Monetary Policy by AMQ25we7


									FIN 30220: Macroeconomic

   Monetary Policy
The National Banking Act of 1863 allowed Nationally chartered banks to
distribute bank notes

                                            National Banks controlled
                                            the supply of currency in
                                            the US through their
                                            lending policies
National Banks were also
the primary source of
emergency credit
                                             Money center banks
                                             were the “root source”
                                             of credit

                           National banks who were short of funds
                           would borrow from money center banks

                 Larger State banks who were short of funds
                 would borrow from National banks

        Small State banks who were short of funds would borrow
        from larger state banks
Credit Channels under
the National/State
Banking System
   The Federal Reserve System was created in
    1913 by Woodrow Wilson.
         Regulate the banking industry
         “Lender of Last Resort”
         Control the money supply
         Provide banking services for the federal
         Check Clearing

Note: The Federal Reserve System is a private bank. It is actually owned by
the banks within the Federal Reserve System
Credit Channels
under the               Federal Reserve

        = Federal Funds Market

        = Discount Window
The Federal Reserve System Divides the country into
12 Districts numbered 1 - 12 from east to west
Each district has a Federal Reserve Bank with a bank president
elected by the bank’s board of directors for 4 year renewable terms

                          Bank President

                        Board of Directors

          Class A (4)           Class B (4)      Class C (4)

      Member Banks          Local Business     Federal Reserve
   The Chairman is elected from the Board for a renewable 4 year term

Randall    Frederic   Kevin      Vacant      Vacant     Ben        Donald
Kroszner   Mishkin    Warsh                             Bernanke   Kohn
(2006)     (2006)     (2006)                            (2003)     (2002)

The Federal Reserve board is headquartered in Washington DC. The Board
Consists of 7 “Governors” appointed by the President and confirmed by the
Senate for 14 Year Non-Renewable terms
  The Federal Open Market Committee (FOMC) is the policymaking
  group of the Federal Reserve System. They meet approximately 8
  times per year. Policies are determined by majority vote

             Board of      NY Fed            Regional Fed
             Governors (7) President (1)     Presidents (4)

Generally, all 12 bank presidents are present at the meeting, but only 5 can
vote. The NY Fed president has a permanent vote while the remaining
presidents vote on a revolving basis.
 Instruments refer to the policy options the
 Fed has to control the supply of money…

                                  Discount Window Loans
                                  The Fed can also influence
                                  reserves by altering the
Open Market Operations
                                  interest rate charged on
By purchasing or selling          loans to commercial
US Treasuries, the Fed can        banks. (MB)
alter the supply of bank
reserves (MB)

                                    Reserve Requirements
                                    Reserve Requirements
    This is the most                influence the ability of
    often used                      banks to create new loans
    instrument!                     which affects the broader
                                    aggregates (M1,M2)
               The Reserve Requirement is the least used of the Fed’s
               policy tools. A Bank is required to keep a minimum
               percentage of its deposits either as cash or on deposit at
               the federal reserve (reserve deposits pay no interest)

       Federal Reserve                          Acme National Bank

  Assets         Liabilities                Assets         Liabilities

                $ 2,500 (Reserves)   $ 2,500 (Cash)       $50,000 (Deposits)
                                     $ 2,500 (Reserves)
                                     $45,000 (T-Bills)

                                                          $100,000 (Equity)

Reserve Accounts are                  Acme currently has 10% of its
liabilities of the Fed                deposit liabilities on Reserve
                                      (Cash + Reserves)/Deposits
                 Suppose Acme Bank wanted to create a $30,000 loan.
                 This is done by establishing a line of credit (i.e. creating
                 a new checkable deposit)

           Acme National Bank

      Assets           Liabilities                  The loan shows up on
                                                    both sides of the
$ 2,500 (Cash)        $50,000 (Deposits)            balance sheet
$ 2,500 (Reserves) $30,000 (Deposit)
$45,000 (T-Bills)
$30,000 (Loan)

                                            Acme’s reserve ratio drops
                      $100,000 (Equity)     to 6.25% (5/80)
Type of Liability                   Reserve Requirement
Transaction Account
    $0 - $7M                                       0%
    $7M - $47.6M                                   3%
    More than $47.6M                              10%

Time Deposits                                      0%
Eurocurrencies                                     0%

The Reserve Requirement has no impact on the monetary base,
but it restricts the ability of banks to create loans – this influences
the broader aggregates.
           The discount window was the primary policy tool of the federal
           reserve when it was first established in 1913. Discount window
           loans are collateralized by the assets of the bank (equal to around
           90% of the loan)

       Federal Reserve                          Acme National Bank

  Assets          Liabilities               Assets         Liabilities

$ 2,500 (Loan)   $ 2,500 (Reserves)   $ 2,500 (Cash)      $80,000 (Deposits)
                 $ 2,500 (Reserves)   $ 2,500 (Reserves)
                                      $ 2,500 (Reserves) $ 2,500 (Disc. Loan)

                                      $45,000 (T-Bills)

                                       Res. Req. = 5%     $50,000 (Equity)

 A $2,500 loan from the discount           This bank would like to create a
 window would raise reserves to the        $70,000 loan, but doesn’t have the
 required 5%                               reserves to back it up
 The Fed actually has several discount lending programs

Type of Credit                    Interest Rate Policy
Primary (No Questions Asked)              Fed Funds + .5%

Secondary (Additional                     Fed Funds + 1.0%
Financial Information

Seasonal (Must demonstrate                Fed Funds + .2%
reoccurring seasonal liquidity
needs, <$500M in Deposits)
Discount Lending (1959-2005)
Discount Lending (1959-2008)
By purchasing and/or selling securities, the Fed can directly control the
quantity of non-borrowed reserves in the banking sector.

  The Fed
  debits/credits the
  reserve account of
  the dealer’s bank

  Federal Reserve
                         Dealers Buy/Sell           Bond Dealer
                         bonds from the Fed

Most transactions are done with repurchase agreements (Repos). These
are purchases/sales along with an agreement to reverse the transaction
at a later date
                 Currently, open market operations are the primary policy
                 tool of the Fed. Trading takes place in NYC

        Federal Reserve                             Acme National Bank

   Assets          Liabilities                 Assets           Liabilities
$ 2,500 (T- Bills) $ 2,500 (Reserves)     $ 2,500 (Cash)       $80,000 (Deposits)
                   $ 2,500 (Reserves)     $ 2,500 (Reserves)
                                          $ 2,500 (Reserves)
                                        - $ 2,500 (T- Bills)
                                          $45,000 (T-Bills)

                                            Res. Req. = 5%     $50,000 (Equity)

    An open market purchase increases the reserves of the banking
    sector – this raises M0
  The Money multipliers describe the relationship between a change in the
  monetary base (controlled by the Fed) and the broader aggregates

         $ Change in M1 = mm1 * $ Change in MB

                                               1 + Deposits
                                       mm =
                                             Cash        Reserves
                                            Deposits     Deposits

         $ Change in M2 = mm2 * $ Change in MB

                                                  Cash    + M2-M1
                                             1 + Deposits   Deposits
                                       mm2 =
                                                 Cash       Reserves
                                                Deposits    Deposits

The Fed can influence total bank reserves, which affects the multipliers!
Fed Policy from start to finish….

Staff economists at each                Bank Presidents/Governors
federal reserve bank brief              present policy
the president of                        recommendations to the
local/national economic                 FOMC – A vote is taken.
conditions                              The monetary base is to be
                                        increased by $100M

Trading desk calls
bond dealers and asks               This order is passed to
for bids                            the trading desk in NYC
 Fed Policy from start to finish….

             Acme National Bank
                                                   The dealers with the winning
        Assets           Liabilities
                                                   bids deliver the bonds. Their
+$100M (Reserves)      + $100M (Deposits)          bank’s reserve accounts are

The bank must keep approximately 5% (reserve requirement) of the new deposit on
reserve, but is free to loan out the remaining $95M. Some of this will be loaned to
business customers, some finds its way into the Federal Funds market

           FF Rate                                     Excess supply of
                                                       reserves pushes down
                                                       the Fed Funds Rate

Fed Policy from start to finish….

                                                 Through the Fed Funds
                                                 Market, the reserves are
                                                 distributed throughout
                                                 the banking sector

                         Fed Funds Market

  Each bank uses its new reserves to create additional loans
As banks increase the supplies of the various aggregates, their
rates drop as well

M1 Rate                               M2 Rate
                     Supply                             Supply

6%                                    7%

                              M1                                  M2

     $ Change                              $ Change
              = mm1 * $100M                         = mm2 * $100M
     in M1                                 in M2

                 2                                      8

These newly created loans are used to purchase labor,
materials, consumer goods, etc.
Eventually, this newly created demand will influence prices…

Wages                                 Prices

                       Demand                                     Demand

                         Hours                                     GDP

    Higher demand for goods and services drive up their prices
    (wages and prices)

    Increases in
    inflation raise              Nominal       Real           Expected
    the nominal                  Interest =    Interest   +
    interest rate                Rate          Rate
Monetary Policy goals address the central bank’s agenda
in general terms

         The Bank of England Follows an explicit Inflation Target.
         Specifically, the goal is to maintain 2% annual inflation.

              The ECB (European Central Bank) and the Federal
              Reserve follow policies of stable prices and
              maintenance of full employment
Intermediate Targets address the question: “How will I meet my goals?”.
Targets are variables that the central bank can more directly control.

                           Goals vs. Targets

                                                   The target is to score
 For Tiger Woods, the
                                                   18 under par (the
 goal is to win the golf
                                                   number he thinks he
                qualify                            needs to win)     qualify

            The Federal Reserve is currently targeting the Federal
            Funds Rate at 0.00%

            The Bank of England is currently targeting the repo rate at

            The European Central Bank is currently targeting the
            lending rate at 1.75%
   Targets can be broadly classified into either “Price
   Targets” or “Quantity Targets”

                  Suppose that the Federal Government could influence
                  the supply of oranges and wanted to regulate the orange

                               Price                      Supply

Lowering the price to
$4 (price target) and      $5/Lb
Raising the quantity to
1,500 (quantity target)
are both describing the
same policy                                                 Demand
(expanding the orange                                              Quantity of
market)                                    1,000 1,500             Oranges
   Your response to demand changes will differ
   across policies

                             Price               Supply

If demand for oranges    $5/Lb                              Target
increases and the Fed                                       Range
is following a price
target, they must
respond by increasing                             Demand
                                                          Quantity of
     However, your response to demand changes
     will differ across policies


                          Price                 Supply

If demand for oranges
increases and the Fed
is following a quantity
target, they must
respond by decreasing
supply                                                   Quantity of
                                     1000Lbs             Oranges
Suppose that the Fed wants to lower its target to 4% (expansionary
monetary policy)

         i            M2
                                              A $250 purchase of
                                              Treasuries would be
    5%                                                   = $250


                                      Md                 Multiplier
                      Change in M2 = $2,000
Suppose that the Fed is Targeting the Interest Rate at
                                          Suppose an increase in
                                          GDP raises Money
     i        M2                          Demand

                                              The Fed needs to
                                              increase the
                                              monetary base by
                                                      = $125
                                              (An Open Market
                                              Purchase of
                             Md               Treasuries)
              Change in M2 = $1,000
During the late 70’s, the federal reserve changed its policy
from an interest rate target to a money target. The money
target was abandoned in the mid eighties.






Jan-70            Jan-74               Jan-78               Jan-82

                           Fed Funds     Discount   Prime
Rules vs. Discretion
Should the Federal Reserve “pre-commit” to a particular course of

                The British have pre-committed to a fixed inflation

                 The ECB (European Central Bank) and the Federal
                 Reserve both follow discretionary policies (i.e.
                 policy is decided at the FOMC meeting)
For most of its history, the US has followed a
gold standard
                                                 US Treasury
  A Gold Standard has two rules:           Assets           Liabilities
  The government sets an
                                      $7,000 (Gold)        $10,000 (Currency)
  official price of gold ($35/oz)     (200 oz. @ $35/oz)
  The government guarantees
  convertibility of currency into
  gold at a fixed price               $3,000 (T-Bills)

                                      Reserve Ratio = 70%

                  Value of Gold Reserves          $7,000
  Reserve Ratio = Currency Outstanding       =

 During most of the gold standard era, the Government had a reserve
 ratio of around 12%
  By committing to convertibility at $35 an ounce, the government
  restricted its ability to increase/decrease the money supply

       US Treasury (P = $35)

    Assets            Liabilities          Price                       Supply

$7,000 (Gold)        $10,000 (Currency)
(200 oz. @ $35/oz)

$3,000 (T-Bills)                          $35

100 oz. Gold
@ $35/oz             $3,500 (Currency)                                   Demand

Reserve Ratio = 70%                                                             Q

  Suppose that the Treasury purchased gold to increase the supply of
  currency outstanding (i.e. increase the money supply)
  By committing to convertibility at $35 an ounce, the government
  restricted its ability to increase/decrease the money supply

       US Treasury (P = $35)
                                            Price                     Supply
    Assets            Liabilities

$7,000 (Gold)        $10,000 (Currency)
(200 oz. @ $35/oz)

$3,000 (T-Bills)                          $35


Reserve Ratio = 70%

 As the market price rises above $35 (due to increased demand),
 households start buying gold from the Treasure @ $35/oz and sell it in
 the open market. This reverses the original transaction
The gold standard and prices:

   Recall that in the long run, the price level is directly
   proportional to the ratio of money to output:

                                    (Gold Reserves)
                                    Reserve Ratio

                 k (i, t ) y

 With a (relatively) fixed supply of money, prices remained stable in the
 long run
  The gold standard and the supply of gold:

       US Treasury (P = $35)
                                            Price                      Supply
    Assets            Liabilities

$7,000 (Gold)        $10,000 (Currency)
(200 oz. @ $35/oz)

$3,000 (T-Bills)

100 oz. Gold         $3,500 (Currency)                                   Demand
@ $35/oz
Reserve Ratio = 70%

   From time to time, new gold deposits were discovered. This increased
   supply would push down the market price. In response, households
   would buy the cheap gold and sell it to the Treasury for $35. This would
   increase the money supply.
  The gold standard and the business cycle:

        US Treasury (P = $35)
                                              Price                       Supply
     Assets           Liabilities

$7,000 (Gold)        $10,000 (Currency)
(200 oz. @ $35/oz)

$3,000 (T-Bills)

  (-) Gold            (-) Currency                                           Demand

Reserve Ratio = 70%

 Typically, during recessions, the price of gold would rise (flight to quality).
 High gold prices would cause households to buy gold from the Treasury to
 sell in the market. This would force the treasury to lose reserves and
 contract the money supply.
Gold Standard: Long Run vs. Short Run

 Long Run: By restricting the long run supply of
 money, the gold standard produced constant, low
 average rates of inflation (bankers are happy)

Short Run: By forcing monetary policy to be
subject to fluctuating gold prices, the gold standard
exacerbated the business cycle (farmers are
  Currently, the Fed follows an interest rate target. The target
  interest rate (Fed Funds Rate) is adjusted according to a
  ‘Taylor Rule”

FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)

Long Run: When the economy is at full employment ( Unemployment = 5%)
and inflation is at its long run target (2%), the Fed targets the Fed Funds
Rate (Nominal) at

       FF = 2% + (2%) - 1.25(5% – 5%) + .5(2% – 2%) = 4%

Short Run: During recessions (when inflation is low and unemployment is
high), the Fed lowers its target. During expansions, when inflation is high
and unemployment is low), the Fed raises its target.
Case study: Productivity Growth during the late 90’s

                               A contraction of the money
                               supply raises interest rates
  i         FE                 and pushes the economy
                               back to capacity

                                      Even with higher capacity,
                                      rapidly expanding
                                      investment demand pushed
                                      the economy beyond
                        IS            capacity – this causes
                              y       rising prices

       Productivity growth expanded US production capacity
             End of 1992 Recession                        Asian Financial Crisis

             Late 90’s Expansion                        Stock Market Bubble

                                                                               Fed Funds
4.5                                                                            Discount
  Jan-94   Nov-94   Sep-95   Jul-96   May-97   Mar-98   Jan-99   Nov-99
Case study: Stock Market Crash and Liquidity Shocks

  i            FE
                                      An increase in the money
                            LM        supply lowers interest rates
                                      and pushes the economy
                                      back to capacity


      Rapidly declining investment demand pushed the
      economy below capacity – this causes falling prices
     Stock Market Crash

                                           Beginning of Recovery
                    Recession of 2001




                                                             Fed Funds
3                                                            Discount Rate



Jan-00     Sep-00      May-01     Jan-02       Sep-02
   Obviously, we can’t observe supply/demand
    curves. Instead, we have to look at the data
    and guess at the underlying cause.
   The outside lag (the amount of time for a
    policy to impact the economy) is “long and

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