THE FED AND INTEREST RATES

 Notes in circulation  Depository institution reserves The FED used its power over the monetary base to control the money supply. Copyright© 2006 John Wiley & Sons, Inc. 2

 Up to this point, we used the term money supply conceptually without providing a specific definition.  There are various definitions of money each focusing on a certain use of money.  M1 is the definition that focuses on money as medium of exchange.  M2 focuses on money as store of value.  MZM includes all financial assets that can be converted into cash immediately (liquidity). Copyright© 2006 John Wiley & Sons, Inc. 3

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 By controlling the monetary base, the Fed substantially influences the money supply.  The more is the excess reserves, the more interest income they lose.(opportunity cost).  What creates the Excess reserves ?  Excess reserves appear as the Fed : 1. buys securities on the open market. 2. lowers the discount rate. 3. cuts reserve requirements.  As depository institutions lend or invest excess reserves, they earn extra interest income. Copyright© 2006 John Wiley & Sons, Inc. 5

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 When the Fed wants to increase the money supply(using any of the three tools),initially the reserves increases creating excess reserves, that the banks can invest or lend. Additionally, the following things happen:  new loans created increases borrower’s transactional balances.  purchase of investment securities/assets increases seller’s transactional balances.  This helps in financing the purchases of the DSUs of goods or services in real sector.  Finally, this all contributes to economic growth.  By expanding or contracting monetary base(increasing or decreasing the money supply), Fed - ◦ increases or decreases excess reserves, thus ◦ raising or lowering incentive to lend or invest, thus ◦ encouraging or discouraging expansion in real sector. 7

 The Fed Funds Market is a Fed-sponsored system in which depository institutions lend and borrow excess reserves overnight among themselves. The interest rate on these transactions—the Fed Funds Rate(FFR)—is set by market forces.  The FFR is a “benchmark” rate in the financial system—it normally represents the lowest possible cost of loanable funds. In other words, it is the inter-banking lending rate and represents the primary cost of short term loanable funds. Copyright© 2006 John Wiley & Sons, Inc. 8

 The Fed does not set the federal funds rate but targets/influences it by controlling overall availability of reserves.  FFR is important because: 1. It measures the return on the most liquid financial assets (bank reserves). 2. It is closely related to the monetary policy. 3. It directly measures the available reserves in the banking system. Copyright© 2006 John Wiley & Sons, Inc. 9

Market Equilibrium Interest Rate 1.Demand for the reserves by the depository institutions (downward sloped) 2.Supply of the reserves by the Fed (upward sloped) 3.Equilibrium FF rate is when D Res = S Res Quantity of Reserves The FF Rate D Res S Res Equilibrium Interest

Monetary Policy & The Fed Funds Rate OMO and its impact on FF rate 1.Purchasing Treasury securities leads to increase reserves in the banking system then the supply curve shifts rightward. As a result, the FF rate will decline. 2.Selling Treasury securities Quantity of reserves The FF Rate S Res 1 S Res 2

Discount rate and its impact on CB rate 1.Increase discount rate means increase opportunity cost of holding reserves. So supply of reserves will decline, the supply curve will shift leftward, then the FFR increases. 2.Decrease discount rate Quantity of Reserves The FF rate D Res S Res 2 S Res 1

RR and its impact on CB rate 1.Increase (RRR) leads to increase RR, decrease ER i.e. the loans to the public, demand for reserves from the FF increases, demand curve shifts rightward, and FFR increases. 2. Decrease (RRR) Quantity of Reserves The FF rate D Res 2 D Res 1 s Res

 Open Market Operations: Buying pressures FFR downward, selling pressures FFR upward ◦ Reserve effects are direct, immediate, dollar-for- dollar. ◦ Ultimate effects on money supply are predictable.  Discount Rate: Cutting discount rate pressures FFR downward, raising discount rate pressures FFR upward ◦ sensitivity of institutions to “Window scrutiny” ◦ The trend is always to keep the discount rate higher than the FFR to encourage banks to borrow in the fed funds system rather than the discount window.  Reserve Requirements: Cutting RR pulls FFR downward, raising RR pushes FFR upward ◦ Reserve effects are direct, immediate, sustained, & too dramatic for “fine tuning” Copyright© 2006 John Wiley & Sons, Inc. 14

 The Fed can influence the FFR only in the short run by using its monetary policy to expand or contract the monetary base and hence affects the level of reserves.  However, in the long run does not have the power to set the FFR. Lets see why is that:  If the Fed tries to keep the FFR at low rate, people will borrow and buy goods extensively, demand of loans will be very high,banks will be short of excess reserves, the Fed will buy securities to increase the money supply to prevent the FFR to increase. People will fear inflation and continue to borrow and the cycle continues.  On the other hand, if the Fed tries to keep the FFR at high rate, few people will borrow, so FFR should drop but the Fed will sell securities to reduce bank reserves and contracts money supply. This can cause depression.  Best Fed can ultimately do is try to promote stable price levels. Copyright© 2006 John Wiley & Sons, Inc. 15

 Changes in the fed funds rate provide a clue to short term changes in the monetary policy.  When the FED wants to contract the economy (decrease the money supply),we expect the FFR to rise as more banks finds themselves short of reserves and tend to borrow at fed funds market.  When the FED wants to expand the economy (increase the money supply),we expect the FFR to decrease. Copyright© 2006 John Wiley & Sons, Inc. 16

Two school of thought about what affects the level of economic activity: 1- Monetarist Economists Monetarists assume propensity to consume— rises as people perceive they have “more money” drops as people perceive they have “less money” The money supply is the key variable that effect on economic activity. adding reserves carefully should promote economic growth subtracting reserves carefully should slow the economy 2- Keynesian Economists John Maynard Keynes was influential British economist of 1930s. The interest rate is the key variable.

 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.  Keynesian believe that monetary policy always works unless the economy is in liquidity trap.  Liquidity Trap: When people already had a lot of money relative to their needs that any extra money will be hoarded and would no longer drive down the interest rates. Copyright© 2006 John Wiley & Sons, Inc. 18

 Increase in market interest rate leads to decrease in the value of fixed – income securities.  Raising discount rate or / and raising reserve requirements leads to a great fall in the stock market.

 Full employment  Economic growth  Price index stability  Interest rate stability  Stable financial system  Stable foreign exchange markets Copyright© 2006 John Wiley & Sons, Inc. 20

 Full employment implies that every person of working age who wishes to work can find employment.  Types of unemployment 1. Frictional unemployment: people unemployed in transition between jobs. 2. Structural unemployment: happens when there is mismatch between a person’s skill levels and available jobs or more jobs in one region of the country but fewer in the others. Copyright© 2006 John Wiley & Sons, Inc. 21

 It is name given for a rising standard of living,measured by output per unit of input.  Economic growth is made possible through increased productivity of labour and capital.  For example: Productivity can be increased by training the labour and applying new technologies to the capital. Copyright© 2006 John Wiley & Sons, Inc. 22

 Price Stability refers to the stability in the average price of all goods and services in the economy.  Inflation is defined as a continuous rise in the average price level or a continuous decrease in the purchasing power of money.  Inflation can be measured by price indexes such as the Consumer Price Index(CPI). Copyright© 2006 John Wiley & Sons, Inc. 23

 It refers to the swings or volatility of interest rates over time.  Large interest rate fluctuations introduce additional uncertainty into the economy and make it harder to plan for the future.  For e.g. high interest rates, this prevents consumer and business spending. Copyright© 2006 John Wiley & Sons, Inc. 24

 Instability of the financial system can prevent the efficient flow of funds between DSU and SSU.  Any reduction in the flow of funds can reduce consumer spending, business investment and thus the economic growth.  For e.g. Role of the Central banks during the Financial crisis. Copyright© 2006 John Wiley & Sons, Inc. 25

 Exchange rates are the value of the local currency relative to foreign currencies.  Fluctuations exchange rates introduce uncertainty. What is the name of that risk?.  For e.g. When the value of dollars increases, what does this mean in terms of exports and imports?. Copyright© 2006 John Wiley & Sons, Inc. 26

 Most of the goals of the Fed are consistent with each other, except price stability and full employment.  When economy is in expansion, 1. unemployment starts to decrease 2. More goods are produced and thus more labour are needed. 3. Wages of labour starts to increase because they became scarce and the same thing applies to raw materials. 4. This increases the cost of production and thus the prices of goods increased.(inflation). Copyright© 2006 John Wiley & Sons, Inc. 27

 Philip’s Curve.  Stagflation. Copyright© 2006 John Wiley & Sons, Inc. 28