Monetary Policy: Conventional and Unconventional 13

Monetary Policy Monetary policy Actions that the Federal Reserve System takes to change interest rates and the money supply Aim is to affect the economy: GDP, employment, inflation We focus on how monetary policy affects interest rates, investment and aggregate demand 2

The Federal Reserve System: The Fed Central bank - a bank for banks Origins and structure of the Fed : four severe banking panics Federal reserve Act: 1913 Set up 12 Federal Reserve Districts – 12 regional banks Technically a corporation Stockholders: member banks Most profits turned over to U.S. Treasury – $78 billion in

The Federal Reserve System Federal Reserve System It is not part of any branch of government Was created by Congress - Federal Reserve Act (1913) Could be eliminated by Congress if it so desired 4

The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve Bank. The Geography of the Federal Reserve System 5 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Federal Reserve System Board of Governors (7 members) Appointed by U.S. President with the advice and consent of the Senate 14-year term Chairperson serves 4-year term: Janet Yellen The Fed Independent from the rest of government It alone has responsibility for monetary policy 6

The Federal Reserve System Federal Open Market Committee (FOMC) 12 members 7 governors of the Fed President of the New York Fed 4 (of 11) district banks presidents Short-term interest rates and size of money supply 7

The Federal Reserve System Central bank independence Central bank’s ability to make decisions without political interference Proponents: Independence keeps politics out Fed can take longer term view Maintain low and stable inflation Opponents: Independence is undemocratic Why let a small group of bankers and economists make decisions that affect everyone 8

Monetary Policy in Normal Times Open-market operations The Fed’s purchase or sale of government securities (usually Treasury bills) through transactions in the open market What does the FOMC so if it wants to lower interest rates Purchases Treasury bills (T-bills) from banks Pays for them with newly created bank reserves 9

Monetary Policy in Normal Times Market for bank reserves Supply of reserves determined by Federal Reserve policy Demand for reserves determined Banks since they are required to hold reserves Required reserves = m x D (transaction deposits) But the demand for D depends on the volume of transactions in the economy Which depends on real GDP and the price level Banks lend reserves to other banks Interest rate on reserves: federal funds rate 10

The Market for Bank Reserves 11 Quantity of Bank Reserves Interest Rate S S D D E For given Fed policy For given Y and P

Monetary Policy in Normal Times Federal funds rate Interest rates that applies when banks borrow reserves from one another Why is there a reserve market? Some banks may be short of reserves so would borrow Some banks may have excess reserves so would lend Important since allows reserves to flow where needed 12

Monetary Policy in Normal Times How the Fed lowers the federal funds rate Purchase T-bills provides additional reserves to market Supply of reserves will Shift out increasing bank reserves and decreasing the federal funds rate 13

Figure 2 The effects of an open-market purchase 14 Quantity of Bank Reserves Interest Rate S0S0 S0S0 D D S1S1 S1S1 E A

Monetary Policy in Normal Times Mechanics of an open market operation Suppose Fed buys $100 million of T-Bills from commercial banks How can this lead to a multiple expansion of the money supply and a decrease in the interest rate? 15

Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed 16 Banks exchange one asset(T-Bills) for another (reserves) Fed “pays “ for T-Bills by crediting banks with additional reserves This Open Market purchase created $100 million in Excess Reserves!

Monetary Policy in Normal Times Mechanics of an open market operation After the purchase, banks have $100 million of excess reserves If m = 0.20, by how much can the money supply expand? = $100 million x (1/0.20) = $500 million Why don’t we subtract off the initial $100 million like before? 17

Monetary Policy in Normal Times Mechanics of an open market operation The actual money supply will increase by less than $500million if: Public chooses to hold more cash Banks decide to hold some excess reserves What if the Fed wants to decrease the money supply and increase interest rates? Sell T-Bills taking reserves out of the banking system This is an Open Market Sale. 18

Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed 19 Banks exchange one asset(reserves) for another (T-Bills) This Open Market sale removes $100 million in Excess Reserves from the banking system! Sells T-Bills Lose reserves

Open-Market Operations Bond prices and interest rates How does the purchase cause interest rates to fall? Private market for T-Bills 20

Figure 3 Open-Market Purchases and Treasury Bill Prices 21 Quantity of Treasury Bills Price of a Treasury Bill S0S0 S0S0 D D S1S1 S1S1 P0P0 P1P1 A B Private demand (unchanged) Fed makes a purchase so supply falls

Open-Market Operations 22

Open-Market Operations Putting it all together: Expansionary policy Fed wants money supply to increase and interest rates to fall, so... they make an open market purchase. Banks excess reserves will increase, so the money supply expands. By buying bonds, the Fed causes the prices of bonds to increase so interest rates decrease 23

Open-Market Operations Putting it all together: Contractionary policy Fed wants money supply to decrease; interest rates to rise, so... they make an open market sale. Banks excess reserves will decrease, so the money supply contracts By selling bonds, the Fed causes the prices of bonds to decrease so interest rates increase 24