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Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20011 Monetary Policy and Its Effect on Financial Markets Andrew B. Abel October.

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Presentation on theme: "Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20011 Monetary Policy and Its Effect on Financial Markets Andrew B. Abel October."— Presentation transcript:

1 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20011 Monetary Policy and Its Effect on Financial Markets Andrew B. Abel October 1, 2001

2 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20012 Goals of Economic Policy Full Employment Lost output is lost forever Okun's Law: one percentage point increase in unemployment rate reduces output by 2.5% Development of human capital Social consequences of unemployment

3 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20013 Goals of Economic Policy (cont’d) Price Stability Cost of inflation anticipated inflation –reflected in asset prices and contracts –economize on money balances: shoe-leather costs –menu costs unanticipated inflation –redistributes income –individual risks reduce welfare and use resources hyperinflation –disrupts payments system and tax collections

4 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20014 Goals of Economic Policy (cont’d) Growth Productivity and real wages capital accumulation (including human capital) technological progress Social Agenda Insure basic needs Income distribution Vital industries Defense

5 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20015 Goals of Economic Policy (cont’d) Environmental Goals Non-renewable resources Pollution control Political Business Cycle

6 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20016 The Federal Reserve System Regional Banks (12) Board of Governors (7) Staggered 14-year terms Chairman has 4-year term Federal Open Market Committee (FOMC) 12 Members 7 Governors President of NY FRB Presidents of 4 of remaining 11 Regional FRBs

7 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20017 12 Federal Reserve Banks Owned by Member Banks Directors Class A: bankers elected by member banks Class B: business (industry, commerce, agriculture) elected by member banks Class C: others, nonbankers appointed by Board of Governors

8 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20018 Federal Reserve Districts Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

9 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 20019 Balance Sheets of the Fed and the Banking Sector Federal Reserve High-powered money (monetary base) Banking System Assets reserves –vault cash –deposits at Fed loans securities Liabilities deposits

10 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200110 Balance Sheets of Fed and Banks (August 2001, billions of dollars)

11 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200111 Definitions of Monetary Terms Reserves Vault cash + deposits at Fed Monetary Base Reserves + currency in circulation Deposits at Fed + total currency (in circulation and in vaults) Money Supply Currency in circulation + deposits

12 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200112 Components of Monetary Base (August 2001, billions of dollars)

13 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200113 Money Supply (August 2001, billions of dollars)

14 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200114 Money Multiplier Money Supply Divided by Monetary Base Fed controls monetary base Public and depository institutions influence money multiplier August 2001 Money supply = $1140.3 billion Monetary base = $613.2 billion Money multiplier = 1.86

15 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200115 Multiple Bank Expansion Process...

16 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200116 Money Multiplier

17 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200117 Monetary Definitions Money Supply: M = CU + DEP Monetary Base: H = CU + RES High-powered money Money Multiplier: mm = M/H Increase in res reduces mm Increase in cu reduces mm

18 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200118 Money Multiplier During the Great Depression March 1930 - March 1933 Monetary base grew by 20% Money multiplier fell from 6.6 to 3.6 Therefore, money supply fell by 35%

19 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200119 Currency-Deposit Ratio and Reserve- Deposit Ratio during Great Depression Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

20 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200120 Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

21 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200121 Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

22 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200122

23 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200123

24 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200124 Tools of Monetary Policy Open Market Operations Discount Rate Reserve Requirements

25 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200125 Open Market Operations Open Market Purchase of Securities Increase monetary base Multiple bank expansion of deposits Interest rate falls stimulates investment stimulates financial outflow –exchange rate depreciates –stimulates exports –restrains imports

26 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200126 Open Market Sale of Securities Decrease Monetary Base Multiple Bank Contraction of Deposits Interest Rate Rises Restrains investment Stimulates financial inflow exchange rate appreciates –restrains exports –stimulates imports

27 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200127 Monetization of the Federal Budget Deficit Printing Money Inflation Federal Reserve-Treasury Accord, 1951 Pegged rates 1942-1952 bills: 0.5% bonds: 2.5%

28 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200128 Foreign Exchange Intervention Defend the Dollar Sell foreign exchange/buy dollars Reduces monetary base Weaken the Dollar Buy foreign exchange/sell dollars Increases monetary base Sterilization

29 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200129 Discount Rate Discount Window Lending Banks borrow from Fed (Discount Window) interest rate is the discount rate Banks also borrow reserves from each other interest rate is Federal funds rate

30 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200130 Federal Funds Rate and Discount Rate Fed funds rate Discount rate

31 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200131 Decrease in the Discount Rate Excess Reserves Fall Loans Increase Money Supply Increases

32 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200132 Reserve Requirements Net Transactions Accounts 3% under $42.8 million as of 12/28/00 10% over $ 42.8 million as of 12/28/00 Nonpersonal Time Deposits Reserve requirements were reduced to zero as of 12/27/90 Fall in Reserve Requirements Loans increase Money supply increases

33 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200133 Inflation and Interest Rates Real vs. Nominal Interest Rates Ex post real rate nominal interest rate minus inflation Ex ante real rate nominal interest rate minus expected inflation

34 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200134

35 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200135 Nominal Real

36 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200136 After-Tax Real Interest Rate After-tax real interest rate = (1-t)i -  3 8 -2 0.6

37 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200137 Increases in the Money Supply and Inflationary Expectations Response of Nominal Interest Rate Liquidity effect - reduce interest rate Inflationary expectations effect - raise interest rate Does Nominal Interest Rate Rise One-for- One with Inflation? Lower real rate of return on money substitute away from money reduces real rates on substitute assets

38 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200138 Intermediate Targets (Instruments) Two Criteria for Intermediate Targets Fed can influence them Related to ultimate goals of policy Examples Monetary aggregates (M1, M2) Short-term interest rates (Fed funds rate)

39 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200139 Interest Rate vs. Money Supply Targets Cannot Target Both Money and Interest Rate Two targets could call for conflicting actions Pegging Interest Rate Requires Surrendering Control of Money Supply

40 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200140 Control Money Interest Rate Adjusts Mitigates effects of shocks to consumption, investment, net exports Does not mitigate effects of shocks to money demand case of the missing money ambiguity and changing nature of money

41 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200141 Control Interest Rate Money Supply Adjusts Fails to mitigate effects of shocks to consumption, investment, net exports Insulates economy from effects of shocks to money demand

42 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200142 The Historical Record October 1979 Policy change emphasized monetary base de-emphasized federal funds rate Consequences increased interest rate volatility

43 Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 200143 October 1982 Policy Change De-emphasized monetary aggregates Emphasized Federal Funds rate Consequences Reduced interest rate volatility Continued volatility of monetary aggregates

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