Macro Economics Chapter 30

If m=0.20 by how much can the money supply expand?

$100 million x (1/0.20) = $500 million

But not always During financial crisis lending went from

$250 million (Aug 2007) to $735 billion (Nov 2008) Now lending back down to pre-crisis levels

Board of Governors

(7 members) Appointed by U.S. President with the advice and consent of the Senate 14-year term Chairperson serves 4-year term: Janet Yellen

Origins and structure of the Fed

1873-1907: four severe banking panics 12 central (regional) banks technically a corporation Stockholder: member banks Most profits turned over to U.S. Treasury

Monetary Policy

Actions that the Federal reserve system takes to change interest rates and the money supply Aim is to affect the economy: GDP, employment, inflation

Money

At one point in time: how much is in your wallet

If Fed increase reserve requirements

Banks have less excess reserves Money contraction and higher interest rates

If Fed decreases reserve requirements

Banks have more excess reserves Money expansion and lower interest rates

Central Bank Independence

Central banks's ability to make decisions without political interference

How a financial crisis can lead to a recession 3

Downward multiplier process pulls entire economy down Worse prospects for loan repayments pushing risk premiums even higher The vicious cycle continues

Federal Open Market Committee

FOMC 12 members 7 governors of the Fed Presidents of the New York Fed 4 (of 11) district banks presidents Short-term interest rates and size of money supply

Which interest rate move?

Fed "controls" Federal funds rate and the Treasury bills rate Fed can "influence" other interest rates: credit cards, auto loans, mortgage rates etc. Normally, interest rates tend to move together During financial crisis relationship broke down

Lending to bank

Fed acts as "lender of last resort" Fed lends to banks at the discount rate Provides banks with excess reserves

Normal expansionary monetary policy may not work

Fed resorts to unconventional policies

Contractionary policy

Fed wants money supply to decrease; interest rates to rise, so they make an open market sale. Banks excess reserves will decrease, so the money supply contracts. By selling bonds, the Fed causes the prices of bonds to decrease so interest rates increase.

Putting it all together: Expansionary policy

Fed wants money supply to increase; interest rates to fall, so they make an open market purchase. Banks excess reserves will increase, so the money supply expands. By buying bonds, the Fed causes the prices of bonds to increase so interest rates decrease.

Interest rate of market for bank reserves

Federal Funds Rate

Normal times

Federal funds rate is not hovering close to zero Risk spreads are roughly constant Different interest rates rise and fall together Banks are not holding as many excess reserves

Bond prices and interest rates

Higher bond prices will cause interest rates to fall Bonds pay fixed number of dollars per year Bond that sells for $1000 with $60 payment (6% interest rate) If price of bond rises to $1,200 (5% interest rate) Higher (lower) bond prices mean lower (higher) interest rates

Why make the distinction?

How does the Federal Reserve create money How interest rates influence the rate at which people can earn income

Changing reserve requirements

If Fed decreases (banks have more excess reserves Money expansion and lower interest rates) If Fed increase (Banks have less excess reserves Money contraction and higher interest rates) 10% of transaction deposits since 1992

Opponents of Central Bank Independence

Independence is undemocratic Why let a small group of bankers sand economists make decisions that affect everyone

Proponents for Central bank independence

Independence keeps politics out Fed can take longer ter view Maintain low and stable inflaiton

The Fed

Independent fro the rest of government Sole responsibility for monetary policy

Risk of default 2

Interest rate on a bond= risk free rate + risk premium Risk Spread = Interest rate on a bond - risk free rate Risk spreads widen (narrow) if investors believe there is a greater (smaller) risk of default

Federal Funds rate

Interest rates that applies when banks borrow reserves from one another

How do interest rates influence spending? Y=C+I+G+(X-IM)

Investment and Net exports sensitive to interest rates When interest rates rise (fall), investment spending falls (rises) So expenditure falls (rises)

Fed can influence the amount banks borrow by changing the discount rate

Lower (higher) discount rate gives banks a greater (smaller) incentive to borrow But Fed cannot really know how much banks will respond Connection between discount rate and volume of borrowing loose Fed normally relies on open market operations rather than discount rate (other central banks do)

The Fed, 2007

Massive amounts of lending to banks Helped keep the financial system functioning Eased the panic for a time

During the financial crisis risk spreads widended

Mortgages, bonds of large banks - looked far riskier than they had before Higher risk premiums, increasing risky interest rates Increased demand of U.S. T-bills - "flight to safety" Higher t-bill price, lower t-bill interest rate

What happens to the price level when the Fed pursues and expansionary policy?

Normally, it will cause the price level to increase How much it causes will depend on the slope of the aggregate supply curve

Expansionary monetary policy

Open-market purchase of T-bills lowers interest rates

Quantitative easing

Open-market purchases of assets other than Treasury bills Treasury bonds [longer dated] Other assets- in 2008 and 2009, to stabilize the mortgage market

Contractionary monetary policy

Open-market sale of T-bills raises interest rates

Income

Over a period of time: how much you earn per hour/year

The actual money supply will increase by less than $500 million

Public holds no more cash Banks may hold on to some excess reserves

How the Fed lowers the federal funds rate

Purchase T-Bills provides additional reserves to market Supply of reserves will shift out increasing bank reserves and decreasing the federal funds rate

What does FOMCc do if it wants to lower interest rates

Purchases Treasury bills (T-Bills from banks Pays for them with newly created bank reserves

Fed believes economy might slip into recession

Pursue an expansionary monetary policy

How a financial crisis can lead to a recession 2

Result: financial market distress Risk premiums rise far above their "normal" levels Interest rates on risky securities are rising Guide household and business decisions Spending on the interest-sensitive components of aggregate demand falls

What if the Fed wants to decrease the money supply and increase interest rates?

Sell T-Bills taking reserves out of the banking system

Why is there a reserve market?

Some banks may be short of reserves so would be borrow Some banks may have excess reserves so would lend Important since allows reserves to flow where needed

How a financial crisis can lead to a recession

Something goes wrong in the financial markets: loss of confidence in some financial assets Failure of a major financial institution (e.g., Lehman Brothers in 2008) Stock market crash (as in 2000) Collapse of real estate prices (as after 2006)

Market for bank reserves

Supply of reserves determined by Federal Reserve policy Demand for reserves determined Banks since they are required to hold reserves Required reserves = m x D (transaction deposits) But the demand for D depends on the volume of transactions Which depends on real GDP and the price level

Mechanics of an open market operation

Suppose Fed buys $100 million of T-bills from commercial banks After the purchase, banks have $100 million of excess reserves

Open-market opoerations

The Fed's purchase or sale of government securities (Treasury bills) through transactions in the open market

Mechanics of an open market operation 2

The actual money supply will increase by less than $500 million

At higher price level

The quantity of bank reserves demanded is higher Holding the supply of reserves fixed, this will lead to higher interest rates Therefore, aggregate demand is lower: negative slope

Risk of Default

The risk that the borrower may not be able to pay in full or on time T-bills are risk free Bank to bank borrowing, federal funds rate, very low risk corporate bonds carry more risk Riskier borrowers pay higher interest rates, to persuade lenders to accept the higher risk

Unconventional monetary policy

Unusual forms (or volumes) of central bank lending and to unusual types of open-market operations (Pushing the federal funds rate down to virtually zero Lending to banks in unprecedented volume Lending to some companies that are not banks Quantitative easing)

What does the Fed do when the federal funds rate is zero and the economy still needs more stimulus?

Use unconventional monetary policies Financial crisis Massive lending to banks and non-financial firms Purchase of assets other than Treasury bills: longer term Treasury bonds and mortgage backed securities Prices up and interest rates down

Central bank

a bank for banks

Higher (lower) bond prices mean lower (higher)

interest rates