Download The Federal Reserve

The Federal Reserve System
I. Its History,
Functions &
Structure
II. Fed Policy
Tools & Goals
ECO 473 – Money & Banking – Dr. D. Foster
The Federal
Reserve – Part II
Policy Tools,
Objectives and
Targets.
ECO 473 – Money & Banking – Dr. D. Foster
Additional Resources on Monetary Policy
The Mission of the Fed
(Federal Reserve Board of Governors)
What are the Goals of U.S. Monetary Policy?
(Federal Reserve Bank of San Francisco)
How does Monetary Policy affect the U.S. Economy?
(Fed’l Reserve Bank of San Francisco)
FYI:
The Federal Reserve System: Purposes & Functions
(Federal Reserve Board of Governors)
Federal Reserve Policy Tools
• Open Market Operations
– Buy/sell Treasury bonds to affect bank reserves.
– The major form of monetary policy.
– What will the Fed do if we run out of Treasury bonds?
• Discount Window
– Lend to member banks to affect bank reserves.
– Purpose is to target the “federal funds rate” – iff
• This is the rate that banks charge each other for very short term loans.
• Required Reserve Ratio (rrD)
–
–
–
–
Changing this affects bank excess reserves directly.
Used more to reflect structural changes.
Was used in 1937 and precipitates more Great Depression.
Time to let this go?
New policy – Pay banks i for ER (!!)
Goals of Monetary Policy
• Inflation goals:
– Low/no inflation with limited year-to-year
variability.
• Output goals:
– High and stable economic (GDP) growth.
• Employment goals:
– Stable employment growth with low
unemployment.
Intermediate Targets of Monetary Policy
• The key rationale for intermediate
targeting:
– The limited long-term information about
the economy available to policymakers.
Choosing an Intermediate Target Variable
• Characteristics:
– Frequently observable
– Consistency with
ultimate goals
– Definable and
measurable
– Controllable
• Potential variables:
– Monetary aggregates
M1, M2, MZM
– Interest rates
(fed’l funds, prime …)
– Others:
• Nominal GDP
• Credit aggregates
• Exchange rates
Getting from bond purchases to interest rates
Bond
$$$
$ $ $ $ $
$
mm/yyyy
Face
value
(FV)
Maturity Coupons &
date
value (C)
(in n years)
• Usually, we talk of annual coupons
• Market price of the bond = present value of income stream
discounted at interest rate i:
When the Fed buys
sells bonds, their prices will ___ and interest rates will ___.
Some simple bond pricing problems
1. A bond has a face value (FV) of $1000, will mature in 2022 and has
an annual coupon of $74 and the market rate of interest is 8.1%.
a) What is the current market price of this bond?
b) Suppose that the current market interest rate falls to 6.54%. What will be the new
market price for this bond?
c) Suppose that when the bond was first sold, it’s market price was $1000. What
must have been the market rate of interest then?
2. Consider a bond with FV=$1000, maturity in 2024, C=$81 and
i=7.25%
a) What is the current price of this bond?
b) If the Fed jumps into the bond market, even though it just buys U.S. Treasuries, it
will affect all interest rates to some extent. If they buy lots of bonds and interest
rates fall to 6.88%, what will happen to the price of your bond?
3. The bond in #2 was given to you by your kindly aunt. She told you it
matures in 2024, but her eyesight isn’t so good. You take a close
look at the bond and see that it matures in 2020. Market i=7.25%.
a) What is the price of this bond? Why is it different than what you calculated in #2a?
Is Policy the Right Choice?
 Time lags make effective policy uncertain.
 Discretionary policy promotes uncertainty.
 Rules and credible adherence can eliminate
bias.
 Independence is a likely key requirement.
Time Lags in Monetary (& Fiscal) Policy
• Policy time lags
– Recognition lag
– Response lag
– Transmission lag
Real
GDP
Business
cycle
time
Monetary Policy may be counterproductive
%
Real
GDP
time
Ideally, policy would dampen the business cycle…
But, dampening the business cycle may lower ave. growth!
Or, if policy kicks in at the wrong time, it could worsen
recessions and exacerbate inflationary periods.
Discretion versus Rules
(Milton Friedman)
• Discretionary policy is the source of instability.
• A policy rule can eliminate that instability.
– Set target for Bank Reserves, Monetary Base,
Money Supply to grow in LR sustainable fashion.
– This is a commitment to a fixed strategy no matter
what happens to other economic variables.
• To be successful, the commitment must be credible.
– The public believes the Fed will act this way.
Rules =
Automatic
Stabilizer
Has the Fed maintained stable prices?
Has the Fed maintained the value of the $?
4%
Making Monetary Policy Transparent
FOMC - PR
March 19, 2014
Yellen’s Press
Conference
March 19, 2014
Making Monetary Policy
Rules Credible
• Place constitutional limits on
monetary policy.
• Achieve credibility by establishing a
reputation.
• Maintain central bank
independence.
• Establish central banker contracts.
• Appoint a “conservative” central
banker.
Making Monetary Policy
Rules Credible
• Place constitutional limits on
monetary policy.
• Achieve credibility by establishing a
reputation.
• Maintain central bank
independence.
• Establish central banker contracts.
• Appoint a “conservative” central
banker.
The Federal Reserve System
I. Its History,
Functions &
Structure
II. Fed Policy
Tools & Goals
ECO 473 – Money & Banking – Dr. D. Foster