5 Sept 30
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Transcript of 5 Sept 30
• Open Market Operations (Review)• Money Supply and Money Demand (Review)• Interest Rates• Economic Consequences of Fed Actions• Fed Responses to the Financial Crisis and Great
Recession: Quantitative Easing I, II and III
Monetary Policy
• Expansionary Monetary Policy—actions which increase the money supply
Monetary Policy
• Expansionary Monetary Policy—actions which increase the money supply
• Contractionary Monetary Policy—actions
which decrease the money supply
Tools of the Fed
• Open Market Operations• The Fed Buys or Sells T-Bonds
An Open Market Operation
• The Fed buys a $100,000 T-Bond from a bond dealer, and pays for it by electronic transfer of $100,000 to the bond dealer’s checking account
Fed Buys $100,000 BondBond Trader’s Balance Sheet
Assets (A) Liabilities (L)
T-Bonds −100,000
Deposits +100,000
An Open Market Operation
• The Fed buys a $100,000 T-Bond from a bond dealer, and pays for it by electronic transfer of $100,000 to the bond dealer’s checking account
• Consequently, the bond dealer’s bank’s balance sheet shows a $100,000 increase in reserves
Fed Buys $100,000 BondBank’s Balance Sheet
Assets (A) Liabilities (L)
Reserves +100,000 Deposits +100,000
Fed Buys $100,000 Bond
Δ Total Deposits
= Initial Δ in Reserves1
(R + E)
= $100,0001
(.1 + 0)
= $100,0001
(.1)
= $100,000 × 10
= $1,000,000
Fed Buys $100,000 Bond
Δ Total Deposits
= $1,000,000
Δ Money Supply = Δ Total Deposits
+ Δ Cash held by the public
= $1,000,000 + $0
= $1,000,000
Buying bonds is expansionary monetary policy
An Open Market Operation
• The Fed sells a $100,000 T-Bond to a bond dealer, and the bond dealer pays for the bond by an electronic transfer of $100,000 from their checking account
Fed Sells $100,000 BondBond Trader’s Balance Sheet
Assets (A) Liabilities (L)
T-Bonds +100,000
Deposits −100,000
An Open Market Operation
• The Fed sells a $100,000 T-Bond to a bond dealer, and the bond dealer pays for the bond by an electronic transfer of $100,000 from their checking account
• Consequently, the bond dealer’s bank’s balance sheet shows a $100,000 decrease in reserves
Fed Sells $100,000 BondBank’s Balance Sheet
Assets (A) Liabilities (L)
Reserves −100,000 Deposits −100,000
Fed Sells $100,000 Bond
Δ Total Deposits
= Initial Δ in Reserves1
(R + E)
= −$100,0001
(.1 + 0)
1
(.1)
× 10
= −$1,000,000
= −$100,000
= −$100,000
Fed Sells $100,000 Bond
Δ Total Deposits
= $−1,000,000
Δ Money Supply = Δ Total Deposits
+ Δ Cash held by the public
= −$1,000,000 + $0
= −$1,000,000
Selling bonds is contractionary monetary policy
Tools of the Fed
• Open Market Operations• The Fed Buys or Sells T-Bonds in the SOMA
• Changing the Reserve Requirement
Tools of the Fed
• Open Market Operations• The Fed Buys or Sells T-Bonds
• Changing the Reserve Requirement• Reserve Lending from the “Discount Window”
• Three Programs:• Primary Credit• Secondary Credit• Seasonal Credit
• Role as “Lender of Last Resort”
• Main policy tool: The Discount Rate
Money Supply Curve
MS
i MS
M
Assumptions:
E constant for all banks
No change in cash held by the public
Fed Buys Bonds
MS
i MS
M
MS′
MS′
Fed Sells Bonds
MS
i MS
M
MS
MS
′
′
Money Demand Curve
i
M
MD
Equilibrium in the Money Market
i
M
MD
MS
i*
M*
Equilibrium in the Money MarketWhat if the Fed buys bonds?
i
M
MD
MS
i*
M*
Equilibrium in the Money MarketWhat if the Fed buys bonds?
i
M
MD
MS
i1*
M1*
i2*
M2*
Equilibrium in the Money MarketWhat if the Fed sells bonds?
i
M
MD
MS
i*
M*
Equilibrium in the Money MarketWhat if the Fed sells bonds?
i
M
MD
MS
i2*
M2*
i1*
M1*
Target Fed Funds RateSince Jan. 1, 2005
Effective Fed Funds RateSince Jan. 1, 2005
Target and Effective Fed Funds RateSince Jan. 1, 2005
Target and Effective Fed Funds RateSince Jan. 1, 1985
Why Does the Fed Target i Instead of M?
• i is easier to control than M
Why Does the Fed Target i Instead of M?
• i is easier to control than M• i is more closely related to the economic variables the Fed ultimately cares about, like
• Inflation• Unemployment
Five Interest Rates Since 1980
Real vs. Nominal Interest Rates
• Nominal interest rate = i
• Real interest rate = r
• Inflation rate = π
i = r + π
r = i – π So, if i = 4%, π = 3%, then r = 1%
If forecasting, use πe, expected inflation:
i = r + πe
Bank wants r = 5%, and πe = 3%, sets i at 8%
Finance Jargon:Basis Points (bps)
What is a “basis point”?
A basis point is 1/100 of a percentage point
Advantage:Avoids the ambiguity between relative and absolute discussions about rates. For example, a "1% increase" in a 10% interest rate could mean an increase from 10% to 10.1%, or from 10% to 11%.
10% to 10.1% = 10 basis points10% to 11% = 100 basis points
Economic Consequences of Fed Actions
Fed buys bonds
Economic Consequences of Fed Actions
Fed buys bonds i↓
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Investment ↑
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Investment ↑
Net Exports ↑
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Investment ↑
Net Exports ↑
Aggregate Demand ↑
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Investment ↑
Net Exports ↑
Aggregate Demand ↑
National Income ↑
Economic Consequences of Fed Actions
Fed buys bonds i↓
Consumption ↑
Investment ↑
Net Exports ↑
Aggregate Demand ↑
National Income ↑
Inflation ↑ (sooner or later)
Economic Consequences of Fed Actions
Fed sells bonds
Economic Consequences of Fed Actions
Fed sells bonds i↑
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Investment ↓
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Investment ↓
Net Exports ↓
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Investment ↓
Net Exports ↓
Aggregate Demand ↓
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Investment ↓
Net Exports ↓
Aggregate Demand ↓
National Income ↓
Economic Consequences of Fed Actions
Fed sells bonds i↑
Consumption ↓
Investment ↓
Net Exports ↓
Aggregate Demand ↓
National Income ↓
Inflation ↓ (sooner or later)
Tools of the Fed
• Open Market Operations• The Fed Buys or Sells T-Bonds
• Changing the Reserve Requirement
• Reserve Lending from the “Discount Window”
______________________
New Fed Tools
Called collectively—”Quantitative Easing”
Quantitative Easing
Conventional monetary policy
Central bank uses open market operations—buying and selling short-term government bonds-- or loans from the discount window to bring short-term interest rates (the Fed Funds rate in the U.S.) in line with a target
Quantitative Easing
When short-term interest rates are already at or near zero, the central bank buys other financial assets from financial institutions in order to inject reserves into the system, lower interest rates on longer-term financial instruments, and stimulate the economy.
In order to be effective, banks must be willing to lend their excess reserves.
Recent Quantitative Easing
Japan Early 2000s
Financial Crisis (2007 – 2009)
Eurozone
Britain
U.S.
QE 1 (Nov. 25, 2008 – March 31, 2010)
QE 2 (Nov. 3, 2010 – June 30, 2011)
QE 3 (Announced Sept. 13, 2012)
Recent Quantitative Easing
QE 1 (Nov. 25, 2008 – March 31, 2010)
Fed bought $1.2T in MBS
Fed bought $175B in bonds from Fannie Mae, Ginnie Mae, and Freddie Mac
Impact: Lower mortgage interest rates
Impact of QE1 on Mortgage Rates
Recent Quantitative Easing
QE 1 (Nov. 25, 2008 – March 31, 2010)
Fed bought $1.2T in MBS
Fed bought $175B in bonds from Fannie Mae, Ginnie Mae, and Freddie Mac
QE 2 (Nov. 3, 2010 – June 30, 2011)
Fed began the purchase of $600B of longer-term T-Bonds
Goal Keep longer-term interest rates, esp. mortgage rates,
low
Impact: Mortgage rates increased, despite the program
Impact of QE2 on Mortgage Rates
Recent Quantitative Easing
QE 3 (Announced Sept. 13, 2012)
Fed announced it would buy $40B/mo. in MBSIncreased buying to $85B/mo. in Dec. 2012
Publicly committed to keep interest rates low through 2015
ECB announced a similar program
Impact
Impact on Banks
Impact on Savers
The “Taper”
• Fed began to reduce, or “taper,” it’s bond buying by $10B with each FOMC meeting since Dec., 2013.
• QE3 is scheduled to end in October with a final $15B/mo. reduction.
• Concerns for the financial markets
The “Taper”
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