Required reading:

Ch 15,16

Lecture 16:
The Federal Reserve and
Monetary Policy
Econ 201, Winter 2018

1 2/27/2018
 The Federal Reserve System

▪ A central bank is an institution that oversees and

regulates the banking system and controls the
monetary base.

▪ The Federal Reserve is a central bank—an

institution that oversees and regulates the banking
system, and controls the monetary base.

▪ The Federal Reserve system consists of the Board of

Governors in Washington, D.C., plus 12 regional
Federal Reserve Banks.
The Federal Reserve System
 The FOMC meets every 5-8 weeks
 Decides the course of Monetary Policy, which open
market operations to carry out

 The New York Fed executes the actual trades on

the New York Markets
 That’s why they are always on the FOMC
 Banks used to be paired
 Now the rest are in groups of 3, besides Chicago and
Cleveland, which are still paired.
 Reserve Requirements and the Discount Rate

▪ The federal funds market allows banks that fall

short of the reserve requirement to borrow funds
from banks with excess reserves.
▪ Allows them to meet their overnight reserve
requirements

▪ The federal funds rate is the interest rate

determined in the federal funds market.
▪ Not under direct Fed Control, but

▪ The discount rate is the rate of interest the Fed

charges on loans to banks.
▪ The Fed funds rate tracks this closely.
Open-Market Operations by the Federal
Reserve
 When the Fed buys assets, it increases the money
supply
 Pays with new money  new loans, increases M1
 When the fed sells assets, it decreases the money
supply
 Takes in money, reducing lending, makes no new loans
 decreases M1
Last Year the European Central Bank
announces
 “On 22 January 2015 the Governing Council of the
European Central Bank (ECB) announced an
expanded asset purchase programme, encompassing
also the asset-backed securities purchase programme
(ABSPP) and the third covered bond purchase
programme (CBPP3), with the aim to fulfil the ECB's
price stability mandate. Under this programme the
ECB will purchase sovereign bonds and private
sector assets for a combined monthly amount of €60
billion. The purchases are intended to be carried out
until at least September 2016 and in any case until the
Governing Council sees a sustained adjustment in the
path of inflation that is consistent with its aim of
achieving inflation rates below, but close to, 2% over
the medium term.”
Open Market Operations
 What assets does the Fed Have?
 Lots!
 Fed is largest holder of US Government Debt
 First built up assets during WWII
 Realized it was creating money almost accidentally

 Fed earns a lot of interest!

 Only profitable branch of government
 Returns extra income to Congress
 After it spends as much as it wants
 Another reason it is autonomous
The Fed Balance Sheet
The Fed Balance Sheet
ECONOMICS IN ACTION
The Fed’s Balance Sheet, Normal and Abnormal
The Fed Responds to the Crisis
Other Central Banks’ Balance Sheets
Size of the Monetary Base in Japan
The Fed Responds to the Crisis
 Buying these new assets was very important
 No one else wanted to!
 The market value of these assets could have
crashed, causing banks to have to cease lending,
or close, reducing the money supply.
The Fed Responds to the Crisis
 Even with assets that aren’t maybe worthless
 Subprime mortgages…

 A crisis might require a “lender of last resort”

 If a company has illiquid assets, but needs quick

cash, they may lose too much money in a fire sale

 The Fed will lend on the basis of illiquid collateral.

 The prevents otherwise valuable assets from crashing
in value
New Regulations in response to the Crisis
 Regulations almost always arise in response to
failures during the last crisis

 Panic of 1907: The Fed itself

 Reserve ration, lender of last resort
 Depression
 FDIC, tighter control of what risks banks are allowed
to take – commercial vs investment
 2008 crisis
 Capital requirements
 Regulate intermediaries other than banks
Open-Market Operations by the Federal
Reserve
 When the Fed buys assets, it increases the money
supply
 Pays with new money  new loans, increases M1
 When the fed sells assets, it decreases the money
supply
 Takes in money, reducing lending, makes no new loans
 decreases M1
 We need to think about what Money is for

The Opportunity Cost of Holding Money

 Short-term interest rates are the interest

rates on financial assets that mature within six
months or less.

 Long-term interest rates are interest rates on

financial assets that mature a number of years in
the future.
 US Treasury Bond Rates, Bank Lending Rates
Maturity Yield Yesterday Last Week Last Month

3 Month 0.25 0.26 0.27 0.32

Federal Funds rate:

6 Month 0.41 0.43 0.41 0.39 0.37
Discount rate:
1.00
2 Year 0.82 0.83 0.69 0.71
Was .75 three
months ago
5 Year 1.33 1.32 1.16 1.25

10 Year 1.83 1.81 1.70 1.83

30 Year 2.66 2.66 2.57 2.64

Interest Rates
 Currency: 0.00%
 Federal Funds Rate: 0.37%
 One Month CDs: 0.15%
 2 Year AAA Municipal Bond: 0.51%
 5 Year T-Bill: 1.36%
 20 Year AAA Municipal Bond: 2.55%
 30 Year T-Bill: 2.62%

 Really low!
 Interest Rates

 Treasury bills generally pay a slightly lower interest

rate than other short-term assets in normal times.
 In the third week of October 2008, one-month CDs
were paying 4.04% interest, but one-month Treasury
bills were paying only 0.26%.
 The reason: fear. A sharp plunge in housing prices
had led to big losses at a number of financial
institutions, leaving investors nervous about the
safety of many nongovernment assets.
 T-Bills are the World’s safest asset.
 On December 10, 2008, in fact, three-month
Treasury bills paid 0% interest for a brief period.
Interest Rates
 Currency: 0.00%
 Federal Funds Rate: 0.37%
 One Month CDs: 0.15%

 CD minus Currency: 0.15%-0.00% = 0.15%

 Fed Funds minus Currency:0.37%-0.00% = 0.37%
Monetary policy by the Fed

 A typical exercise of Monetary Policy:

 The Fed buys T-Bills, pays with new money

 This new money leads to new lending by the
commercial banking system
 This shifts the money supply curve outward

 This lowers the equilibrium interest rate

 That’s why we say the Fed “sets” interest rates

 Choosing 𝑀𝑆 is the same as choosing 𝑟 ∗
 The Effect of an Increase in the Money Supply on the
Interest Rate
Interest
rate, r An increase
in the money
supply . . .

MS MS
1 2

r E
. . . leads to 1 1
a fall in the
E
interest rate. r 2
2
MD

M M Quantity of money
1 2
 Interest
rate, r
Suppose the Money
supply is currently MS
2
MS
1
MS1. If the Fed
want the interest r E
2
T
rate to be rT, what r
1
E
1
MD

should they do? M2 M

1
Quantity of money

A. An open market
sale
B. An open market
purchase
Setting the Federal Funds Rate

Pushing the Interest Rate Up to the Target Rate

Interest
rate, r An open-
market
sale . . .

MS MS
2 1

. . . drives r E
2
T
the interest E
r 1
rate up. 1 MD

M2 M
1
Quantity of money
Setting the Federal Funds Rate
Pushing the Interest Rate Down to the Target Rate

Interest The target federal

rate, r An open- funds rate is the
market
purchase . . .
Federal Reserve’s
MS1 MS2 desired federal funds
rate.

. . . drives the r1 E1
interest rate E2
rT
down. MD

M1 M2
Quantity of money
Suppose the Federal Reserve raised the
reserve requirement. This would have the
effect of

A. Decreasing the money

supply and decreasing
interest rates
B. Increasing the money
supply and decreasing
interest rates
C. Decreasing the money
supply and increasing
interest rates
D. Increasing the money
supply and increasing
interest rates
Setting the Federal Funds Rate
 This is why we act as though the Federal Funds
Rate is under the Fed’s control

 It’s basically the shortest-term interest rate there

is
 It is the interest rate the Fed can effect the most
easily

 So the FOMC decides on a Fed Funds Rate target

every 5-8 Weeks
 The NY Fed executes trades constantly to keep the
interest rate on target
Open-Market Operations by the Federal
Reserve
 When the Fed buys assets, it increases the money
supply
 Pays with new money  new loans, increases M1
 When the fed sells assets, it decreases the money
supply
 Takes in money, reducing lending, makes no new loans
 decreases M1
Setting the Federal Funds Rate
 So, suppose to raise the interest rate, the Fed has
to reduce the money supply by 500 million.
 If the rr is .10, then they need the total change in
money supply to be 500 million:

∆𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒
= −500 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑟𝑟
∆𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒
= −500 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
.10
∆𝑀𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝐵𝑎𝑠𝑒 = −50 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Monetary Policy and Aggregate Demand

▪ What about effects on the real economy?

▪ Expansionary monetary policy is monetary

policy that increases aggregate demand.

▪ Contractionary monetary policy is monetary

policy that reduces aggregate demand.
Expansionary and Contractionary Monetary Policy
The Fed Reverses Course
Expansionary and Contractionary Monetary
Policy
 Remember our story about planned investment!

 𝐼𝑃 depends on firms’ decisions about investment

opportunities

 The lower the interest rate, the more projects are

profitable

 Lower interest rate  higher planned investment

 Higher interest rate  lower planned investment
Two Different Multipliers in Effect
 A change in the Monetary Base, from the open
market operation
 Either paying with new money, or taking money in out
of circulation
 This leads to multiplier effect on Bank Balance
sheets, as lending either expands or contracts
 This lowers the interest rate
 This increases Planned Investment

 This leads to a multiplier effect in consumption

 New investment spending is new income and so on
 Expansionary and Contractionary Monetary Policy in the Income-
Expenditure Model

(a) Expansionary Monetary Policy (b) Contractionary Monetary Policy

Planned Planned
aggregate 45-degree line aggregate 45-degree line
spending spending

AE AE
2 1

AE AE
1 2

Y Y Y Y
1 2 Real GDP 2 1 Real GDP
Monetary Policy and the Multiplier
Expansionary Monetary Policy to Fight a Recessionary Gap
Contractionary Monetary Policy to Fight an Inflationary
Gap
Suppose the economy is currently in
equilibrium at an output above potential
output. To close this gap, the Fed could

A. Sell T-Bills, thus

lowering the
interest rate.
B. Buy T-Bills, thus
lowering the
interest rate
C. Sell T-Bills, thus
raising the interest
rate
D. Buy T-Bills, thus
raising the interest
rate.
What the Fed Wants, the Fed Gets
 In this story, the Fed can move AD to wherever it
wants

 It can do so much faster than Fiscal Policy

 No debate
 Investment is much more volatile than consumption
 Change course easily

 So AD is always wherever the Fed wants it

 Total Conquest of Recession! Fed can close any
Gap
What the Fed Wants, the Fed Gets
 That was the “triumphalist” view in 50s and 60s
 For good reason!
What the Fed Wants, the Fed Gets
 But in the 70s…
 What the Fed Wants, the Fed Gets

 Contractionary monetary policy is sometimes used to

eliminate inflation that has become embedded in
the economy.

 In this case, the Fed needs to create a recessionary

gap—not just eliminate an inflationary gap—to
wring embedded inflation out of the economy.

 That’s why it’s sometimes said the unemployment

rate is whatever the Fed wants it to be
Moderate Inflation and Disinflation

 In the short run, policies that produce a booming

economy also tend to lead to higher inflation,
and policies that reduce inflation tend to depress
the economy.

 This creates both temptations and dilemmas for

governments.
What About the Long Run?
 The Money supply was not part of the story in
chapter 9
 Can the Fed create growth forever?

 Or more precisely, why not just keep shifting AD

outwards?
 It would lead to higher prices, but that’s a small price
to pay for higher output.
 Most people would agree to having unemployment a
little lower and prices a little higher
 Why can’t that work?
Money and Real Effects

 Money supply shifts interest rate via Money

Demand equilibrium
 Interest rate shifts Planned investment
 This shifts AE, shifting AD

 AD and AS intersect to determine Y

 What about in the Long run?
Money, Output, and Prices in the Long Run
Aggregate
price level An increase in the
money supply reduces
the interest rate and
increases aggregate
demand . . . LRAS

SR AS
2
SRAS
1
E
P 3
3 . . . but the eventual
rise in nominal wages
P E leads to a fall in
2 2
short-run aggregate
P AD
1 E 2 supply and aggregate
1 AD output falls back to
1
potential output.

Y Y
1 2 Real GDP

Potential output
The Long-Run Determination of the Interest Rate
Interest
rate, r
MS MS An increase in the
1 2
money supply lowers
the interest rate in the
short run…

…but in the long run higher

prices lead to greater money
E demand, raising the interest
r 1 E rate to its original level.
1 3

E
r 2
2 MD
MD 2
1

M M Quantity of money
1 2
 Monetary Neutrality

 In the long run, changes in the money supply

affect the aggregate price level but not real GDP
or the interest rate.

 In fact, there is monetary neutrality: changes

in the money supply have no real effect on the
economy. So, monetary policy is ineffectual in
the long run.
 The Output Gap and the Unemployment Rate

 When actual aggregate output is equal to

potential output, the actual unemployment rate
is equal to the natural rate of unemployment.

 When the output gap is positive (an inflationary

gap), the actual unemployment rate is below the
natural rate.

 When the output gap is negative (a recessionary

gap), the actual unemployment rate is above the
natural rate.
An Inflationary Gap: Unemployment will be lower
than the natural rate

Potential
output Inflationary gap
A Recessionary Gap – Unemployment will be higher
than the natural rate

Recessionary gap

Potential
output
Cyclical Unemployment and the Output Gap
Cyclical Unemployment and the Output Gap
Shifting of Aggregate Demand:
Short-Run Effects
(a) Contractionary Policy (b) Expansionary Policy

Aggregate Aggregate
price level price level
Contractionary Expansionary
Policy… policy...

SRAS SRAS

...leads to a higher
P1 E1 P2 E
2 aggregate price
...leads to a lower level and higher
P2
E2 aggregate price level P E1 aggregate output.
1
and lower aggregate
AD1 AD2
output.
AD2 AD1
Y2 Y Y Y2
1 1 Real GDP
Real GDP
Unemployment and Inflation, 1955–1968
 Next Class:
Monetary Policy Continued

59 9/6/2011