Money banking and the financial system 1e by hubbard and OBrien chapter 15

We use a graph of the banking system’s demand for and the Fed’s supply of reserves to see how the Fed uses its policy tools to influence the federal funds rate and the money supply.. The

System

Describe the goals of monetary policy

Understand how the Fed uses monetary policy tools to influence the federal funds rate

Trace how the importance of different monetary policy tools has changed over time

15.4 Explain the role of monetary targeting in monetary policy

BERNANKE’S DILEMMA

•During the financial crisis of 2007–2009, the Fed took extraordinary policy

actions, including huge asset purchases that expanded bank reserves and the monetary base

•The Fed had hoped for a strong recovery, where it could begin its “exit strategy”

of returning bank reserves and the monetary base to more normal levels

Unfortunately, as of July 2010, the economy was recovering more slowly than the Fed had hoped

•Since most macroeconomic policy consists of monetary policy, it was not

surprising that Bernanke was the center of attention as the economy struggled through a slow recovery in 2010

INSIDE LOOK AT POLICY on page 472

C H A P T E R 15

Monetary Policy

Key Issue and Question

Issue: During the financial crisis, the Federal Reserve employed a

series of new policy tools in an attempt to stabilize the financial system

Question: Should price stability still be the most important policy goal

of central banks?

15.1 Learning Objective

Describe the goals of monetary policy

The Fed has set six monetary policy goals that are intended to promote a

well-functioning economy:

The Goals of Monetary Policy

Inflation, or persistently rising prices, erodes the value of money as a medium

of exchange and as a unit of account

Most industrial economies have set price stability as a policy goal

Inflation makes prices less useful as signals for resource allocation Uncertain

future prices complicate decisions households and firms have to make

Inflation can also arbitrarily redistribute income

Rates of inflation in the hundreds or thousands of percent per year—known as

hyperinflation—can severely damage an economy’s productive capacity

The range of problems caused by inflation—from uncertainty to economic

devastation—make price stability a key monetary policy goal

Price Stability

High employment, or a low rate of unemployment, is another key monetary

policy goal

Unemployment reduces output and causes financial and personal distress

Congress and the president share responsibility for the goal of high

employment

Even under the best economic conditions, some frictional and structural

unemployment always remains The tools of monetary policy are ineffective in

reducing these types of unemployment Instead, the Fed attempts to reduce

levels of cyclical unemployment, which is unemployment associated with

business cycle recessions

Most economists estimate that the natural rate of unemployment is between 5% and 6%

High Employment

The Goals of Monetary Policy

Economic growth provides the only source of sustained real increases in

household incomes

Economic growth depends on high employment With high unemployment,

businesses have unused productive capacity and are much less likely to invest

in capital improvements

Stable economic growth allows firms and households to plan accurately and

encourages the long-term investment that is needed to sustain growth

Economic Growth

Economic growth Increases in the economy’s output of goods and services

over time; a goal of monetary policy

When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources.

The stability of financial markets and institutions makes possible the efficient

matching of savers and borrowers

The Fed responded vigorously to the financial crisis that began in 2007, but it

initially underestimated its severity and was unable to head off the deep

recession of 2007–2009

Some economists believe that actions to deflate asset bubbles may be

counterproductive, but the severity of the 2007–2009 recession has made

financial stability a more important Fed policy goal

Stability of Financial Markets and Institutions

The Goals of Monetary Policy

Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms

The Fed’s goal of interest rate stability is motivated by political pressure as well

as by a desire for a stable saving and investment environment

Sharp interest rate fluctuations cause problems for banks and other financial

firms So, stabilizing interest rates can help to stabilize the financial system

Interest Rate Stability

In the global economy, foreign-exchange market stability, or limited fluctuations

in the foreign-exchange value of the dollar, is an important monetary policy goal

of the Fed

A stable dollar simplifies planning for commercial and financial transactions

Fluctuations in the dollar’s value change the international competitiveness of

U.S industry: A rising dollar makes U.S goods more expensive abroad,

reducing exports, and a falling dollar makes foreign goods more expensive in

the United States

In practice, the U.S Treasury often originates changes in foreign-exchange

policy, although the Fed implements these policy changes

Foreign-Exchange Market Stability

15.2 Learning Objective

Understand how the Fed uses monetary policy tools to influence the

federal funds rate

The Fed’s three traditional policy tools are:

1. Open market operations.

Open market operations The Federal Reserve’s purchases and sales of

securities, usually U.S Treasury securities, in financial markets

2. Discount policy.

Discount policy The policy tool of setting the discount rate and the terms of

discount lending

Discount window The means by which the Fed makes discount loans to

banks, serving as the channel for meeting the liquidity needs of banks

3. Reserve requirements.

Reserve requirement The regulation requiring banks to hold a fraction of

checkable deposits as vault cash or deposits with the Fed

Monetary Policy Tools and the Federal Funds Rate

During the financial crisis, the Fed introduced two new policy tools connected

with bank reserve accounts that were still active in the fall of 2010:

1. Interest on reserve balances.

By raising the interest rate it pays, the Fed can increase banks’ holdings of

reserves, potentially restraining banks’ ability to extend loans and increase the

money supply By reducing the interest rate, the Fed can have the opposite

effect

2. Term deposit facility.

Similar to certificates of deposit, the Fed’s term deposits are offered to banks in periodic auctions The interest rates are determined by the auctions and have

been slightly above the interest rate the Fed offers on reserve balances The

more funds banks place in term deposits, the less they will have available to

expand loans and the money supply

Federal funds rate The interest rate that banks charge each other on very

short-term loans; determined by the demand and supply for reserves in the

federal funds market.

The target for the federal funds rate is set at meetings of the Federal Open

Market Committee (FOMC)

We use a graph of the banking system’s demand for and the Fed’s supply of

reserves to see how the Fed uses its policy tools to influence the federal funds

rate and the money supply

The Federal Funds Market and the Fed’s Target Federal Funds Rate

Demand for and Supply of Reserves The figure that follows shows both the

demand and supply curves for reserves

Monetary Policy Tools and the Federal Funds Rate

Figure 15.1

Equilibrium in the Federal Funds Market

Equilibrium in the federal funds market occurs at the intersection of the demand

curve for reserves, D, and

the supply curve for

reserves, S

The Fed determines the

level of reserves, R, the discount rate, i d, and the interest rate on banks’

reserve balances at the

Fed, i rb Equilibrium reserves are

R*, and the equilibrium

federal funds rate is i* ff.•

Equilibrium in the Federal Funds Market

Open Market Operations and the Fed’s Target for the Federal Funds Rate

Figure 15.2 (1 of 2)

Effects of Open Market Operations on the

Federal Funds Market

In panel (a), an open market purchase of securities by the Fed increases reserves in the banking system, shifting the supply curve to the

right from S1 to S2 The equilibrium level of reserves increases from

R*1 to R*2 while the equilibrium federal funds rate falls from 1.5% to 1% The discount rate is also cut from 1.75% to 1.25%.

Monetary Policy Tools and the Federal Funds Rate

by the Fed reduces reserves, shifting the supply curve to the left

from S1 to S2 The equilibrium level of reserves decreases from

R*1 to R*2 while the equilibrium federal funds rate rises from 5% to 5.25%.

The discount rate is also increased from 6% to 6.25%.•

Open Market Operations and the Fed’s Target for the Federal Funds Rate

Changes in the Discount Rate Since 2003, the Fed has kept the discount rate

higher than the target for the federal funds rate This makes the discount rate a

penalty rate, which means that banks pay a penalty by borrowing from the Fed

rather than from other banks in the federal funds market

Changes in the Required Reserve Ratio The Fed rarely changes the required

reserve ratio Changing the required reserve ratio without also engaging in

open market operations would cause a change in the equilibrium federal funds

rate If the Fed changes the required reserve ratio, it will likely carry out

offsetting open market operations to keep the target for the federal funds rate

unchanged (see figure 15-3)

The Effect of Changes in the Discount Rate and in Reserve Requirements

Figure 15.3

The Effect of a Change in the Required Reserve Ratio on the Federal Funds Market

In panel (a), the Fed increases the required reserve ratio, which shifts the demand curve for

reserves from D1 to D2

The equilibrium federal funds rate rises from i* ff1 to i* ff2.

In panel (b), the Fed increases the required reserve ratio, which shifts the demand curve

from D1 to D2

The Fed offsets the effects of the increase in the required reserve ratio with an open market

purchase, shifting the supply curve from S1 to S2

The level of reserves increases from to R* to R* , while the target federal funds rate

Solved Problem 15.2

Analyzing the Federal Funds Market

Use demand and supply graphs for the federal funds market to analyze the

following two situations Be sure that your graphs clearly show changes in the

equilibrium federal funds rate and equilibrium level of reserves, and also any

shifts in the demand and supply curves

a Suppose that banks decrease their demand for reserves Show how the Fed can offset this change through open market operations in order to keep the

equilibrium federal funds rate unchanged

b Suppose that in equilibrium the federal funds rate is equal to the interest rate

the Fed is paying on reserves If the Fed carries out an open market purchase,

show the effect on the equilibrium federal funds rate

Solved Problem

Step 2 Answer part (a) by drawing the appropriate graph

Solving the Problem

Step 1 Review the chapter material.

Solved Problem 15.2

Analyzing the Federal Funds Market

Monetary Policy Tools and the Federal Funds Rate

Solved Problem

Solving the Problem

Step 3 Answer part (b) by drawing the appropriate graph

Solved Problem 15.2

Analyzing the Federal Funds Market

15.3 Learning Objective

Trace how the importance of different monetary policy tools has changed over time

In 1935, Congress established the FOMC to guide open market operations.

An open market purchase of Treasury securities causes the prices to increase,

thereby decreasing their yield Because the purchase will increase the

monetary base, the money supply will expand An open market sale has the

opposite effects

Because open market purchases reduce interest rates, they are considered an

expansionary policy Open market sales increase interest rates and are

considered a contractionary policy.

Open Market Operations

More on the Fed’s Monetary Policy Tools

Implementing Open Market Operations The FOMC issues a policy directive

to the Federal Reserve System’s account manager, who is a vice president of

the Federal Reserve Bank of New York and who has the responsibility of

implementing open market operations and hitting the FOMC’s target for the

federal funds rate

The Open Market Trading Desk is linked electronically through the Trading

Room Automated Processing System (TRAPS) to about 18 primary dealers.

Each morning, the trading desk notifies the primary dealers of the size of the

open market purchase or sale being conducted and asks them to submit offers

to buy or sell Treasury securities

Dynamic open market operations are intended to change monetary policy as

directed by the FOMC

Defensive open market operations are intended to offset temporary fluctuations

in the demand or supply for reserves, not to carry out changes in monetary

policy

Dynamic open market operations are likely to be conducted as outright

purchases and sales of Treasury securities to primary dealers Defensive open

market operations are much more common, and are conducted through

repurchase agreements

Making the Connection

A Morning’s Work at the Open Market Trading Desk

7:00 A.M The account manager receives an estimate of the supply of reserves

for that day and for the remaining days of the current maintenance period.

8:00 A.M.–9:00 A.M The account manager begins to assess conditions in the

government securities market, and estimates the demand for reserves and how the prices of government securities will change during the trading day

9:10 A.M The account manager studies the FOMC’s directive, or the level of

the federal funds rate desired, and designs dynamic open market operations

and defensive open market operations to offset temporary disturbances to

reserves as predicted by the staff

9:30 A.M Traders notify primary dealers of the Fed’s desired transactions and

request quotations for asked/bid prices

9:40 A.M The primary dealers submit their propositions to the trading desk.

9:41 A.M The trading desk selects the lowest prices (for purchases) and

highest prices (for sales) and returns the results to dealers

10:30 A.M By this time, the transactions have been completed.

More on the Fed’s Monetary Policy Tools

Open Market Operations versus Other Policy Tools The benefits of open

market operations include control, flexibility, and ease of implementation

Discount loans depend in part on the willingness of banks to request the loans

and so are not as completely under the Fed’s control

The Fed can make both large and small open market operations Often,

dynamic operations require large purchases or sales whereas defensive

operations call for small

Reversing open market operations is simple for the Fed Discount loans and

reserve requirement changes are more difficult to reverse quickly This is a key

reason that the Fed has left reserve requirements unchanged since 1992

The Fed can implement its open market operations rapidly, with no

administrative delays Changing the discount rate or reserve requirements

requires lengthier deliberation