Ch03 The Fed and Interest Rates.docx

CHAPTER 3 THE FED AND INTEREST RATES CHAPTER OVERVIEW AND LEARNING OBJECTIVES This chapter explains how and why the Fed influences the money supply and interest rates. Monetary policy and the economy are linked. Changes in monetary policy first impact the financial sector. Then consumers and businesses in the real sector react to perceived changes in the costs and benefits of borrowing, spending, saving, or investing. Study the linkages carefully, especially Exhibit 3-8 in the text. Reason through the effects of a given change in monetary policy. Start with the “tools” and work through the financial variables: the monetary base, money supply, and interest rates. Consider how a business or household might reasonably react. Then consider how the same reaction across many businesses and households would change economic outcomes in the real sector. For example, if businesses are not investing in new plant or equipment, how does that affect the economy? Foundations for understanding this chapter include the main accounts on the Fed's balance sheet and the tools of monetary policy, covered in the last chapter. You may also find it helpful to review Chapter 1 on the basics of financial markets and instruments. Chapter 3 may take several readings, outlines, and plenty of ink in the margins. But a basic understanding of the Fed’s role in the financial system is crucial. CAREER PLANNING NOTE: BUSINESS CYCLES, CAPITALISM, AND YOU As you consider the historical material in these chapters on the Fed, reflect on the recurring cycles in economic activity: boom and bust, bull and bear, advance and retreat, try and fail, try and succeed, try again. Modern central banks were created in large part to smooth out business cycles. Not to eliminate them—that is probably impossible, and may not even be desirable—but to make them more manageable. The story of central banking is, to a great extent, the story capitalism’s adaptation to business cycles. The lessons of history are important. Business cycles teach us that what is past truly is prologue, as the saying goes. As you move into and through the workplace, pay attention to the world around you. Know where you are in the business cycle, and time important career and financial decisions accordingly. Learn from the successes of those who came before you, but learn from their mistakes as well. And above all, persevere. That’s the essence of capitalism, and of capitalists. THE WALL STREET JOURNAL ONLINE If you have subscribed to the Journal you also have access to the online version. When you receive your bill, you will receive a card with a link to set up your online account. Using the mail label from your paper edition, establish your password online. When finally in, set up your personal opening page. You can specify industries, companies, and personalities in which you are interested, and search extensive and well-organized archives. TOPIC OUTLINE AND KEY TERMS I. How the Fed measures and manages the money supply. The monetary base and the money supply are not the same thing. 1. The monetary base chiefly comprises the Fed’s 2 largest liabilities: a. Federal Reserve Notes in circulation, and b. Deposits of financial institutions with the Fed (e.g. reserves). The money supply has some elements in common with the monetary base but involves the Monetary Aggregates: M1 = currency, coin and travelers checks in circulation + demand checking deposits or checking accounts + “NOW” accounts and similar interest-on-checking accounts M2 = M1 + savings deposits and money market deposit accounts + overnight repurchase agreements + Eurodollars + noninstitutional or “retail” money market mutual funds + small time deposits (under $100,000) B. The Fed substantially controls the money supply by exclusively controlling the monetary base. 1. Depository institutions must transact with the Fed in monetary base assets by either— a. depositing adequate reserves at the FRB for their district or b. maintaining adequate quantities of Federal Reserve Notes in their vaults. 2. Either way, reserves earn no interest. The more cash or reserves an institution holds above requirements, the more it wants to avoid lost interest income. a. Ideally, an institution might try to maintain “zero excess reserves” but b. Practically, some excess reserves are necessary for— (1) clearing checks and other payment items and (2) settling any other transactions with the Fed. Excess reserves appear as the Fed— a. buys securities on open market (the most frequent method), b. lends at Discount Window, or c. lowers reserve requirements. As depository institutions lend or invest excess reserves, M1 increases. a. New loans or investments increase M1 and finance purchases in the real sector. b. By expanding or contracting monetary base, the Fed— (1) increases or decreases excess reserves, thus (2) raising or lowering incentive to lend or invest, thus (3) encouraging or discouraging expansion in real sector. II. How the Fed influences interest rates. A. The Fed targets but does not set the Fed Funds Rate 1. The Fed Funds Market: a. a Fed-sponsored system in which b. depository institutions lend and borrow excess reserves among themselves. The Fed Funds Rate: a. Set by market forces as institutions bargain with each other. b. A benchmark rate in the financial system, measuring— (1) return on bank reserves (most liquid of all assets); (2) availability of reserves to finance credit demand; (3) intent and effect of monetary policy. B. As the Fed adjusts tools of monetary policy, reserve effects influence the Fed Funds Rate significantly in the short run. Open Market Operations: a. Buying pressures FFR downward by increasing supply of excess reserves. b. Selling pressures FFR upward by decreasing supply of excess reserves. c. Reserve effects are direct, immediate, dollar-for-dollar. Discount Rate: a. Cutting discount rate pressures FFR downward: (1) Discount Window becomes less costly relative to Fed Funds (2) Institutions re-evaluate costs and benefits of “going to The Window” b. Raising discount rate pressures FFR upward. (1) Fed Funds become less costly relative to Discount Window. (2) Institutions resist “Window scrutiny”. c. Reserve effects depend on— (1) sensitivity of institutions to “Window scrutiny” and (2) differential between Discount Rate & FFR . Reserve Requirements: a. Cutting RR pulls FFR downward by increasing supply of excess reserves. b. Raising RR pushes FFR upward by decreasing supply of excess reserves. c. Reserve effects are direct, sustained, and too dramatic for “fine tuning”. C. The Fed cannot set the Fed Funds Rate in the long run. 1. Ultimately, factors in the real sector determine credit demand: the Fed cannot artificially sustain the FFR at a level too low or too high. a. If borrowing costs are too low— (1) M1 may grow too rapidly and (2) Real investment decisions may be distorted (e.g., borrowing may just finance hoarding of assets). b. If Borrowing costs are too high— (1) M1 may not “keep up with” the real sector and (2) The economy may falter as real investment declines. The best the Fed can ultimately do is try to promote stable price levels. III. Why central banks manipulate reserves or rates: 2 schools of thought A. Monetarists believe the key financial variable for changing economic activity is the money supply. 1. Monetarists assume that the propensity to consume— a. Rises as people perceive they have “more money”; b. Drops as people perceive they have “less money”; c. Is distorted by volatility in prices. Thus the money supply can be used to influence aggregate demand. a. Adding reserves carefully should promote economic growth b. Subtracting reserves carefully should slow the economy c. A central bank can distort price levels by over-adjusting either way. 3. To monetarists, short-term interest rates merely indicate monetary policy’s effects. B. Keynesians believe the key financial variable is interest rates. John Maynard Keynes was an influential British economist of the 1930s. Keynesians discount or disregard direct money supply effects Thus real sector economic growth is— a. Stimulated by falling rates as economic activity costs less to finance; b. Slowed by rising rates as economic activity costs more to finance; c. Always and significantly susceptible to influence of monetary policy (except in the rare case of a “liquidity trap”—see pp. 65 of text). To Keynesians, money supply changes reflect reactions to interest rates IV. Monetary Policy: Goals, transmission, complications. Six basic goals of monetary policy, set by the Humphrey-Hawkins Act of 1978. 1. Full Employment. a. Some unemployment is probably inevitable. (1) “Frictional unemployment” occurs as workers transition between jobs. (2) “Structural unemployment” occurs as skills fall out of demand. b. Does full employment risk inflation? (1) No conclusive evidence. (2) This assumption is probably more political than economic. c. The Fed tries to maintain financial conditions under which employers can plan beyond the short term. Economic growth. a. Increases in GDP translate to rising standard of living, at least in the aggregate. b. The Fed is interested in stable growth—smoothing out the business cycle. 3. Price stability (this really means price index stability). a. Inflation and deflation are equally problematic. (1) Inflation is a loss in purchasing power associated with a continuous increase in general price levels. (2) Deflation is a general decline in real asset values. b. The Fed tries to adjust money supply proportionately to economic activity. 4. Interest rate stability. a. Large interest rate fluctuations seriously complicate financial planning. b. The Fed tries to change monetary policy incrementally, not dramatically. 5. Stability of the financial system. a. Disruptions in the financial system inhibit the public’s willingness to take the financial risks on which economic growth and social progress depend. b. The Fed is a credible lender of last resort. c. The Fed is a principal regulator of the financial system. 6. Stable foreign exchange markets. a. Any major U.S. firm’s profitability is affected by currency fluctuations. b. The Fed coordinates closely with other central banks to stabilize the dollar against other major world currencies. Three channels of the transmission process for monetary policy. 1. Business investment in real assets. a. Present values of future cash flows depend significantly on interest rates. (1) As rates fall, PVFCF rises. i. Projects already in place become more valuable. ii. Projects under consideration become more attractive. (2) As rates rise, PVFCF drops. i. Projects already in place lose value. ii. New projects become less likely. b. Most capital expenditures are debt-financed; thus interest expense is material in the marginal profitability and financial planning of most businesses. (1) As rates fall, attractive projects cost less to finance. (2) As rates rise, projects already less attractive cost more to finance. c. Monetary policy thus involves material incentives or disincentives for business investment. The Fed can manipulate incentives, but not compel results. 2. Consumer spending for durable goods & housing. Much consumer spending is on credit, so it tends to vary directly with credit conditions. (1) Falling interest rates tend to encourage spending. i. Saving becomes less attractive because of lower returns. ii. Fixed-rate financial assets rise in value, creating a “wealth effect”. iii. “Big ticket” items cost less to finance. (2) Rising interest rates tend to discourage spending. i. Saving becomes more attractive because of higher returns. ii. Fixed-rate assets lose value, reversing the “wealth effect”. iii. “Big ticket” items cost less to finance. b. Monetary policy can thus often affect aggregate demand, but consumers don’t necessarily make financial decisions the way businesses do— (1) Businesses are mostly rational and profit-maximizing. (2) Consumers are partly rational and partly emotional. 3. Net exports (gross exports minus gross imports). a. Interest rates affect exchange rates. (1) Falling interest rates in a country tend to “weaken” its currency. (2) Rising interest rates in a country tend to “strengthen” its currency. b. Exchange rates affect imports and exports. (1) As domestic currency weakens— i. Domestic demand for imports drops as they become more costly. ii. Foreign demand for exports rises as they become less costly. (2) As domestic currency strengthens— i. Domestic demand for imports rises as they become less costly. ii. Foreign demand for exports drops as they become more costly c. Monetary policy thus usually affects net exports. The Fed can weaken or strengthen the dollar, for reasons related or unrelated to export effects. C. Complications of monetary policy: controlling the money supply is not easy. 1. Technical factors demand constant adjustment. a. Cash Drains. (1) Cash holdings by the public “use up” the monetary base. (2) The Fed offsets drains with carefully calibrated open market purchases. b. The float. (1) DACI – CIPC = Float, a net extension of credit by the Fed. (2) The Fed offsets the float with carefully calibrated open market sales. c. U.S. Treasury deposits. (1) Treasury payments cause large shifts in reserves. (2) The Fed and the Treasury try to coordinate any large fluctuations. 2. The velocity of money is difficult to predict a. The velocity of money is the ratio of gross domestic product to money supply (i.e., the turnover rate of a unit of money in the economy). b. For given change in money supply, Fed— (1) can expect the general direction of change in the economy but (2) cannot ensure a particular degree of change in the economy. COMPLETION QUESTIONS 1. The “tools” of monetary policy are ________________________________________________ , ____________________________________ , and ___________________________________ . 2. Open market sales by the Fed (increase/decrease) excess reserves, (increase/decrease) the Fed Funds Rate, and (increase/decrease) the monetary base. 3. (Raising/Lowering) the Discount Rate may signal an attempt to stimulate economic growth. 4. The Fed would (ease/tighten) monetary policy to stimulate a faltering economy by (buying/selling) securities on the open market, thus pressuring money market security prices (upward/downward) and short-term interest rates (upward/downward). 5. Increasing the money supply increases the (supply/demand) of loanable funds and (increases/decreases) the level of interest rates. 6. Monetary policy begins in the __________ sector with the intent to influence the _____ sector. 7. For a permanent structural increase in excess reserves, the Fed would (raise/lower) reserve requirements. 8. Over the years control of monetary policy has shifted from the ________ ________ ______ to the _______ ___ __________ . 9. There are ____ Federal Reserve Banks, ____ Governors appointed to ____-year terms, and ____ voting members of the FOMC. 10. The _______ establishes the Fed Funds rate; the ________ sets the Discount Rate. TRUE/FALSE QUESTIONS T F 1. When a bank orders Federal Reserve notes from the Fed, the monetary base increases. T F 2. An increase in Federal Reserve float increases the monetary base. T F 3. Cash drains decrease the monetary base, but not the money supply. T F 4. The Fed exclusively controls the money supply. T F 5. Increasing interest rates will increase financial wealth. T F 6. Interest rates and the money supply tend to vary inversely, at least in the short term. T F 7. Investment is inversely related to interest rates. T F 8. Monetary policy first affects financial markets and institutions, then the real economy. T F 9. Transaction deposits, such as DDAs, expand when the Fed sells securities. T F 10. When the Fed increases the Fed Funds Rate, financial institutions “go to the Window”. MULTIPLE-CHOICE QUESTIONS 1. Which of the following powers or tools of the Fed impacts the monetary base most significantly? a. discount rate b. Reg Q c. open market operations d. Bank examination 2. The monetary base excludes which Fed balance sheet items? a. U.S. Treasury securities b. “Agency” securities” c. “DACI” d. all of the above 3. M2 includes a. currency in circulation b. demand deposits c. both of the above d. none of the above 4. Which of the following is not a channel of transmission of monetary policy? a. Reg Q interest rate ceilings b. consumer spending for durable goods and housing c. net exports d. business investment in real assets 5. “Easing” monetary policy would have what impact on the value of the dollar against other currencies? a. increase b. decrease c. no effect d. none of the above 6. The “tools” of monetary policy, whether “viable” or not, include all the following except a. changing the discount rate. b. open market operations. c. changes in reserve requirements. d. changes in the Federal Funds rate. 7. Which of the following would most likely decrease the Federal Funds rate? a. decrease in the discount rate. b. sale of securities by the Fed. c. decrease in reserve requirements. d. none of the above 8. Which of the following was not a responsibility of the early Federal Reserve System? a. replace the National Banking system b. improve the payments system c. establish more rigorous bank supervision d. act as “lender of last resort” 9. Consumption spending should tend to increase if a. financial wealth decreases. b. reserve requirements decrease. c. interest rates increase. d. credit availability decreases. 10. Monetarists and Keynesians agree that a. monetary policy influences the real sector b. changes in the money supply drive changes in interest rates c. changes in interest rates drive changes in the money supply d. monetary policy does not influence the real sector SUPPLEMENTARY ASSIGNMENTS The Board of Governors and the Federal Reserve Banks publish extensive material on banking, the financial system, and the economy. Each Federal Reserve Bank has a monthly economic review, presenting current staff research. Visit the web site of the your region’s FRB and request a list of publications. Board publications are listed at the back of each Federal Reserve Bulletin. FOMC actions are published in the Bulletin 90 days after meetings. From a recent Bulletin or at the Board’s web site, find the "Record of Policy Actions of the FOMC" or the semiannual "Monetary Policy Reports to Congress". If you are interested in a particular period in the past, look up reports in the bound volumes of the Bulletin or the Annual Report, Board of Governors of the Federal Reserve System. SOLUTIONS TO COMPLETION QUESTIONS 1. open market operations; discount rate; reserve requirements 2. decrease; increase; decrease 3. Lowering 4. ease; buying; upward; downward 5. supply; decreases 6. financial; real 7. lower 8. Federal Reserve Banks; Board of Governors 9. 12; 7; 14; 12 10. market; Fed SOLUTIONS TO TRUE/FALSE QUESTIONS 1. F Composition of the base changes, but not size. The bank decreased its reserve balances to pay for the Federal Reserve Notes: one component of the monetary base decreased; the other increased. 2. T Float is a net asset to the Fed (CIPC less DACI); increasing it means increasing the monetary base. The Fed will likely offset this “technical factor” with a carefully calibrated open market sale. 3. T Cash drains represent transfer of issued Federal Reserve Notes into the public’s hands through ATM withdrawals, check-cashing, etc. The currency was already part of M1, but is no longer part of the monetary base. The Fed offsets drains with carefully calibrated open market purchases. 4. F This statement is potentially much too absolute, depending on how inclusively the “money supply” is defined. M2 includes large proportions of financial claims arising privately among SSUs, DSUs and financial institutions. Their choices about these transactions are significantly influenced by the Fed, but not exclusively controlled by it. 5. F The direct and immediate effect is to reduce financial wealth as prices of fixed-rate financial assets fall. However, rising interest rates may encourage additional saving, which could lead indirectly and eventually to increased financial wealth. 6. T Interest rates and the money supply vary inversely, at least in the short-term. Which one affects the other depends on which school of thought governs the analysis—monetarist or Keynesian. 7. F Without clarifying what “investment” means, the statement is ambiguous. Business investment in real assets should decline as interest rates rise. However, marginal investment in financial assets paying interest would become more attractive. 8. T The traditional linkage of monetary policy is from financial sector to real sector via interest rates. 9. F When the Fed sells securities, transactional balances decrease as buyers pay the Fed. 10. F The Fed influences but does not set the Fed Funds Rate. Depository institutions, not financial institutions generally, can go to the Window. A rising FFR would lower the perceived disincentive to go to the Window, but the decision would involve other factors, including “Window scrutiny”. SOLUTIONS TO MULTIPLE-CHOICE QUESTIONS 1. c Open market operations change reserves directly, immediately, and dollar-for-dollar. 2. d The monetary base comprises reserve balances and Federal Reserve Notes in circulation. 3. d By definition M2 includes M1, which includes the indicated items. 4. c Reg Q is a nonmonetary power of the Fed, and its rate ceilings were phased out years ago. 5. b Money supply growth may decrease interest rates, lessen capital flow into U.S. money markets (demand for dollar-denominated securities), and thus weaken the dollar against other currencies. 6. d While all the tools listed influence the Fed Funds Rate, it is a market rate, not set by the Fed. 7. c “b” would pressure the FFR upward; “a” would pressure it downward, but not directly. 8. a The National Banking system is still with us, somewhat altered since 1862. 9. b If reserve requirements decrease, more reserves become excess reserves. The new supply of funds pulls interest rates downward. Saving becomes less attractive and “big ticket” items become less costly to buy on credit. 10. a Both are schools of thought about how a central bank should try to influence the real sector.