18 – Monetary Policy

1. 18 – Monetary Policy Chapter 18

2. Monetary Policy Tools • Policy tools • Target federal funds rate • Discount rate • Reserve requirement • Effective policy tools • Observable • Controllable • Linked to Objectives • Objectives of Fed • Low stable inflation • High, stable output • Stable interest rates

3. 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

4. Target Federal Funds Rate • Rate is determined by supply and demand for reserves

5. Target Federal Funds Rate

6. 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.

7. 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

8. Discount Lending • Not used as a primary policy instrument • Used to • Ensure short-term financial stability • Eliminate bank panics • Prevent sudden collapse of institutions

9. 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

10. 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

11. 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.

12. 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.

13. Policy Instruments • Observable • Controllable • Linked to Objectives • Interest rates • How are they linked to objectives? • Inflation targeting?

14. 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

15. Monetary Targeting

16. 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

17. 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

18. 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.

19. 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%

20. 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.

21. 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.

22. 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

23. How Good are Our Assumptions? • The Fed hits its target Fed Funds rate each day

24. 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.

25. 19 – Exchange Rate Policy Chapter 19

26. 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?

27. 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

28. 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

29. Fixed Exchange Rates in the Short Run • If exchange rate is fixed, then implying

30. 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

31. 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.

32. 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

33. 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