1. FIN 30220: Macroeconomic Analysis The Federal Reserve and Monetary Policy

2. The National Banking Act of 1863 allowed Nationally chartered banks to distribute bank notes National Banks controlled the supply of currency in the US through their lending policies

3. National Banks were the primary source of credit Small State banks who were short of funds would borrow from larger state banks Larger State banks who were short of funds would borrow from National banks National banks who were short of funds would borrow from money center banks Money center banks were the “root source” of credit

4. Credit Channels under the National/State Banking System

5. The Federal Reserve System was created in 1913 by Woodrow Wilson. Regulate the banking industry “Lender of Last Resort” Control the money supply Provide banking services for the federal government Check Clearing Note: The Federal Reserve System is a private bank. It is actually owned by the banks within the Federal Reserve System

6. Credit Channels under the Federal Reserve System Federal Reserve = Federal Funds Market = Discount Window

7. The Federal Reserve System Divides the country into 12 Districts numbered 1 - 12 from east to west

8. Each district has a Federal Reserve Bank with a bank president elected by the bank’s board of directors for 4 year renewable terms Board of Directors Bank President Class A (4)Class B (4)Class C (4) Member BanksLocal BusinessFederal Reserve Board

9. The Federal Reserve board is headquartered in Washington DC. The Board Consists of 7 “Governors” appointed by the President and confirmed by the Senate for 14 Year Non-Renewable terms Sarah Raskin (2010) Daniel Tarullo (2009) Jerome Powell (2012) Ben Bernanke (2003) Janice Yellen (Vice Chairman) (2010) Elizabeth Duke (2008) Jeremy Stein (2012) The Chairman is elected from the Board for a renewable 4 year term

10. The Federal Open Market Committee (FOMC) is the policymaking group of the Federal Reserve System. They meet approximately 8 times per year. Policies are determined by majority vote Board of Governors (7) NY Fed President (1) Regional Fed Presidents (4) Generally, all 12 bank presidents are present at the meeting, but only 5 can vote. The NY Fed president has a permanent vote while the remaining presidents vote on a revolving basis.

11. Instruments refer to the policy options the Fed has to control the supply of money… Open Market Operations By purchasing or selling US Treasuries, the Fed can alter the supply of bank reserves (MB) Discount Window Loans The Fed can also influence reserves by altering the interest rate charged on loans to commercial banks. (MB) Reserve Requirements Reserve Requirements influence the ability of banks to create new loans which affects the broader aggregates (M1,M2) This is the most often used instrument!

12. The Reserve Requirement is the least used of the Fed’s policy tools. A Bank is required to keep a minimum percentage of its deposits either as cash or on deposit at the federal reserve (reserve deposits pay no interest) AssetsLiabilitiesAssetsLiabilities $45,000 (T-Bills) $50,000 (Deposits) $100,000 (Equity) Federal Reserve Acme National Bank $100,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) Acme currently has 10% of its deposit liabilities on Reserve (Cash + Reserves)/Deposits Reserve Accounts are liabilities of the Fed

13. Suppose Acme Bank wanted to create a $30,000 loan. This is done by establishing a line of credit (i.e. creating a new checkable deposit) AssetsLiabilities $45,000 (T-Bills) $50,000 (Deposits) $100,000 (Equity) Acme National Bank $100,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) Acme’s reserve ratio drops to 6.25% (5/80) $30,000 (Loan) $30,000 (Deposit) The loan shows up on both sides of the balance sheet

14. Type of LiabilityReserve Requirement Transaction Account $0 - $7M0% $7M - $47.6M3% More than $47.6M10% Time Deposits0% Eurocurrencies0% The Reserve Requirement has no impact on the monetary base, but it restricts the ability of banks to create loans – this influences the broader aggregates.

15. The discount window was the primary policy tool of the federal reserve when it was first established in 1913. Discount window loans are collateralized by the assets of the bank (equal to around 90% of the loan) AssetsLiabilitiesAssetsLiabilities $45,000 (T-Bills) $80,000 (Deposits) $50,000 (Equity) Federal Reserve Acme National Bank $130,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) This bank would like to create a $70,000 loan, but doesn’t have the reserves to back it up Res. Req. = 5% A $2,500 loan from the discount window would raise reserves to the required 5% $ 2,500 (Reserves) $ 2,500 (Loan) $ 2,500 (Disc. Loan)

16. Type of CreditInterest Rate Policy Primary (No Questions Asked)Fed Funds +.5% Secondary (Additional Financial Information Required) Fed Funds + 1.0% Seasonal (Must demonstrate reoccurring seasonal liquidity needs, <$500M in Deposits) Fed Funds +.2% The Fed actually has several discount lending programs

17. Discount Lending (1959-2005)

18. Discount Lending (1959-Present)

19. By purchasing and/or selling securities, the Fed can directly control the quantity of non-borrowed reserves in the banking sector. Bond Dealer Federal Reserve Dealers Buy/Sell bonds from the Fed The Fed debits/credits the reserve account of the dealer’s bank Most transactions are done with repurchase agreements (Repos). These are purchases/sales along with an agreement to reverse the transaction at a later date

20. Currently, open market operations are the primary policy tool of the Fed. Trading takes place in NYC AssetsLiabilitiesAssetsLiabilities $45,000 (T-Bills) $80,000 (Deposits) $50,000 (Equity) Federal Reserve Acme National Bank $130,000(Loans) $ 2,500 (Cash) $ 2,500 (Reserves) Res. Req. = 5% An open market purchase increases the reserves of the banking sector – this raises M0 $ 2,500 (Reserves) - $ 2,500 (T- Bills) $ 2,500 (Reserves) $ 2,500 (T- Bills)

21. The Money multipliers describe the relationship between a change in the monetary base (controlled by the Fed) and the broader aggregates $ Change in M1= mm1 * $ Change in MB mm = 1 + Cash Deposits Cash Deposits Reserves Deposits + $ Change in M2= mm2 * $ Change in MB mm2 = 1 + Cash Deposits Cash Deposits Reserves Deposits + M2-M1 Deposits + The Fed can influence total bank reserves, which affects the multipliers!

22. Fed Policy from start to finish…. Staff economists at each federal reserve bank brief the president of local/national economic conditions Bank Presidents/Governors present policy recommendations to the FOMC – A vote is taken. The monetary base is to be increased by $100M This order is passed to the trading desk in NYC Trading desk calls bond dealers and asks for bids

23. Fed Policy from start to finish…. AssetsLiabilities Acme National Bank +$100M (Reserves)+ $100M (Deposits) The dealers with the winning bids deliver the bonds. Their bank’s reserve accounts are credited The bank must keep approximately 5% (reserve requirement) of the new deposit on reserve, but is free to loan out the remaining $95M. Some of this will be loaned to business customers, some finds its way into the Federal Funds market Reserves FF Rate 5% Excess supply of reserves pushes down the Fed Funds Rate Supply

24. Fed Policy from start to finish…. Fed Funds Market Through the Fed Funds Market, the reserves are distributed throughout the banking sector Each bank uses its new reserves to create additional loans

25. M1 M1 Rate 6% Supply As banks increase the supplies of the various aggregates, their rates drop as well M2 M2 Rate 7% Supply $ Change in M1 = mm1 * $100M $ Change in M2 = mm2 * $100M 2 8 These newly created loans are used to purchase labor, materials, consumer goods, etc.

26. Hours Wages Demand Eventually, this newly created demand will influence prices… GDP Prices Demand Higher demand for goods and services drive up their prices (wages and prices) Increases in inflation raise the nominal interest rate Nominal Interest Rate = Real Interest Rate + Expected Inflation

27. Monetary Policy goals address the central bank’s agenda in general terms The Bank of England Follows an explicit Inflation Target. Specifically, the goal is to maintain 2% annual inflation. The ECB (European Central Bank) and the Federal Reserve follow policies of stable prices and maintenance of full employment

28. Intermediate Targets address the question: “How will I meet my goals?”. Targets are variables that the central bank can more directly control. For Tiger Woods, the goal is to win the golf tournament The target is to score 18 under par (the number he thinks he needs to win) The Federal Reserve is currently targeting the Federal Funds Rate at 0.00% The Bank of England is currently targeting the repo rate at 0.50% Goals vs. Targets The European Central Bank is currently targeting the lending rate at 1.50%

29. Targets can be broadly classified into either “Price Targets” or “Quantity Targets” Suppose that the Federal Government could influence the supply of oranges and wanted to regulate the orange market Quantity of Oranges Price Demand Supply $5/Lb Lowering the price to $4 (price target) and Raising the quantity to 1,500 (quantity target) are both describing the same policy (expanding the orange market) 1,0001,500 $4/Lb

30. Quantity of Oranges Price Demand Supply $5/Lb If demand for oranges increases and the Fed is following a price target, they must respond by increasing supply Target Range Your response to demand changes will differ across policies

31. Quantity of Oranges Price Demand Supply If demand for oranges increases and the Fed is following a quantity target, they must respond by decreasing supply 1000Lbs Target Range However, your response to demand changes will differ across policies

32. Suppose that the Fed wants to lower its target to 4% (expansionary monetary policy) 5% M2 Multiplier Change in M2 = $2,000 4% 2,000 8 = $250 A $250 purchase of Treasuries would be required

33. Suppose that the Fed is Targeting the Interest Rate at 5% 5% Suppose an increase in GDP raises Money Demand Change in M2 = $1,000 The Fed needs to increase the monetary base by 1,000 8 = $125 (An Open Market Purchase of Treasuries)

34. During the late 70’s, the federal reserve changed its policy from an interest rate target to a money target. The money target was abandoned in the mid eighties.

35. Rules vs. Discretion Should the Federal Reserve “pre-commit” to a particular course of action? The British have pre-committed to a fixed inflation rate. The ECB (European Central Bank) and the Federal Reserve both follow discretionary policies (i.e. policy is decided at the FOMC meeting)

36. For most of its history, the US has followed a gold standard A Gold Standard has two rules:  The government sets an official price of gold ($35/oz)  The government guarantees convertibility of currency into gold at a fixed price AssetsLiabilities $7,000 (Gold) (200 oz. @ $35/oz) $10,000 (Currency) US Treasury $3,000 (T-Bills) Reserve Ratio = 70% Reserve Ratio = Value of Gold Reserves Currency Outstanding = $7,000 $10,000 During most of the gold standard era, the Government had a reserve ratio of around 12%

37. Price Demand Supply $35 AssetsLiabilities $10,000 (Currency) US Treasury (P = $35) $3,000 (T-Bills) Reserve Ratio = 70% Q By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply Suppose that the Treasury purchased gold to increase the supply of currency outstanding (i.e. increase the money supply) 100 oz. Gold @ $35/oz $3,500 (Currency) $7,000 (Gold) (200 oz. @ $35/oz)

38. Price Demand Supply $35 AssetsLiabilities $10,000 (Currency) US Treasury (P = $35) $3,000 (T-Bills) Reserve Ratio = 70% Q By committing to convertibility at $35 an ounce, the government restricted its ability to increase/decrease the money supply As the market price rises above $35 (due to increased demand), households start buying gold from the Treasure @ $35/oz and sell it in the open market. This reverses the original transaction $7,000 (Gold) (200 oz. @ $35/oz)

39. The gold standard and prices: Recall that in the long run, the price level is directly proportional to the ratio of money to output: M = (Gold Reserves) Reserve Ratio With a (relatively) fixed supply of money, prices remained stable in the long run

40. Price Demand Supply $35 AssetsLiabilities $10,000 (Currency) US Treasury (P = $35) $3,000 (T-Bills) Reserve Ratio = 70% Q The gold standard and the supply of gold: From time to time, new gold deposits were discovered. This increased supply would push down the market price. In response, households would buy the cheap gold and sell it to the Treasury for $35. This would increase the money supply. 100 oz. Gold @ $35/oz $3,500 (Currency) $7,000 (Gold) (200 oz. @ $35/oz)

41. Price Demand Supply $35 AssetsLiabilities $10,000 (Currency) US Treasury (P = $35) $3,000 (T-Bills) Reserve Ratio = 70% Q The gold standard and the business cycle: Typically, during recessions, the price of gold would rise (flight to quality). High gold prices would cause households to buy gold from the Treasury to sell in the market. This would force the treasury to lose reserves and contract the money supply. (-) Gold (-) Currency $7,000 (Gold) (200 oz. @ $35/oz)

42. Gold Standard: Long Run vs. Short Run Long Run: By restricting the long run supply of money, the gold standard produced constant, low average rates of inflation (bankers are happy) Short Run: By forcing monetary policy to be subject to fluctuating gold prices, the gold standard exacerbated the business cycle (farmers are unhappy)

43. Currently, the Fed follows an interest rate target. The target interest rate (Fed Funds Rate) is adjusted according to a ‘Taylor Rule” FF = 2% + (Inflation) - 1.25(Unemployment – 5%) +.5(Inflation – 2%) Long Run: When the economy is at full employment ( Unemployment = 5%) and inflation is at its long run target (2%), the Fed targets the Fed Funds Rate (Nominal) at FF = 2% + (2%) - 1.25(5% – 5%) +.5(2% – 2%) = 4% Short Run: During recessions (when inflation is low and unemployment is high), the Fed lowers its target. During expansions, when inflation is high and unemployment is low), the Fed raises its target.

44. Case study: Productivity Growth during the late 90’s 4% Productivity growth expanded US production capacity Even with higher capacity, rapidly expanding investment demand pushed the economy beyond capacity – this causes rising prices A contraction of the money supply raises interest rates and pushes the economy back to capacity

45. End of 1992 Recession Late 90’s Expansion Asian Financial Crisis Stock Market Bubble

46. 4% Rapidly declining investment demand pushed the economy below capacity – this causes falling prices An increase in the money supply lowers interest rates and pushes the economy back to capacity Case study: Stock Market Crash and Liquidity Shocks

47. Stock Market Crash Recession of 2001 Beginning of Recovery

48. Problems Obviously, we can’t observe supply/demand curves. Instead, we have to look at the data and guess at the underlying cause. The outside lag (the amount of time for a policy to impact the economy) is “long and variable”