The Federal Reserve System

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The Federal Reserve System

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A policy rule can eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. – PowerPoint PPT presentation

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Title: The Federal Reserve System


1
The Federal Reserve System
I. Its History, Functions Structure
II. Fed Policy Tools Goals
  • ECO 473 Money Banking Dr. D. Foster

2
The Federal Reserve Part II
Policy Tools, Objectives and Targets.
ECO 473 Money Banking Dr. D. Foster
3
Additional Resources on Monetary Policy
The Mission of the Fed (Federal Reserve Board of
Governors) What are the Goals of U.S. Monetary
Policy? (Federal Reserve Bank of San
Francisco) How does Monetary Policy affect the
U.S. Economy? (Fedl Reserve Bank of San
Francisco) FYIThe Federal Reserve System
Purposes Functions (Federal Reserve Board of
Governors)
4
Federal Reserve Policy Tools
  • Open Market Operations
  • Buy/sell Treasury bonds to affect bank reserves.
  • The major form of monetary policy.
  • What will the Fed do if we run out of Treasury
    bonds?
  • Discount Window
  • Lend to member banks to affect bank reserves.
  • Purpose is to target the federal funds rate
    iff
  • This is the rate that banks charge each other for
    very short term loans.
  • Required Reserve Ratio (rrD)
  • Changing this affects bank excess reserves
    directly.
  • Used more to reflect structural changes.
  • Was used in 1937 and precipitates more Great
    Depression.
  • Time to let this go?

New policy Pay banks i for ER (!!)
5
Goals of Monetary Policy
  • Inflation goals
  • Low/no inflation with limited year-to-year
    variability.
  • Output goals
  • High and stable economic (GDP) growth.
  • Employment goals
  • Stable employment growth with low unemployment.

6
Intermediate Targets of Monetary Policy
  • The key rationale for intermediate targeting
  • The limited long-term information about the
    economy available to policymakers.

7
Choosing an Intermediate Target Variable
  • Characteristics
  • Frequently observable
  • Consistency with ultimate goals
  • Definable and measurable
  • Controllable
  • Potential variables
  • Monetary aggregatesM1, M2, MZM
  • Interest rates(fedl funds, prime )
  • Others
  • Nominal GDP
  • Credit aggregates
  • Exchange rates

8
Getting from bond purchases to interest rates
Bond

mm/yyyy
Face value (FV)
Maturity date(in n years)
Coupons value (C)
  • Usually, we talk of annual coupons
  • Market price of the bond present value of
    income stream discounted at interest rate i

When the Fed buys bonds, their prices will ___
and interest rates will ___.
sells
9
Some simple bond pricing problems
  • A bond has a face value (FV) of 1000, will
    mature in 2022 and has an annual coupon of 74
    and the market rate of interest is 8.1.
  • What is the current market price of this bond?
  • Suppose that the current market interest rate
    falls to 6.54. What will be the new market
    price for this bond?
  • Suppose that when the bond was first sold, its
    market price was 1000. What must have been the
    market rate of interest then?
  • Consider a bond with FV1000, maturity in 2024,
    C81 and i7.25
  • What is the current price of this bond?
  • If the Fed jumps into the bond market, even
    though it just buys U.S. Treasuries, it will
    affect all interest rates to some extent. If
    they buy lots of bonds and interest rates fall to
    6.88, what will happen to the price of your
    bond?
  • The bond in 2 was given to you by your kindly
    aunt. She told you it matures in 2024, but her
    eyesight isnt so good. You take a close look at
    the bond and see that it matures in 2020. Market
    i7.25.
  • What is the price of this bond? Why is it
    different than what you calculated in 2a?

10
Is Policy the Right Choice?
  • Time lags make effective policy uncertain.
  • Discretionary policy promotes uncertainty.
  • Rules and credible adherence can eliminate bias.
  • Independence is a likely key requirement.

11
Time Lags in Monetary ( Fiscal) Policy
  • Policy time lags
  • Recognition lag
  • Response lag
  • Transmission lag

Real GDP
Business cycle
time
12
Monetary Policy may be counterproductive
?Real GDP
time
Ideally, policy would dampen the business cycle
But, dampening the business cycle may lower ave.
growth!
Or, if policy kicks in at the wrong time, it
could worsen recessions and exacerbate
inflationary periods.
13
Discretion versus Rules(Milton Friedman)
  • Discretionary policy is the source of
    instability.
  • A policy rule can eliminate that instability.
  • Set target for Bank Reserves, Monetary Base,
    Money Supply to grow in LR sustainable fashion.
  • This is a commitment to a fixed strategy no
    matter what happens to other economic variables.
  • To be successful, the commitment must be
    credible.
  • The public believes the Fed will act this way.

Rules Automatic Stabilizer
14
Has the Fed maintained stable prices?
15
Has the Fed maintained the value of the ?
16
Making Monetary Policy Transparent
Yellens Press Conference March 19, 2014
FOMC - PR March 19, 2014
17
Making Monetary Policy Rules Credible
  • Place constitutional limits on monetary policy.
  • Achieve credibility by establishing a reputation.
  • Maintain central bank independence.
  • Establish central banker contracts.
  • Appoint a conservative central banker.

18
Making Monetary Policy Rules Credible
  • Place constitutional limits on monetary policy.
  • Achieve credibility by establishing a reputation.
  • Maintain central bank independence.
  • Establish central banker contracts.
  • Appoint a conservative central banker.

19
The Federal Reserve System
I. Its History, Functions Structure
II. Fed Policy Tools Goals
  • ECO 473 Money Banking Dr. D. Foster