Post on 08-Jan-2018
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18 – Monetary Policy
Chapter 18
Monetary Policy Tools
Policy tools– Target federal funds rate– Discount rate– Reserve requirement
Effective policy tools– Observable– Controllable– Linked to Objectives
Objectives of Fed
1) Low stable inflation2) High, stable output3) Stable interest rates
Target Federal Funds Rate
Federal Funds Rate– Rate at which banks lend to each other overnight– Limits amount of excess reserves banks need to hold– Unsecured loans
Fed does not participate directly in market– As borrower, would have to pay interest– Credit risk– “Free” market provides valuable information on bank health
Target Federal Funds Rate
Rate is determined by supply and demand for reserves
Target Federal Funds Rate
Interest Rates
Banks with excess reserves always have the option of– Attracting new borrowers– Loaning out reserves in Fed-Funds market
As Fed Funds rate increases, so must other rates on loans to consumers.– Otherwise banks maximize profits by loaning out
in Fed-Funds market.
Interest Rates and Demand
As Interest rates increase– More expensive for firms to borrow– More expensive for consumers to borrow– Demand decreases
Lower inflation, output
As Interest rates decrease– Less expensive for firms to borrow– Less expensive for consumers to borrow– Demand increases
Higher inflation output
Discount Lending
Not used as a primary policy instrument
Used to– Ensure short-term financial stability– Eliminate bank panics– Prevent sudden collapse of institutions
Discount Lending
Primary Credit– Overnight loans to banks deemed to be financially
sound– Banks must post some sort of collateral– Primary Discount Rate: 100 basis point above
target Fed Funds rate
– Puts ceiling on Fed Funds Rate
Discount Lending
Secondary Credit– Banks that are not financially Sound– Secondary Discount Rate: 50 basis points above
primary discount rate
– Considered a bad signal for bank
Reserve Requirements
Primary Purpose: help stabilize demand for reserves
Not a good policy tool because– Small changes in reserve requirement lead to
excessive changes in deposits.– Continually fluctuating reserve requirements creates
greater uncertainty for banks and make liquidity management more difficult.
Reserve Requirements
During Great Depression– Banks built up piles of excess reserves– Fed became worried stock piles could quickly be
depleted, leading to inflation– August 1936 – Fed doubled reserve requirement– Banks spent next few years building up excess
reserves.
Policy Instruments
Observable Controllable Linked to Objectives
Interest rates– How are they linked to objectives?– Inflation targeting?
Inflation Targeting
Advantages– Does not rely on stable relationship between
money and inflation.– Understood by public - simple and clear– Increases accountability
Disadvantages– Delayed signaling – how good in the bank doing?– Too much rigidity that can lead to volatile output
Monetary Targeting
Fed Funds Futures Contracts
Fed Funds Futures Contract traded on CBOT since October 1988.
Time 0: Traders agree to go long or short at futures price, F0
Settlement Price (ST): 100 minus the average daily fed funds overnight rate for the delivery month
Contract size: $5 million
Settled at end of last business day of the month– Long party gets: ST-F0
– Short party gets: F0-ST
Fed-Funds Futures Example
Contract is for January, 2008 Current Futures price today: 95.68 I go long a January Fed-Funds futures contract today
(in December). On January 31 contract settlement is determined. Clearing house looks at actual average Fed-Funds
rate over January.– Assume it has been 4.25%– I get paid (95.75-95.68)*.01*5M =.07*5M=$3,500
Fed Funds Futures
The lower the Fed Funds rate over January, the more I win.– Long positions in Fed futures hedge against
falling Fed-Funds rates.
The higher the Fed Funds rate over January, the more the short party wins.– Short positions in Fed futures hedge against
rising Fed-Funds rates.
Predicting What the Fed will Do
Example:– 19 days left in December– The Fed meets in 7 days– Will not meet again until January– Current Target Fed Funds rate: 5.25%
Predicting What the Fed will Do
Assume– The Fed hits its target Fed Funds rate each day– The Fed does not enact new monetary policy until
the Wednesday after its meeting– Fed Funds futures prices are set so that the
expected, or average payoff to either side is zero.
Predicting What the Fed will Do
Implications:
– For 19 days of December, the Fed Funds rate will be 5.25
Only 19 days left: for the first 12 days it was 5.25 For the next 7 days it will be 5.25 Includes date of FOMC meeting
– The Fed Funds rate for the remaining 12 trading days in December will depend on what the Fed decides to do.
Predicting What the Fed will Do
Averages for December– If Fed lowers by 25bp: (19*5.25+12*5.00)/31 = 5.15– If Fed keeps rates steady: 5.25– If Fed raises by 25bp: (19*5.25+12*5.50)/31 = 5.35
If market expects– Average to be 5.15, then F0 =100-5.15 = 94.85– Average to be 5.25, then F0 =100-5.25 = 94.75– Average to be 5.35, then F0 =100-5.35 = 94.65
How Good are Our Assumptions?
The Fed hits its target Fed Funds rate each day
How Good Are the Assumptions?
The Fed does not enact new monetary policy until the days after its meeting
Fed may take a few days to fully implement policy.
19 – Exchange Rate Policy
Chapter 19
Fixed Exchange Rates
PPP: Inflation erodes the value of currency
If a country wants to fix its exchange rate with another country, it must conduct monetary policy so that the two countries’ inflation rates match.
A central bank must choose between a fixed exchange rate and an independent monetary policy.
But PPP only holds over long periods. What about in the short term?
Fixed Exchange Rates in the Short Run
When buying a foreign bond FVf = Face value of bond in foreign currency Pf = Price of bond in foreign currency rf= return on bond in terms of foreign currency
1f
ff PFV
r
Fixed Exchange Rates in the Short Run
What you care about is return in dollars. rf= return on bond in terms of foreign currency Et = dollar-foreign ex-rate at time t Assume bond is purchased at time t Assume bond matures at time t+1
1*
1
1
1
t
t
f
f
tf
tfd
EXEX
PFV
EXPEXFV
r
Fixed Exchange Rates in the Short Run
If exchange rate is fixed, then
implying
11
t
t
EXEX
ff
fd r
PFV
r 1
Fixed Exchange Rates in the Short Run
Conclusion: As long as capital is able to flow across
borders freely, monetary authorities can choose to control either– Exchange rate– Interest rate
Mechanics of Exchange rate Intervention
Central banks agrees to exchange currency for dollars at a fixed rate.
Bank must maintain a substantial amount of dollar reserves to keep currency from depreciating.
Fixed Exchange Rate Costs/Benefits
Benefits– Eliminate exchange rate risk– Effective way to control inflation in inflation-prone
countries
Costs– Import monetary policy– Central bank must have ample dollar reserves
Methods of Fixing Exchange Rate
Currency Boards– Central bank holds enough dollars to keep
currency from depreciating– Example: Argentina
Dollarization– Country adopts dollar as official currency– Example: Ecuador