Monetary Policy

1. Monetary Policy Chapter 16

2. Monetary Policy • Monetary Policy • It is based on the government’s ability to manipulate access to financial capital or liquidity • Simply…adjusting the money supply • Every country or collection of countries (e.g., the Euro zone) that has an independent currency has a monetary policy managed by a central bank.

3. Central (Nation’s) Banks • Examples of Central Banks: • Bank of Japan • Bank of England • South African Reserve Bank • Bank of Mexico • People’s Bank of China • European Central Bank (for the Euro Zone countries)

4. The FED • In the U.S. monetary policy is managed by the Federal Reserve (“the FED”) • The FED was established in 1913 to bring coherence to a national banking system that had suffered from regular financial panics • The Federal Reserve Act of 1913 • Federalists vs. Anti Federalists

5. FED Governance • The Federal Reserve Board (Board of Governors) that runs the FED has 7 members, one of whom serves as chair • The chair and all members are appointed by the President and must be confirmed by the Senate • Each Member serves a 14 year non-renewable term • This is intended to given him/her a significant degree of independence from political influence. • The member who serves as chair does so for a 4 year renewable term

6. District Banks • The headquarters of the FED is in Washington • The Federal Reserve System is divided into 12 geographic districts, each of which has a District Federal Reserve Bank

7. FOMC • The Monetary Policy of the U.S. is determined by the Federal Open Market Committee (FOMC) • The FOMC is chaired by the Chair of the FED Reserve Board and is made up of • 7 members of the Board • President of the NY District Bank • 4 of the other District Bank Presidents who serve as voting members on a rotating basis

8. FED vs. Treasury Dept. • The Treasury Dept. is part of the Executive Branch. It collects taxes and pays the bills of the nation (Consider it the nation’s accountant/ financial planner/checking account). • The FED is a separate agency.

9. The FED • The nation’s bank • Holds the treasury's account • Accounts of member banks (your banks) • Regulates the money supply (supply and demand) • Circulates/Issues currency • Buys/sells debt (securities) • Supervise banking practices

10. Financial Systems • The FED lies at the top of the financial system • This system constitutes the framework for supply and demand of financial capital • It include various capital markets (stocks/bonds, mutual funds, pension funds etc…) and financial intermediaries (institutions that connect investors and borrowers…banks, insurance companies, finance companies, brokerage firms etc…they make money off your money)

11. FED Policy • Easy money policy (expansionary) • Increasing the money supply or making money more available • Used to stimulated the economy • Tight money policy (contractionary) • Taking money out of circulation or reducing the money supply • Used to slow the economy

12. Government Debt • When the government needs to cover a deficit, the Treasury sells “debt paper” (bonds, bills, notes). • Those who buy this debt paper are essentially loaning the U.S. government money, and they earn interest on this “debt paper.”

13. “Debt Paper (Bonds)” • When financial institutions purchase U.S. debt paper, they resell it to others on the open market • Individuals and Institutions (e.g., banks) have traditionally held U.S. debt paper as a part of their portfolio because the U.S. has never defaulted (failed to pay-up) when its debt came due. • It has been and is, as of now, the gold standard of financial assets.

14. Open Market Operations • FED Monetary Policy is implemented by the Federal Open Market Committee (FOMC) • The name includes open market because the FED implements its monetary policy by participating in the open market for U.S. debt paper • To understand how, we have to consider a very simplistic version of a bank’s portfolio …

15. Bank’s Portfolio • Consider the Portfolio of CP Bank: CP Bank Assets Liabilities This includes anything you hold that has value in the market, e.g., cash, real estate, debt paper (from individuals, firms, or the government), … These are claims that others have on your assets, e.g., the bank’s depositors can withdraw their money

16. Reserves • Assets can be distinguished by their “liquidity” • Liquid assets can be quickly transformed into another shape (cash) quickly without losing value. (Savings) • Illiquid assets can be transformed into another shape quickly, but only with the probability of losing significant value. (Real Estate) CP Bank Assets Liabilities

17. Reserves • The liquid assets a bank holds are called Reserves, because they are in reserve, ready to cover any exercise of a claim on the banks assets without any risk that the bank will lose value in the transaction • e.g., cash on hand to cover withdrawals Assets Liabilities CP Bank

18. Reserves • A bank is perfectly safe if all of its assets are held in the form of reserves (full reserve system) • but, this isn’t good for the bank or the economy • it turns valuable liquidity (financial capital) that could be loaned out to finance productive investments, and in the process make the bank money on the loans, unusable capital

19. Fractional Reserves • Banks have an incentive to loan out their liquidity because they can make interest on each loan. • As long as the bank holds a prudent fraction of its assets as reserves to cover reasonable expectations about the day to day claims on its assets (e.g., withdrawals) it is generally fine. • This is a “fractional reserve system”

20. Reserves • Historically, some banks have pushed the envelope. • Reserves don’t earn much or anything, they lend out most of their assets and hold very small reserves. • If withdrawals overwhelm reserves, which is very possible if word gets out that the bank has made loans that have gone bad, the bank becomes insolvent • Its assets won’t cover it’s liabilities. This can cause a bank panic (bank runs).

21. Reserve Requirements • The Federal Reserve established a “reserve requirement” (RRR) • even that was not sufficient to avoid a “bank panic”, a “run on the banks”, in the Great Depression. When people lose confidence in the financial system, they want their money ... NOW! • No fractional reserve system can withstand a run because, most of the banks’ assets are illiquid … debts they are owed. (can’t get it back quickly)

22. FDIC • To address this danger, the government guarantees deposits of banks and some other financial institutions • Federal Deposit Insurance Corporation • This doesn’t ensure the stability of the system if large numbers of financial institutions make “bad bets” as occurred before the financial crisis of 2007-8

23. FOMC Operations • Tools of Monetary Policy • Interest rates • Federal Funds • Discount • Security (bonds) purchases/sales • Reserve requirements

24. Reserve Requirements CP Bank Liabilities Assets $60 Loans $100 DD (demand deposit – a checking account) $20 Treasury Bonds $20 Reserves Supposethis is the condition of the bank at opening on a given day If the FED’s reserve requirement is 20%, this bank is meeting the FED’s reserve requirement (20% reserves) and it is solvent (its assets cover its liabilities)

25. Reserve Requirements Suppose that in the course of the day, the bank makes transactions (withdrawals, new loans, etc.) such that its portfolio looks like this at the end of the day: Liabilities Assets $70 Loans $100 DD (demand deposit – a checking account) $20 Treasury Bonds $10 Reserves What’s its problem? Given the 20% reserve requirement, the bank can’t close its books for the day and meet the requirements of the FED … So, what’s it do?

26. Borrow Reserves • While this bank (A) has ended the day with inadequate reserves, another bank (B) has ended the day with excess reserves. • B doesn’t want “dead” money in its vault even for a night and A needs reserves, so A takes out an overnight loan from B. • This allows B to make a little return on its excess reserves and A to close its books with no problem.

27. Federal Funds Rate • This overnight loan market in which banks borrow/lend reserves from/to one another for the night is called the Federal Funds Market • The interest rate paid on these loans is called the Federal Funds Rate • As an overnight rate, it is the shortest of short rates.

28. Federal Funds Rate Recall that the long term capital market supply line rests on a short rate capital market floor* which brings us up to The long rate line r S and an “inflationary expectation” premium To that “floor” we add a “waiting premium” s This is the short rate line – the “floor” * Q$

29. Federal Funds Rate • The FED can raise or lower this Federal Funds Rate, the “floor”, and in turn, ceteris paribus, raise or lower the long term capital market supply line

30. Interest Rates? • How do they influence you? • You want to buy a new car… • You also want to save… • Interest rates go up. What do you do? Why? • Interest rates go down. What do you do? Why?

31. Federal Funds Rate • If the supply of these reserves expands in the Federal Funds Market, the overnight rate (Federal Funds Rate) borrowers have to pay for these reserves will go down, and … • If the supply of excess reserves contracts in the Federal Funds market, the overnight rate (Federal Funds Rate) borrowers have to pay for these reserves will go up.

32. Monetary Policy“Open Market Operations” • The FOMC can expand or contract the amount of reserves in the system by raising or lowering the Fed Funds Rate by buying or selling government debt paper from/to banks in the open market. • This is called Open Market Operations

33. Open Market Operations • If the FOMC buys treasury bonds from banks it injects more cash (which are reserves) into the banks… • So at the end of the day there will be an increase in excess reserves and the overnight cost of borrowing these reserves, the Federal Funds Rate, will go down.

34. Open Market Operations • If the FOMC sells bonds to banks, that contracts reserves of the banks …with fewer reserves available the overnight cost of borrowing these reserves, the Federal Funds Rate, will go up.

35. Open Market Operations • The banks participate because the FOMC has the resources to make the transaction attractive. • The FOMC can carry out these transactions until the Federal Funds Rate has reached the FOMC’s target level. • By raising and lowering the target level of the Fed Funds Rate (the short rate), the FOMC can, ceteris paribus, raise or lower the level of the supply line in the long term capital market.

36. Federal Funds Rate then a fall in the short rates would, ceteris paribus, lower long rates, in turn, lowering the long term interest rate, and If DI looked like this, r S raising the level of investment, I S r r s s DI I I Q$

37. Lowering Rates • The response depends on demand conditions in the long term capital market … • Assuming demand is stable and elastic as shown, then lowering long rates… AD Y I r UNEMP

38. Federal Funds Rate then a rise in the short rates would, ceteris paribus, raise long rates, in turn, raising the long term interest rate, and If DI looked like this, r S lowering the level of investment, I S r r s s DI I I Q$

39. Raising Rates • The response depends on demand conditions in the long term capital market … • Assuming demand is stable and elastic as shown, then raising long rates… r AD Y I UNEMP

40. Monetary PolicyFed Funds Rate since 1963

41. Monetary PolicyInflation and Fed Funds Rate since 1963

42. Monetary PolicyInfla, Unemp, FF, Defaults from 2004

43. Discount Rate • The discount rate is the rate that the FED charges to banks for borrowing money to cover their required reserves • Banks borrow from each other more often than they borrow from the FED • Raising or lowering this rate results in the same effect as a changing the Federal Funds Rate • Lowering makes money cheaper…more C and I= increasing GDP

44. Required Reserve Ratio • The FED may also change the RRR (Required Reserve Ratio) • Will increase or decrease capital depending on the requirement change

45. Monetary Policy Interventionist vs. Non-Interventionist • Who’s right? • Your answer depends on how much you are willing to trust … • Markets to be efficient and just and/or Government to be effective and just… and it may not be “a one size fits all” • Both approaches can work • Timing and amount is the main factor

46. Monetary PolicyInterventionist v. Non-Interventionist • Mr. Volcker’s policy to tame inflation and Mr. Bernanke’s policy to increase employment represent significant FED interventions. • Volcker… FED Chair in late 70’s/early 80’s…slow the economy through increasing interest rates • Bernanke… FED Chair during Great Recession… stimulate the economy through decreasing interest rates