THE FED AND INTEREST RATES. Notes in circulation Depository institution reserves The FED used its...

THE FED AND INTEREST RATES

Notes in circulation

Depository institution reserves

The FED used its power over the monetary base to control the money supply.

Copyright© 2006 John Wiley

& Sons, Inc.2

Up to this point, we used the term money supply conceptually without providing a specific definition.

There are various definitions of money each focusing on a certain use of money.

M1 is the definition that focuses on money as medium of exchange.

M2 focuses on money as store of value. MZM includes all financial assets that can

be converted into cash immediately (liquidity).


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By controlling the monetary base, the Fed substantially influences the money supply.

The more is the excess reserves, the more interest income they lose.(opportunity cost).

What creates the Excess reserves ? Excess reserves appear as the Fed :1. buys securities on the open market.2. lowers the discount rate.3. cuts reserve requirements. As depository institutions lend or invest excess

reserves, they earn extra interest income.Copyright© 2006 John Wiley

& Sons, Inc.5


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When the Fed wants to increase the

money supply(using any of the three tools),initially the reserves increases creating excess reserves, that the banks can invest or lend. Additionally, the following things happen: new loans created increases borrower’s

transactional balances. purchase of investment securities/assets

increases seller’s transactional balances. This helps in financing the purchases of the DSUs

of goods or services in real sector. Finally, this all contributes to economic growth .

By expanding or contracting monetary base(increasing or decreasing the money supply), Fed - ◦ increases or decreases excess reserves, thus ◦ raising or lowering incentive to lend or invest,

thus ◦ encouraging or discouraging expansion in real

sector.7

The Fed Funds Market is a Fed-sponsored system in which depository institutions lend and borrow excess reserves overnight among themselves. The interest rate on these transactions—the Fed Funds Rate(FFR)—is set by market forces.

The FFR is a “benchmark” rate in the financial system—it normally represents the lowest possible cost of loanable funds. In other words, it is the inter-banking lending rate and represents the primary cost of short term loanable funds.


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The Fed does not set the federal funds rate but targets/influences it by controlling overall availability of reserves.

FFR is important because:1. It measures the return on the most liquid

financial assets (bank reserves).2. It is closely related to the monetary policy.3. It directly measures the available reserves

in the banking system.


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Market Equilibrium Interest Rate1.Demand for the reserves by the depository institutions (downward sloped) 2.Supply of the reserves by the Fed (upward sloped)3.Equilibrium FF rate is when DRes = SRes

Quantity of Reserves

The FF Rate

DRes

SRes

Equilibrium Interest

Monetary Policy & The Fed Funds Rate

• OMO and its impact on FF rate1.Purchasing Treasury securities leads to increase reserves in the banking system then the supply curve shifts rightward. As a result, the FF rate will decline.

2.Selling Treasury securities

Quantity of reserves

The FF Rate

SRes1SRes2

•Discount rate and its impact on CB rate1.Increase discount rate means increase opportunity cost of holding reserves. So supply of reserves will decline, the supply curve will shift leftward, then the FFR increases.

2.Decrease discount rate Quantity of Reserves

The FF rate

DRes

SRes2

SRes1

• RR and its impact on CB rate1. Increase (RRR) leads to increase RR, decrease

ER i.e. the loans to the public, demand for reserves from the FF increases, demand curve shifts rightward, and FFR increases.

2. Decrease (RRR)

Quantity of Reserves

The FF rate

DRes2

DRes1

sRes

Open Market Operations: Buying pressures FFR downward, selling pressures FFR upward◦ Reserve effects are direct, immediate, dollar-for-

dollar.◦ Ultimate effects on money supply are predictable.

Discount Rate: Cutting discount rate pressures FFR downward, raising discount rate pressures FFR upward◦ sensitivity of institutions to “Window scrutiny”◦ The trend is always to keep the discount rate higher than the FFR

to encourage banks to borrow in the fed funds system rather than the discount window.

Reserve Requirements: Cutting RR pulls FFR downward, raising RR pushes FFR upward◦ Reserve effects are direct, immediate, sustained, &

too dramatic for “fine tuning”Copyright© 2006 John Wiley

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The Fed can influence the FFR only in the short run by using its monetary policy to expand or contract the monetary base and hence affects the level of reserves.

However, in the long run does not have the power to set the FFR. Lets see why is that:

If the Fed tries to keep the FFR at low rate, people will borrow and buy goods extensively, demand of loans will be very high ,banks will be short of excess reserves, the Fed will buy securities to increase the money supply to prevent the FFR to increase. People will fear inflation and continue to borrow and the cycle continues.

On the other hand, if the Fed tries to keep the FFR at high rate, few people will borrow, so FFR should drop but the Fed will sell securities to reduce bank reserves and contracts money supply. This can cause depression.

Best Fed can ultimately do is try to promote stable price levels.


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Changes in the fed funds rate provide a clue to short term changes in the monetary policy.

When the FED wants to contract the economy (decrease the money supply),we expect the FFR to rise as more banks finds themselves short of reserves and tend to borrow at fed funds market.

When the FED wants to expand the economy (increase the money supply),we expect the FFR to decrease .


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Two school of thought about what affects the level of economic activity:

1- Monetarist EconomistsMonetarists assume propensity to consume—

• rises as people perceive they have “more money”• drops as people perceive they have “less money”

The money supply is the key variable that effect on economic activity.

adding reserves carefully should promote economic growthsubtracting reserves carefully should slow the economy

2- Keynesian EconomistsJohn Maynard Keynes was influential British economist of 1930s.

The interest rate is the key variable.

Real sector economic growth is—◦ Stimulated by falling rates as economic

activity costs less to finance.◦ Slowed by rising rates as economic activity

costs more to finance. Keynesian believe that monetary policy

always works unless the economy is in liquidity trap.

Liquidity Trap:

When people already had a lot of money relative to their needs that any extra money will be hoarded and would no longer drive down the interest rates.


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Increase in market interest rate leads to decrease in the value of fixed – income securities.

Raising discount rate or / and raising reserve requirements leads to a great fall in the stock market.

•

Full employment Economic growth Price index stability Interest rate stability Stable financial system Stable foreign exchange markets


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Full employment implies that every person of working age who wishes to work can find employment.

Types of unemployment1. Frictional unemployment: people

unemployed in transition between jobs.2.Structural unemployment: happens when

there is mismatch between a person’s skill levels and available jobs or more jobs in one region of the country but fewer in the others.


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It is name given for a rising standard of living ,measured by output per unit of input.

Economic growth is made possible through increased productivity of labour and capital.

For example: Productivity can be increased by training the labour and applying new technologies to the capital.


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Price Stability refers to the stability in the average price of all goods and services in the economy.

Inflation is defined as a continuous rise in the average price level or a continuous decrease in the purchasing power of money.

Inflation can be measured by price indexes such as the Consumer Price Index(CPI).


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It refers to the swings or volatility of interest rates over time.

Large interest rate fluctuations introduce additional uncertainty into the economy and make it harder to plan for the future.

For e.g. high interest rates , this prevents consumer and business spending.


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Instability of the financial system can prevent the efficient flow of funds between DSU and SSU.

Any reduction in the flow of funds can reduce consumer spending, business investment and thus the economic growth.

For e.g. Role of the Central banks during the Financial crisis.


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Exchange rates are the value of the local currency relative to foreign currencies.

Fluctuations exchange rates introduce uncertainty. What is the name of that risk?.

For e.g. When the value of dollars increases, what does this mean in terms of exports and imports?.


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Most of the goals of the Fed are consistent with each other, except price stability and full employment.

When economy is in expansion, 1.unemployment starts to decrease2.More goods are produced and thus more

labour are needed.3.Wages of labour starts to increase because

they became scarce and the same thing applies to raw materials.

4.This increases the cost of production and thus the prices of goods increased.(inflation).


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Philip’s Curve. Stagflation.


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