Copyright© 2006 John Wiley & Sons, Inc.1 Power Point Slides for: Financial Institutions, Markets, and Money, 9 th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson University And Lanny R. Martindale, Texas A&M University

CHAPTER 3 THE FED AND INTEREST RATES

Copyright© 2006 John Wiley & Sons, Inc.3 The monetary base comprises the Fed’s 2 largest liabilities: Federal Reserve Notes in circulation Depository institution reserves (reserve account balances and vault cash)

Copyright© 2006 John Wiley & Sons, Inc.4 The money supply involves the Monetary Aggregates

Copyright© 2006 John Wiley & Sons, Inc.5 The Fed controls the monetary base…. To meet reserve requirements, depository institutions must transact with Fed in monetary base assets. They either - deposit adequate reserves at FRB or maintain adequate cash in vault Either way, reserves - required or excess - earn no interest. The more cash or reserves an institution holds above its requirements with the Fed, the more it wants to make new loans or investments to avoid lost interest income.

Copyright© 2006 John Wiley & Sons, Inc.6 …Thus the Fed controls the money supply…. Excess reserves appear as Fed - buys securities on open market, lends at Discount Window, or lowers reserve requirements As depository institutions lend or invest excess reserves, M1 increases new loan of excess reserves increases borrower’s transactional balances purchase of investment securities increases seller’s transactional balances

Copyright© 2006 John Wiley & Sons, Inc.7 …and the Money Supply affects the economy. Proceeds of new loans or investments not only increase M1 but finance purchases by DSUs of goods or services in real sector, contributing to economic growth. By expanding or contracting monetary base, Fed - increases or decreases excess reserves, thus raising or lowering incentive to lend or invest, thus encouraging or discouraging expansion in real sector.

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9 To influence interest rates, Fed targets but does not set Fed Funds Rate Fed Funds market is Fed-sponsored system in which depository institutions lend and borrow excess reserves among themselves Fed Funds Rate, set by market forces as institutions bargain with each other, is benchmark rate, measuring - return on bank reserves (most liquid of all assets) availability of reserves to finance credit demand intent and effect of monetary policy

Copyright© 2006 John Wiley & Sons, Inc.10 As Fed adjusts tools of monetary policy, reserve effects influence Fed Funds rate significantly in short run Open Market Operations: Buying pressures FFR downward, selling pressures FFR upward Reserve effects are direct, immediate, dollar-for-dollar Discount Rate: Cutting discount rate pressures FFR downward, raising discount rate pressures FFR upward Reserve effects depend on— sensitivity of institutions to “Window scrutiny” differential between Discount Rate & FFR Reserve Requirements: Cutting RR pulls FFR downward, raising RR pushes FFR upward Reserve effects are direct, immediate, sustained, & too dramatic for “fine tuning”

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Copyright© 2006 John Wiley & Sons, Inc.12 Fed cannot set Fed Funds rate in long run Ultimately, factors in real sector determine credit demand: Fed cannot artificially sustain FFR too low or high Borrowing costs too low— M1 may grow too rapidly Real investment decisions may be distorted (e.g., borrowing may just finance hoarding of assets) Borrowing costs too high— M1 may not “keep up with” real sector Economy may falter as real investment declines Best Fed can ultimately do is try to promote stable price levels

Copyright© 2006 John Wiley & Sons, Inc.13 Why central banks manipulate reserves or rates: 2 schools of thought Monetarists Keynesians

Copyright© 2006 John Wiley & Sons, Inc.14 Monetarists: Key financial variable for changing economic activity is the money supply. Monetarists assume propensity to consume— rises as people perceive they have “more money” drops as people perceive they have “less money” is distorted by volatility in prices Thus money supply can be used to influence aggregate demand adding reserves carefully should promote economic growth subtracting reserves carefully should slow the economy central bank can distort price levels by over-adjusting either way Short-term interest rates merely indicate monetary policy’s effects

Copyright© 2006 John Wiley & Sons, Inc.15 Keynesians: Key financial variable for changing economic activity is interest rates. John Maynard Keynes was influential British economist of 1930s Keynesians discount or disregard direct money supply effects Real sector economic growth is— Stimulated by falling rates as economic activity costs less to finance Slowed by rising rates as economic activity costs more to finance Always and significantly susceptible to influence of monetary policy To Keynesians, money supply changes reflect reactions to interest rates

Copyright© 2006 John Wiley & Sons, Inc.16 6 basic goals of monetary policy, set by the Humphrey-Hawkins Act of 1978 Full employment Economic growth Price index stability Interest rate stability Stable financial system Stable foreign exchange markets

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Copyright© 2006 John Wiley & Sons, Inc.20 3 channels of the transmission process for monetary policy Business investment in real assets Consumer spending for durable goods and housing Net exports (Gross exports less gross imports)

Copyright© 2006 John Wiley & Sons, Inc.21 Business investment in real assets Present values of future cash flows from real assets depend significantly on general level of interest rates Rates fall, PVFCF rises Rates rise, PVFCF drops Most capital expenditures are debt-financed; interest expense is thus material in profitability of most businesses Monetary policy thus always involves material incentives or disincentives for business investment Fed can manipulate incentives but not compel results

Copyright© 2006 John Wiley & Sons, Inc.22 Consumer spending for durable goods & housing Much consumer spending is on credit, so it tends to vary directly with credit conditions Falling interest rates tend to encourage spending Rising interest rates tend to discourage spending Monetary policy can thus often affect aggregate demand to some extent Fed can encourage/discourage but not necessarily compel; Consumers don’t necessarily make financial decisions the way businesses do - Businesses are mostly rational and profit-maximizing Consumers are partly rational and partly emotional

Copyright© 2006 John Wiley & Sons, Inc.23 Net exports Interest rates affect exchange rates Falling interest rates in a country tend to “weaken” its currency Rising interest rates in a country tend to “strengthen” its currency Exchange rates affect imports and exports As domestic currency weakens— Domestic demand for imports drops as they become more costly but Foreign demand for exports rises as they become less costly As domestic currency strengthens— Domestic demand for imports rises as they become less costly and Foreign demand for exports drops as they become more costly Monetary policy thus usually affects net exports. Fed can weaken or strengthen dollar, but may do so for any of numerous reasons, related or unrelated to export effects

Copyright© 2006 John Wiley & Sons, Inc.24 Complications of monetary policy: controlling the money supply is not easy. Technical factors demand constant adjustment Velocity of money is difficult to predict

Copyright© 2006 John Wiley & Sons, Inc.25 Technical factors demand constant adjustment Cash drains Cash holdings by public “use up” monetary base Fed must try to offset with carefully calibrated open market purchases The float DACI – CIPC = Float, net extension of credit by Fed Fed must try to offset float with carefully calibrated open market sales US Treasury deposits Treasury payments cause large shifts in reserves Fed and Treasury try to coordinate any large fluctuations

Copyright© 2006 John Wiley & Sons, Inc.26 Velocity of money is difficult to predict Ratio of gross domestic product to money supply (turnover rate of unit of money in economy ) For given change in money supply, Fed— can expect general direction of change in economy cannot ensure particular degree of change in economy