monetary policy: conventional and unconventional 13 part 2

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Page 1: Monetary Policy: Conventional and Unconventional 13 Part 2

Monetary Policy: Conventional and Unconventional

13Part 2

Page 2: Monetary Policy: Conventional and Unconventional 13 Part 2

Open-Market Operations

• Which interest rate?• Fed “controls” Federal funds rate and the

Treasury bills rate (next slide)

• Fed can “influence” other interest rates such as credit cards, auto loans, mortgage rates etc.

• Normally, interest rates tend to move together

• During financial crisis relationship broke down

2

Page 3: Monetary Policy: Conventional and Unconventional 13 Part 2

As the Fed increases or decreases the FFR, the T-bill rate follows.

Page 4: Monetary Policy: Conventional and Unconventional 13 Part 2

Open-Market Operations

• Risk of default• The risk that the borrower may not pay in full or

on time• T-Bills are risk free• Bank to bank borrowing, federal funds rate, very

low risk

• Corporate bonds carry more risk . . .• Riskier borrowers pay higher interest rates, to

persuade lenders to accept the higher risk

4

Page 5: Monetary Policy: Conventional and Unconventional 13 Part 2

Open-Market Operations

• Risk of default• Interest rate on a bond = Risk free rate +

Risk premium• Risk spread = Interest rate on a bond – risk

free rate• Risk spreads widen (narrow) if investors

believe there is a greater (smaller) risk of default

5

Page 6: Monetary Policy: Conventional and Unconventional 13 Part 2

Table 2 Selected U.S. Interest Rates, September 2014 (in percent)

6

http://www.federalreserve.gov/releases/H15/update/

Page 7: Monetary Policy: Conventional and Unconventional 13 Part 2

Open-Market Operations

• During the financial crisis risk spreads widened• Mortgages, bonds of large banks - looked far riskier than

they had before• Higher risk premiums, increasing risky interest rates

• Increased demand of U.S. T-bills – “flight to safety” • Higher T-bill price, lower T-bill interest rate

7

Page 8: Monetary Policy: Conventional and Unconventional 13 Part 2

Risk Spreads During Financial Crisis

Commercial paper rate – 3-month T-Bill rate

Page 9: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• Lending to banks• Fed acts as “lender of last resort”• Fed lends to banks at the discount rate, the

interest rate the Fed charges for loans to banks• This provides banks with excess reserves

• The Fed, 2007• Massive amounts of lending to banks• Helped keep the financial system functioning• Eased the panic for a time

9

Page 10: Monetary Policy: Conventional and Unconventional 13 Part 2

Table 3 Balance Sheet Changes: Bank Borrows from the Fed

10

Fed lends reserves to banks, increasing the amount of Excess Reserves in the banking systemFed loans can increase the money supply.

Page 11: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• Fed can influence the amount banks borrow by changing the discount rate• Lower (higher) discount rate gives banks a greater

(smaller) incentive to borrow• But Fed cannot really know how much banks will

respond• Connection between discount rate and volume of

borrowing loose• Fed normally relies on open market operations

rather than discount rate.

11

Page 12: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• However, during financial crisis Fed lending went from• $250 million (Aug 2007) to $735 billion (Nov 2008)• Now lending back down to pre-crisis levels

• The Fed in 2007-2008 was acting as the “lender of last resort”. It was not trying to increase the money supply.

12

Page 13: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• Changing reserve requirements• If Fed decreases

• Banks have more excess reserves• Money expansion and lower interest rates

• If Fed increase• Banks have less excess reserves• Money contraction and higher interest rates

• Reserve requirement is set at 10% of transaction deposits since 1992

13

Page 14: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• Unconventional monetary policy• Unusual forms (or volumes) of central bank lending

and to unusual types of open-market operations• Pushing the federal funds rate down to virtually

zero• Lending to banks in unprecedented volume• Lending to some companies that are not banks• Quantitative easing

14

Page 15: Monetary Policy: Conventional and Unconventional 13 Part 2

Other Instruments of Monetary Policy

• Quantitative easing • Open-market purchases of assets other than

Treasury bills

• Treasury bonds [longer dated]

• Other assets – in 2008 and 2009, to stabilize the mortgage market

• http://www.federalreserve.gov/releases/h41/current/h41.htm

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Page 16: Monetary Policy: Conventional and Unconventional 13 Part 2

How Monetary Policy Works

• Normal times• Federal funds rate is not hovering close to zero

• Risk spreads are roughly constant • Different interest rates rise and fall together

• Banks are not holding many excess reserves

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Page 17: Monetary Policy: Conventional and Unconventional 13 Part 2

How Monetary Policy Works

• Expansionary monetary policy• Open-market purchase of T-bills lowers interest

rates

• Contractionary monetary policy• Open-market sale of T-bills raises interest rates

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Page 18: Monetary Policy: Conventional and Unconventional 13 Part 2

Figure 4 The Effects of Monetary Policy on Interest Rates

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Bank Reserves

Inte

rest

Rat

e

S0

S0D

D

S1

S1

E

A

(a)Expansionary Monetary Policy

Bank Reserves

Inte

rest

Rat

e

S0

S0

D

D

S2

S2

E

B

(b)Contractionary Monetary Policy

Page 19: Monetary Policy: Conventional and Unconventional 13 Part 2

How Monetary Policy Works

• How do interest rates influence spending?• Y = C + I + G + (X – IM)

• Investment and Net exports and consumer spending are sensitive to interest rates

• When interest rates rise (fall), spending falls (rises)

• So expenditure falls (rises)

19

Page 20: Monetary Policy: Conventional and Unconventional 13 Part 2

Figure 5 The Effect of Interest Rates on Total Expenditure

20

Real GDP

Rea

l Exp

endi

ture

45°

C+I+G+(X-IM)

C+I+G+(X-IM)(lower interest rate)

C+I+G+(X-IM)(higher interest rate)

Page 21: Monetary Policy: Conventional and Unconventional 13 Part 2

How Monetary Policy Works

• Fed believes economy might slip into recession• Pursue an expansionary monetary policy• Putting it all together

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Page 22: Monetary Policy: Conventional and Unconventional 13 Part 2

Monetary Policy Chain of Causation

Expansionary Policy

(1) Injection of reserves into the banking system pushes down interest rates

Need to know how sensitive interest rates are to change in reserves

Page 23: Monetary Policy: Conventional and Unconventional 13 Part 2

Monetary Policy Chain of Causation

Expansionary Policy

(1) Injection of bank reserves pushes down interest rates

Need to know how sensitive C and I are to changes in interest rates

(2) Lower r, stimulates investment and possibly consumer spending

(3) An increase in I and C causes total spending to increase

(4) GDP increases: multiplier analysis

Page 24: Monetary Policy: Conventional and Unconventional 13 Part 2

Figure 6 The Effect of Expansionary Monetary Policy on Total Expenditure

24

Rea

l Exp

endi

ture

45°

C+I1+G+(X-IM)

C+I0+G+(X-IM)

E0

E1

6,5006,0000

Real GDP

5,500 7,000

Page 25: Monetary Policy: Conventional and Unconventional 13 Part 2

Monetary Policy Chain of Causation

Contractionary Policy

What would occur if the Fed pursued a contractionary policy?

Page 26: Monetary Policy: Conventional and Unconventional 13 Part 2

Money and the Price Level

• What happens to the price level when the Fed pursues an expansionary policy?• Normally, it will cause the price level to increase• How much it causes will depend on the slope of

the aggregate supply curve

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Page 27: Monetary Policy: Conventional and Unconventional 13 Part 2

The Inflationary Effects of Expansionary Monetary Policy

27

Pric

e Le

vel

0

Real GDP

6,4006,000

SRAS

AD0

AD0

100

E103

AD1

AD1

BAny shock that shifts the AE curve shifts the AD curve.The increase in the money supply increases Real GDP and prices.

Page 28: Monetary Policy: Conventional and Unconventional 13 Part 2

The Inflationary Effects of Expansionary Monetary Policy

28

Pric

e Le

vel

0

Real GDP

6,4006,000

SRAS

AD0

100

E103

AD1

B

113

AD2

AD3

Impact on the price level depends on the slope of the aggregate supply curve

Page 29: Monetary Policy: Conventional and Unconventional 13 Part 2

Complete Monetary Policy Story

Page 30: Monetary Policy: Conventional and Unconventional 13 Part 2

Another reason the Aggregate Demand Curve Slopes Downward

• At a higher price level• The quantity of bank reserves demanded is higher• Holding the supply of reserves fixed, this will lead to

higher interest rates• Which means lower business investment and concumer

spending • Therefore, quantity demanded lower: negative slope

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Page 31: Monetary Policy: Conventional and Unconventional 13 Part 2

Figure 8 The Effect of a Higher Price Level on the Market for Bank Reserves

31

Bank Reserves

Inte

rest

Rat

e

S

S D0

D0

D1

D1

Effect of ahigher P

E1

E0

Page 32: Monetary Policy: Conventional and Unconventional 13 Part 2

Unconventional Monetary Policies

• What does the Fed do when the federal funds rate is zero and the economy still needs more stimulus?• Use unconventional monetary policies• During the Financial crisis

• Massive lending to banks and non-financial firms• Open market purchase of assets other than Treasury

bills: longer term Treasury bonds and mortgage-backed securities. This is Quantitative Easing we discussed earlier.

• Objective – lower interest rates on mortgages and long-term government bonds.

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Page 33: Monetary Policy: Conventional and Unconventional 13 Part 2

As the Fed increases or decreases the FFR, the T-bill rate follows.

Page 34: Monetary Policy: Conventional and Unconventional 13 Part 2

From Financial Distress to Recession

• How a financial crisis can lead to a recession• Something goes wrong in the financial

markets: loss of confidence in some financial assets• Failure of a major financial institution (e.g.,

Lehman Brothers in 2008)• Stock market crash (as in 2000)• Collapse of real estate prices (as after 2006)

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Page 35: Monetary Policy: Conventional and Unconventional 13 Part 2

From Financial Distress to Recession

• How a financial crisis can lead to a recession• Result: financial market distress• Risk premiums rise far above their

“normal” levels• Interest rates on risky securities are rising• Spending on the interest-sensitive components

of aggregate demand falls

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Page 36: Monetary Policy: Conventional and Unconventional 13 Part 2

From Financial Distress to Recession

• How a financial crisis can lead to a recession• Downward multiplier process pulls entire economy down• Worse prospects for loan repayments• Pushing risk premiums even higher• The vicious cycle continues

• Normal expansionary monetary policy may not work • Fed resorts to unconventional policies

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Page 37: Monetary Policy: Conventional and Unconventional 13 Part 2

From Models to Policy Debates

• How do we use this theory to address policy issues?• The debate over the conduct of stabilization policy• The debate over budget deficits• The effects of policy on economic growth• The tradeoff between inflation and unemployment