1. 1 Frank & Bernanke 4 th edition, 2009 Ch. 12: Stabilizing the Economy: The Role of the Federal Reserve

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3. 3 Origins of the Federal Reserve System Resistance to establishment of a central bank Resistance to establishment of a central bank Fear of centralized power Fear of centralized power Distrust of moneyed interests Distrust of moneyed interests No lender of last resort No lender of last resort Nationwide bank panics on a regular basis Nationwide bank panics on a regular basis Panic of 1907 so severe that the public was convinced a central bank was needed Panic of 1907 so severe that the public was convinced a central bank was needed Federal Reserve Act of 1913 Federal Reserve Act of 1913 Elaborate system of checks and balances Elaborate system of checks and balances Decentralized Decentralized

4. 4 Board of Governors of the Federal Reserve System Seven members headquartered in Washington, D.C. Seven members headquartered in Washington, D.C. Appointed by the president and confirmed by the Senate Appointed by the president and confirmed by the Senate 14-year non-renewable term 14-year non-renewable term Required to come from different districts Required to come from different districts Chairman is chosen from the governors and serves four-year term Chairman is chosen from the governors and serves four-year term

5. 5 Federal Open Market Committee (FOMC) Meets eight times a year Meets eight times a year Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks Consists of seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and the presidents of four other Federal Reserve banks Chairman of the Board of Governors is also chair of FOMC Chairman of the Board of Governors is also chair of FOMC Issues directives to the trading desk at the Federal Reserve Bank of New York Issues directives to the trading desk at the Federal Reserve Bank of New York

6. 6 Federal Reserve System Source: Federal Reserve Bulletin.

7. 7 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Suppose: Depositors lose confidence in their bank. Depositors lose confidence in their bank. They attempt to withdraw their funds. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures. The bank fails and further erodes depositor confidence which triggers additional failures.

8. 8 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: The Fed to the rescue: Instill confidence Instill confidence Discount lending Discount lending Open Market Operations Open Market Operations

9. 9 The Great Depression The Fed did not prevent the Great Depression. The Fed did not prevent the Great Depression. Both currency held by the public and reserve- deposit ratio rose, reducing money supply. Both currency held by the public and reserve- deposit ratio rose, reducing money supply. The Fed increased the reserves but not enough. The Fed increased the reserves but not enough. Lack of enough reserves forced bank bankruptcies. Lack of enough reserves forced bank bankruptcies. One-third of U.S. banks closed One-third of U.S. banks closed

10. 10 Policy Tools in the Federal Reserve System

11. 11 Why did money supply fell during the Great Depression even though the Fed kept reserves up? What would M value be in 1932 if reserve ratio did not change?

12. 12 Fed’s Control of Nominal Interest Rate By buying or selling bonds, the Fed increases or decreases the RESERVES in the system. By buying or selling bonds, the Fed increases or decreases the RESERVES in the system. If the Fed buys securities, reserves increase, then banks can easily find required funds => lower federal funds rate of interest. If the Fed buys securities, reserves increase, then banks can easily find required funds => lower federal funds rate of interest.

13. 13 The Federal Funds Rate, 1970-2004

14. 14 http://research.stlouisfed.org/publications/mt/page9.pdf

15. 15 Fed Funds Rate vs. Prime If Fed can affect the federal funds rate, why should we care? If Fed can affect the federal funds rate, why should we care? We might be interested in the interest rates on CDs, mortgage rates, credit card interest rates. We might be interested in the interest rates on CDs, mortgage rates, credit card interest rates. Usually, interest rates all go hand in hand. Usually, interest rates all go hand in hand. When the Fed increases the federal funds rate, banks increase their prime rates, too. When the Fed increases the federal funds rate, banks increase their prime rates, too.

16. 16 Real and Nominal Interest Rates If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? If the amount of savings and investments in an economy determine the real interest rate, and real interest rate is more important for the decisions that will affect the wealth of the society, why should we care what the Fed does? Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate. Because in the short run, prices are constant, so inflation does not increase: any change in nominal interest rates is reflected in the real interest rate.

17. 17 Real and Nominal Interest Rates Remember the Fisher Effect: Remember the Fisher Effect: i = r +  i = r +   f the expected inflation hasn’t changed (short-run: prices constant) but the Fed has increased i, then r is also increased.  f the expected inflation hasn’t changed (short-run: prices constant) but the Fed has increased i, then r is also increased. In the long run  adjusts and it is the savings and investments that determine the real rate of interest. In the long run  adjusts and it is the savings and investments that determine the real rate of interest.

18. 18 Federal Funds Rate and the Economy PAE responds to C, I, G, NX changes. PAE responds to C, I, G, NX changes. Only real interest rate impacts INVESTMENTS and SAVINGS Only real interest rate impacts INVESTMENTS and SAVINGS Real interest up => S up => C down Real interest up => S up => C down Real interest up => I down Real interest up => I down Real interest up => USD appreciates => Imports cheaper; exports more expensive => NX down Real interest up => USD appreciates => Imports cheaper; exports more expensive => NX down r up => C, I, NX down => PAE shifts down r up => C, I, NX down => PAE shifts down

19. 19 Real Interest Rates and Aggregate Demand Y = C + I + G + NX Y = C + I + G + NX C = 400 + 0.8(Y-T) - 200r C = 400 + 0.8(Y-T) - 200r I = 300 - 600r I = 300 - 600r G = 250; T = 200; NX = 10 G = 250; T = 200; NX = 10 Explain in words how this economy operates. Explain in words how this economy operates.

20. 20 Solving for the Unknowns If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. If the real interest rate is 3%, find the values of C, I, and Y for the previous economy and draw the Keynesian cross to show the Y. If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph. If the Fed has increased the real interest rate to 5%, find the values of C, I, and Y and show the new AD curve on your graph.

21. 21 Fighting Recession The Fed reduced the fed funds rate 11 times in 2001-2002 from a high of 6.5%. The Fed reduced the fed funds rate 11 times in 2001-2002 from a high of 6.5%. On Nov. 6, 2002, it was 1.75% and the Fed decided to lower it further. On Nov. 6, 2002, it was 1.75% and the Fed decided to lower it further. What was the effect of Fed’s lowering of interest rates on AD? What was the effect of Fed’s lowering of interest rates on AD? What was the Fed policy between 2007- 2010 (look at slide #13)? What was the Fed policy between 2007- 2010 (look at slide #13)?

22. 22 Fighting Recession Fed lowers r => I, C, NX increase => PAE shifts up => For every $1 increase (shift) in PAE, Y increases by the value of the multiplier => Equilibrium Y is no longer at recession value => Y-Y*=0. Fed lowers r => I, C, NX increase => PAE shifts up => For every $1 increase (shift) in PAE, Y increases by the value of the multiplier => Equilibrium Y is no longer at recession value => Y-Y*=0.

23. 23 The Fed Fights A Recession Output Y Planned aggregate expenditure PAE Y = PAE 5,000 Recessionary gap E Expenditure line (r = 5%) 4,800 Y* Expenditure line (r = 1%) F A reduction in r shifts the expenditure line upward Multiplier = 5 Output gap = 200 Fed wants to increase PAE by 200/5 = 40 C = 1,010 – 1,000r 1% change in r will change C by 10 Reduce r to 0.01

24. 24 Fighting Inflation From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%. From the middle of 1999 to the middle of 2000, the Fed raised the fed funds rate from 4.75% to 6.50%. At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%. At the beginning of 1977 the fed funds rate was 4.5%. By the end of 1978 it was 10%. A year later it was 13.75%. By April 1980, it reached 17.6%. What happens to PAE? What happens to PAE?

25. 25 Raising Interest Rates Real GDP growth of nearly 6% in late 2003 and 4.4% in 2004 and a falling unemployment rate to 5.6% in June 2004 indicated the possible emergence of an expansionary gap. Real GDP growth of nearly 6% in late 2003 and 4.4% in 2004 and a falling unemployment rate to 5.6% in June 2004 indicated the possible emergence of an expansionary gap. From June 2004 to June 2005 the Fed Funds Rate rose from 1.0% to 3.25%. From June 2004 to June 2005 the Fed Funds Rate rose from 1.0% to 3.25%.

26. 26 The Fed Fights Inflation Output Y Planned aggregate expenditure PAE Expenditure line (r = 5%) Y = PAE 4,800 Expansionary gap E 4,600 Y* G Expenditure line (r = 9%) An increase in r shifts the expenditure line downward

27. 27 Inflation and the Stock Market Inflation is watched very closely by the Fed. Inflation is watched very closely by the Fed. Any sign of inflation makes Fed increase interest rates. Any sign of inflation makes Fed increase interest rates. Higher real interest rates slow down the economy and lower future profits. Higher real interest rates slow down the economy and lower future profits. Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices. Higher real interest rates lower the price of bonds and shift the demand away from stocks to bonds, lowering stock prices. If there is no inflation but there is an asset bubble, should the Fed increase the interest rate? If there is no inflation but there is an asset bubble, should the Fed increase the interest rate?

28. 28 Policy Reaction Function If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. If there is a pattern of policies adopted under the same economic circumstances, then we have a policy reaction function. For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation. For example, if there is a correlation between low unemployment rates and lax immigration policies and high unemployment rates and strict immigration policies, this can be shown with an equation.

29. 29 A Monetary Policy Reaction Function for the Fed 0.00 (= 0%)0.02 (= 2%) 0.010.03 0.020.04 0.030.05 0.040.06 Rate of inflation,  Real interest rate set by Fed, r

30. 30 An Example of a Fed Policy Reaction Function Real interest rate set by Fed, r 0.01 0.02 0.03 0.04 0.05 0.06 0.020.030.04 Fed’s monetary policy rule Inflation  If the Fed sets the target inflation as 2%, what interest rate will it set?

31. 31 What is Demand for Money? Demand for Money (Liquidity Preference) Demand for Money (Liquidity Preference) The amount of wealth an individual chooses to hold in the form of money. The amount of wealth an individual chooses to hold in the form of money. The portfolio allocation decision is made by comparing return relative to risk. The portfolio allocation decision is made by comparing return relative to risk. Risk can be reduced by diversifying the portfolio. Risk can be reduced by diversifying the portfolio. Most people choose to hold some wealth as money. Most people choose to hold some wealth as money.

32. 32 The Demand for Money Money (currency + checking deposits) is one of the assets a person, a household, a business holds. Money (currency + checking deposits) is one of the assets a person, a household, a business holds. The benefit of money is its acceptability in paying debts (liquidity). The benefit of money is its acceptability in paying debts (liquidity). The cost of money is the opportunity cost of losing a return on other assets one could hold. The cost of money is the opportunity cost of losing a return on other assets one could hold.

33. 33 The Demand for Money If the opportunity cost of holding money increases, less money will be held in portfolio. If the opportunity cost of holding money increases, less money will be held in portfolio. The higher the nominal interest rate, the lower is the demand for money. The higher the nominal interest rate, the lower is the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. The more the income, the more will be the amount kept in money form: the higher will be the demand for money. The higher the price level, the higher will be the demand for money. The higher the price level, the higher will be the demand for money.

34. 34 The Money Demand Curve Money M Nominal interest rate i MD MD’ Shifts in MD Changes in Y & P MD will increase if Y or P increase Technological changes Foreign demand

35. 35 Shifts in Money Demand Businesses hold more than half of the total money stock. Businesses hold more than half of the total money stock. Changes in real income (real GDP). Changes in real income (real GDP). Changes in price level. Changes in price level. Technological change and sophisticated financial markets have reduced the demand for money in the U.S. Technological change and sophisticated financial markets have reduced the demand for money in the U.S. Changes in foreign holdings of USD. Changes in foreign holdings of USD. Between 1960 and 2004 M 1 as a percent of GDP fell from 28% to 12%. Between 1960 and 2004 M 1 as a percent of GDP fell from 28% to 12%. Psychological changes. Psychological changes. Seasonal changes. Seasonal changes.

36. 36 Foreign Holdings of USD More than $300 billion in currency circulating outside the U.S. More than $300 billion in currency circulating outside the U.S. Foreign citizens will hold dollars to avoid the impact of high inflation. Foreign citizens will hold dollars to avoid the impact of high inflation. Foreign citizens will hold dollars to protect against political instability. Foreign citizens will hold dollars to protect against political instability.

37. 37 Money Supply By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. By engaging in open market operations, the Fed increases (buy bonds) or decreases (sell bonds) the amount of money in the system. If the demand for money remains the same, the action of the Fed affects the federal funds rate. If the demand for money remains the same, the action of the Fed affects the federal funds rate. S up; D same => P down S up; D same => P down

38. 38 Equilibrium in the Market for Money Explain how and why the market reaches equilibrium. Nominal interest rate Money

39. 39 Equilibrium in the Market for Money If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. If at the existing interest rate, supply exceeds demand, that means people would like to hold less money than there is. How do people adjust their portfolios? How do people adjust their portfolios? They buy other assets with the excess money in their checking accounts. They buy other assets with the excess money in their checking accounts. The price of bonds (non-money assets) goes up: interest rate goes down. The price of bonds (non-money assets) goes up: interest rate goes down.

40. 40 The Fed Wants to Raise i Fed sells bonds Fed sells bonds The money supply falls The money supply falls Creates a shortage of money Creates a shortage of money People sell non-money assets People sell non-money assets Non-money asset prices fall and the interest rate increases Non-money asset prices fall and the interest rate increases

41. 41 http://www.federalreserve. gov/newsevents/press/mo netary/20110315a.htm

42. 42 Interest Rates and Money Supply The Fed cannot set the interest rate and the money supply independently. The Fed cannot set the interest rate and the money supply independently. The Fed controls the money supply by controlling bank reserves. The Fed controls the money supply by controlling bank reserves. Bank reserves influence the federal funds rate. Bank reserves influence the federal funds rate. Therefore, the federal funds rate reflects the impact of open market operations. Therefore, the federal funds rate reflects the impact of open market operations.

43. 43 The Fed and Money Supply Second Way : Discount Window Lending Second Way : Discount Window Lending The lending of reserves by the Federal Reserve to commercial banks The lending of reserves by the Federal Reserve to commercial banks Discount Rate (primary credit rate): The interest rate that the Fed charges commercial banks to borrow reserves. Discount Rate (primary credit rate): The interest rate that the Fed charges commercial banks to borrow reserves.

44. 44 The Fed and Money Supply Third Way: Changing Reserve Requirements Third Way: Changing Reserve Requirements Set by the Fed Set by the Fed The minimum values of the ratio of bank deposits that commercial banks are allowed to maintain The minimum values of the ratio of bank deposits that commercial banks are allowed to maintain Lowering the reserve ratio increases the ability of banks to make loans and therefore expand the money supply. Lowering the reserve ratio increases the ability of banks to make loans and therefore expand the money supply. Increasing the reserve ratio reduces the ability of banks to make loans and create money. Increasing the reserve ratio reduces the ability of banks to make loans and create money.

45. 45 The New Tools http://www.federalreserve.gov/monetarypolicy/default.htm