Federal Reserve Tools and Targets

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

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

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

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.

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.

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.

Changes to the Discount Window Feature Previous SystemPrimary Credit Rate Fed funds rate lessFed funds rate plus basis points100 basis points Term OvernightOvernight Eligibility SubjectiveSound banks only Administration Evaluated forMinimal, appropriatenessMarket based Use of funds Can’t resellNo restrictions

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.

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.

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.

Targets

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

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.

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.

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.

i 0 Money Demand ihih ilil MD low MD high 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. Money Demand

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

Targeting the Money Supply i 0 Money i3i3 i1i1 Supply MD 1 MD 2 MD 3 i2i2 Let money demand fluctuate between MD 1 and MD 3, causing interest rates to fluctuate between i 1 and i 3. Targeting the money supply leads to loss of control over interest rates.

Targeting Interest Rates i 0 Money MS 2 MD 1 MD 2 MD 3 i* Let money demand fluctuate between MD 1 and MD 3, causing interest rates to fluctuate between i 1 and i 3. To set interest at i*, money supply must fluctuate between MS 1 and MS 3. Targeting interest rates leads to loss of control over the money supply. MS 1 MSs 3

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.

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.

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.

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.

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.

Lags Data lag –Time to obtain information Recognition lag –Time to understand the information Legislative lag –Time to decide on policy

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.