Download The Fed and The Interest Rates

The Fed and The Interest Rates
Chapter 3
FIN 221
Fed Reserve Control of The Money supply
• Measures of The Money supply
Monetary Base & Money Supply Changes
The CB changes the money supply by changing the monetary
base (MB) through its monetary policy tools.
In case of Restrictive monetary policy:
OMO - sell securities, reduce bank reserves and the
monetary base.
RR - increase reserve requirements, reduces excess
reserves and the deposit expansion multiplier.
Discount rate -- increase the discount rate, reduce the
money supply or its growth rate; increase interest rates.
The Fed’s Control Over Interest Rates
• The central bank (Fed) funds rate is the interbank lending rate.
• The interbank lending rate represent the primary cost of shortterm loanable funds.
• The Fed (CB) rate:
1. It measures the return on the most liquid of all financial
assets.
2. It is closely related to monetary policy.
3. It directly measures the available reserves in the banking
system which in turn influences commercial bank’s decision on
making loans to consumers , businesses or other borrowers.
Market Equilibrium Interest Rate
1. Demand for the reserves by the depository
institutions (Negative)
2. Supply of the reserves by the CB (Positive)
3. Equilibrium CB rate is when DRes = SRes
The CB
Rate
SRes
Equilibrium
Interest
DRes
Quantity of Reserves
Monetary Policy & The Fed Funds Rate
• OMO and its impact on CB rate
1.Purchasing T – Treasury leads to increase reserves
in the banking system then the supply curve shifts
rightward. As a result, the market interest will decline.
The
CB
Rate
SRes1
2.Selling T – Treasury
SRes2
Quantity of reserves
•Discount rate and its impact on CB rate
1. Increase
discount
rate
means
increase
opportunity cost of holding reserves. So supply of
reserves will decline, the supply curve will shift
leftward, then the interest increases.
The
CB
rate
SRes2
SRes1
DRes
2. Decrease discount rate
Quantity of Reserves
•RR and its impact on CB rate
1. Increase k (RRR) leads to increase RR, decrease
ER i.e. the loans to the public, demand for
reserves from the CB increases, demand curve
shifts rightward, and interest increases.
The
CB
rate
sRes
DRes2
DRes1
Quantity of Reserves
2. Decrease k (RRR)
The Market Environment
•The CB can influence the CB funds rate ONLY in
the very short run
•The CB does NOT have the power to set the CB
funds rate in the long run
Importance of the Fed (CB) rate:
1- Monetary Theory (monetarist economists)
The money supply is the key variable that effect on
economic activity.
2- Keynesian School
• The interest rate is the key variable.
• Example: in case of recession: CB will take a
expansionary
Monetary Policy, this will lead to
decline in interest rate, this lead to increase
components of AD and finally this leads to pushing
the economy (Unless it is in a liquidity trap)
• both schools about how CB should try to effect
on real sector
• What Is Liquidity Trap?
The CB’s Impact on Stock and Bond
Markets
• Increase in market interest rate leads to decrease
in the value of fixed – income securities.
• Raising discount rate or / and raising reserve
requirements leads to a great fall in the stock market.
Objectives of Monetary Policy
1. Full Employment:
•
•
•
•
•
Definition
Frictional Unemployment
Structural Unemployment
Natural Rate of unemployment
Consequents of unemployment: economic and
social results
2. Economic Growth:
• Definition
• PPF and economic Growth
3. Stable Prices:
• Definition
• The relationship between Prices and
purchasing power (money value)
• Effects of unanticipated inflation
4. Interest Rate Stability:
• Definition
• Interest rate fluctuations effects
5. Stability of financial System:
• Definition
• Fluctuation in financial system and
efficiency
• Instability in banking system
• The role of CB
• Example: 11 Sep., 2001
6. Stability of Foreign Exchange Market:
• Definition
• International Trade
• Devaluation / overvaluation and the effects
on X & M
Possible Conflict Among Objectives
• Conflict between inflation & unemployment
• Philips Curve
The Fed and The Economy
OMO – Expansionary monetary policy
1- buying securities -- increase in banks’ reserves
2- the increase in reserves will lead to an increase in banks’
assets, banks’ investments and banks’ loans.
3- each of the Above has additional effects as follows:
• The increase in banks’ assets will lead to an increase in
money supply.
• The increase in investments will increase securities’
prices and lead to decrease in interest rates.
• The increase in loans will increase credit availability and
lead to a decrease in interest rates.
The increase in money supply and decrease in
interest rates will:
- Increase Investment expenditure ( I )
- Increase consumption expenditure
(durable – houses)
(C)
- Increase government expenditure ( G)
-Increase net exports (since exports increase and
imports decrease )
( NX)
-Decrease foreign exchange rate.
i.e, expenditure on domestically produced goods will
increase and the RGDP (= C+I+G+NX) will increase,
- also the price level will increase.
Business investment in real assets
• Present values of future cash flows from real assets depend
significantly on general level of interest rates:
–
Rates fall, PVFCF rises
–
Rates rise, PVFCF drops
• Most capital expenditures are debt-financed; interest expense
is thus material in profitability of most businesses.
• Monetary policy thus always involves material incentives or
disincentives for business investment.
• The CB can manipulate incentives but not compel results.
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Consumer spending for durable goods & housing
• Much consumer spending is on credit, so it tends to vary
directly with credit conditions:
– Falling interest rates tend to encourage spending.
– Rising interest rates tend to discourage spending.
• Monetary policy can thus often affect aggregate demand to
some extent.
• The CB can encourage/discourage but not necessarily
compel; Consumers don’t necessarily make financial
decisions the way businesses do:
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Net exports
• Interest rates affect exchange rates as follows:
– Falling interest rates in a country tend to “weaken” its
currency.
– Rising interest rates in a country tend to “strengthen” its
currency.
• Exchange rates affect imports and exports
– As domestic currency weakens—
• Domestic demand for imports decreases as they become
more expensive BUT
• Foreign demand for exports increases as they become less
expensive (cheaper).
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