monetary policy: conventional and unconventional 13
TRANSCRIPT
Monetary Policy: Conventional and Unconventional
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Monetary Policy
• Monetary policy• Actions that the Federal Reserve System takes to change
interest rates and the money supply• Aim is to affect the economy: GDP, employment, inflation
• We focus on how monetary policy affects interest rates, investment and aggregate demand
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The Federal Reserve System: The Fed
• Central bank - a bank for banks• Origins and structure of the Fed
• 1873-1907: four severe banking panics• Federal reserve Act: 1913• Set up 12 Federal Reserve Districts – 12 regional banks
• Technically a corporation• Stockholders: member banks• Most profits turned over to U.S. Treasury – $78 billion
in 2014.
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The Federal Reserve System
• Federal Reserve System
• It is not part of any branch of government• Was created by Congress - Federal Reserve Act (1913)
• Could be eliminated by Congress if it so desired
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•The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank.
The Geography of the Federal Reserve System
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The Federal Reserve System
• Board of Governors (7 members)• Appointed by U.S. President with the advice and consent
of the Senate• 14-year term• Chairperson serves 4-year term: Janet Yellen
• The Fed• Independent from the rest of government • It alone has responsibility for monetary policy
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The Federal Reserve System
• Federal Open Market Committee (FOMC)• 12 members
• 7 governors of the Fed• President of the New York Fed• 4 (of 11) district banks presidents
• Short-term interest rates and size of money supply
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The Federal Reserve System
• Central bank independence• Central bank’s ability to make decisions without political
interference• Proponents: Independence keeps politics out
• Fed can take longer term view• Maintain low and stable inflation
• Opponents: Independence is undemocratic• Why let a small group of bankers and economists
make decisions that affect everyone
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Monetary Policy in Normal Times
• Open-market operations• The Fed’s purchase or sale of government securities
(usually Treasury bills) through transactions in the open market
• What does the FOMC so if it wants to lower interest rates• Purchases Treasury bills (T-bills) from banks• Pays for them with newly created bank reserves
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Monetary Policy in Normal Times
• Market for bank reserves• Supply of reserves determined by Federal Reserve policy• Demand for reserves determined
• Banks since they are required to hold reserves• Required reserves = m x D (transaction deposits)• But the demand for D depends on the volume of
transactions in the economy• Which depends on real GDP and the price level
• Banks lend reserves to other banks• Interest rate on reserves: federal funds rate
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The Market for Bank Reserves
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Quantity of Bank Reserves
Inte
rest
Rat
e
S
SD
D
E
For given Fed policy
For given Y and P
Monetary Policy in Normal Times
• Federal funds rate• Interest rates that applies when banks borrow reserves
from one another
• Why is there a reserve market?• Some banks may be short of reserves so would borrow• Some banks may have excess reserves so would lend• Important since allows reserves to flow where needed
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Monetary Policy in Normal Times
• How the Fed lowers the federal funds rate• Purchase T-bills provides additional reserves to market
• Supply of reserves will• Shift out increasing bank reserves and decreasing the
federal funds rate
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Figure 2 The effects of an open-market purchase
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Quantity of Bank Reserves
Inte
rest
Rat
e
S0
S0
D
D
S1
S1
E
A
Monetary Policy in Normal Times
• Mechanics of an open market operation• Suppose Fed buys $100 million of T-Bills from commercial
banks• How can this lead to a multiple expansion of the money
supply and a decrease in the interest rate?
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Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed
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Banks exchange one asset(T-Bills) for another (reserves)
Fed “pays “ for T-Bills by crediting banks with additional reserves
This Open Market purchase created $100 million in Excess Reserves!
Monetary Policy in Normal Times
• Mechanics of an open market operation• After the purchase, banks have $100 million of excess
reserves
• If m = 0.20, by how much can the money supply expand?• = $100 million x (1/0.20) = $500 million• Why don’t we subtract off the initial $100 million like
before?
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Monetary Policy in Normal Times
• Mechanics of an open market operation• The actual money supply will increase by less than $500million if:
• Public chooses to hold more cash• Banks decide to hold some excess reserves
• What if the Fed wants to decrease the money supply and increase interest rates?
• Sell T-Bills taking reserves out of the banking system• This is an Open Market Sale.
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Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed
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Banks exchange one asset(reserves) for another (T-Bills)
This Open Market sale removes $100 million in Excess Reserves from the banking system!
Sells T-Bills
Lose reserves
Open-Market Operations
• Bond prices and interest rates• How does the purchase cause interest rates to fall?• Private market for T-Bills
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Figure 3 Open-Market Purchases and Treasury Bill Prices
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Quantity of Treasury Bills
Pric
e of
a T
reas
ury
Bill
S0
S0
D
D
S1
S1
P0
P1A
B
Private demand(unchanged)
Fed makes a purchase so supply falls
Open-Market Operations
• Bond prices and interest rates• Higher bond prices will cause interest rates to fall
• Bonds pay fixed number of dollars per year• Bond that sells for $1,000 with $60 payment
• 6% interest rate: = .06 = 6%• If price of bond rises to $1,200
• 5% interest rate =.05 = 5%• Higher (lower) bond prices mean lower (higher)
interest rates
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Open-Market Operations
• Putting it all together: Expansionary policy• Fed wants money supply to increase and interest
rates to fall, so . . .• they make an open market purchase. Banks excess
reserves will increase, so the money supply expands.
• By buying bonds, the Fed causes the prices of bonds to increase so interest rates decrease
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Open-Market Operations
• Putting it all together: Contractionary policy• Fed wants money supply to decrease; interest
rates to rise, so . . .• they make an open market sale. Banks excess
reserves will decrease, so the money supply contracts
• By selling bonds, the Fed causes the prices of bonds to decrease so interest rates increase
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