Macro Federal Reserve Highlights WCC

Transcription

1 Macro Federal Reserve Highlights WCC Federal Reserve ystem Established in 1913 Central bank of the United tates (really our third) Bank of England, Bundesbank Roles of a central bank Control the size of the mony supply Regulate/supervise banks and financial institutions Perform as the government s bank tores tax revenue Arranges government loans Pays government obligations erve as a banker s bank Clears checks Holds deposits/reserves of member banks erve as a lender of last resort Provides the Federal Reserve notes to banks The ystem Run by the Board of Governors 7 members, 14 year terms, one appointed every other year quasi-independent governmental entity 12 regional district banks (we re in Chicago) each technically a private corporation owned by member commercial banks each elects 6 of 9 district directors with 3 appoited by BOG all returns exceeding 6% returned to U.. Treasury policy making by FOMC s 12 members 7 from BOG plus 5 district bank presidents, including New York Fed has a variety of tools it can use to influence the monetary base and money supply. Monetary base = Reserves + Currency and coin in circulation federalreservehighlights.doc 1 4/16/2007

2 The "Oversimplified Money Multiplier" OMM = 1/RR aka the "imple Deposit Multiplier" The actual money multiplier is less than this due to leakages (not all loan amounts are redeposited), and excess reserve holdings (some banks hold more than the required reserves) Fed tools 1) Reserve requirement the Fed changes the required reserve ratio 2) Discount rate the Fed changes the rate at which the Fed makes loans to banks 3) Open market operations the Fed buys and sells government securities 4) Other tools Jawboning stock market margin requirements about 50% now, 10% prior to crash of 1929 Reserve requirement Directly affect the money multiplier Rarely changed (30 times since Great Depression) Open market operations Most flexible tool, Fed favorite Reversible uick When the Fed buys government securities, it increases reserves and the monetary base, and potentially increases the money supply When the Fed sells government securities, it decreases reserves and the monetary base, and potentially decreases the money supply Idea of monetary base = currency + bank reserves ales and purchases follow an auction format Actually daily sales and purchases occur Adjust maturities Deceive market watchers federalreservehighlights.doc 2 4/16/2007

3 Discount rate Banks sometimes borrow directly from Fed to meet the reserve requirement Increasing the rate reduces borrowing and thus lending Decreasing the rate increases borrowing and lending Changes a few times a year Pegged just above/below the fed funds rate Fed does not set the Fed Funds Rate directly targets it thru open market operations when the Fed buys government securities, it gives banks additional reserves, thus lowering the Fed Funds Rate because the supply of excess reserves has increased when the Fed sells government securities, it takes away bank reserves, thus raising the Fed Funds Rate because the supply of excess reserves has decreased Expansionary/Contractionary monetary policy expansionary monetary policies are those Fed actions that increase the money supply contractionary monetary policies are those Fed actions that decrease the money supply Tool Expansionary Policy Contractionary Policy Discount rate Decrease Increase Reserve requirement Decrease Increase Open market operations Fed buys government securities Fed sells government securities We still need to understand how changes in the money supply affect the money market, the bond market, and the foreign exchange market. federalreservehighlights.doc 3 4/16/2007

4 The Money Market Build the money market assume a vertical money supply curve in other words, changes in interest rates do not affect the money supply money supply can change in response to other factors though open market operations, other Fed interventions will shift this curve add a negatively sloped total money demand curve Why is the total money demand curve negatively sloped? understand two components of this demand to understand its behavior transactions demand - money held to make day-to-day purchases of G& affected by output and prices, transfer costs, not particularly affected by interest rate anything that changes nominal GDP shifts transactions demand curve essentially vertical asset demand - money held as a form of wealth not affected by output and prices affected primarily by interest rate cash in pocket earns no interest as interest rate rises OC of holding cash increases individuals hold less cash curve downward sloping total demand for money has a negative slope i i E D Money Mkt federalreservehighlights.doc 4 4/16/2007

5 hifting curves changes in price level of g&s, output, transfer costs shift money demand changes in fed policy shift money supply as curves shift out and back, interest rates move up and down expansionary/easy money policy increases the money supply and lowers interest rate contractionary/tight money policy decreases the money supply and raises interest rates inverse relationship between the money supply and interest rates Extent of Fed's ability to control interest rates and money supply cannot precisely control money supply shift because banks may not lend all excess reserves and individuals may not redeposit loaned funds lack of knowledge regarding the slope of money demand curve means that even a known shift in the money supply curve produces an unkown change in interest rates flatter curve produces smaller change in interest rate, steeper curve produces greater change the Fed is unable to control both interest rate and money supply simultaneously, because it does not control both curves The Bond Market Relationship between bond prices and interest rates simplest form of a bond pays no interest face value price term to maturity sells at a discount the return or interest rate you receive depends on how far apart the face value and price are bond prices and interest rates are inversely related Building the Bond market demand for bonds consists of those with money to lend negative slope because low price equals high interest rate and vice versa supply of bonds represents those who are borrowing positive slope because low price equals high interest rates and vice versa federalreservehighlights.doc 5 4/16/2007

6 An example of the effects of an expansionary monetary policy on the bond and money markets The Fed purchases government securities through open market operations, shifting the bond demand curve out and increasing the price of bonds. Commercial banks take the additional reserves they get from selling those government securities and begin to make loans, shifting out the money supply curve and lowering the equilibrium interest rate. again, bond prices and interest rates are inversely related Graph effects of open market purchase on bond and money markets P i P E P E 0 D i E i E D Bond Market D Money Mkt Build the Foreign Exchange market demand for dollars results from foreigners wishing to buy U.. produced g&s along with financial instruments supply of dollars consists of U.. citizens wishing to buy foreign produced g&s and financial instruments consider the effect of higher interest rates on U.. gov t securities on exhange rate increases demand for dollars, demand shifts right, value of the dollar rises federalreservehighlights.doc 6 4/16/2007

7 Graph effect of open market purchase by Fed on value of the dollar against the yen /$ 120 /$ 105 /$ D 1 D 0 Market for the Dollar Effects of monetary policy on the value of the dollar expansionary monetary policy lowers interest rates lower interest rates decrease demand for us government securities by residents of other countries as demand for the dollar shifts back in the foreign exchange market, the value of the dollar falls compared to other currencies federalreservehighlights.doc 7 4/16/2007