Federal Reserve

1
Federal Reserve

• Tools and Targets

2
Open Market Operations

• Types
• Dynamic
• Designed to change base
• Defensive
• Meant to offset other factors affecting base
• Purpose
• Change the monetary base.

3
Open Market Operations

• Advantages
• Controlled by the Fed
• Flexible and precise
• Easily reversed
• Implemented quickly

4
Discount Loans

• Purpose
• Influence reserves in the banking system
• Lender of Last Resort
• Prevent bank panics
• Prevent non-bank financial panics

5
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.

6
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.

7
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.

8
Changes to the Discount Window
Feature Previous System Primary Credit Rate
Fed funds rate less Fed funds rate plus
25-50 basis points 100 basis points Term
Overnight Overnight Eligibility
Subjective Sound banks only Administration
Evaluated for Minimal, appropriateness Mark
et based Use of funds Cant resell No
restrictions
9
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.

10
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.

11
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.

12
Targets
13
Monetary Policy Goals

• The goals of monetary policy are
• High employment
• Economic growth
• Price stability
• Interest rate stability
• Financial markets stability
• Exchange rate stability

14
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.

15
Targets

• Intermediate Targets
• Monetary aggregates such as M1and M2
• Interest rates
• Operating Targets
• Reserve aggregates such as reserves, non-borrowed
  reserves, monetary base, non-borrowed base.
• Interest rates such as the federal funds rate or
  the Treasury bill rate.

16
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.

17
Money Demand
At high rates of interest, people hold interest
bearing assets so money demand is low. At low
rates of interest, people hold fewer interest
bearing assets so money demand is higher.
i
ih
il
Money Demand
0
Money
MD low MDhigh
18
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
19
Targeting the Money Supply
Money Supply
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.
i
i3
i2
MD3
i1
MD2
MD1
0
Money
20
Targeting Interest Rates
MS2
MS1
MSs3
Let money demand fluctuate between MD1 and MD3,
causing interest rates to fluctuate between i1
and i3. To set interest at i, money supply
must fluctuate between MS1 and MS3. Targeting
interest rates leads to loss of control over the
money supply.
i
i
MD3
MD2
MD1
0
Money
21
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.

22
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.

23
Target Criteria

• Controllability
• Intermediate Targets
• The Feds 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.

24
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.

25
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.

26
Lags

• Data lag
• Time to obtain information
• Recognition lag
• Time to understand the information
• Legislative lag
• Time to decide on policy

27
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.