CHAPTER 3 THE FED AND INTEREST RATES. Copyright© 2003 John Wiley and Sons, Inc. Definition of the...

CHAPTER 3

THE FED AND INTEREST RATES

Copyright© 2003 John Wiley and Sons, Inc.

Definition of the Monetary BaseMoney Aggregates

M1—”Medium of Exchange”, Currency and Checking Deposits.M2– M1+ saving deposits, money market deposit accounts, overnight repurchase agreements, Eurodollars, small time deposits.MZM – M2– small denomination time deposits + institutional money market mutual funds.M3 – M2+ institutional money market mutual funds, large time deposits, and repurchase agreements and Eurodollars > 1 day maturityL – All liquid assets economy wide including U.S. Treasury Bills maturing 1 year or less.


Objectives of Fed Monetary PolicyFull Employment

Frictional Unemployment• The rate of unemployment created by job

mobility

Structural Unemployment• Created by immobile workers or poor job

skills (education)

“Natural Rate of Unemployment”• The rate of unemployment generally

tolerated by governments


Objectives of Fed Monetary PolicyEconomic Growth

Gross Domestic Product (GDP) per Capita

• The general measure of a countries wealth

The goal has been to have a steadily rising level of real GDP (inflation adjusted)

• This has not been the case however, as inflation has eaten away at GDP.


Objectives of Fed Monetary PolicyPrice Stability

Goal has been to provide steady average prices in the economy on averageInflation

• Book Definition – a continuous rise in average prices over time.

• Class Definition – An increase in the money supply resulting in a general rise in average prices as the purchasing power of the monetary unit falls due to proliferation and the resulting loss in purchasing power.


Objectives of Fed Monetary PolicyInterest Rate Stability

The goal is to provide a steady level of interest rates reflective of market risk while reducing interest rate volatility.Economic/Financial Calculation is more difficult with uncertainty regarding future interest rates.


Objectives of Fed Monetary PolicyFinancial System Stability

The Fed as Lender of Last Resort• The Fed is to stand ready in the event of

catastrophic losses in the financial system• The Fed would provide liquidity to increase

public confidence in the system


Objectives of Fed Monetary PolicyForeign Exchange Stability

A primary goal of the Fed is to provide stable purchasing power of the U.S. Dollar relative to foreign currenciesThis is expressed in stable exchange rates.The Fed may seek to weaken the dollar during economic downturns to increase exports giving U.S. firms a boost in demand


Objectives of Fed Monetary PolicyInconsistencies and Limitations

The Fed can not continually inflate the money supply as this has serious domestic and international consequences.Remember inflation is not your friendHigh inflation rates domestically make life more expensive to liveLikewise, high inflation causes an international asset drain as U.S. assets are sent oversees to find more stability in other markets


Objectives of Fed Monetary PolicyThe Alternative (My personal view)

A hard money standardEliminating the Fed and tying the U.S. Dollar to Gold and SilverThe afore mentioned goals thus would be metLarge and Powerful Banks and Financial Service firms would not profit as easily through this system


The Monetary Base and Changes in the Money Supply

Reserves are a % of the total Liabilities of the Bank

ie: Total Liabilities of $800 mil. w/ 10% reserve requirement = $80 mil in required reserves

Excess ReservesThose in excess of requirements imposed by the FedBanks hold only minimal excess reserves as the Fed pays no interest on excess reserves held at the Fed


Impacts of Federal Reserve Policy

Expansionary monetary policyOpen market operations -- purchase securities -- increase bank excess reserves and the monetary base.Reserve requirements -- reduce reserve requirements -- increase excess reserves and increase the deposit expansion multiplier.Discount rate -- reduce the rate -- reduce the cost of borrowing reserves.Expands the money supply; reduces interest rates.


Impacts of Federal Reserve Policy (concluded)

Restrictive monetary policyOpen market operations -- sell securities, reduce bank reserves and the monetary base.Reserve requirements -- increase reserve requirements, reduces excess reserves and the deposit expansion multiplier.Discount rate -- increase the discount rate and the cost of borrowing reserve deficiencies.Reduce the money supply or its growth rate; increase interest rates.


Effects of Federal Reserve Policy in the Financial System

Changes in the Money SupplyWhen the Fed either increases the monetary base or reduces reserve requirements, banks’ excess reserves increase.Excess reserves are loaned out or invested.Transaction deposits increase as loaned or invested funds are deposited.The money supply increases.


Effects of Policy Changes

Changes in Interest RatesExpansion of the monetary base or reductions in reserve requirements increase bank liquidity.Federal Funds rate declines.Price of other money market securities increase (rates decline) as banks invest their liquidity.Loan rates and other security rates decline with continued increases in bank liquidity.Monetary policy starts in the bank money market and spreads to other financial institutions and markets and to the real economy.


Effects of Policy Changes

Credit availability is increased with the expansion of bank liquidity and reduced interest rates.Wealth Effects -- reduced interest rates (increased security prices) increases the wealth of individuals.

Increased wealth prompts increased spending.Increased spending has a current income, Y, impact and a multiplier effect in future income periods.


Short-Run Effects of Monetary Policy

Monetary policy affects spendingInvestment.Consumption.State and local government.

Effects of Monetary Policy on Changes in Investment

Investment demand, traditionally, has been sensitive to changes in interest rates.


Short-Run Effects of Monetary Policy (continued)

Housing investment -- both credit availability and mortgage rates have been impacted severely by monetary policy.Plant and equipment investment is related to expected rates of return relative to the cost of financing.Planned inventory investment is sensitive to the cost and availability of credit.


Short-Run Effects of Monetary Policy (continued)

Consumption expenditures are affected several ways:

Increased or decreased holdings of money affect spending.Credit availability and interest rate levels affect the purchase of durable goods.Changes in wealth affect spending in the current period.


Short-Run Effects of Monetary Policy (concluded)

Foreign trade is affected by monetary policy.

Increased interest rates increase the value of the dollar relative to the other currencies.Increased dollar exchange rates encourage imports; discourage exports.

State and Local Government ExpendituresMonetary policy affects capital project expenditures.Higher interest rates limit expenditures.


Changes in the Discount Rate


Change in Money Supply and Interest Rates and the Economy


Long-Run Effects of Monetary Policy

Expectations are affected by current, short-run monetary policy actions.High money growth to stimulate the economy may increase interest rates (interest rate effects).

Market expects inflation from near-term policy action.Investors sell long-term bonds, prices fall, and interest rates increase.


Long-Run Effects of Monetary Policy (concluded)

Expected inflation may cause increased spending and borrowing and increased interest rates.

Pay back lower value debts.Buy before the price goes up psychology.May move the economy to inflationary income levels.Cost increases (interest and labor) faster than price increases will cause reductions in investment spending.


Practical Considerations in Monetary Policy

Expectations may nullify intent of policy.Time lags in implementing monetary policy reduce its effectiveness.Political pressures influence Federal Reserve policy.


Complications in Implementing Policy

The Velocity of MoneyThe rate money changes hands in the economyV= Y/M or M x V = Y• V= Velocity• M= Money Supply• Y= GDP

CHAPTER 3 THE FED AND INTEREST RATES. Copyright© 2003 John Wiley and Sons, Inc. Definition of the...

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