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The Federal Reserve

The Federal Reserve. Policy Tools, Objectives and Targets. ECO 473 – Money & Banking – Dr. D. Foster. Federal Reserve Policy Tools. Open Market Operations Buy/sell Treasury bonds to affect bank reserves. The major form of monetary policy.

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The Federal Reserve

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  1. The Federal Reserve Policy Tools, Objectives and Targets. ECO 473 – Money & Banking – Dr. D. Foster

  2. Federal Reserve Policy Tools • Open Market Operations • Buy/sell Treasury bonds to affect bank reserves. • The major form of monetary policy. • What will the Fed do if we run out of Treasury bonds? • Discount Window • Lend to member banks to affect bank reserves. • Purpose is to target the “federal funds rate” – iff • This is the rate that banks charge each other for very short term loans. • Required Reserve Ratio (rrD) • Changing this affects bank excess reserves directly. • Used more to reflect structural changes. • Was used in 1937 and precipitates more Great Depression. • Time to let this go? New policy – Pay banks i for ER (!!)

  3. Goals of Monetary Policy Inflation goals: Low/no inflation with limited year-to-year variability. Output goals: High and stable economic (GDP) growth. Employment goals: Stable employment growth with low unemployment.

  4. Intermediate Targets of Monetary Policy The key rationale for intermediate targeting: The limited long-term information about the economy available to policymakers.

  5. Choosing an Intermediate Target Variable Characteristics: Frequently observable Consistency with ultimate goals Definable and measurable Controllable Potential variables: Monetary aggregatesM1, M2, MZM Interest rates(fed’l funds, prime …) Others: Nominal GDP Credit aggregates Exchange rates

  6. Getting from bond purchases to interest rates Bond $$$ $ $ $ $ $ $ mm/yyyy Face value (FV) Maturity date(in n years) Coupons & value (C) • Usually, we talk of annual coupons • Market price of the bond = present value of income stream discounted at interest rate i: When the Fed buys bonds, their prices will ___ and interest rates will ___. sells

  7. Some simple bond pricing problems • A bond has a face value (FV) of $1000, will mature in 2022 and has an annual coupon of $74 and the market rate of interest is 8.1%. • What is the current market price of this bond? • Suppose that the current market interest rate falls to 6.54%. What will be the new market price for this bond? • Suppose that when the bond was first sold, it’s market price was $1000. What must have been the market rate of interest then? • Consider a bond with FV=$1000, maturity = 2024, C=$81 and i=7.25% • What is the current price of this bond? • If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it will affect all interest rates to some extent. If they buy lots of bonds and interest rates fall to 6.88%, what will happen to the price of your bond? • The bond in #2 was given to you by your kindly aunt. She told you it matures in 2024, but her eyesight isn’t so good. You take a close look at the bond and see that it matures in 2020. Market i=7.25%. • What is the price of this bond? Why is it different than what you calculated in #2a?

  8. Is Policy the Right Choice? Time lagsmake effective policy uncertain. Discretionary policy promotes uncertainty. Rulesand credibleadherence can eliminate bias. Independenceis a likely key requirement.

  9. Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag Real GDP Business cycle time

  10. Monetary Policy may be counterproductive %Real GDP time Ideally, policy would dampen the business cycle… But, dampening the business cycle may lower ave. growth! Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

  11. Discretion versus Rules(Milton Friedman) Discretionary policy is the sourceof instability. A policy rulecan eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supplyto grow in LR sustainable fashion. This is a commitment to a fixed strategy no matter whathappens to other economic variables. To be successful, the commitment must be credible. The public believes the Fed will act this way.

  12. Has the Fed maintained stable prices?

  13. Has the Fed maintained the value of the $? 4%

  14. Making Monetary Policy Transparent Yellen’s Press Conference Sept. 17, 2014 FOMC - PR Sept. 17, 2014

  15. Making Monetary Policy Rules Credible Place constitutional limitson monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

  16. Making Monetary Policy Rules Credible • Place constitutional limits on monetary policy. • Achieve credibility by establishing a reputation. • Maintain central bank independence. • Establish central banker contracts. • Appoint a “conservative” central banker.

  17. The Federal Reserve Policy Tools, Objectives and Targets. ECO 473 – Money & Banking – Dr. D. Foster

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