Download Federal Reserve

Federal Reserve
Tools and Targets
Open Market Operations
• Types:
– Dynamic
• Designed to change base
– Defensive
• Meant to offset other factors affecting base
• Purpose:
– Change the monetary base.
Open Market Operations
• Advantages:
–
–
–
–
Controlled by the Fed
Flexible and precise
Easily reversed
Implemented quickly
Discount Loans
• Purpose:
– Influence reserves in the banking system
– Lender of Last Resort
• Prevent bank panics
• Prevent non-bank financial panics
Types of Discount Loans
• Primary Credit
– Restricts eligibility to generally sound
institutions.
• The goal is to eliminate institutions’ incentive to
borrow to exploit the positive spread of money
market rates over the discount rate.
• The Fed expects that the restriction of eligibility will
reduce its need to review borrowers’ funding
situations; thereby, encouraging banks to use the
discount window during tight markets.
Types of Discount Loans
• Primary Credit
– Primary credit is extended at a rate that is above
the usual level of short term market interest
rates, including the federal funds rate.
Types of Discount Loans
• Secondary Credit
– Secondary credit is available in appropriate
circumstances to depositary institutions that do
not qualify for primary credit.
– Secondary credit is extended at an interest rate
that is 50 basis point above the primary
discount rate.
Changes to the Discount Window
Feature
Previous System
Primary Credit
Rate
Fed funds rate less
25-50 basis points
Fed funds rate plus
100 basis points
Term
Overnight
Overnight
Eligibility
Subjective
Sound banks only
Administration Evaluated for
appropriateness
Use of funds
Can’t resell
Minimal,
Market based
No restrictions
Discount Loans
• Advantages:
– Lender of Last Resort function.
• Disadvantages:
– Confusion interpreting discount rate changes.
– Fluctuations in discount loans can cause
unintended fluctuations in the money supply.
– Not fully controlled by the Fed.
Reserve Requirements
• Types:
– Required reserves
– Excess reserves
• Purpose:
– Originally, reserve requirements were meant to
provide a cushion of reserves to meet
unexpected depositor demands for funds.
Reserve Requirements
• Advantages:
– Changes in reserve requirements can change the
rate of growth in the money supply rapidly.
• Disadvantages:
– Increases can cause serious liquidity problems
for banks.
– Continually fluctuating reserve requirements
create uncertainty for banks and make liquidity
management more difficult.
Targets
Monetary Policy Goals
• The goals of monetary policy are:
–
–
–
–
–
–
High employment
Economic growth
Price stability
Interest rate stability
Financial markets stability
Exchange rate stability
Monetary Policy Targets
• The central bank wants to achieve its goals,
but it does not directly influence the goals.
• It has a set of tools that affect the goals
indirectly after a period of time.
• Therefore, the Fed must aim at targets that
lie between its tools and its goals.
Targets
• Intermediate Targets:
– Monetary aggregates such as M1and M2
– Interest rates
• Operating Targets:
– Reserve aggregates such as reserves, nonborrowed reserves, monetary base, nonborrowed base.
– Interest rates such as the federal funds rate or
the Treasury bill rate.
Choosing the Target
• There are two types of targets:
– Aggregates (Monetary and Reserve)
– Interest rates.
• When the Fed chooses one target, it loses
control over the other.
Money Demand
At high rates of interest, people hold
interest bearing assets so money demand
is low.
i
ih
At low rates of interest, people hold
fewer interest bearing assets so money
demand is higher.
il
Money
Demand
0
MD low
MDhigh
Money
Money Supply
Money
Supply
i
The money supply is determined by the
Federal Reserve.
At every rate of interest, the money supply
is the same.
0
MS
Money
Targeting the Money Supply
Money
Supply
i
Let money demand fluctuate between
MD1 and MD3, causing interest rates
to fluctuate between i1 and i3.
Targeting the money supply leads to
loss of control over interest rates.
i3
i2
i1
0
MD3
MD2
MD1
Money
Targeting Interest Rates
MS1
i
MS2
MSs3
Let money demand fluctuate between
MD1 and MD3, causing interest rates
to fluctuate between i1 and i3.
i*
MD3
To set interest at i*, money supply must
fluctuate between MS1 and MS3.
MD2 Targeting interest rates leads to loss
MD1 of control over the money supply.
0
Money
Monetary Policy Targets
• It is not possible for the Federal Reserve to
change economic conditions directly.
• Strategy:
– Decide on goals for the overall economy.
– Choose a set of variables called intermediate
targets that it believes will have an impact on
the overall economy.
– Choose another set of variables called
operating targets that impact the intermediate
targets.
Target Criteria
• Measurability
– Intermediate Targets
• Data on monetary aggregates are available after a
two week delay.
• Data on interest rates are available daily.
– But real interest rates (interest rates adjusted for expected
inflation) are hard to measure because there is no direct
way to measure expected inflation.
– Operating Targets
• Data on reserve aggregates and the federal funds
rate are available daily.
Target Criteria
• Controllability
– Intermediate Targets
• The Fed’s control of the money supply is good but
not perfect.
• The Fed can change interest rates through open
market operations.
– Operating Targets
• The Fed easily controls base and the federal funds
rate.
Target Criteria
• Predictable Effect on Goals
– Intermediate Targets
• The ultimate economic goal is the target of the
intermediate target.
– If the goal is price stability, a change in the money supply
or interest rates should change the price level.
– If the goal is economic growth, a change in the money
supply of interest rates should change the rate of growth in
GDP.
Target Criteria
• Predictable Effect on Goals
– Operating Targets
• The intermediate target is the goal of the operating
target.
– If the intermediate target is interest rates, the operating
target will also be an interest rate variable such as the
federal funds rate.
– If the intermediate target is a monetary aggregate, the
operating target will also be a reserve aggregate variable
such as base.
Lags
• Data lag
– Time to obtain information
• Recognition lag
– Time to understand the information
• Legislative lag
– Time to decide on policy
Lags
• Implementation lag
– Time to implement the policy
• Effectiveness lag
– Time for the policy to take effect.
• Monetary policy has a long and variable
effectiveness lag.