18 – Monetary Policy Chapter 18

Monetary Policy Tools Policy tools – Target federal funds rate – Discount rate – Reserve requirement Effective policy tools – Observable – Controllable – Linked to Objectives Objectives of Fed 1)Low stable inflation 2)High, stable output 3)Stable interest rates

Target Federal Funds Rate Federal Funds Rate – Rate at which banks lend to each other overnight – Limits amount of excess reserves banks need to hold – Unsecured loans Fed does not participate directly in market – As borrower, would have to pay interest – Credit risk – “Free” market provides valuable information on bank health

Target Federal Funds Rate Rate is determined by supply and demand for reserves

Target Federal Funds Rate

Interest Rates Banks with excess reserves always have the option of – Attracting new borrowers – Loaning out reserves in Fed-Funds market As Fed Funds rate increases, so must other rates on loans to consumers. – Otherwise banks maximize profits by loaning out in Fed-Funds market.

Interest Rates and Demand As Interest rates increase – More expensive for firms to borrow – More expensive for consumers to borrow – Demand decreases Lower inflation, output As Interest rates decrease – Less expensive for firms to borrow – Less expensive for consumers to borrow – Demand increases Higher inflation output

Discount Lending Not used as a primary policy instrument Used to – Ensure short-term financial stability – Eliminate bank panics – Prevent sudden collapse of institutions

Discount Lending Primary Credit – Overnight loans to banks deemed to be financially sound – Banks must post some sort of collateral – Primary Discount Rate: 100 basis point above target Fed Funds rate – Puts ceiling on Fed Funds Rate

Discount Lending Secondary Credit – Banks that are not financially Sound – Secondary Discount Rate: 50 basis points above primary discount rate – Considered a bad signal for bank

Reserve Requirements Primary Purpose: help stabilize demand for reserves Not a good policy tool because – Small changes in reserve requirement lead to excessive changes in deposits. – Continually fluctuating reserve requirements creates greater uncertainty for banks and make liquidity management more difficult.

Reserve Requirements During Great Depression – Banks built up piles of excess reserves – Fed became worried stock piles could quickly be depleted, leading to inflation – August 1936 – Fed doubled reserve requirement – Banks spent next few years building up excess reserves.

Policy Instruments Observable Controllable Linked to Objectives Interest rates – How are they linked to objectives? – Inflation targeting?

Inflation Targeting Advantages – Does not rely on stable relationship between money and inflation. – Understood by public - simple and clear – Increases accountability Disadvantages – Delayed signaling – how good in the bank doing? – Too much rigidity that can lead to volatile output

Monetary Targeting

Fed Funds Futures Contracts Fed Funds Futures Contract traded on CBOT since October Time 0: Traders agree to go long or short at futures price, F 0 Settlement Price (S T ): 100 minus the average daily fed funds overnight rate for the delivery month Contract size: $5 million Settled at end of last business day of the month – Long party gets: S T -F 0 – Short party gets: F 0 -S T

Fed-Funds Futures Example Contract is for January, 2008 Current Futures price today: I go long a January Fed-Funds futures contract today (in December). On January 31 contract settlement is determined. Clearing house looks at actual average Fed-Funds rate over January. – Assume it has been 4.25% – I get paid ( )*.01*5M =.07*5M=$3,500

Fed Funds Futures The lower the Fed Funds rate over January, the more I win. – Long positions in Fed futures hedge against falling Fed-Funds rates. The higher the Fed Funds rate over January, the more the short party wins. – Short positions in Fed futures hedge against rising Fed-Funds rates.

Predicting What the Fed will Do Example: – 19 days left in December – The Fed meets in 7 days – Will not meet again until January – Current Target Fed Funds rate: 5.25%

Predicting What the Fed will Do Assume – The Fed hits its target Fed Funds rate each day – The Fed does not enact new monetary policy until the Wednesday after its meeting – Fed Funds futures prices are set so that the expected, or average payoff to either side is zero.

Predicting What the Fed will Do Implications: – For 19 days of December, the Fed Funds rate will be 5.25 Only 19 days left: for the first 12 days it was 5.25 For the next 7 days it will be 5.25 Includes date of FOMC meeting – The Fed Funds rate for the remaining 12 trading days in December will depend on what the Fed decides to do.

Predicting What the Fed will Do Averages for December – If Fed lowers by 25bp: (19* *5.00)/31 = 5.15 – If Fed keeps rates steady: 5.25 – If Fed raises by 25bp: (19* *5.50)/31 = 5.35 If market expects – Average to be 5.15, then F 0 = = – Average to be 5.25, then F 0 = = – Average to be 5.35, then F 0 = = 94.65

How Good are Our Assumptions? The Fed hits its target Fed Funds rate each day

How Good Are the Assumptions? The Fed does not enact new monetary policy until the days after its meeting Fed may take a few days to fully implement policy.

19 – Exchange Rate Policy Chapter 19

Fixed Exchange Rates PPP: Inflation erodes the value of currency If a country wants to fix its exchange rate with another country, it must conduct monetary policy so that the two countries’ inflation rates match. A central bank must choose between a fixed exchange rate and an independent monetary policy. But PPP only holds over long periods. What about in the short term?

Fixed Exchange Rates in the Short Run When buying a foreign bond FV f = Face value of bond in foreign currency P f = Price of bond in foreign currency r f = return on bond in terms of foreign currency

Fixed Exchange Rates in the Short Run What you care about is return in dollars. r f = return on bond in terms of foreign currency E t = dollar-foreign ex-rate at time t Assume bond is purchased at time t Assume bond matures at time t+1

Fixed Exchange Rates in the Short Run If exchange rate is fixed, then implying

Fixed Exchange Rates in the Short Run Conclusion: As long as capital is able to flow across borders freely, monetary authorities can choose to control either – Exchange rate – Interest rate

Mechanics of Exchange rate Intervention Central banks agrees to exchange currency for dollars at a fixed rate. Bank must maintain a substantial amount of dollar reserves to keep currency from depreciating.

Fixed Exchange Rate Costs/Benefits Benefits – Eliminate exchange rate risk – Effective way to control inflation in inflation-prone countries Costs – Import monetary policy – Central bank must have ample dollar reserves

Methods of Fixing Exchange Rate Currency Boards – Central bank holds enough dollars to keep currency from depreciating – Example: Argentina Dollarization – Country adopts dollar as official currency – Example: Ecuador