The Fed and The Interest Rates Chapter 3 FIN 221

Fed Reserve Control of The Money supply Measures of The Money supply

Monetary Base & Money Supply Changes The CB changes the money supply by changing the monetary base (MB) through its monetary policy tools. In case of Restrictive monetary policy: OMO - sell securities, reduce bank reserves and the monetary base. RR - increase reserve requirements, reduces excess reserves and the deposit expansion multiplier. Discount rate -- increase the discount rate, reduce the money supply or its growth rate; increase interest rates.

The Fed’s Control Over Interest Rates The central bank (Fed) funds rate is the interbank lending rate. The interbank lending rate represent the primary cost of short-term loanable funds. The Fed (CB) rate: It measures the return on the most liquid of all financial assets. It is closely related to monetary policy. It directly measures the available reserves in the banking system which in turn influences commercial bank’s decision on making loans to consumers , businesses or other borrowers.

Market Equilibrium Interest Rate Demand for the reserves by the depository institutions (Negative) Supply of the reserves by the CB (Positive) Equilibrium CB rate is when DRes = SRes SRes The CB Rate Equilibrium Interest DRes Quantity of Reserves

Monetary Policy & The Fed Funds Rate OMO and its impact on CB rate Purchasing T – Treasury leads to increase reserves in the banking system then the supply curve shifts rightward. As a result, the market interest will decline. Selling T – Treasury The CB Rate SRes1 SRes2 Quantity of reserves

Discount rate and its impact on CB rate Increase discount rate means increase opportunity cost of holding reserves. So supply of reserves will decline, the supply curve will shift leftward, then the interest increases. Decrease discount rate SRes2 SRes1 The CB rate DRes Quantity of Reserves

RR and its impact on CB rate Increase k (RRR) leads to increase RR, decrease ER i.e. the loans to the public, demand for reserves from the CB increases, demand curve shifts rightward, and interest increases. 2. Decrease k (RRR) The CB rate sRes DRes2 DRes1 Quantity of Reserves

The Market Environment The CB can influence the CB funds rate ONLY in the very short run The CB does NOT have the power to set the CB funds rate in the long run

Importance of the Fed (CB) rate: 1- Monetary Theory (monetarist economists) The money supply is the key variable that effect on economic activity. 2- Keynesian School The interest rate is the key variable. Example: in case of recession: CB will take a expansionary Monetary Policy, this will lead to decline in interest rate, this lead to increase components of AD and finally this leads to pushing the economy (Unless it is in a liquidity trap) both schools about how CB should try to effect on real sector What Is Liquidity Trap?

The CB’s Impact on Stock and Bond Markets 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.

Objectives of Monetary Policy Full Employment: Definition Frictional Unemployment Structural Unemployment Natural Rate of unemployment Consequents of unemployment: economic and social results

2. Economic Growth: Definition PPF and economic Growth 3. Stable Prices: The relationship between Prices and purchasing power (money value) Effects of unanticipated inflation

4. Interest Rate Stability: Definition Interest rate fluctuations effects 5. Stability of financial System: Fluctuation in financial system and efficiency Instability in banking system The role of CB Example: 11 Sep., 2001

Possible Conflict Among Objectives 6. Stability of Foreign Exchange Market: Definition International Trade Devaluation / overvaluation and the effects on X & M Possible Conflict Among Objectives Conflict between inflation & unemployment Philips Curve

The Fed and The Economy OMO – Expansionary monetary policy 1- buying securities -- increase in banks’ reserves 2- the increase in reserves will lead to an increase in banks’ assets, banks’ investments and banks’ loans. 3- each of the Above has additional effects as follows: The increase in banks’ assets will lead to an increase in money supply. The increase in investments will increase securities’ prices and lead to decrease in interest rates. The increase in loans will increase credit availability and lead to a decrease in interest rates.

The increase in money supply and decrease in interest rates will: - Increase Investment expenditure ( I ) Increase consumption expenditure (durable – houses) ( C ) - Increase government expenditure ( G) Increase net exports (since exports increase and imports decrease ) ( NX) Decrease foreign exchange rate. i.e, expenditure on domestically produced goods will increase and the RGDP (= C+I+G+NX) will increase, - also the price level will increase.

Business investment in real assets Present values of future cash flows from real assets depend significantly on general level of interest rates: Rates fall, PVFCF rises Rates rise, PVFCF drops Most capital expenditures are debt-financed; interest expense is thus material in profitability of most businesses. Monetary policy thus always involves material incentives or disincentives for business investment. The CB can manipulate incentives but not compel results.

Consumer spending for durable goods & housing Much consumer spending is on credit, so it tends to vary directly with credit conditions: Falling interest rates tend to encourage spending. Rising interest rates tend to discourage spending. Monetary policy can thus often affect aggregate demand to some extent. The CB can encourage/discourage but not necessarily compel; Consumers don’t necessarily make financial decisions the way businesses do:

Interest rates affect exchange rates as follows: Net exports Interest rates affect exchange rates as follows: Falling interest rates in a country tend to “weaken” its currency. Rising interest rates in a country tend to “strengthen” its currency. Exchange rates affect imports and exports As domestic currency weakens— Domestic demand for imports decreases as they become more expensive BUT Foreign demand for exports increases as they become less expensive (cheaper).