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 inflation2) High, stable output3) 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 1988.

Time 0: Traders agree to go long or short at futures price, F0

Settlement Price (ST): 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: ST-F0

– Short party gets: F0-ST

Fed-Funds Futures Example

Contract is for January, 2008 Current Futures price today: 95.68 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 (95.75-95.68)*.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*5.25+12*5.00)/31 = 5.15– If Fed keeps rates steady: 5.25– If Fed raises by 25bp: (19*5.25+12*5.50)/31 = 5.35

If market expects– Average to be 5.15, then F0 =100-5.15 = 94.85– Average to be 5.25, then F0 =100-5.25 = 94.75– Average to be 5.35, then F0 =100-5.35 = 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 FVf = Face value of bond in foreign currency Pf = Price of bond in foreign currency rf= return on bond in terms of foreign currency

1f

ff PFV

r

Fixed Exchange Rates in the Short Run

What you care about is return in dollars. rf= return on bond in terms of foreign currency Et = dollar-foreign ex-rate at time t Assume bond is purchased at time t Assume bond matures at time t+1

1*

1

1

1

t

t

f

f

tf

tfd

EXEX

PFV

EXPEXFV

r

Fixed Exchange Rates in the Short Run

If exchange rate is fixed, then

implying

11

t

t

EXEX

ff

fd r

PFV

r 1

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