CHAPTER 3 THE FED AND INTEREST RATES

Copyright© 2003 John Wiley and Sons, Inc. Definition of the Monetary Base Money Aggregates M1—”Medium of Exchange”, Currency and Checking Deposits. M2– M1+ saving deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, small time deposits. MZM – M2– small denomination time deposits + institutional money market mutual funds. M3 – M2+ institutional money market mutual funds, large time deposits, and repurchase agreements and Eurodollars > 1 day maturity L – All liquid assets economy wide including U.S. Treasury Bills maturing 1 year or less.

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Full Employment Frictional Unemployment The rate of unemployment created by job mobility Structural Unemployment Created by immobile workers or poor job skills (education) “Natural Rate of Unemployment” The rate of unemployment generally tolerated by governments

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Economic Growth Gross Domestic Product (GDP) per Capita The general measure of a countries wealth The goal has been to have a steadily rising level of real GDP (inflation adjusted) This has not been the case however, as inflation has eaten away at GDP.

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Price Stability Goal has been to provide steady average prices in the economy on average Inflation Book Definition – a continuous rise in average prices over time. Class Definition – An increase in the money supply resulting in a general rise in average prices as the purchasing power of the monetary unit falls due to proliferation and the resulting loss in purchasing power.

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Interest Rate Stability The goal is to provide a steady level of interest rates reflective of market risk while reducing interest rate volatility. Economic/Financial Calculation is more difficult with uncertainty regarding future interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Financial System Stability The Fed as Lender of Last Resort The Fed is to stand ready in the event of catastrophic losses in the financial system The Fed would provide liquidity to increase public confidence in the system

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Foreign Exchange Stability A primary goal of the Fed is to provide stable purchasing power of the U.S. Dollar relative to foreign currencies This is expressed in stable exchange rates. The Fed may seek to weaken the dollar during economic downturns to increase exports giving U.S. firms a boost in demand

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy Inconsistencies and Limitations The Fed can not continually inflate the money supply as this has serious domestic and international consequences. Remember inflation is not your friend High inflation rates domestically make life more expensive to live Likewise, high inflation causes an international asset drain as U.S. assets are sent oversees to find more stability in other markets

Copyright© 2003 John Wiley and Sons, Inc. Objectives of Fed Monetary Policy The Alternative (My personal view) A hard money standard Eliminating the Fed and tying the U.S. Dollar to Gold and Silver The afore mentioned goals thus would be met Large and Powerful Banks and Financial Service firms would not profit as easily through this system

Copyright© 2003 John Wiley and Sons, Inc. The Monetary Base and Changes in the Money Supply Reserves are a % of the total Liabilities of the Bank ie: Total Liabilities of $800 mil. w/ 10% reserve requirement = $80 mil in required reserves Excess Reserves Those in excess of requirements imposed by the Fed Banks hold only minimal excess reserves as the Fed pays no interest on excess reserves held at the Fed

Copyright© 2003 John Wiley and Sons, Inc. Impacts of Federal Reserve Policy Expansionary monetary policy Open market operations -- purchase securities -- increase bank excess reserves and the monetary base. Reserve requirements -- reduce reserve requirements -- increase excess reserves and increase the deposit expansion multiplier. Discount rate -- reduce the rate -- reduce the cost of borrowing reserves. Expands the money supply; reduces interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Impacts of Federal Reserve Policy (concluded) Restrictive monetary policy Open market operations -- sell securities, reduce bank reserves and the monetary base. Reserve requirements -- increase reserve requirements, reduces excess reserves and the deposit expansion multiplier. Discount rate -- increase the discount rate and the cost of borrowing reserve deficiencies. Reduce the money supply or its growth rate; increase interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Federal Reserve Policy in the Financial System Changes in the Money Supply When the Fed either increases the monetary base or reduces reserve requirements, banks’ excess reserves increase. Excess reserves are loaned out or invested. Transaction deposits increase as loaned or invested funds are deposited. The money supply increases.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Policy Changes Changes in Interest Rates Expansion of the monetary base or reductions in reserve requirements increase bank liquidity. Federal Funds rate declines. Price of other money market securities increase (rates decline) as banks invest their liquidity. Loan rates and other security rates decline with continued increases in bank liquidity. Monetary policy starts in the bank money market and spreads to other financial institutions and markets and to the real economy.

Copyright© 2003 John Wiley and Sons, Inc. Effects of Policy Changes Credit availability is increased with the expansion of bank liquidity and reduced interest rates. Wealth Effects -- reduced interest rates (increased security prices) increases the wealth of individuals. Increased wealth prompts increased spending. Increased spending has a current income, Y, impact and a multiplier effect in future income periods.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy Monetary policy affects spending Investment. Consumption. State and local government. Effects of Monetary Policy on Changes in Investment Investment demand, traditionally, has been sensitive to changes in interest rates.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (continued) Housing investment -- both credit availability and mortgage rates have been impacted severely by monetary policy. Plant and equipment investment is related to expected rates of return relative to the cost of financing. Planned inventory investment is sensitive to the cost and availability of credit.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (continued) Consumption expenditures are affected several ways: Increased or decreased holdings of money affect spending. Credit availability and interest rate levels affect the purchase of durable goods. Changes in wealth affect spending in the current period.

Copyright© 2003 John Wiley and Sons, Inc. Short-Run Effects of Monetary Policy (concluded) Foreign trade is affected by monetary policy. Increased interest rates increase the value of the dollar relative to the other currencies. Increased dollar exchange rates encourage imports; discourage exports. State and Local Government Expenditures Monetary policy affects capital project expenditures. Higher interest rates limit expenditures.

Copyright© 2003 John Wiley and Sons, Inc. Changes in the Discount Rate

Copyright© 2003 John Wiley and Sons, Inc. Change in Money Supply and Interest Rates and the Economy

Copyright© 2003 John Wiley and Sons, Inc. Long-Run Effects of Monetary Policy Expectations are affected by current, short-run monetary policy actions. High money growth to stimulate the economy may increase interest rates (interest rate effects). Market expects inflation from near-term policy action. Investors sell long-term bonds, prices fall, and interest rates increase.

Copyright© 2003 John Wiley and Sons, Inc. Long-Run Effects of Monetary Policy (concluded) Expected inflation may cause increased spending and borrowing and increased interest rates. Pay back lower value debts. Buy before the price goes up psychology. May move the economy to inflationary income levels. Cost increases (interest and labor) faster than price increases will cause reductions in investment spending.

Copyright© 2003 John Wiley and Sons, Inc. Practical Considerations in Monetary Policy Expectations may nullify intent of policy. Time lags in implementing monetary policy reduce its effectiveness. Political pressures influence Federal Reserve policy.

Copyright© 2003 John Wiley and Sons, Inc. Complications in Implementing Policy The Velocity of Money The rate money changes hands in the economy V= Y/M or M x V = Y V= Velocity M= Money Supply Y= GDP