Download Entire Unit Module - Tippie College of Business

The Iowa Electronic Markets
Federal Reserve Monetary
Policy and the IEM
Course Materials using the IEM
Prepared for the Spring 2000 Money & Banking Courses
By
Jan E. Christopher
Eric Rahimian
Delaware State University
Alabama A&M University
Teaching Objectives
Federal Reserve Monetary Policy and the IEM
Apply the IEM to Understand Federal Reserve Monetary Policy
Students should be able to:
1. Recognize the Goals of Monetary Policy
2. Understand the instruments to achieve Monetary Policy Goals
3. Determine the factors that guide the Monetary Policy Process
4. Understand how Monetary Policy is implemented by the FOMC
5. Trade shares in the FedPolicy Market on the IEM
Evaluation of students’ performance
Students should be able to:
1. Understand Current Economic Conditions and the Impact on the Federal Reserve Monetary
Policy Market
2. Use the Federal Reserve Monetary Policy Market to Predict and Evaluate the Decisions of the
Federal Open Market Committee
Implement investment /trading strategies
Submit reports on their trading activities of the Federal Reserve Monetary Policy Market on the IEM
based on sound financial analysis
Important Aspects of the Assignment

Students replicate analysis from the lecture.

Students start with the FedPolicy Market and learn how the actual financial markets operate.

Students build on previous knowledge and experience.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
2
Lecture Outline
Federal Reserve Monetary Policy and the IEM
1. Introduction
2. Macroeconomic Issues
3. Definition of Concepts
4. Federal Monetary Policy Instruments
5. Applying the IEM
6. Conclusions
Lecture Notes
The Federal Reserve System (the Fed) is the central bank of the United States. It is in
charge of implementation of the nation’s monetary policy. An objective of the monetary
policy is to provide sufficient money and credit for economy to allow long-run economic
growth without creating inflationary pressures. The Fed also tries to minimize the shortrun fluctuations causing a recession or an excessive inflation.
The Federal Reserve System functions
1. Supervision of regulation of the financial systems.
2. Maintaining an easy-running payments system by clearing checks and provision of
sufficient amount of currency and coins for circulation.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
3
3. Serving as the fiscal agent of the government. The Fed handles the United States
government’s debt and cash balances. The Fed also clears the treasury checks and
issues and redeems securities.
Federal Reserve System history
An in-depth discussion of the background and history of the United States Federal
Reserve System is in your text. Briefly, in the early 20th century the lawmakers decided
that the nation needs a central bank that functions as the bank of banks. The Fed was
established in 1913. Since the lack of confidence in commercial banks and their weakness
in responding to large scale deposits withdrawals were considered the main causes of the
1907 banking crisis, the Fed was established to monitor the commercial banks and to lend
funds to them during emergencies. It is this duty that entitles the Fed as the lender of the
last resort. The reason for this function is to preserve the soundness of the financial
systems. Even from the beginning, it was realized that the Fed, as the central bank of the
United States, needs to decentralize its policy-making authority. Hence, the original
Federal Reserve Act (1913) created 12 Reserve Banks.
The Fed was created as an independent agency to prevent the political process from
dictating its policies. Its internal structure supports this independence. The Board of
Governors of the Fed is on the top of the organizational structure. It has seven members,
each of whom is appointed to a 14-year term. There is no appropriation from the
Congress for the Fed and its Board of Governors. The Fed earns its funds from the
interest on loans to depository institutions and its holdings of government securities. The
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
4
Board members do not need to defend their actions to the Congress, the President of the
United States and the public. In addition the law and regulations of the Fed provide for its
exemption from the Freedom of Information Act and “government in the sunshine”
legislation, which call for openness of policy making meetings. It is important to note that
the independence of the Fed should not be interpreted as a sign of complete separation
from the Federal Government. Actually, the Congress can pass laws that the Fed must
obey in the future. Also, though unlikely, the Congress can abolish the Fed.
Nevertheless, the Fed is not under the direct supervision of anyone in the executive or
legislative branches of government.
Responsibilities of the Fed Board of Governors
1. Setting the required reserve ratio. This is the percentage of the deposits in the
depository institutions that must be kept in required reserve account in the Fed.
2. Setting the discount rate. This is the interest rate on loans that the Fed makes to
depository institutions.
3. Supervising and regulating the member banks and bank holding companies.
4. Overseeing the Federal Reserve Banks.
5. Establishing and administering the regulations in consumer finance.
Responsibilities of the Federal Reserve Banks:
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
5
1. Proposing discount rates.
2. Lending funds to depository institutions (discount policy).
3. Furnishing currency
4. Collecting and clearing checks and transfer funds for depository institutions
5. Handling the US government debt and cash balances.
The Federal Open Market Committee
This committee is an important element of the Federal Reserve System. It directs the daily
purchases and sales of government securities. It regularly meets and makes decisions on
the targeted short-term interest rates. These are mainly the discount rate and the federal
funds rate.
The discount rate is the rate that depository institutions are charged on the borrowings of
reserves from the Fed. Federal funds may be defined as the reserves of the depository
institutions in the federal reserve banks. These funds are now frequently borrowed by
commercial banks on a short-term basis. The interest rate charged on the borrowed
reserves is called the federal funds rate. Today, the federal funds market is much larger
than before. Commercial banks, particularly large ones, borrow these funds for any
shortage of their required reserve as well as for earning additional interest by investing
them or transferring them to sources of funds for loans with higher interests.
In summary, the Fed pursues several goals including high employment, price stability,
exchange rate stability and sustainable economic growth. Unemployment beyond the
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
6
natural rate leads to lower national output. High and unanticipated inflation rates distort
the distribution of income and create uncertainty for investors and financial markets.
Consistency and stability of the dollar’s exchange rate make international trade less risky.
Hence, in addition to monitoring the interest rate, the Fed oversees the dollar fluctuations
in the foreign exchange markets.
Monetary policy can support or be used as an alternative to fiscal policy. Fiscal policy also
can be used to support monetary policy. However, it is important to note that excessive
use of one policy may make the implementation of the other policy more difficult. For
example, a long-term deficit spending policy causes the accumulation of national debt and
makes monetizing the debt difficult.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
7
Federal Reserve Monetary Policy and the IEM
Assignment
Introduction to the IEM
The Iowa Electronic Market (IEM for short) is a computerized market on which financial contracts are
(bought or sold). For this assignment, we will be using a series of contracts based on the monetary
policy decisions of the Federal Reserve's Federal Open Market Committee (FOMC) at their regularly
scheduled meetings. Contracts listed in this market will initially appear in sets of three, with each set
referring to a particular FOMC meeting. The three contracts will represent the three possible FOMC
decisions made at that meeting regarding the federal-funds rate target -- to raise the target, to lower it,
or to leave it unchanged.
These contracts are listed on the IEM under the market label “Federal Reserve Monetary Policy
Market” or “FedPolicy” for short. These contracts are described briefly later in this note and in more
depth in the IEM Trader’s Manual. Detailed descriptions of these markets are available at the IEM web
site:
http://www.biz.uiowa.edu/iem/markets/computer.html
Objectives
The objectives of the IEM assignments are to help you apply class concepts in a "real world" way to
learn how to:
1. Apply the IEM to Understand Federal Reserve Monetary Policy
2. Evaluate students’ performance
3. Implement investment /trading strategies
Opening an IEM Account
All students need to open an account with the Iowa Electronic Markets. This involves a minimum
deposit of $5.00 dollars. Funds remaining in your account are refundable at the end of the semester.
You can open an IEM account over the Internet. To do so, go to the sign-up web page:
http://iemweb.biz.uiowa.edu/signup/
and follow the instructions given to you by your instructor. (DO NOT use forms other than those given
to you by your instructor. Using other forms may result in fees or decreased deposits in your account.)
After filling out your signup forms, you may need to deposit cash with the IEM office (319-335-0881).
Your instructor will give you details about any deposits you need to make.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
8
Accessing the IEM
You can access the IEM through its web site address:
http://www.biz.uiowa.edu/iem/
The IEM market has several contracts trading under it. The contracts of interest for our course are the
Federal Reserve Monetary Policy Market (FedPolicy, for short).
You access your trading account from the market pages or directly at:
http://iemweb.biz.uiowa.edu/
Federal Reserve Monetary Policy Market
The Federal Reserve Monetary Policy Contracts consist of three contracts. After every FOMC meeting,
existing contracts in the series are liquidated and payments are made as described below. Then, new
contracts are created as described below. The schedule of FOMC meetings can be found at the
Federal Reserve System's web site: http://www.bog.frb.fed.us/fomc/.
The Directors of the IEM reserve the right to introduce new contracts to the market as spin-offs of
existing contracts. When a contract spin-off occurs, an original contract will be replaced by new
contracts. This divides the payoff range of the original contract into sub-intervals. No holder of the prespin-off contracts will be adversely affected. Traders will receive the same number of each of the new
contracts as they held in the original. The sum of the liquidation values of the new contracts will equal
the liquidation value that would be paid to the original in the absence of a spin-off. Decisions to spin-off
a contract will be announced at least two days in advance of the spin-off. The new contract names, the
specifications regarding liquidation values and the timing of the spin-off will be included in the
announcement. This announcement will appear as a News Bulletin on the WebEx login screen.
Liquidation values will be set according to the contract descriptions. For example, if, at the close of the
regularly scheduled FOMC meeting in month MMYY, the FOMC announces a decision to raise the
target for the federal-funds rate, then each FRupMMYY contract held by a trader will be redeemed for
$1.00, while the FRsameMMYY and FRdownMMYY contracts will expire with a $0.00 redemption
value.
Note that liquidation values will depend solely on decisions made at the specific regularly scheduled
FOMC meeting to change or not change the federal-funds rate target from its level as of the start of that
same meeting. Neither changes in the federal-funds rate target made during the inter-meeting period
nor decisions regarding other monetary policy issues or instruments will have any direct bearing on
those liquidation values.
Contracts will be designated by a symbol and letter denoting up, down, or the same and the month and
year of contract liquidation. Thus, the contracts traded in this market for liquidation in month “MM” and
year “YY” are:
Code
FRupMMYY
FRsameMMYY
FRdownMMYY
Contract Description / Liquidation Value
$1.00 if the fed-funds rate target rises; $0 otherwise
$1.00 if the fed-funds rate target remains unchanged; $0 otherwise
$1.00 if the fed-funds rate target falls; $0 otherwise
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
9
The practice of the FOMC, initiated at the May 18, 1999 meeting, has been to release a public
announcement shortly after each regular meeting describing the funds rate target decision. (See
http://www.bog.frb.fed.us/boarddocs/press/General/1999/.) So long as that practice continues, this
public announcement will be the official source of FOMC policy decisions for purposes of determining
liquidation values. If no such statement is released by the FOMC, the Wall Street Journal will become
the official source. Specifically, the most definitive statement of FOMC actions appearing in the three
consecutive issues of the WSJ (Central Edition) after the close of the FOMC meeting will be taken as
the policy decision. If the decision of the FOMC remains unclear even after three consecutive WSJ
issues, the outcome "fed-funds rate target remains unchanged" will be declared the result for purposes
of determining liquidation values. The judgment of the IEM Board of Governors will be final in resolving
questions regarding the nature of the FOMC decision, including questions arising from typographical or
clerical errors.
Trading in a set of contracts will continue for as much as two days beyond the end of the meeting on
which those contracts are based. If an official announcement of the FOMC decision is made at the end
of the meeting or within two days thereafter, the market will close and contracts will be liquidated as
soon as is possible after the appearance of that announcement. If no official announcement has been
made by 5:00 PM CST on the second business day after the end of the meeting, the market will close
to further trading at that time. The following business day a decision regarding liquidation values will be
made by the Board of Governors of the IEM based on reports appearing in the WSJ, with liquidations
occurring shortly thereafter.
Trading on the IEM
You can trade on the IEM in several ways. First, you can buy or sell unit portfolios (i.e., bundles). A
unit portfolio is a set of bundles, consisting of one of each of the three contracts (FRupMMYY,
FRsameMMYY, and FRdownMMYY) associated with each FOMC meeting, can be purchased from or
sold to the IEM system at any time at the price of $1.00 per bundle. Note that, regardless of the
announced FOMC policy decision, the liquidation values of the three contracts in a bundle will total
$1.00, the same as the price at which the bundles can be bought or sold. The bundles will be
designated FR1$MMYY, where the suffix MMYY identifies the month of the FOMC meeting. To buy
and sell bundles, select the FR1$MMYY bundle from the "Market Order" drop down menu on the
market trading screen.
Second, you can buy or sell using a "market order." On the market screen, you will see that some
individuals have posted an order to buy or to sell a contract (e.g., FRupMMYY, the contract for
liquidation in the Federal Reserve Monetary Policy) at a specific price. If you believe that a posted
order represents a good deal, you can buy or sell at the posted price. (To do this, select the
appropriate contract under “Buy at Best Ask” or “Sell at Best Bid” in the “Market Order” drop down
menu. Enter a quantity and press the “Market Order” button.)
Third, you can buy or sell using a "limit order." To do so, you state the price at which you are willing to
buy or sell a contract and post a limit order on the screen. In doing so, you are waiting for someone
who is willing to buy or sell at your stated price. In this manner, when your order executes, it will
execute at your stated price, not at somebody else’s. The negative is that the order may never execute
because nobody likes your price because it is too high or low. (To place a limit order, select the
appropriate contract under “Post a Bid” or “Post an Ask” in the “Limit Order” drop down menu. Enter a
price, quantity and expiration date and press the “Limit Order” button.)
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
10
Completing Your Assignments and Submitting Them
As you can see below, the IEM assignments are extensive, multi-part assignments that draw together
many concepts from the class. It would be wise to work on the various parts of the assignments as we
go over the relevant topics in class. To prepare the assignments for submission, please use the
following guidelines:
1. Each assignment must be typed. Label clearly each assignment with a cover page giving
your name, student number, and section number.
2. Complete each part in a separate section clearly labeling them Part 1, Part 2, etc.
3. Within each section, give the requested information, including sources of information
gathered and equations used to calculate results.
4. Turn in your completed assignment to your instructor on the date it is due.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
11
IEM Assignment
Part 1: Finding and Graphing Federal Funds Rates DUE: ___________
GOAL
In this part of the assignment, you will study current and historical federal funds rates and will graph the
changes of the targeted against actual federal funds rates from
to the present time.
Current Federal Funds Rates
The Current Federal Funds Rate may be found by going to the Federal Reserve System’s web site:
http://www.bog.frb.fed.us or to the Wall Street Journal within three days after each FOMC meeting. If
you use a print source such as the Wall Street Journal, notice that, typically, the decision is printed in
the Central Edition within three days of the FOMC meeting. Note: While you are free to use any
source, the contracts are liquidated based on FOMC public announcements and the Wall Street
Journal.
Historical Federal Funds Rates
Download the historical target Federal Funds Rate data from the IEM web site at:
http://www.biz.uiowa.edu/iem/markets/fedfundfund.html
You will use these data in later parts of this exercise.
Download 5 years of the actual Federal Funds Rate data from the Federal Reserve Board’s web site as
follows.
Go to http://www.bog.frb.fed.us/releases/H15/data/d/fedfund.txt
Save this data in Excel for later use.
Graph the Actual and Targeted Federal Funds Rates on an X-Y graph for comparison. For each of the
dates when the Fed changes the target rate, enter two observations, one with the old target rate and
one with the new target rate. To do this, insert a row before each date when the target rate changes.
Then, copy the date up into this row to show the date of the change. Then, copy the old target rate
down from the previous row. (For example, the Fed changed the rate from 5.5% to 6% on February
1,1999, so you should have two rows for February 1, 1999: the first one with the 5.5% rate and the
second one with the 6% rate. This should lead to a graph in which the rates stay flat between meetings
when the Fed changes the rate. You do not need to follow this procedure when graphing the daily
actual rates, just when you are graphing the target rates.)
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
12
Returns to IEM Contracts
Conduct at least one trade in the FedPolicy market between the ________ and ________. Report the
date of the trade, the contract traded and the price. Attach a printout showing your trading activity.
(You can either submit a “Processed Orders” report or an ‘Order History” report. To get the first report,
make sure that the “confirm” box is checked on the trading screen. You will be asked to “execute” the
order. Upon execution, the “Processed Orders” report will appear. To get the second report, go to “My
Account Information” select “view order history” and print the resulting report.)
Based on the date of your trade, what are the holding periods (in days) to the contract buyer if each
contract is held to its liquidation date?
Calculate and report the return over this holding period to the contract buyer if the contract liquidates for
$1.
Also calculate and report the return over the holding period to the contract buyer if the contract
liquidates for $0.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
13
Assignment 2
Using Unemployment Data to Analyze Monetary Policy DUE: ________
Procedure
In this assignment, search for U.S. unemployment and the civilian labor force data by using
the Bureau of Labor Statistics’ web site http://www.bls.gov . Download the data into Excel.
Explain how the Federal Reserve System uses the unemployment rate to make decisions
on monetary policy.
Historical Analysis of BLS Unemployment Rates
Use the monthly BLS statistics downloaded in part one for this part of the assignment. Analyze these
data by reporting the following information (all numbers can be computed in Excel):
1. Report the historical average monthly unemployment data and discuss how the
unemployment rate has changed since 1948.
2. Report the historical average monthly unemployment rate data and graph it against the actual
Federal Funds Rate data obtained in Assignment 1, which was obtained from
http://www.bog.frb.fed.us/releases/H15/data/d/fedfund.txt
3. Graph and compare the fluctuations in the unemployment data with the actual federal funds
rates.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
14
Test Questions:
I.
Essay Questions:
a. What is the Fed? Why does it appear to have such a great influence on the
economy?
b. What are the four tools to achieve monetary policy?
c. How does an increase in the Federal Funds Rate indicate a tighter monetary
policy?
d. How does your experience with the FedPolicy Market help you understand the
impact of economic conditions (inflation, unemployment and stock prices) on the
fluctuations and the volatility of the financial markets?
e. Discuss whether an adverse aggregate supply shock can cause inflation.
f. The economy has just experienced an n increase in aggregate demand. What
should the Fed do?
g. The economy has just experienced an n decrease in aggregate demand. What
should the Fed do?
h. Will the Fed have less power to affect the economy in the future?
i. Is a financial crisis more likely to occur when the economy is experiencing
inflation or deflation?
j. What are the goals of monetary policy?
Answers:
a. What is the Fed? Why does it appear to have such a great influence on the
economy?
The Fed is the central bank of the nation and it has a significant power due to
its function of implementing monetary policy. The Fed can change the
amount of liquidity in the financial system. By changing the interest rate, it can
change the amount of investment expenditures by businesses and the
consumption of consumers. These changes impact the amount of real GDP
and the price level in the economy.
b. What are the four tools to achieve monetary policy?
When the Fed sells securities (Open Market Operations), it takes reserves
(liquidity) out of the system and hence with fewer reserves in the banks,
fewer loans will be made. When the Fed decreases the Discount Rate, the
member banks can borrow more reserves from the Fed and hence can
increase credit to their customers. If the Fed increases the Required
Reserve Ratio, the banks are required to set aside more required reserves
and have less money to lend. The change in the Federal Funds Rate as a
short-term interest rate is important in changing the ability of banks to borrow
on a short-term basis.
c. How does an increase in the Federal Funds Rate indicate a tighter
monetary policy?
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
15
d.
e.
f.
g.
An increase in the targeted Federal Funds Rate is a sign of the decision of
the Fed to tighten the money supply. This is because many banks borrow
reserves from the Federal Funds Market on a short-term basis to enhance
their ability to provide more credit on a continuous basis to businesses.
How does your experience with the FedPolicy market help you
understand the impact of economic conditions (inflation, unemployment
and stock prices) on the fluctuations and the volatility of the financial
markets?
Comparing the Federal Funds Rate, Inflation Rate, and Unemployment
data over some period of time, one can observe that higher Federal Funds
Rates are established to either slow down the rate of the inflation or to
ease the tightness in the labor market. One of the assignments of this
class required the comparison of historical data on the unemployment rate
and the Federal Funds Rate.
Discuss whether an adverse aggregate supply shock can cause inflation?
An adverse supply shock causes real output and employment to fall while
prices will rise, an accommodating policy will reduce the recession but may
aggravate the inflation. Cost-push inflation may result when the general
price level rises due to increases in the prices of inputs.
The economy has just experienced an increase in aggregate demand.
What should the Fed do?
An increase in aggregate demand may create demand-pull inflation and
increase in output beyond the natural level. The Fed may follow a laissezfaire policy and let the economy return to long-run equilibrium at higher
prices and the natural level of output. The Fed may also implement a
contractionary monetary policy to control increases in the price level.
Raising the Federal Funds Rate does this.
The economy has just experienced a decrease in aggregate demand.
What should the Fed do?
A decrease in aggregate demand may create unintended increases in
inventories. Businesses may cut production, employment, and prices,
which may lead to a recession. The Fed response depends on its current
policy objectives. It may choose to do nothing, in which case price
expectations will decrease, the price level will decrease, and the short-run
aggregate supply curve will shift to the right. Long-run equilibrium will be
achieved at the full employment output level and a lower price level. On
the other hand, if the Fed responds by expansionary monetary policy,
aggregate demand will shift to the right and the economy will return to its
pre-recession equilibrium.
h. Will the Fed have less power to affect the economy in the future?
If the share of intermediation by the banking system decreases, then the
control over the banks declines. Also global economic forces may become
stronger and hence, the Fed’s power may decline in the future.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
16
i. Is a financial crisis more likely to occur when the economy is
experiencing inflation or deflation?
Financial crisis is defined as a critical reversal in the financial markets
reflected by sharp declines in asset prices and the default of business
firms in their financial obligations. In periods of inflation, financial crisis
could result in the Fed raising interest rates and thus restricting business
output; individuals may become less creditworthy thus bringing more risky
borrowers into the credit markets. In periods of deflation, consumers and
businesses alike would have difficulty meeting their financial obligations. If
one party defaults, this often sets off a chain reaction. The drop in
incomes, high rate of unemployment, increases in inventories, and layoffs
can also exacerbate the problem. Unanticipated declines in the overall
level of prices can intensify the risk of a financial crisis.
j. What are the goals of monetary policy?
Price stability, full employment, and satisfactory balance of payments are
the short-term goals of monetary policy. Sustainable economic growth is
the long-term goal of monetary policy.
FALL 2000 EDITION LAST EDITED ON 9/00
WWW.BIZ.UIOWA.EDU/IEM/ASSIGNMENTS
17