Download 18 – Monetary Policy

18 – Monetary Policy
Chapter 18
Monetary Policy Tools
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Policy tools
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Target federal funds rate
Discount rate
Reserve requirement
Effective policy tools
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Observable
Controllable
Linked to Objectives
Objectives of Fed
1) Low stable inflation
2) High, stable output
3) Stable interest rates
Target Federal Funds Rate
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Federal Funds Rate
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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
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As borrower, would have to pay interest
Credit risk
“Free” market provides valuable information on bank health
Target Federal Funds Rate
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Rate is determined by supply and demand
for reserves
Target Federal Funds Rate
Interest Rates
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Banks with excess reserves always have the
option of
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Attracting new borrowers
Loaning out reserves in Fed-Funds market
As Fed Funds rate increases, so must other
rates on loans to consumers.
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Otherwise banks maximize profits by loaning out
in Fed-Funds market.
Interest Rates and Demand
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As Interest rates increase
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More expensive for firms to borrow
More expensive for consumers to borrow
Demand decreases
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Lower inflation, output
As Interest rates decrease
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Less expensive for firms to borrow
Less expensive for consumers to borrow
Demand increases
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Higher inflation output
Discount Lending
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Not used as a primary policy instrument
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Used to
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Ensure short-term financial stability
Eliminate bank panics
Prevent sudden collapse of institutions
Discount Lending
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Primary Credit
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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
Discount Lending
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Secondary Credit
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Banks that are not financially Sound
Secondary Discount Rate: 50 basis points above
primary discount rate
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Considered a bad signal for bank
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Reserve Requirements
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Primary Purpose: help stabilize demand for
reserves
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Not a good policy tool because
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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.
Reserve Requirements
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During Great Depression
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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.
Policy Instruments
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Observable
Controllable
Linked to Objectives
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Interest rates
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How are they linked to objectives?
Inflation targeting?
Inflation Targeting
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Advantages
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Does not rely on stable relationship between
money and inflation.
Understood by public - simple and clear
Increases accountability
Disadvantages
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Delayed signaling – how good in the bank doing?
Too much rigidity that can lead to volatile output
Monetary Targeting
Fed Funds Futures Contracts
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Fed Funds Futures Contract traded on CBOT since October 1988.
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Time 0: Traders agree to go long or short at futures price, F0
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Settlement Price (ST): 100 minus the average daily fed funds
overnight rate for the delivery month
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Contract size: $5 million
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Settled at end of last business day of the month
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Long party gets: ST-F0
Short party gets: F0-ST
Fed-Funds Futures Example
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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.
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Assume it has been 4.25%
I get paid (95.75-95.68)*.01*5M =.07*5M=$3,500
Fed Funds Futures
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The lower the Fed Funds rate over January,
the more I win.
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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.
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Short positions in Fed futures hedge against
rising Fed-Funds rates.
Predicting What the Fed will Do
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Example:
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19 days left in December
The Fed meets in 7 days
Will not meet again until January
Current Target Fed Funds rate: 5.25%
Predicting What the Fed will Do
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Assume
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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.
Predicting What the Fed will Do
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Implications:
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For 19 days of December, the Fed Funds rate will
be 5.25
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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.
Predicting What the Fed will Do
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Averages for December
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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
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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
How Good are Our Assumptions?
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The Fed hits its target Fed Funds rate each
day
How Good Are the Assumptions?
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The Fed does not enact new monetary policy
until the days after its meeting
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Fed may take a few days to fully implement
policy.
19 – Exchange Rate Policy
Chapter 19
Fixed Exchange Rates
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PPP: Inflation erodes the value of currency
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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.
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A central bank must choose between a fixed
exchange rate and an independent monetary policy.
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But PPP only holds over long periods.
What about in the short term?
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Fixed Exchange Rates in the Short Run
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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
rf 
FV f
Pf
1
Fixed Exchange Rates in the Short Run
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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
rd 
FV f EX t 1
Pf EX t
FV f
1
EX t 1

*
1
Pf
EX t
Fixed Exchange Rates in the Short Run
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If exchange rate is fixed, then
EX t 1
1
EX t
implying
rd 
FV f
Pf
 1  rf
Fixed Exchange Rates in the Short Run
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Conclusion:
As long as capital is able to flow across
borders freely, monetary authorities can
choose to control either
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Exchange rate
Interest rate
Mechanics of Exchange rate
Intervention
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Central banks agrees to exchange currency
for dollars at a fixed rate.
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Bank must maintain a substantial amount of
dollar reserves to keep currency from
depreciating.
Fixed Exchange Rate Costs/Benefits
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Benefits
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Eliminate exchange rate risk
Effective way to control inflation in inflation-prone
countries
Costs
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Import monetary policy
Central bank must have ample dollar reserves
Methods of Fixing Exchange Rate
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Currency Boards
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Central bank holds enough dollars to keep
currency from depreciating
Example: Argentina
Dollarization
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Country adopts dollar as official currency
Example: Ecuador