Question 19 (21)

Chapter 18. Monetary Policy: Using

Interest Rates to ta!ili"e the #o$estic
%cono$y
Now that we've studied the money supply process, we take a closer look at how
the Fed impacts the domestic economy. The Fed has three tools at it's disposal
to impact the money supply: (1) open market operations (the federal funds rate
taret), (!) discount lendin, (") the reserve re#uirement. $n this chapter we see
how each tool impacts the federal funds market and evaluate its usefulness.
&he Mar'et (or Reser)es an* the +e*eral +un*s Rate
%ecall that the federal funds rate is the short term interest rate for the inter&ank
lendin market where &anks lend reserves to each other. The Fed conducts
monetary policy primarily throuh affectin this market, which in turn impacts
other de&t markets and the economy.
The fiure &elow shows the market for reserves, which determines the
e#uili&rium federal funds rate:
Note that the demand for reserves is downward slopin with respect to the
federal funds rate. This is &ecause the federal funds rate is the opportunity cost
for a &ank holdin e'cess reserves, since the &ank could lend out those reserves
at the federal funds rate. (o the hiher the federal funds rate, the hiher the
opportunity cost of holdin e'cess reserves, so the #uantity of e'cess reserves
(and reserves) will &e lower.
The supply curve is upward slopin &ecause as the federal funds rates rises,
&anks will provide more reserves for other &anks to &orrow.
)ow do the three tools of monetary policy impact this market*
+e have seen in chapter 1, how an open market purchases increases
reserves in the &ankin system. (o an open $ar'et purchase increases
the supply o( reser)es, causing the (e*eral (un*s rate to (all. -n open
$ar'et sale causes the (e*eral (un*s rate to rise.
+e have seen in chapter 1, how increases in discount loans will increase
reserves. o a lo.er *iscount rate .ill encourage !an' !orro.ing,
increasing the supply o( reser)es an* *ecreasing the (e*eral (un*s
rate.
+ith an increase in the re#uired reserve ratio, &anks must hold more
reserves. - higher reser)e re/uire$ent increases the *e$an* (or
reser)es an* causes the (e*eral (un*s rate to rise.
0pen Mar'et 0perations
-pen market operations are the most important tool of monetary policy. .n
open market purchase increases the monetary &ase and the money supply,
lowerin short/term interest rates. $n theory the Fed could conduct open market
operations with any type of de&t security. $n reality it uses Treasury securities
&ecause this market is lare and li#uid, so it can a&sor& lare transactions.
The F-01 votes on open market operations &y votin on a federal funds rate
taret to &e acheived throuh open market operations. The actual &uyin and
sellin is left to the Federal %eserve 2ank of New 3ork (which is why the
F%2N3 president always has a vote on the F-01). 4very tradin day, the
F%2N3 open market operations staff surveys conditions in financial markets to
determine what type and how much of open market operations are need. They
then line up potential &uyers and sellers of Treasury securities &y ettin price
#uotes from lare dealers in securities known as primary dealers. There are
a&out "5 primary dealers. (F3$: 1antor Fit6erald, a &ond tradin firm that lost
789 people in the +T1 attack in (eptem&er, did almost !8: of the tradin
volume in Treasury securities. They have since recovered that market share.)
Trades are e'ecuted throuhout the day, while watchin for the desired impact
in the federal funds market.
Now the F-01 can set a taret and the F%2N3 &uys and sells to keep the
e#uili&rium federal funds rate as close to the taret as possi&le. The difference
&etween the taret and actuall federal funds rate is shown in fiure 19.!, pae
;7;.
-0- are the primary tool of monetary policy. They are fle'i&le, so the Fed
and chane the federal funds rate &y a little or a lot. They are #uick and
precises, with same day impact on the inter&ank lendin market, with other
short/term interest rates followin #uickly. They are reversi&le. $f the Fed
&uys too many securities, they can turn around and sell some of them.
#iscount 1en*ing
<iscount loans increase the monetary &ase and money supply. 4ach Federal
%eserve district &ank has a discount window where loans are made. They affect
the volume of discount loans &y settin the discount rate and &y decidin when
to make loans.
<iscount loans are made to &anks for very short/term li#udity pro&lems at the
primary discount rate = federal funds rate > 155 &asis points. They are also
iven to &anks in reions with seasonal fluctuations in reserves (such as
aricultural areas), and finally to &anks in serious trou&le at the secondary
discount rate = federal funds rate > 85 &asis points. )owever, &anks have an
incentive not to come to the discount window too often, since this would invite
additional scutiny from reulators concerned a&out the &ank's li#uidity
manaement.
2eyond their a&ility to affect the monetary &ase, discount loans et to the
oriinal purpose of the Fed: To &e a len*er o( last resort to &anks in trou&le in
order to prevent larer &ank and financial panics. The Fed, frankly, messed up
this role durin the ?reat <epression, &ut have done well in the post/++$$
period in its role as lender of last resort. 4ven with the F<$1 to insure deposits,
the Fed still needs to &e willin to provide li#uidity to protect lare depositors
and to keep the F<$1 from oin &ankrupt in the case of too many &ank
failures.
<espite the importance of discount loans for financial market sta&ility, they are
not an ideal tool for chanin the money supply:
1. 1hanes in the discount rate may &e taken as a sinal of monetary policy
(an announce$ent e((ect) when the Fed is only tryin to keep up with
market interest rates. The fluctuatin spread &etween the federal funds
rate and discount rate will cause the volume of discount loans and the
money supply to fluctuate, actually makin it harder to control the
money supply.
!. <iscount loans are not co$pletely un*er +e* control. They depend on
&ank &ehavior as well.
". <iscount rate chanes are not easily re)ersi!le, since the rates on
previous loans cannot &e chaned.
Reser)e Re/uire$ents
The Federal %eserve 2oard of ?overnors sets the reserve re#uirements for
depository institutions. )iher reserve re#uirements reduce the money
multiplier and the money supply, causin short/term interest rates to rise.
%e#uired reserves on checka&le deposits are ": up to @;;." million and 15:
on the amount over @;;." million.
1hanin the reserve re#uirement is certainly effective. $n fact it is a very
powerful tool. This is actually a disadvantae. The Fed usually wants to make
small adAustments to the money supply, and that is not possi&le with the reserve
re#uirment. .s one of my economics professors once said, Bit's like usin a
nuclear warhead when Aust a fly swatter will do.B
.lso, practically speakin, the reserve re#uirement is e'pensive to chane:
2anks must chane all types of li#uidity and asset manaement strateies.
Fre#uent chanes in the reserve re#uirement would force &anks to hold a lare
cushion of e'cess reserves to deal with the resultin uncertainty, cuttin into
their profits.
+hile reserves were oriinally re#uired to ensure the soundness of the &ankin
system in meetin depositor withdrawals, today the reserves deposited at the
Fed help the Fed maintain the federal funds rate taret.
&he 2oals o( Monetary Policy
There are ; &asic oals of monetary policy , which are really desira&le oals we
want to see for the economy:
3igh %$ploy$ent (1o. une$ploy$ent). The federal overnment is
re#uired under laws passed in 1C;7 and 1C,9 to promote hih
employment consistent with price sta&ility. $t is clear why hih
unemployment would &e &ad: unused resources mean lost output and
there are hue personalDsocial costs as well. 2ut what level of
unemployment is accepta&le* .s we learned in Erinciples of
0acroeconomics the oal for unemployment is N-T 6ero. There will
always &e frictional and structural unemployment. The oal for
unemployment is the natural rate o( une$ploy$ent, estimated to &e
somewhere &etween ; and 8:. The current unemployment rate is around
8.1:. F3$: The unemployment rate for the (yracuse area is currently at
;:, lower than the N3( ;.7:.
%cono$ic 2ro.th. This oal is closely related to the oal of hih
employment since stron economic rowth leads to Ao& creation and hih
employment while stanant or fallin economic rowth means layoffs.
4conomic rowth (the : chane in real ?<E) in the F.(. averaes a&out
":, althouh the averaes for rowth in the 1C,5s and 1C95s were
lower, &ut have re&ounded in the 1CC5s. $n !557 real ?<E rose a&out
!.,:.
Price ta!ility (1o. in(lation). Today this is view as the most
important oal of monetary policy, not only &y the Fed &ut &y the
4uropean central &anks as well. .t hih levels, inflation creates
uncertainty, lower investments, and lower economic rowth. )ow hih is
too hih* $n the F.(. currently, the Fed wants an inflation rate of a&out
!:, with hiher than ;: &ein unaccepta&le. $nflation is a concern in
!55,, iven risin enery and food prices. $n !557 prices rose a&out
!.8: as measured &y the 1E$.
+inancial Mar'et ta!ility. This cateory includes the sta&ility of
financial institutions, interest rates, and forein e'chane rates. $nterest
rate sta&ility creates a more favora&le investment climate and promotes
economic rowth. (teppin in to avoid financial crises also avoids the
e'treme recessions that can follow such crises. . sta&le e'chane rate
promotes international trade. This last oal often re#uires international
cooperation with many central &anks around the world.
1in'ing &ools to 0!4ecti)es
To function as an effective instrument a tool must &e
easily o&serva&le &y all
controlla&le &y the Fed
predicta&ly related to the o&Aectives of monetary policy such as
economic rowth, low inflation, low unemployment, etc.
These criteria rule out discount lendin and reserve re#uirement, and leave
open market operations. +hy*
1. The Fed has co$plete control over open market operations. Not true
with discount loans, where the &anks decide to &orrow or not.
!. -pen market operations are (le5i!le. They can do a little or a lot,
dependin on the si6e of the chane desired.
". -pen market operations are easily re)ersi!le. $f the initial purchase is
too lare, then the Fed Aust has to sell some.
;. -pen market operations are /uic'. Trades and their impact appear
almost immediately durin the tradin day.
&o su$$ari"e, all 6 tools at the +e*7s *isposal are capa!le o( changing the
$oney supply an* interest rates, !ut only one tool, open $ar'et
operations, is o( practical use (or con*ucting $onetary policy. 8e .ill see
ho. this tool is use* to achie)e econo$ic goals
The Fed has these ultimate oals, &ut they only have direct control over a open
market operations. Fnfortunately it can take over a year for the tools to
eventually impact the economic oals. )ow does the Fed aue its proress*
Throuh the use of tarets. These tarets are other varia&les related to &oth the
tools and the oals of monetary policy. 2y lookin at these varia&les, the Fed
knows if it is on the riht track.
The process looks like this:
First, the operatin tarets are varia&les closely related to the tools, and respond
immediately to chanes in the tools. Eossi&le operatin tarets include reserves,
the federal funds rate, or a T&ill rate. 1urrently the F-01 tarets the federal
funds rate.
The intermediate tarets are varia&les affected &y the operatin taret, &ut are
closely associated with the oals. Eossi&ilities includes the money areates
(01, 0!, 0") or other short/term and lon/term interest rates in the economy.
?iven the &reakdown &etween monetary tarets and the economy is recent
decades, intermediate tarets are not as important as they used to &e.
(o for e'ample, the Fed may want a 8: rowth rate for nominal ?<E. To do
this, they &elieve they need ;: rowth in 0!, which will &e accomplished with
": rowth in the monetary &ase. Then, the Fed conducts open market
purchases to increase the monetary &ase &y ": (the operatin taret), which is
measures fairly #uickly. -ver the ne't few months it follows chanes in 0! to
hit a rowth rate of ;:. $f 0! rowth is too low, the Fed will conduct more
open market purchases. $f the rowth rate is too hih the Fed will reverse and
conduct open market sales.
)owever, the F-01 0F(T make a choice &etween monetary and interest
rates tarets: they cannot simultaneously taret &othG Het's see why.
(uppose the Fed wants to taret the money supply 0I. .s money demand
fluctuates, the e#uili&rium interest rate will chane. This is &ecause the Fed is
committed to 0I as a taret so it does not shift the 0( curve when 0< shifts.
The result is an interest rates that fluctuates with money demand:
(uppose instead the Fed wants to taret an interest rate iI. .s money demand
fluctuates, the e#uili&rium interest rate will rise a&ove or fall &elow iI, the
taret. To prevent this, the Fed must increase or decrease the money supply to
compensate, keep the e#uili&rium interest rate at iI. The result is that the
money supply fluctuates when money demand fluctuates as the Fed pursues its
interest rate taret.
I( the +e* targets the $oney supply, then it loses control o( interest rates. I(
the +e* targets interest rates, then it loses control o( the $oney supply.
&he &aylor Rule
The federal funds rate is clearly a popular taret for monetary policy. )ow
should this taret &e chosen*
The Taylor Ruleis currently a popular policy rule created &y John Taylor of
(tanford Fniversity. The Taylor rule is an e#uation the says the taret federal
funds rate should &e &ased on the current inflation rate, the real federal funds
rate (a lon/run e#uili&rium rate), the ap &etween real ?<E and full
employment ?<E, and the ap &etween actual inflation and the inflation taret.
FF rate taret = !.8 > current inflation > (1D!)(current/taret inflation) > (1D!)
(current / potential ?<E)
(o when inflation rises a&ove its taret level, the federal funds rate taret
should rise. +hen output falls &elow its potential level then the federal funds
rate taret will &e lower. (o the rule responds to economic conditions, includin
&oth prices and output. This relationship makes the federal fund rate taret
&ased on concerns a&out &oth price sta&ility and the &usiness cycle.
Fiure 19.7 plots the F-01's actual federal funds rate taret aainst the rate
under the Taylor rule. There is a close correspondence &etween the two. +hile
the rule is a helpful uide, keep in mind that discretion is also important for the
une'pected, such as CD11.
+9I: Relate* 1in's