1. Monetary Policy: Conventional and Unconventional13
Part 2
Monetary Policy: Conventional and Unconventional

2. Open-Market Operations
Which interest rate?
Fed “controls” Federal funds rate and the Treasury bills rate (next slide)
Fed can “influence” other interest rates such as credit cards, auto loans, mortgage rates etc.
Normally, interest rates tend to move together
During financial crisis relationship broke down

3. As the Fed increases or decreases the FFR, the T-bill rate follows.
Release: H.15 Selected Interest Rates
As the Fed increases or decreases the FFR, the T-bill rate follows.

4. Open-Market Operations
Risk of default
The risk that the borrower may not pay in full or on time
T-Bills are risk free
Bank to bank borrowing, federal funds rate, very low risk
Corporate bonds carry more risk . . .
Riskier borrowers pay higher interest rates, to persuade lenders to accept the higher risk

5. Open-Market Operations
Risk of default
Interest rate on a bond = Risk free rate + Risk premium
Risk spread = Interest rate on a bond – risk free rate
Risk spreads widen (narrow) if investors believe there is a greater (smaller) risk of default

6. Table 2 Selected U.S. Interest Rates, September 2014 (in percent)

7. Open-Market Operations
During the financial crisis risk spreads widened
Mortgages, bonds of large banks - looked far riskier than they had before
Higher risk premiums, increasing risky interest rates
Increased demand of U.S. T-bills – “flight to safety”
Higher T-bill price, lower T-bill interest rate

8. Risk Spreads During Financial Crisis
Commercial paper rate – 3-month T-Bill rate

9. Other Instruments of Monetary Policy
Lending to banks
Fed acts as “lender of last resort”
Fed lends to banks at the discount rate, the interest rate the Fed charges for loans to banks
This provides banks with excess reserves
The Fed, 2007
Massive amounts of lending to banks
Helped keep the financial system functioning
Eased the panic for a time

10. Table 3 Balance Sheet Changes: Bank Borrows from the Fed
Fed lends reserves to banks, increasing the amount of
Excess Reserves in the banking system
Fed loans can increase the money supply.

11. Other Instruments of Monetary Policy
Fed can influence the amount banks borrow by changing the discount rate
Lower (higher) discount rate gives banks a greater (smaller) incentive to borrow
But Fed cannot really know how much banks will respond
Connection between discount rate and volume of borrowing loose
Fed normally relies on open market operations rather than discount rate.

12. Other Instruments of Monetary Policy
However, during financial crisis Fed lending went from
$250 million (Aug 2007) to $735 billion (Nov 2008)
Now lending back down to pre-crisis levels
The Fed in was acting as the “lender of last resort”. It was not trying to increase the money supply.

13. Other Instruments of Monetary Policy
Changing reserve requirements
If Fed decreases
Banks have more excess reserves
Money expansion and lower interest rates
If Fed increase
Banks have less excess reserves
Money contraction and higher interest rates
Reserve requirement is set at 10% of transaction deposits since 1992

14. Other Instruments of Monetary Policy
Unconventional monetary policy
Unusual forms (or volumes) of central bank lending and to unusual types of open-market operations
Pushing the federal funds rate down to virtually zero
Lending to banks in unprecedented volume
Lending to some companies that are not banks
Quantitative easing

15. Other Instruments of Monetary Policy
Quantitative easing
Open-market purchases of assets other than Treasury bills
Treasury bonds [longer dated]
Other assets – in 2008 and 2009, to stabilize the mortgage market

16. How Monetary Policy Works
Normal times
Federal funds rate is not hovering close to zero
Risk spreads are roughly constant
Different interest rates rise and fall together
Banks are not holding many excess reserves

17. How Monetary Policy Works
Expansionary monetary policy
Open-market purchase of T-bills lowers interest rates
Contractionary monetary policy
Open-market sale of T-bills raises interest rates

18. Figure 4 The Effects of Monetary Policy on Interest Rates S0 S2 S1 S0D
Interest Rate D E B A E
Bank Reserves
Bank Reserves
(a)
Expansionary Monetary Policy
(b)
Contractionary Monetary Policy

19. How Monetary Policy Works
How do interest rates influence spending?
Y = C + I + G + (X – IM)
Investment and Net exports and consumer spending are sensitive to interest rates
When interest rates rise (fall), spending falls (rises)
So expenditure falls (rises)

20. Figure 5 The Effect of Interest Rates on Total Expenditure 45°
Real Expenditure
C+I+G+(X-IM)
(lower interest rate)
C+I+G+(X-IM)
C+I+G+(X-IM)
(higher interest rate)
Real GDP

21. How Monetary Policy Works
Fed believes economy might slip into recession
Pursue an expansionary monetary policy
Putting it all together

22. Monetary Policy Chain of Causation Expansionary Policy
(1) Injection of reserves into the banking system pushes down interest rates
Need to know how sensitive interest rates are to change in reserves

23. Monetary Policy Chain of Causation Expansionary Policy
(1) Injection of bank reserves pushes down interest rates
(2) Lower r, stimulates investment and possibly consumer spending
(3) An increase in I and C causes total spending to increase
Need to know how sensitive C and I are to changes in interest rates
(4) GDP increases: multiplier analysis

24. Figure 6
The Effect of Expansionary Monetary Policy on Total Expenditure
45°
Real Expenditure
C+I1+G+(X-IM) E1
C+I0+G+(X-IM) E0
6,500
6,000
Real GDP
5,500
7,000

25. Monetary Policy Chain of Causation Contractionary Policy
What would occur if the Fed pursued a contractionary policy?

26. Money and the Price Level
What happens to the price level when the Fed pursues an expansionary policy?
Normally, it will cause the price level to increase
How much it causes will depend on the slope of the aggregate supply curve

27. The Inflationary Effects of Expansionary Monetary Policy
AD1
Price Level
SRAS
AD0
Any shock that shifts the AE curve shifts the AD curve.
The increase in the money supply increases Real GDP and prices. B
103 E
6,400
100
6,000
Real GDP

28. The Inflationary Effects of Expansionary Monetary Policy
SRAS
113
Price Level
Impact on the price level depends on the slope of the aggregate supply curve
AD1
AD0 B
103 E
6,400
100
AD3
6,000
AD2
Real GDP

29. Complete Monetary Policy Story

30. Another reason the Aggregate Demand Curve Slopes Downward
At a higher price level
The quantity of bank reserves demanded is higher
Holding the supply of reserves fixed, this will lead to higher interest rates
Which means lower business investment and concumer spending
Therefore, quantity demanded lower: negative slope

31. Figure 8
The Effect of a Higher Price Level on the Market for Bank Reserves S
Interest Rate D0 D1 E1
Effect of a
higher P E0
Bank Reserves

32. Unconventional Monetary Policies
What does the Fed do when the federal funds rate is zero and the economy still needs more stimulus?
Use unconventional monetary policies
During the Financial crisis
Massive lending to banks and non-financial firms
Open market purchase of assets other than Treasury bills: longer term Treasury bonds and mortgage-backed securities. This is Quantitative Easing we discussed earlier.
Objective – lower interest rates on mortgages and long-term government bonds.

33. As the Fed increases or decreases the FFR, the T-bill rate follows.
Release: H.15 Selected Interest Rates
As the Fed increases or decreases the FFR, the T-bill rate follows.

34. From Financial Distress to Recession
How a financial crisis can lead to a recession
Something goes wrong in the financial markets: loss of confidence in some financial assets
Failure of a major financial institution (e.g., Lehman Brothers in 2008)
Stock market crash (as in 2000)
Collapse of real estate prices (as after 2006)

35. From Financial Distress to Recession
How a financial crisis can lead to a recession
Result: financial market distress
Risk premiums rise far above their “normal” levels
Interest rates on risky securities are rising
Spending on the interest-sensitive components of aggregate demand falls

36. From Financial Distress to Recession
How a financial crisis can lead to a recession
Downward multiplier process pulls entire economy down
Worse prospects for loan repayments
Pushing risk premiums even higher
The vicious cycle continues
Normal expansionary monetary policy may not work
Fed resorts to unconventional policies

37. From Models to Policy Debates
How do we use this theory to address policy issues?
The debate over the conduct of stabilization policy
The debate over budget deficits
The effects of policy on economic growth
The tradeoff between inflation and unemployment