Federal Reserve

1. Federal Reserve Tools and Targets

2. Open Market Operations • Types: • Dynamic • Designed to change base • Defensive • Meant to offset other factors affecting base • Purpose: • Change the monetary base.

3. Open Market Operations • Advantages: • Controlled by the Fed • Flexible and precise • Easily reversed • Implemented quickly

4. Discount Loans • Purpose: • Influence reserves in the banking system • Lender of Last Resort • Prevent bank panics • Prevent non-bank financial panics

5. Types of Discount Loans • Primary Credit • Restricts eligibility to generally sound institutions. • The goal is to eliminate institutions’ incentive to borrow to exploit the positive spread of money market rates over the discount rate. • The Fed expects that the restriction of eligibility will reduce its need to review borrowers’ funding situations; thereby, encouraging banks to use the discount window during tight markets.

6. Types of Discount Loans • Primary Credit • Primary credit is extended at a rate that is above the usual level of short term market interest rates, including the federal funds rate.

7. Types of Discount Loans • Secondary Credit • Secondary credit is available in appropriate circumstances to depositary institutions that do not qualify for primary credit. • Secondary credit is extended at an interest rate that is 50 basis point above the primary discount rate.

8. Changes to the Discount Window Feature Previous System Primary Credit Rate Fed funds rate less Fed funds rate plus 25-50 basis points 100 basis points Term Overnight Overnight Eligibility Subjective Sound banks only Administration Evaluated for Minimal, appropriateness Market based Use of funds Can’t resell No restrictions

9. Discount Loans • Advantages: • Lender of Last Resort function. • Disadvantages: • Confusion interpreting discount rate changes. • Fluctuations in discount loans can cause unintended fluctuations in the money supply. • Not fully controlled by the Fed.

10. Reserve Requirements • Types: • Required reserves • Excess reserves • Purpose: • Originally, reserve requirements were meant to provide a cushion of reserves to meet unexpected depositor demands for funds.

11. Reserve Requirements • Advantages: • Changes in reserve requirements can change the rate of growth in the money supply rapidly. • Disadvantages: • Increases can cause serious liquidity problems for banks. • Continually fluctuating reserve requirements create uncertainty for banks and make liquidity management more difficult.

12. Targets

13. Monetary Policy Goals • The goals of monetary policy are: • High employment • Economic growth • Price stability • Interest rate stability • Financial markets stability • Exchange rate stability

14. Monetary Policy Targets • The central bank wants to achieve its goals, but it does not directly influence the goals. • It has a set of tools that affect the goals indirectly after a period of time. • Therefore, the Fed must aim at targets that lie between its tools and its goals.

15. Targets • Intermediate Targets: • Monetary aggregates such as M1and M2 • Interest rates • Operating Targets: • Reserve aggregates such as reserves, non-borrowed reserves, monetary base, non-borrowed base. • Interest rates such as the federal funds rate or the Treasury bill rate.

16. Choosing the Target • There are two types of targets: • Aggregates (Monetary and Reserve) • Interest rates. • When the Fed chooses one target, it loses control over the other.

17. Money Demand At high rates of interest, people hold interest bearing assets so money demand is low. At low rates of interest, people hold fewer interest bearing assets so money demand is higher. i ih il Money Demand 0 MD low MDhigh Money

18. Money Supply Money Supply i The money supply is determined by the Federal Reserve. At every rate of interest, the money supply is the same. 0 MS Money

19. Targeting the Money Supply Money Supply Let money demand fluctuate between MD1 and MD3, causing interest rates to fluctuate between i1 and i3. Targeting the money supply leads to loss of control over interest rates. i i3 i2 MD3 i1 MD2 MD1 0 Money

20. Targeting Interest Rates MS1 MS2 MSs3 Let money demand fluctuate between MD1 and MD3, causing interest rates to fluctuate between i1 and i3. To set interest at i*, money supply must fluctuate between MS1 and MS3. Targeting interest rates leads to loss of control over the money supply. i i* MD3 MD2 MD1 0 Money

21. Monetary Policy Targets • It is not possible for the Federal Reserve to change economic conditions directly. • Strategy: • Decide on goals for the overall economy. • Choose a set of variables called intermediate targets that it believes will have an impact on the overall economy. • Choose another set of variables called operating targets that impact the intermediate targets.

22. Target Criteria • Measurability • Intermediate Targets • Data on monetary aggregates are available after a two week delay. • Data on interest rates are available daily. • But real interest rates (interest rates adjusted for expected inflation) are hard to measure because there is no direct way to measure expected inflation. • Operating Targets • Data on reserve aggregates and the federal funds rate are available daily.

23. Target Criteria • Controllability • Intermediate Targets • The Fed’s control of the money supply is good but not perfect. • The Fed can change interest rates through open market operations. • Operating Targets • The Fed easily controls base and the federal funds rate.

24. Target Criteria • Predictable Effect on Goals • Intermediate Targets • The ultimate economic goal is the target of the intermediate target. • If the goal is price stability, a change in the money supply or interest rates should change the price level. • If the goal is economic growth, a change in the money supply of interest rates should change the rate of growth in GDP.

25. Target Criteria • Predictable Effect on Goals • Operating Targets • The intermediate target is the goal of the operating target. • If the intermediate target is interest rates, the operating target will also be an interest rate variable such as the federal funds rate. • If the intermediate target is a monetary aggregate, the operating target will also be a reserve aggregate variable such as base.

26. Lags • Data lag • Time to obtain information • Recognition lag • Time to understand the information • Legislative lag • Time to decide on policy

27. Lags • Implementation lag • Time to implement the policy • Effectiveness lag • Time for the policy to take effect. • Monetary policy has a long and variable effectiveness lag.