Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University Money, Banking, and Financial Markets : Econ. 212 Stephen G. Cecchetti Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University The Federal Reserve’s Monetary Policy Toolbox  The central bank can control the quantity of reserves that commercial banks hold.  Besides the quantity of reserves, the central bank can control either the size of the monetary base or the price of its components.  The two prices it concentrates on are the interest rate at which banks borrow and lend reserves overnight (the federal funds rate) and the interest rate at which banks can borrow reserves from the Fed (the discount rate).  The central bank has three monetary policy tools, or instruments: the target federal funds rate, the discount rate, and the reserve requirement.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University

 The Target Federal Funds Rate and Open Market Operations  The target federal funds rate is the FOMC’s primary policy instrument. FOMC meetings always end with a decision on the target level, and the statement that is released after the meeting begins with an announcement of that decision.  The federal funds rate is determined in the market, rather than being controlled by the Fed.  The name “federal funds” comes from the fact that the funds banks trade are their deposit balances at the Fed.  If the Fed wanted to, it could force the market federal funds rate to equal the target rate all the time by participating directly in the market for overnight reserves, both as a borrower and as a lender.  As a lender, the Fed would need to make unsecured loans to commercial banks, and as a borrower, the Fed would in effect be paying interest on excess reserves.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  The Fed has never done this because it does not want the credit risk that would come with uncollateralized lending, because policymakers believe that the federal funds market provides valuable information about the health of specific banks, and because the Fed has stated it will only pay interest on reserves at the request of Congress.  The Fed chooses to control the federal funds rate by manipulating the quantity of reserves through open market operations: the Fed buys or sells securities to add or drain reserves as required.  Day-to-day control of the supply of federal funds is the job of the Open Market trading desk at the New York Federal Reserve Bank.  Most days the market rate is close to the target rate, although on occasion there have been spikes in the market rate. These surprises have become less frequent as information systems at banks and at the Fed have improved.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  Discount Lending, the Lender of Last Resort and Crisis Management  Lending to commercial banks is not an important part of the Fed’s day-to-day monetary policy.  However, such lending is the Fed’s primary tool for ensuring short-term financial stability, for eliminating bank panics, and preventing the sudden collapse of institutions that are experiencing financial difficulties.  The central bank is the lender of last resort, making loans to banks when no one else can or will, but a bank must show that it is sound to get a loan in a crisis.  The current discount lending procedures also help the Fed meet its interest-rate stability objective.  The Fed makes three types of loans: primary credit, secondary credit, and seasonal credit.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  Primary credit is extended on a very short-term basis, usually overnight, to sound institutions. It is designed to provide additional reserves at times when the day’s reserve supply falls short of the banking system’s demand. The system provides liquidity in times of crisis, ensures financial stability, and restricts the range over which the market federal funds rate can move (helping to maintain interest-rate stability).  Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit. Banks may seek secondary credit due to a temporary shortfall in reserves or because they have longer-term problems that they need to work out.  Seasonal credit is used primarily by small agricultural banks to help in managing the cyclical nature of farmers’ loans and deposits.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  Reserve Requirements  By adjusting the reserve requirement, the central bank can influence economic activity because changes in the requirement affect deposit expansion.  Unfortunately, the reserve requirement turns out not to be very useful because small changes in the reserve requirement have large (really too large) impacts on the level of deposits.  Today, the reserve requirement exists primarily to stabilize the demand for reserves and help the Fed to maintain the market federal funds rate close to target; it is not used as a direct tool of monetary policy.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University

 Linking Tools to Objectives: Making Choices  Desirable Features of a Policy Instrument  A good monetary policy instrument is easily observable by everyone, is controllable and easily changed, and is tightly linked to the policymakers’ objectives.  These requirements leave policymakers with few choices, and over the years central banks have switched between controlling the quantity and controlling the prices.  Operating Instruments and Intermediate Targets  Operating instruments refer to actual tools of policy, instruments that the central bank controls directly. Intermediate target refers to instruments that are not directly under the control of the central bank but that lie between their policymaking tools and their objectives.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University

 A Guide to Central Bank Interest Rates: The Taylor Rule  A simple formula approximates what the FOMC does, tracking the behavior of the target federal funds rate and relating it to the real interest rate, inflation, and output.  The formula is:  Target Fed Funds rate = 2½ + current inflation + ½ (inflation gap) + ½ (output gap)  The 2½ term is the assumed long-term real interest rate. The inflation gap is current inflation minus an inflation target, and the output gap is current GDP minus its potential level.  When inflation rises about its target level, the response is to raise interest rates; when output falls below the target level, the response is to lower interest rates.  One interesting property of the Taylor Rule is that increases in inflation raise the real interest rate.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  The “½” terms in the equation depend on how sensitive the economy is to interest rate changes and on the preferences of central bankers.  Some caveats: the Taylor Rule is too simple to take into account sudden threats to financial stability. Also, the lack of real-time data limits its usefulness in ongoing policymaking.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University Lessons of Chapter 18  The Federal Reserve has three monetary policy tools.  The target federal funds rate is the primary instrument of monetary policy. i. Open market operations are used to control the federal funds rate. ii. The Fed forecasts the demand for reserves each day and then supplies the amount needed to meet the demand at the target rate.  The discount lending rate is used to supply funds to banks primarily during crises. i.The Fed sets the primary lending rate 100 basis points above the target federal funds rate. ii.In setting the primary lending rate above the target federal funds rate, the Fed is attempting to stabilize the interest rate on overnight interbank lending. iii.The Fed also makes loans to banks in distress, through the secondary lending facility, and to banks in need of seasonal liquidity. Reserve requirements are used to stabilize the demand for reserves. i.Banks are required to hold reserves against certain deposits. ii.Banks can hold either deposits at Federal Reserve Banks or vault cash, neither of which earns interest. iii.Reserves are accounted for in such a way that everyone knows the level of reserves that is required several weeks before banks must hold them.  The European Central Bank’s primary objective is price stability.  The ECB provides liquidity to the banking system through weekly auctions called refinancing operations.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University  The minimum bid rate on the main refinancing operations, also know as the target- refinancing rate, is the target interest rate controlled by the Governing Council.  The ECB allows banks to borrow from the marginal lending facility at an interest rate that is 100 basis points above the target-refinancing rate.  Banks with excess reserves can deposit them at central bank and receive interest at 100 basis points below the target-refinancing rate.  European banks are required to hold reserves. They receive interest on their balances at a rate that is equal to the average of the rate in recent refinancing operations.  Monetary policymakers use several tools to meet their objectives.  The best tools are observable, controllable, and tightly linked to objectives.  Short-term interest rates are the best tools for monetary policymaking.  Modern central banks do not use intermediate targets like money growth.  The Taylor rule is a simple equation that describes movements in the federal funds rate. It suggests that  When inflation rises, the FOMC raises the target interest rate by 1½ times the increase.  When output rises above potential by 1 percent, the FOMC raises the target interest rate ½ a percentage point.

Economics of International Finance Prof. M. El-Sakka CBA. Kuwait University

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