Download Ch12

Frank & Bernanke
4th edition, 2009
Ch. 12: Stabilizing the
Economy: The Role of
the Federal Reserve
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Origins of the Federal
Reserve System

Resistance to establishment of a central
bank
 Fear
of centralized power
 Distrust of moneyed interests

No lender of last resort
 Nationwide
bank panics on a regular basis
 Panic of 1907 so severe that the public was
convinced a central bank was needed

Federal Reserve Act of 1913
 Elaborate
system of checks and balances
 Decentralized
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Board of Governors of the
Federal Reserve System

Seven members headquartered in
Washington, D.C.

Appointed by the president and
confirmed by the Senate

14-year non-renewable term

Required to come from different districts

Chairman is chosen from the governors
and serves four-year term
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Federal Open Market
Committee (FOMC)

Meets eight times a year

Consists of seven members of the Board of
Governors, the president of the Federal Reserve
Bank of New York and the presidents of four
other Federal Reserve banks

Chairman of the Board of Governors is also
chair of FOMC

Issues directives to the trading desk at the
Federal Reserve Bank of New York
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Federal Reserve System
Source: Federal Reserve Bulletin.
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The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

Suppose:
 Depositors
lose confidence in their bank.
 They attempt to withdraw their funds.
 Bank may not have enough reserves (fractional)
to meet the depositors demand.
 The bank fails and further erodes depositor
confidence which triggers additional failures.
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The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

The Fed to the rescue:
 Instill
confidence
 Discount lending
 Open Market Operations
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The Great Depression




The Fed did not prevent the Great Depression.
Both currency held by the public and reservedeposit ratio rose, reducing money supply.
The Fed increased the reserves but not enough.
Lack of enough reserves forced bank
bankruptcies.
 One-third
of U.S. banks closed
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Policy Tools in the Federal
Reserve System
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MONETARY STATISTICS DURING GREAT DEPRESSION
Currency Res/Dep Reserves
M1
Dec-29
3.85
0.075
3.15
45.9
Dec-30
3.79
0.082
3.31
44.1
Dec-31
4.59
0.095
3.11
37.3
Dec-32
4.82
0.109
3.18
34.0
Dec-33
4.85
0.133
3.45
30.8
Why did money supply fell during the Great
Depression even though the Fed kept reserves up?
What would M value be in 1932 if reserve ratio
did not change?
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Fed’s Control of Nominal Interest Rate
By buying or selling bonds, the Fed
increases or decreases the RESERVES in
the system.
 If the Fed buys securities, reserves
increase, then banks can easily find
required funds => lower federal funds rate
of interest.

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The Federal Funds Rate, 1970-2004
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http://research.stlouisfed.org/publications/mt/page9.pdf
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Fed Funds Rate vs. Prime

If Fed can affect the federal funds rate, why
should we care?
We might be interested in the interest rates on
CDs, mortgage rates, credit card interest rates.
 Usually, interest rates all go hand in hand.
 When the Fed increases the federal funds rate,
banks increase their prime rates, too.

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Real and Nominal Interest Rates
If the amount of savings and
investments in an economy determine
the real interest rate, and real interest
rate is more important for the decisions
that will affect the wealth of the society,
why should we care what the Fed does?
 Because in the short run, prices are
constant, so inflation does not increase:
any change in nominal interest rates is
reflected in the real interest rate.

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Real and Nominal Interest Rates
Remember the Fisher Effect:
i=r+p
 If the expected inflation hasn’t changed
(short-run: prices constant) but the Fed has
increased i, then r is also increased.
 In the long run p adjusts and it is the savings
and investments that determine the real rate
of interest.

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Federal Funds Rate
and the Economy
PAE responds to C, I, G, NX changes.
 Only real interest rate impacts
INVESTMENTS and SAVINGS

Real interest up => S up => C down
 Real interest up => I down

Real interest up => USD appreciates =>
Imports cheaper; exports more expensive
=> NX down
 r up => C, I, NX down => PAE shifts down

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Real Interest Rates and
Aggregate Demand
Y = C + I + G + NX
 C = 400 + 0.8(Y-T) - 200r
 I = 300 - 600r
 G = 250; T = 200; NX = 10
 Explain in words how this economy
operates.

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Solving for the Unknowns
If the real interest rate is 3%, find the
values of C, I, and Y for the previous
economy and draw the Keynesian cross
to show the Y.
 If the Fed has increased the real
interest rate to 5%, find the values of C,
I, and Y and show the new AD curve on
your graph.

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Fighting Recession
The Fed reduced the fed funds rate 11
times in 2001-2002 from a high of 6.5%.
 On Nov. 6, 2002, it was 1.75% and the
Fed decided to lower it further.
 What was the effect of Fed’s lowering of
interest rates on AD?
 What was the Fed policy between 20072010 (look at slide #13)?

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Fighting Recession

Fed lowers r => I, C, NX increase => PAE
shifts up => For every $1 increase (shift) in
PAE, Y increases by the value of the
multiplier => Equilibrium Y is no longer at
recession value => Y-Y*=0.
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The Fed Fights A Recession
Expenditure
line (r = 1%)
Planned aggregate expenditure PAE
• Multiplier = 5
• Output gap = 200
• Fed wants to
increase PAE by
200/5 = 40
• C = 1,010 – 1,000r
• 1% change in r will
change C by 10
• Reduce r to 0.01
Y = PAE
Expenditure line
(r = 5%)
F
A reduction in r shifts the
expenditure line upward
E
Recessionary gap
4,800
5,000
Y*
Output Y
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Fighting Inflation
From the middle of 1999 to the middle
of 2000, the Fed raised the fed funds
rate from 4.75% to 6.50%.
 At the beginning of 1977 the fed funds
rate was 4.5%. By the end of 1978 it
was 10%. A year later it was 13.75%.
By April 1980, it reached 17.6%.
 What happens to PAE?

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Raising Interest Rates
Real GDP growth of nearly 6% in late
2003 and 4.4% in 2004 and a falling
unemployment rate to 5.6% in June 2004
indicated the possible emergence of an
expansionary gap.
 From June 2004 to June 2005 the Fed
Funds Rate rose from 1.0% to 3.25%.

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The Fed Fights Inflation
Planned aggregate expenditure PAE
Y = PAE
Expenditure
line (r = 5%)
E
G
Expenditure line
(r = 9%)
An increase in r shifts the
expenditure line downward
Expansionary gap
4,600 4,800
Y*
Output Y
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Inflation and the Stock Market





Inflation is watched very closely by the Fed.
Any sign of inflation makes Fed increase interest
rates.
Higher real interest rates slow down the economy
and lower future profits.
Higher real interest rates lower the price of bonds
and shift the demand away from stocks to bonds,
lowering stock prices.
If there is no inflation but there is an asset bubble,
should the Fed increase the interest rate?
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Policy Reaction Function
If there is a pattern of policies adopted
under the same economic circumstances,
then we have a policy reaction function.
 For example, if there is a correlation
between low unemployment rates and lax
immigration policies and high
unemployment rates and strict
immigration policies, this can be shown
with an equation.

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A Monetary Policy Reaction
Function for the Fed
Rate of inflation, p
Real interest rate set by Fed, r
0.00 (= 0%)
0.02 (= 2%)
0.01
0.03
0.02
0.04
0.03
0.05
0.04
0.06
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An Example of a Fed
Policy Reaction Function
Real interest rate set by Fed, r
0.06
Fed’s monetary policy
rule
0.05
0.04
If the Fed sets the
target inflation as 2%,
what interest rate will
it set?
0.03
0.02
0.01
0.02
0.03
Inflation p
0.04
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What is Demand for Money?

Demand for Money (Liquidity Preference)
The amount of wealth an individual chooses
to hold in the form of money.
 The portfolio allocation decision is made by
comparing return relative to risk.
 Risk can be reduced by diversifying the
portfolio.
 Most people choose to hold some wealth as
money.

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The Demand for Money
Money (currency + checking deposits)
is one of the assets a person, a
household, a business holds.
 The benefit of money is its acceptability
in paying debts (liquidity).
 The cost of money is the opportunity
cost of losing a return on other assets
one could hold.

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The Demand for Money

If the opportunity cost of holding money
increases, less money will be held in
portfolio.

The higher the nominal interest rate, the lower
is the demand for money.
The more the income, the more will be the
amount kept in money form: the higher will
be the demand for money.
 The higher the price level, the higher will
be the demand for money.

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Nominal interest rate i
The Money Demand Curve
Shifts in MD
• Changes in Y & P
• MD will increase if Y or P
increase
• Technological changes
• Foreign demand
MD’
MD
Money M
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Shifts in Money Demand






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
Businesses hold more than half of the total
money stock.
Changes in real income (real GDP).
Changes in price level.
Technological change and sophisticated financial
markets have reduced the demand for money in
the U.S.
Changes in foreign holdings of USD.
Between 1960 and 2004 M1 as a percent of GDP
fell from 28% to 12%.
Psychological changes.
Seasonal changes.
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Foreign Holdings of USD
 More
than $300 billion in currency
circulating outside the U.S.
 Foreign citizens will hold dollars to
avoid the impact of high inflation.
 Foreign citizens will hold dollars to
protect against political instability.
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Money Supply
By engaging in open market operations,
the Fed increases (buy bonds) or
decreases (sell bonds) the amount of
money in the system.
 If the demand for money remains the
same, the action of the Fed affects the
federal funds rate.


S up; D same => P down
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Nominal interest rate
Equilibrium in the Market for Money
Money
Explain how and why the market reaches equilibrium.
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Equilibrium in the Market for Money
If at the existing interest rate, supply
exceeds demand, that means people
would like to hold less money than there is.
 How do people adjust their portfolios?
 They buy other assets with the excess
money in their checking accounts.
 The price of bonds (non-money assets)
goes up: interest rate goes down.

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The Fed Wants to Raise i
Fed sells bonds
 The money supply falls
 Creates a shortage of money
 People sell non-money assets
 Non-money asset prices fall and the
interest rate increases

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http://www.federalreserve.
gov/newsevents/press/mo
netary/20110315a.htm
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Interest Rates and Money Supply
The Fed cannot set the interest rate and
the money supply independently.
 The Fed controls the money supply by
controlling bank reserves.
 Bank reserves influence the federal funds
rate.
 Therefore, the federal funds rate reflects
the impact of open market operations.

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The Fed and Money Supply

Second Way : Discount Window Lending
The lending of reserves by the Federal Reserve
to commercial banks
 Discount Rate (primary credit rate): The interest
rate that the Fed charges commercial banks to
borrow reserves.

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The Fed and Money Supply

Third Way: Changing Reserve Requirements




Set by the Fed
The minimum values of the ratio of bank deposits that
commercial banks are allowed to maintain
Lowering the reserve ratio increases the ability of banks
to make loans and therefore expand the money supply.
Increasing the reserve ratio reduces the ability of banks
to make loans and create money.
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The New Tools
http://www.federalreserve.gov/monetarypolicy/default.htm
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