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Lecture 7 The Federal Reserve, The Treasury and Monetary Policy Detail

Lecture 7 The Federal Reserve, The Treasury and Monetary Policy Detail. Outline:  The Federal Reserve Treasury and Monetary Policy  A. The Federal Reserve and the Treasury   I. The Treasury  II. The Federal Reserve   III. Treasury - Fed Interactions ("Monetizing the Debt")

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Lecture 7 The Federal Reserve, The Treasury and Monetary Policy Detail

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  1. Lecture 7 The Federal Reserve, The Treasury and Monetary Policy Detail

  2. Outline: •  The Federal Reserve Treasury and Monetary Policy •  A. The Federal Reserve and the Treasury •   I. The Treasury •  II. The Federal Reserve •   III. Treasury - Fed Interactions ("Monetizing the Debt") • B. Money Stock Determination • I. What is Money •  II. What Determines the Amount of Money in the Economy: A Primer • C. Day to Day Federal Reserve Operating Procedures: Description and Implication

  3. A. The Federal Reserve and the Treasury I. The Treasury Besides its role as a bank charterer/regulator (thru OCC, OTS), the role of the Treasury (primarily) is to finance government expenditures. It does this by making sure the following budget constraint holds GOVT PURCHASES + TRANSFERS = GOVT TAX RECEIPT + NEW BONDS ISSUED BY GOVT The significance of this particular budget constraint is that it clearly highlights the fact that the Treasury does not print money to pay for what it buys.

  4. II. The Federal Reserve •  The Fed has two primary roles: • A) Regulate banks and Bank Holding Companies along with the other regulators. • B) Control the money stock and interest rates to facilitate economic growth. •  Who are the key players in the Federal Reserve System? • A) Board of Governors in Washington (7 individuals appointed by the President to 14 year terms). • B) Twelve regional federal reserve banks. • C) Federal Open Market Committee (FOMC), which makes US monetary policy and which consists of the seven governors plus five regional federal reserve bank presidents (NY Fed pres. is always on the FOMC, the other four serve on a rotating basis with one year terms).

  5. B. Bank’s Role in Monetary Policy: Money Stock Determination • I. What is Money? • a. Money is something that serves three purposes • medium of exchange • standard of value (unit of account) • store of value

  6. b. An age old problem is that nothing satisfies all these purposes, but almost anything satisfies some of them. Consequently, many monies have been tried. • 1. commodity money (tobacco, gold, yap stones). • 2. Fiat money (US dollar, for example). • c. Since we really do not know what money is we define different monies. Basically (see formal definitions on next page).

  7. M1 = the sum of: currency held outside the vaults of depository institutions, Federal Reserve Banks, and the U.S. Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions, except demand deposits due to the Treasury and depository institutions, minus cash items in process of collection and Federal Reserve float. M2 = M1 plus: savings deposits (including money market deposit accounts) and small denomination(less than $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments of less than $50,000), net or retirement accounts. M3 = M2 plus: large denomination ($100,000 or more) time deposits; repurchase agreements issued by depository institutions; Eurodollar deposits, specifically, dollar- denominated deposits due to nonblank U.S. addresses held at foreign offices of U.S. banks worldwide and all banking offices in Canada and the United Kingdom; and institutional money market mutual funds (funds with initial investments of $50,000 or more).

  8. d. So which money should the Fed try to control? It tries to control all three, but usually puts more weight on one depending upon economic conditions. Note however that the choice of which to control is not innocuous since the three aggregates do not look alike (M1 is currently about $1,137 billion, M2 is $5,223 billion) and more importantly they do not act alike!   CHECK OUT EARLY 1990-92! M1 RISING, M2 FALLING!! Money with zero maturity ?

  9. e. Most economists believe that the best money is the one   A) most readily controlled by the Fed B) that has the most stable and predictable relation to the thing the Fed ultimately wants to control-GDP, that is the money with the most stable and predictable VELOCITY. Before 1982 M1 was the aggregate of choice. Since 1982 M2 is the preferred aggregate.

  10. Memory Check: Velocity is "bang per buck"

  11. 1950 - 1980 M1 Controllable M1 IN M1 Velocity Stable  1980 - 1990 M1 Controllable M1 OUT M1 Velocity unpredictable M2 Less Controllable M2 IN M2 Velocity more predictable  1990 - 1996 M2 More Uncontrollable (No R.R.) M2 Velocity somewhat unpredictable M2 More or Less OUT 1997  “sweeps” make reserve requirements nonbinding so even M1 uncontrollable and M1 or M2 velocity unpredictable so M1, M2 continue to be out as monetary policy tool

  12. II. What Determines the Amount of Money in the Economy ? REMARK: Let’s just use M1 as an example. M1 = Currency in hands of public + checkable deposits Before we can hold this, currency/ coin has to “escape” Federal Reserve Treasury. Same here, because we need “cash” reserves to issue checkable deposits. The amount of currency that has “escaped” from the Fed Treasury is called the Monetary Base or Source base or Hi-Powered money.

  13. The course base or the monetary base or hi-powered money • Late December 1999 ($Billions) • Sources of Currency, Coin and Bank Reserves Uses • Federal Reserve Credit ($700) I. Reserves at Fed ($13) • A. US Securities held by Fed $700) • B. Discounts/advances to banks ($0.2) • C. Float ($0) • Treasury Currency Outstanding ($36) II. Vault Cash of Banks ($44) • Gold, SDR Accounts ($13) III. Currency in Hands of Public ($692) • Other Assets of Fed ($40) A. Assets denominated in foreign currency B. Buildings, etc. • Treasury Currency Holdings ($0.3) • Nonreserve Deposits at Fed ($37) A. Treasury Deposits B. Foreign central banks C. UN, IMF D. Other fed liabilities • TOTALS $750 $750 Bank Reserves Back into Fed/ Treasury Back into Fed/ Treasury

  14. B. Deposit Creation by Banks ASSUME a) numerous banks b) everyone is happy holding deposits c) reserve requirement is 20% d) $100 falls from the sky and is deposited in bank one

  15. Bank One Initially Bank Two Initially Reserve 100 Deposits a 100 Reserve 80 Deposit c 80 RR 20 RR 16 ER 80 ER 64 Bank One After Loan Bank Two After Loan Reserve 100 Deposit a 100 Reserve 80 Deposit c 80 Loan 80 Deposit b 80 Loan 64 Deposit d 64 Bank One After Check Clears Bank Two After Check Clears Reserves 20 Deposit a 100 Reserves 16 Deposit c 80 Loan 80 Deposit b 0 Loan 64 Deposit d 0

  16. Important Point of the role of the Banking System. • No individual bank has created money but the system has! • Bank New Deposits • One 100 • Two 80 • Three 64 • • • • Total 500

  17. So Who Determines the Money Stock?  1. Federal Reserve   A) Open Market Operations change the base or reserves  B) Set reserve requirements and hence affect multiplier  C) Set discount rate and thereby affect the base or reserves  2. The Banks  A) Decide how many excess reserves to hold which affects the multiplier  B) Decide how many reserves to borrow at the Fed which affects the base  3. The Public  A) Set currency and time deposit ratios which affect the multiplier  4. The Treasury  A) Set amount of currency they want to hold in tax and loan accounts which affects the base

  18. To increase money stock Fed could  (1) Buy Government securities (raises the Monetary Base).  (2) Lower discount rate (bank borrowing up, Base increases)  (3) Lower reserve requirements (raises the multiplier)

  19. THREE POINTS • The Fed can use monetary policy to control different things. • If they try to control one thing, something bad might happen to another thing. • So, monetary policy is not so simple or straightforward.

  20. Day-to-Day Fed Operating Procedures • The Fed can “target” different things. Impact monetary policy has on economy depends on what Fed targets. • TargetFed Operating Procedure • Economic Activity 1. GDP M  GDP  (Stabilizing) • Interest Rates 2. GDP  Interest  M  GDP  (Destabilizing) • Exchange Rates 3. Interest  $  M  GDP  (Destabilizing) • GDP  • Imports  $  M  GDP  Stabilizing

  21. Was Now In the old days, whenever the unemployment rate dropped or capacity utilization increased we always got inflation and higher interest rates. With countercyclical policy, this won’t happen.

  22. Advanced topic New policy works as long as demand stocks dominate P S D Output

  23. Demand Shocks Move the Economy • P AS (oil prices technology) • • • E • AD AD(Money), Exports, Investment) • GDP • ` P1 • P0 AD1 Y0 Y1

  24. Supply Shocks Move the Economy • P AS • AS (oil prices, technology) • • • E • AD AD (Money, Exports, Investment) • GDP PREALLY HIGH • So Raise AD in order to keep output the same PHIGH P0 AD` YLOW Y0

  25. Supply Shocks Move the Economy • P AS • AS (oil prices, technology) • • • E • AD AD (Money, Exports, Investment) • GDP PREALLY HIGH Or lower AD to keep prices the same PHIGH • P0 AD` AD`` YVERY LOW YLOW Y0 But then Output is at YVERY LOW (NOT GOOD)

  26. The “Taylor” Rule • A formula that describes how the Fed sets the fed funds rate. • Some feel they can use this to predict Fed policy actions. Let I* = Fed’s desired inflation target – 2% I = Actual inflation currently (over the last year) G* = Percent by which current real output deviates from the economy’s potential real output (if positive, current output is above potential; if negative, it is belowa. Then, Taylor Rule says Fed fund rates = “natural” real + I + .5(I – I*) + .5G* Nominal rate if economy says” make the says “make the rate is performing at Fed’s funds rate even higher if actual desired level higher if actual actual real GDP inflation exceeds exceeds potential target inflation” GDP”

  27. Does it work?i.e. does it predict the funds rate? Consider 2001:I • 5.45 = 2.0% + 2.3% + .5(2.3% - 2.0%) + .5(2%)b • 5.40 = actual 2000:I average • Problems with this approach. • Based on data from a period of time when Fed only had to battle demand shocks, i.e. would Fed react the same if an oily embargo raised inflation and reduced output? • Have to have a pretty good idea of what I* is. • a. • b.

  28. The research of many commentators has already thrown much darkness on this subject. And, it is probable that if they continue, we shall soon know nothing at all about it ! Mark Twain

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