CHAPTER 3

1. CHAPTER 3 THE FED AND INTEREST RATES

2. Definition of the Monetary Base • Money 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 maturity • L – All liquid assets economy wide including U.S. Treasury Bills maturing 1 year or less.

3. Objectives of Fed Monetary Policy • Full 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

4. Objectives of Fed Monetary Policy • Economic 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.

5. Objectives of Fed Monetary Policy • Price Stability • Goal has been to provide steady average prices in the economy on average • Inflation • 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.

6. Objectives of Fed Monetary Policy • Interest 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.

7. Objectives of Fed Monetary Policy • Financial 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

8. Objectives of Fed Monetary Policy • Foreign Exchange Stability • A primary goal of the Fed is to provide stable purchasing power of the U.S. Dollar relative to foreign currencies • This 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

9. Objectives of Fed Monetary Policy • Inconsistencies and Limitations • The Fed can not continually inflate the money supply as this has serious domestic and international consequences. • Remember inflation is not your friend • High inflation rates domestically make life more expensive to live • Likewise, high inflation causes an international asset drain as U.S. assets are sent oversees to find more stability in other markets

10. Objectives of Fed Monetary Policy • The Alternative (My personal view) • A hard money standard • Eliminating the Fed and tying the U.S. Dollar to Gold and Silver • The afore mentioned goals thus would be met • Large and Powerful Banks and Financial Service firms would not profit as easily through this system

11. 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 Reserves • Those in excess of requirements imposed by the Fed • Banks hold only minimal excess reserves as the Fed pays no interest on excess reserves held at the Fed

12. Impacts of Federal Reserve Policy • Expansionary monetary policy • Open 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.

13. Impacts of Federal Reserve Policy (concluded) • Restrictive monetary policy • Open 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.

14. Effects of Federal Reserve Policy in the Financial System • Changes in the Money Supply • When 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.

15. Effects of Policy Changes • Changes in Interest Rates • Expansion 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.

16. 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.

17. Short-Run Effects of Monetary Policy • Monetary policy affects spending • Investment. • Consumption. • State and local government. • Effects of Monetary Policy on Changes in Investment • Investment demand, traditionally, has been sensitive to changes in interest rates.

18. 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.

19. 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.

20. 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 Expenditures • Monetary policy affects capital project expenditures. • Higher interest rates limit expenditures.

21. Changes in the Discount Rate

22. Change in Money Supply and Interest Rates and the Economy

23. 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.

24. 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.

25. 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.

26. Complications in Implementing Policy • The Velocity of Money • The rate money changes hands in the economy • V= Y/M or M x V = Y • V= Velocity • M= Money Supply • Y= GDP