 0.026 0.067 or 6.7% Principle Inverse Relationship between Interest Rates and Bond Prices Given InP & PM , and vice-versa PB iB Both interest return and capital gain go down, so the yield from holding the bond goes down Extensions • Formula for Interest Rates on Bonds of Higher Maturity More Complicated But same Principle emerges • Formula can be applied to Stock Replace Interest Payment by Dividend Replace Price at Maturity by Expected Price When Stock is sold Market for Federal Funds • Recent Headline: Fed lowers Federal Funds Rate by !%! • How does the Fed do this? • What are “Federal Funds”? The excess reserves of banks- banks that have excess can lend to bands who are reserves deficient • What are the implications for financial markets and the economy? Federal Funds • Federal Funds are the Excess Reserves of Banks • Banks with Excess Reserves can lend Reserves to Banks who are “Reserve Deficient” • “Reserve Deficient” Banks need Reserves to satisfy Legal Reserve Requirements • Federal Funds Rate, iFF , is the Interest Rate Banks charge each other to borrow Reserves Interest rate on reserves lent from one back to another An Example Bank A $20 DD R RR $40 Res Def $20 $400 *Banks could go to Feds but interest rate is high and gets reputation for doing this regularly. *Has to satisfy the legal RR every two weeks. Bank B R $90 RR ER $50 $40 DD $500 10% Legal Reserve Requirement Percentage R R = Required Reserves ER = Excess Reserves R es Def = Reserve Deficiency Bank A is "Reserve Deficient" Bank B has "Excess Reserves" Bank B can lend Reserves to Bank A at the Fed Funds Rate Characteristics: Market for Federal Funds Definitions: FF i FF Quantity of Federal Funds Federal Funds Interest Rate Demand for Federal Funds--D FF D FF D ( iFF , ,... ) Slope Position OTE , OTE , iFF D FF D FF The lower the reserve rate, the higher demand for federal funds (vice-versa) Supply of Federal Funds--SFF S FF S ( i FF , OMO,...) Slope Position S FF OTE , iFF OTE , OMO OMPur S FF OTE , OMO OMSale S FF Equilibrium Condition D FF S FF **The lower the federal funds rate, the more federal funds banks want!! Federal reserve doesn't set federal funds rate. Federal Funds Market Open Market Purchase Effects on the Federal Funds Market Open Market Purchase Effects on the Federal Funds Market • OMPur Injects Reserves into the Banking System • Shifts Supply Curve for Federal Funds, to the Right • Lowers the Federal Funds Rate, iFF • Intuition: More Banks now have Excess Reserves to Lend Fewer Banks are now “Reserve Deficient”, i.e., fewer banks need Reserves to satisfy Legal Requirements Puts downward pressure on iFF Open Market Sale Effects on the Federal Funds Market Open Market Sale Effects on the Federal Funds Market • OMSale Drains Reserves from the Banking System • Shifts Supply Curve for Federal Funds, to the Left • Raises the Federal Funds Rate, iFF • Intuition: Fewer Banks now have Excess Reserves to lend More Banks are now “Reserve Deficient”, i.e., need Reserves to satisfy Legal Requirements Puts upward pressure on iFF Chain Reaction in Financial Markets Financial Instruments Interest Rates Federal Funds iFF US Gov. Bonds iGB Corporate Bonds iCB Loans to Bus Firms iLN ^Business Mortgages Etc. _________________ Average Interest Rate iMORT Etc. -Feds Control federal funds rate through open market operations Fed can indirectly control the federal funds rate through open market operations but cannot control other interest rates, only influence them with the federal funds rate (chain reaction federal reserve activity) ________ i Average interest rate on all the markets Open Market Purchase Effects on Interest Rates Effects of Fed Actions : Injects Reserves into Banking System: Buys GovSec: PGB iGB When feds buy government securities, pushes up the price of securities. and when the price of a bond goes up, the interest rate goes down R iFF Reserves of banks go up, Federal funds rate goes down. Pushing down of federal funds rate is the most visible item. Effects of Bank Actions Make Loans: iLN & iMort Lower the interest rates that they're offering on the loans...so see a decline?!?! Purchase Bonds: iGB & iCorp Banks can purchase government bonds and safe corporate bonds. Tends to push up prices of government and corporate bonds which pushes down interest rates. Over-all Effects Define i OMPur Average Interest Rate i Principle: Open Market Purchase Effects on Financial Markets Open Market Purchase of Gov Sec by the Fed Injects Reserves into the Banking System R& iFF Banks lend and invest the newly created Reserves Expands Deposits and Creates Money DD & M Lowers the Over-all or Average Level of Interest Rates i Principle: Open Market Sale Effects on Financial Markets Open Market Sale of Gov Sec by the Fed Drains Reserves from the Banking System R& iFF Banks call in loans and sell-off bonds to acquire Reserves Contracts Deposits and Destroys Money DD & M Raises the Over-all or Average Level of Interest Rates i Open Market Operations • Key Tool of Monetary Policy for the Fed • Decomposition of Effects: Effects on Financial Markets Effects on Expenditure & Output Markets • Connecting Link: Mainly Changes in Interest Rates Interest rates tie financial markets and goods markets together ...
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