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“It is well enough that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning.” Henry Ford. Monetary Policy Tools. Chapter 13: Managing Aggregate Demand. to. G. Taxes. pay. T. NX.

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slide1

“It is well enough that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning.”

Henry Ford

monetary policy tools

Monetary Policy Tools

Chapter 13: Managing Aggregate Demand

© 2002 Claudia Garcia-Szekely

circular flow diagram

to

G

Taxes

pay

T

NX

S

C

Saving

I

Interest

Rent

Profits

Wages

Circular Flow Diagram

Rest of World

AE = C + I + G + NX

G

Firms

Households

Goods and Services

Aggregate Expenditures

monetary policy
Monetary Policy
  • Changes in Monetary Policy Tools
  • In order to affect Aggregate Expenditures

Expansionary Policy

Increase AE

Contractionary Policy

Decrease AE

monetary policy objectives
Monetary Policy Objectives
  • Maintain “stable prices” = inflation below 3%.
  • Maintain “sustainable economic growth” = Output Growth at least 3%
1 open market operations

1. Open Market Operations

Example with r = 10%

The entire banking system consists of only five banks and they hold their reserves at the Fed.

© 2002 Claudia Garcia-Szekely

banking system deposits

D=590

d1= 100

d2= 80

d3= 120

d4= 125

d5= 165

Banking System Deposits
  • Bank 1 has 100
  • Bank 2 has 80
  • Bank 3 has 120
  • Bank 4 has 125
  • Bank 5 has 165

Total deposits in the banking system are $590

reserves 10 of deposits

All Banks

Reserves

R=59

Reserves = 10% of Deposits
  • Bank 1 has 100 (0.1) = 10 in reserves
  • Bank 2 has 80 (0.1) = 8in reserves.
  • Bank 3 has 120 (0.1) =12 in reserves
  • Bank 4 has 125(0.1)=12.5 in reserves
  • Bank 4 has 165(0.1)=16.5 in reserves

Total reserves in the banking system are $59

m s deposits currency outside banks

All Banks

Deposits

D=590

All Banks

Reserves

d1= 100

d2= 80

d3= 120

R=59

d4= 125

d5= 165

Ms = Deposits + Currency outside banks.

r = 0.1

R=59

D=590

L= 531

Assume currency outside banks is zero

Ms = 590

531 are in loans.

government bonds
Government Bonds
  • Treasury Bills
    • Mature in one yearor less (1,3 and 6 months) do not pay interest prior to maturity; instead they are sold at a discount to create a positive yield to maturity. The least risky investment available to U.S. investors.
  • Treasury Notes
    • Mature in two to ten years (2, 5 or 10 years). Pay interest every six months, and are commonly issued for denominations from $100 to $1,000,000.
    • The 10-year Treasury note commonly used as a proxy for long-term interest rates in general.
  • Treasury Bonds
    • Longest maturity, ten years to thirty years. Pay interest every six months like T-Notes.
the fed s t account

Bank 1= 10

Bank 2 = 8

Bank 3= 12

R=59

Bank 4= 12.5

Bank 5= 16.5

The Fed’s T- Account

Federal

Reserve

Bank

Liabilities

Assets

Bonds

The Fed holds Government bonds as part of their Assets.

Bank’s reserves are liabilities to the Fed

slide12

Assets

1999

1998

Gold certificates

$ 11,048

$11,046

Special drawing rights certificates

6,200

9,200

Coin

207

358

Items in process of collection

6,524

6,933

Loans to depository institutions

233 17

Securities purchased under agreements to resell (tri-party)

140,640

U.S. government and federal agency securities, net

483,902

488,911

Investments denominated in foreign currencies

16,140

19,768

Accrued interest receivable

5,314

4,680

Bank premises and equipment, net

1,861

1,787

Other assets

2,391

1,942

Total assets

$674,460

$544,642

Liabilities and Capital

Liabilities

Federal Reserve notes outstanding, net

$600,662

$491,657

Deposits

Depository institutions

24,027

26,306

U.S. Treasury, general account

28,402

6,086

Other deposits

274

413

Deferred credit items

6,117

5,924

Surplus transfer due U.S. Treasury

1,066

1,373

Accrued benefit cost

816

780

Other liabilities

234

199

Total liabilities

661,598

532,738

Capital

Capital paid-in

6,431

5,952

Surplus

6,431

5,952

Total capital

12,862

11,904

Total liabilities and capital

$674,460

$544,642

THE FEDERAL RESERVE BANKS COMBINED STATEMENTS

Dec. 31 in Millions

the fed buys 10 in bonds from mr anderson

Bank 1= 10

Bank 2= 8

Bank 3= 12

R=59

Bank 4= 12.5

Bank 5= 16.5

The Fed Buys $10 in Bonds From Mr. Anderson

Liabilities

Assets

FED

50

Bonds

60

Bonds

10 Bond

Mr. Anderson

Fed pays with a check which Anderson deposits at his bank

mr anderson deposits the fed s check at bank 1

D=590

d1= 100

d2= 80

d3= 120

d4= 125

d5= 165

Mr. Anderson Deposits the Fed’s Check at Bank 1

All Banks

Deposits

New deposit

At bank One

+10

a bond purchase increases bank s reserves

How did the fed pay for those bonds?

Bank 1= 10

Bank 2= 8

Bank 3= 12

R=59

Bank 4= 12.5

Bank 5= 16.5

Fed manufactures the funds out of thin air!

A Bond Purchase Increases Bank’s Reserves

Liabilities

Assets

FED

50

Bonds

60

Bonds

+10

Fed credits Bank One’s reserves

Bank 1 presents Fed’s check

to the Fed for clearing

10

when bank one s reserves increase
When Bank One’s Reserves Increase
  • Bank One holds now more reserves than required: it has excess reserves
  • Bank One will make more loans
    • To other banks
    • To the public

Until it holds only required reserves.

  • The loans generated become new deposits at other banks which keep 10% as reserves and loan the rest…
with 10 in extra reserves

D R

x

1

r

1

10

x

0.1

With $10 in extra reserves…

D D =

D D=100

D D =

Deposits increase by 100 when reserves increase by 10.

This 100 includes a 90 increase in loans.

at the end of the money multiplier process
At the end of the Money Multiplier Process…

All Banks

After

All Banks

Before

r=10%

r=10%

D = 590

D = 690

R = 59

R = 69

L = 531

L = 621

D R=10;D D=100; D L = 90

m s deposits currency outside banks19

All Banks

Deposits

D=590+100

All Banks

Reserves

d1= 100+10

d2= 80+20

d3= 120+15

R=59+10

d4= 125+25

d5= 165+30

Ms = Deposits + Currency outside banks.

r = 0.1

R=59+10

D=590+100

L= 531+90

Ms = 590+100

531+90=621 are in loans.

in summary

r=10%

D = 590

R = 59

L =531

In Summary
  • When the Fed Buys Bonds
  • New Reserves become available for banks to loan out
  • Money is created
  • The Money Supply increases.

R=10%

DD = DR(1/r)

DR = Fed’s Purchase

DL = DD - DR

the fed sells 10 in bonds to mr brown

Bank 1= 10

Bank 2= 8

Bank 3= 12

R=59

Bank 4= 12.5

Bank 5= 16.5

The Fed Sells $10 in Bonds to Mr. Brown

Liabilities

Assets

FED

50

Bonds

40

Bonds

10 Bond

Mr. Brown

Brown pays with a check from his bank: Bank 3

a bond sale decreases bank s reserves

Bank 1= 10

Bank 2= 8

Bank 3= 12

R=59

Bank 4= 12.5

Bank 5= 16.5

A Bond Sale Decreases Bank’s Reserves

Liabilities

Assets

FED

50

Bonds

40

Bonds

Fed erases Bank 3 reserves

-10

Fed clears Brown’s check by reducing Bank 3 reserves

-10

bank 3 decreases mr brown s account by 10

D=590

d1= 100

d2= 80

d3= 120

d4= 125

d5= 165

Bank 3 decreases Mr. Brown’s account by $10

All Banks

Deposits

Brown’s deposit account decreases by $10

-10

in summary24

r=10%

D = 590

R = 59

L =531

R=10%

In Summary
  • When the Fed Sells Bonds
  • Fed clears payment by erasing bank reserves.
  • Reserves are no longer enough: bank must decrease loans outstanding.
  • Money is destroyed.
  • The Money Supply decreases.

DD = DR(1/r)

DR = Fed’s sale

DR = -10

DD = -10(1/0.1)

DD = -100

DL = DD - DR

DL = -100 – (-10) = - 90

when the fed sells bonds

All Banks

Deposits

D=590-100

All Banks

Reserves

d1= 100-10

d2= 80-20

d3= 120-15

R=59-10

d4= 125-25

d5= 165-30

When the Fed Sells Bonds

r = 0.1

R=59-10

D=590-100

L= 531-90 = 441

Ms = 590-100

531-90=441 are in loans.

the federal funds rate
The Federal Funds Rate

Federal Funds Rate

New Supply

Supply

Banks with excess reserves lend (Supply) funds in this market

Fed buys bonds

Federal Funds Rate

io

Banks short of reserves Borrow (Demand) funds in this market

i1

Demand

Quantity Bank Reserves

the federal funds rate27
The Federal Funds Rate

New Supply

Federal Funds Rate

Supply

Fed sells bonds

i1

io

Demand

Quantity Bank Reserves

open market operations
Open Market Operations

Fed buys/sells bonds from the public or banks

Fed Injects/reduces banking system reserves

Federal Funds Rate Decreases/Increases

Investment Changes

GDP Changes

Long Term interest rates change

Credit easier/harder to get

All Short term interest rates change with the fed funds rate

slide32

Banks are fully loaned up r=10%

  • The fed sells 2B in bonds, calculate:
  • The change in deposits:
  • The change in Loans:
  • The change in Reserves:
  • The change in the Money Supply:
  • Fill in the blanks with one of the choices provided in parenthesis.
  • If the Fed is selling bonds, we can conclude that the Fed is concerned with (inflation/unemployment)__________________.
  • The Fed sells bonds in order to (increase/decrease) ________________ the Federal Funds rate.
  • This change in the Federal funds rate will cause a (an) (increase/decrease) ____________________ in short term interest rates to consumers which will (slow down/increase) ___________________Aggregate Demand thus (slowing down/speeding up) ___________________ the (inflation/unemployment) _____________________________rate.
slide33

Tuesday September 16The central bank said it was keeping its target for the federal funds rate, at 2 percent.

Fed said "strains in financial markets have increased significantly and labor markets have weakened further."

However, the central bank also remained concerned about inflation pressures.

"The downside risks to growth and the upside risks to inflation are both of significant concern to the committee," the Fed officials said.

changing the discount rate d

Changing the Discount Rate: d

d=5%

The interest rate charged by the Federal Reserve Bank on loans to Banks: “Lender of Last Resort”

© 2002 Claudia Garcia-Szekely

slide35

Banks lend at this rate

Federal Funds Rate

Discount Rate

Banks borrow at this rate from the Fed

effective january 9 2003
Effective January 9, 2003
  • Replaces discount rate, which was below-market rate, with a new type of discount window credit called primary credit.
  • Primary credit will be available for very shortterms as a backup source of liquidity to depository institutions that are in generally sound financial condition in the judgment of the lending Federal Reserve Bank.
  • Reserve Banks will extend primary credit at a rate above the federal funds rate, which should eliminate the incentive for institutions to borrow for the purpose of exploiting the positive spread of money market rates over the discount rate
effective january 9 200337
Effective January 9, 2003
  • By charging an above-marketrate and restricting eligibility to generally sound institutions, the primary credit program should considerably reduce the need for the Federal Reserve to review the funding situations of borrowers and monitor the use of borrowed funds.
  • This reduced administration in turn should make the discount window a more attractive funding source for depository institutions when money markets tighten.
slide38

Banks borrow at this rate from the Fed

Primary Credit Rate

Federal Funds Rate

2.25%

1.81%

Banks lend at this rate

slide39

Where does the money for these loans come from?

Lending rate

Prime Rate

Borrow from Fed

Primary Credit Rate

Borrow from Other banks

Federal Funds Rate

Fed manufactures the funds out of thin air!

decreasing the primary credit rate d
Decreasing the Primary Credit Rate d
  • When funds from the Fed become “cheaper” banks find it less necessary to hold excess reserves…
  • In case of need, banks can borrow funds from the Fed.
  • Banks are induced to borrow from the fed rather than keep excess reserves to cover emergencies…
a decrease in d two possible scenarios
A decrease in d: two possible scenarios
  • Banks borrow more reserves from the Fed
    • Reserves in the banking system increase: the Fed injects new reserves which generate new loans and new deposits
  • Banks decrease Excess Reserves
    • Banks hold on to less excess reserves and thus make more loans generating new deposits.

The Money Supply increases and interest rates drop

an increase in d
An increase in d

With higher rates, banks will be less willing to borrowfrom the fed to cover emergency needs for reserves.

Banks will beef up their reserves to avoid having to borrow at high rates: As loans are paid back, banks do not make new loans thus increasing excess reserves

Loans and deposits through the banking system decrease.

The Money Supply decreases and interest rates increase

fed now lends directly to companies

Tuesday October 7, 2008

Fed now lends directly to Companies!
  • The central bank invoked emergency powers to lend money to companies outside the financial sector
  • Fed announced it would begin buying companies' short-term debt that firms use to pay for everyday expenses like salaries and supplies.
  • The powers were bestowed during the Depression as part of the Federal Reserve Act.
changing the discount rate d44
Changing the Discount Rate: d

Fed lowers primary credit rate

Banks borrow more from the fed

Lower cost of borrowing is passed to consumers and firms

Investment Increases

GDP Increases

Long Term interest rates drop

Credit easier to get

All Short term interest rates drop when the primary credit rate drops

changing the discount rate d45

Lower interest rates normally result in higher share prices

Changing the Discount Rate: d

Fed lowers primary credit rate

Banks borrow more from the fed

Lower cost of borrowing is passed to consumers and firms

Stock Prices Increase

Higher Profits

More consumption and investment

All Short term interest rates drop when the primary credit rate drops

changing the discount rate d46

Higher interest rates normally result in lower share prices

Changing the Discount Rate: d

Fed increases primary credit rate

Banks borrow less from the fed

higher cost of borrowing is passed to consumers and firms

Stock Prices Decrease

Lower Profits

Less consumption and investment

All Short term interest rates increase when the primary credit rate increases

3 changing the required reserve ratio
3.Changing the Required Reserve Ratio.

DD = DR(1/r)

All Banks

r=20%

r = 10%

DD = 10,000(1/0.1)

R = 20,000

D = 100,000

DD = 100,000

AR = 20,000

RR = 10,000

ER = 10,000

D = 200,000

L = 80,000

Hold 10%=1,000

New loan = 10,000

New Deposit

Hold 10%= 900

New loan = 9,000

New Deposit

Hold 10%=810

New loan = 8100

New Deposit

New loan …

changing the required reserve ratio

All Banks

After

All Banks

Before

r=10%

r=20%

+100,000

180,000

+100,000

200,000

D = 100,000

R = 20,000

L = 80,000

Changing the Required Reserve Ratio.

R = 20,000

D = 200,000

L = 180,000

Reserves do not change.

The Fed Decreases r to 10%

Now 20,000 in reserves must be 10% of total deposits 20,000= (0.1) D

D = 20,000/0.1

D= 200,000

10,000 excess reserves leave the banks temporarily to multiply via loans:

DD = DR(1/r)

DD = 10,000(1/0.1) = 100,000

DL = DD - DR

DL = 100,000 – 0 = 100,000

when the required reserve ratio decreases to 10

When the Required Reserve Ratio decreases to 10%

Deposits increase by 100,000.

© 2002 Claudia Garcia-Szekely

reserve required ratio

.

Category

Reserve Requirement (%)

Net transaction accounts:

$0 to $44.3 million

3

Over $44.3 million

$1,329,000 (=3% of 44.3 million) + 10% of amount over $44.3 million

Eurocurrency Liabilities

0%

Reserve Required Ratio
4 margin requirements since 1934

4. Margin RequirementsSince 1934

Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin.

The fraction of a stock purchase that must be put up by the person buying the stock: the Down payment

© 2002 Claudia Garcia-Szekely

leveraging your money
Leveraging your Money

Loan = $20,000

Margin Deposit = $5,000 in cash + 250 shares (250*20=5,000)

Margin Deposit = $5,000 in cash + 250 shares (250*30=7,500)

Stock Price = $30

Stock Price = $20

Number of Shares = 1,000

Number of Shares = 1,000

Value of Stock = $30,000

Value of Stock = $20,000

Margin Deposit = 5,000 + 7,500 = 12,500

Loan = 20,000

You owe the bank = 20,000 – 12,500 = 7,500

Stock you own is worth 30,000 – loan (7,500) = 22,500

You invest 5,000 to get 22,500 Return = 17,500/5,000=350%

a margin call
A Margin Call

Loan = $20,000

Margin Deposit = $5,000 in cash + 250 shares (250*20=5,000)

Margin Deposit = $5,000 in cash + 250 shares (250*5=1,250) SHORT =3,750

Stock Price = $5

Stock Price = $20

Number of Shares = 1,000

Number of Shares = 1,000

Value of Stock = $5,000

Value of Stock = $20,000

When stock prices fall unpredictably low, hundreds of margin calls are triggered: investors scramble for money to cover the margin requirement.

margin requirements selected years

During the recessions of 1949 and 1953 the fed cut the margins back to 50% to help booster the economy: green light to banks to grant stock–supported loans: more loans, more deposits, more money and more jobs.

Year

Margin

Year

Margin

1940

50

1960

70

WAR

Inflation

1942

75

1962

50

1945

100

1963

70

1947

75

1970

65

Recession

1953

50

1974

50

1958

90

1994

50

Margin RequirementsSelected Years

1940- 45 (war) inflationary pressures built up. Fed rises margins from 50 to 100% to discourage speculative bank loans.

margin requirements
Margin Requirements
  • Between 1934 and 1974, the Fed changed this margin requirement 22 times to restrain "speculation" in the stock market.
  • But for 26 years the Fed has kept the margin requirement constant, at 50%.
margin requirements56
Margin Requirements
  • Increasing the margin requirement serves as a warning to investors not to leverage themselves up excessively and would work in the direction of cooling the market.
  • It is the most important step the Fed can take when stock market price skyrocket beyond rational valuations.
5 moral suasion
5. Moral Suasion
  • A persuasion tactic to influence and pressure, but not force, banks into adhering to policy. Tactics used are
    • Closed-door meetings with bank directors, increased severity of inspections, appeals to community spirit, or vague threats.
    • Fed Chairman speaks on the markets - his opinion on the overall economy can send financial markets falling or flying.
  • The 'moral' aspect comes from the pressure for 'moral responsibility' to operate in a way that is consistent with furthering the good of the economy.
between 1980 and 2000 savings were channeled away from banks
Between 1980 and 2000 Savings were channeled away from Banks
  • In 1980 banks and thrifts together held 60% of financial assets.
  • By 2000 their share had dropped to 30%.
  • Today banks provide 20% of the financing of commerce and industry.
  • Other financial institutions expanded their share of financial assets:
    • Pension funds, insurance firms,securities firms, mutual fund companies.
moral hazard
Moral Hazard

250,000

  • FDIC insures deposits up to 100,000
  • Banks cannot be allowed to fail
    • FED is lender of last resort: Provides liquidity for banks short of reserves in order to stop runs on banks.
    • FED should NOT provide support to insolvent banks.

The problem: an illiquid bank becomes an insolvent bank fairly quickly

moral hazard60
Moral Hazard

You take the depositors money to the racetrack and bet it on number six. If number six wins, you keep the winnings; if number six falls asleep at the track, the government pays the losses.

long term capital management 1998
Long Term Capital Management 1998

The biggest of the hedge funds “the engines of great wealth that only the rich can ride”.

  • With computer oriented trading and statistical distributions and normal curves: “they did not take risks because they understood the probabilities of all the price movements and placed their bets scientifically.”
  • Because they said they were not risky, they had been able to BORROW 100% of the money they bet (some from banks, some from securities houses).
  • Incorporated in the Cayman Islands (out of reach of the supervision of the fed).
slide62

Rescue Cost = $3.6 Billion.

LTCM
  • The fund’s operations were conducted in absolute secrecy. Investors who asked questions were told to take their money somewhere else.
  • Despite the minimum initial payment of $10 million frozen for three years, there was a rush to invest and the results appeared to be well up to expectations.
  • After taking 2% for "administrative expenses" and 25% of the profits, the fund was able to offer its shareholders returns of 42.8% in 1995, 40.8% in 1996, and "only" 17.1% in 1997 (the year of the Asian crisis).
  • But in September, after mistakenly gambling on a convergence in interest rates, it found itself on the verge of bankruptcy.
moral hazard63
Moral Hazard

“If I get in big trouble, the Fed will come and save me”

The head of one of the largest hedge funds in the world shortly after the Fed rescued Long Term Capital Management.

central bank independence

Central Bank Independence

Central Bank Independence: What does it mean?

© 2002 Claudia Garcia-Szekely

slide65

Less

More

Spain

New Zealand

Italy

UK

Denmark

Australia

France/Norway/Sweden

Japan

Canada

Belgium

Netherlands

UNITED STATES

Switzerland

Germany

nixon on central bank independence
“I respect his independence. However I hope that independently he will conclude that my views are the ones that should be followed”

Richard Nixon swearing in chairman Arthur Burns as Fed chairman.

Nixon on Central Bank Independence
slide68
Total Deposits in the Banking System = 120,000

r=10%. Calculate New D, R,Ms

Fed Buys 2,000 in bonds

Fed Sells 1,000 in bonds

Fed Increases r to 20%

Fed decreases r to 5%

Fed Wants to increase Ms by 80,000 buy/sell bonds? How much?

Fed Wants to increase Ms by 80,000 Increase/decrease r? to what level?

Fed Wants to decrease Ms by 20,000 buy/sell bonds? How much?

Fed Wants to decrease Ms by 20,000 Increase/decrease r? to what level?

Fed wants to increase/decrease the Ms. The fed should increase/decrease the discount rate? Why? Explain the process clearly.

press release february 2 2005
Press Release February 2, 2005

The Federal Open Market Committee decided today to raise its target for the federal funds rate to 2-1/2 percent. (Interfere to slow inflation)

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Output appears to be growing at a moderate pace and labor market conditions continue to improve gradually. Inflation and longer-term inflation expectations remain well contained. (Will not interfere: Inflation is not a concern)

The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. (May stop interfering or may be not)

Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability. (May interfere or maybe not)

slide70

First seven meetings of 2000,the Committee indicated that the balance of risks were “mainly toward conditions

that may generate heightenedinflation

pressures in the foreseeable future.”

At the eighth meeting, on December 19, 2000, the FOMC reversed the balance-of-risks statement, indicating that “it

believes that the risks are weighted mainly toward conditions that may generate economicweaknessin the foreseeable future.”