Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 1

Monetary Policy and Its Effect on Financial Markets

Andrew B. Abel

October 1, 2001

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 2

Goals of Economic Policy

• Full Employment• Lost output is lost forever

• Okun's Law: one percentage point increase in unemployment rate reduces output by 2.5%

• Development of human capital • Social consequences of unemployment

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 3

Goals of Economic Policy(cont’d)

• Price Stability• Cost of inflation

• anticipated inflation– reflected in asset prices and contracts– economize on money balances: shoe-leather costs– menu costs

• unanticipated inflation– redistributes income– individual risks reduce welfare and use resources

• hyperinflation– disrupts payments system and tax collections

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 4

Goals of Economic Policy(cont’d)

• Growth• Productivity and real wages

• capital accumulation (including human capital)• technological progress

• Social Agenda• Insure basic needs• Income distribution• Vital industries• Defense

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 5

Goals of Economic Policy(cont’d)

• Environmental Goals• Non-renewable resources• Pollution control

• Political Business Cycle

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 6

The Federal Reserve System• Regional Banks (12)• Board of Governors (7)

• Staggered 14-year terms

• Chairman has 4-year term• Federal Open Market Committee (FOMC)

• 12 Members• 7 Governors

• President of NY FRB

• Presidents of 4 of remaining 11 Regional FRBs

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 7

12 Federal Reserve Banks• Owned by Member Banks• Directors

• Class A: bankers• elected by member banks

• Class B: business (industry, commerce, agriculture)

• elected by member banks

• Class C: others, nonbankers• appointed by Board of Governors

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 8

Federal Reserve Districts

Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 9

Balance Sheets of the Fed and the Banking Sector

• Federal Reserve• High-powered money (monetary base)

• Banking System• Assets

• reserves– vault cash– deposits at Fed

• loans• securities

• Liabilities• deposits

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 10

Balance Sheets of Fed and Banks(August 2001, billions of dollars) FEDERAL RESERVE BANKS

Assets Liabilities Gold 11.0 Reserve deposits of Banks 7.6 US Govt securities 541.9 Currency 605.6 less: vault cash 44.0 Treasury deposits 5.0 circulation 561.6 Net other assets 65.3Total 613.2 Total 613.2

CONSOLIDATED BANKS AND THRIFTSAssets Liabilities Reserves 51.6 Transactions deposits 570.3 deps at Fed 7.6 Nontrans deps in M2 4124.0 vault cash 44.0 Nontrans deps in M3 only 2366.5 Loans,other net assets 7009.2

Total 7060.8 Total 7060.8

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 11

Definitions of Monetary Terms

• Reserves • Vault cash + deposits at Fed

• Monetary Base• Reserves + currency in circulation• Deposits at Fed + total currency (in circulation

and in vaults)• Money Supply

• Currency in circulation + deposits

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 12

Components of Monetary Base(August 2001, billions of dollars)

Reserves bank deposits at Fed 7.6 vault cash 44.0Total reserves 51.6Currency in circulation 561.6Monetary Base 613.2

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 13

Money Supply(August 2001, billions of dollars)

M1 1140.3Currency 561.6Travelers' checks 8.4Demand deposits 314.6Other checkable deposits 255.7

M2 5264.3Components of M1 1140.3Savings deposits, including MMDAs 2123.2Small-denomination time deposits 1011.8MMMF (retail) 989.0

M3 7630.8Components of M2 5264.3Large-denomination time deposits 797.5MMMFs (institutional) 983.7Repurchase agreements 369.9Eurodollars 215.4

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 14

Money Multiplier

• Money Supply Divided by Monetary Base• Fed controls monetary base• Public and depository institutions influence

money multiplier• August 2001

• Money supply = $1140.3 billion• Monetary base = $613.2 billion• Money multiplier = 1.86

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 15

Multiple Bank Expansion Process

...

currency-deposit ratio 0.9705 (travelers checks in deposits)reserve-deposit ratio 0.0892 (travelers checks in deposits)

Person 1 gets 105.96 currency 52.19 deposits 53.78

BANK 1Assets Liabilities reserves 4.79 deposits 53.78 loans 48.98

Person 2 gets 48.98 currency 24.12 deposits 24.86

BANK 2Assets Liabilities reserves 2.22 deposits 24.86 loans 22.64

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 16

Money MultiplierIncrease in money supply = 105.96

+ 48.98 + 22.64 + 10.47 + . . .

Eventually: money supply increases by 197.05deposits increase by 100.00currency increases by 97.05reserves increase by 8.92monetary base increases by 105.96

money multiplier = 1.86

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 17

Monetary Definitions

• Money Supply: M = CU + DEP• Monetary Base: H = CU + RES

• High-powered money• Money Multiplier: mm = M/H

• Increase in res reduces mm• Increase in cu reduces mm

mmCU DEP

CU RES

cu

cu res

11

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 18

Money Multiplier Duringthe Great Depression

• March 1930 - March 1933

• Monetary base grew by 20%

• Money multiplier fell from 6.6 to 3.6

• Therefore, money supply fell by 35%

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 19

Currency-Deposit Ratio and Reserve-Deposit Ratio during Great Depression

Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 20

Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 21

Abel/Bernanke, Macroeconomics, © 2001 Addison Wesley Longman, Inc.

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 22

M1 Multiplier in the US

0

0.5

1

1.5

2

2.5

3

3.5

1962 1967 1972 1977 1982 1987 1992 1997 2002

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 23

Factors Affecting Money Multiplier

0

0.20.4

0.60.8

11.2

1962 1967 1972 1977 1982 1987 1992 1997 2002

CU/Dep

Res/Dep

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 24

Tools of Monetary Policy

• Open Market Operations• Discount Rate• Reserve Requirements

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 25

Open Market Operations

• Open Market Purchase of Securities• Increase monetary base• Multiple bank expansion of deposits• Interest rate falls

• stimulates investment• stimulates financial outflow

– exchange rate depreciates– stimulates exports – restrains imports

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 26

Open Market Sale of Securities

• Decrease Monetary Base• Multiple Bank Contraction of Deposits• Interest Rate Rises

• Restrains investment• Stimulates financial inflow

• exchange rate appreciates– restrains exports– stimulates imports

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 27

Monetization of the Federal Budget Deficit

• Printing Money• Inflation

• Federal Reserve-Treasury Accord, 1951• Pegged rates 1942-1952

• bills: 0.5%• bonds: 2.5%

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 28

Foreign Exchange Intervention

• Defend the Dollar• Sell foreign exchange/buy dollars• Reduces monetary base

• Weaken the Dollar• Buy foreign exchange/sell dollars• Increases monetary base

• Sterilization

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 29

Discount Rate

• Discount Window Lending

• Banks borrow from Fed (Discount Window)

• interest rate is the discount rate

• Banks also borrow reserves from each other

• interest rate is Federal funds rate

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 30

Federal Funds Rateand Discount Rate

Fed Funds Rate and Discount Rate

0

5

10

15

20

1970 1975 1980 1985 1990 1995 2000

pe

rce

nt

pe

r ye

ar

Fed funds rate

Discount rate

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 31

Decrease in the Discount Rate

• Excess Reserves Fall• Loans Increase• Money Supply Increases

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 32

Reserve Requirements

• Net Transactions Accounts• 3% under $42.8 million as of 12/28/00• 10% over $ 42.8 million as of 12/28/00

• Nonpersonal Time Deposits• Reserve requirements were reduced to zero as

of 12/27/90• Fall in Reserve Requirements

• Loans increase• Money supply increases

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 33

Inflation and Interest Rates

• Real vs. Nominal Interest Rates• Ex post real rate

• nominal interest rate minus inflation

• Ex ante real rate• nominal interest rate minus expected inflation

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 34

CPI Inflation in the U.S. (12-month average)

0

2

4

6

8

10

12

14

16

1960 1965 1970 1975 1980 1985 1990 1995 2000

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 35

Nominal and Real Interest Rates (1 yr. T-bill)

-8

-4

0

4

8

12

16

1960 1965 1970 1975 1980 1985 1990 1995 2000

Nominal

Real

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 36

After-Tax Real Interest Rate

1980 2001

Prime rate (nominal) 20 6

Inflation rate 12 3

Real interest rate

Tax rate 0.5 0.4

After-tax real interest rate

After-tax real interest rate = (1-t)i -

38

-2 0.6

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 37

Increases in the Money Supply and Inflationary Expectations

• Response of Nominal Interest Rate • Liquidity effect - reduce interest rate• Inflationary expectations effect - raise interest

rate• Does Nominal Interest Rate Rise One-for-

One with Inflation?• Lower real rate of return on money

• substitute away from money• reduces real rates on substitute assets

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 38

Intermediate Targets (Instruments)

• Two Criteria for Intermediate Targets

• Fed can influence them

• Related to ultimate goals of policy

• Examples

• Monetary aggregates (M1, M2)

• Short-term interest rates (Fed funds rate)

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 39

Interest Rate vs. Money Supply Targets

• Cannot Target Both Money and Interest Rate

• Two targets could call for conflicting actions• Pegging Interest Rate Requires

Surrendering Control of Money Supply

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 40

Control Money

• Interest Rate Adjusts• Mitigates effects of shocks to consumption,

investment, net exports• Does not mitigate effects of shocks to money

demand• case of the missing money• ambiguity and changing nature of money

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 41

Control Interest Rate

• Money Supply Adjusts• Fails to mitigate effects of shocks to

consumption, investment, net exports• Insulates economy from effects of shocks to

money demand

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 42

The Historical Record

• October 1979• Policy change

• emphasized monetary base• de-emphasized federal funds rate

• Consequences• increased interest rate volatility

Monetary Policy and Its Effect on Financial Markets, Andrew Abel, October 1, 2001 43

October 1982

• Policy Change• De-emphasized monetary aggregates• Emphasized Federal Funds rate

• Consequences• Reduced interest rate volatility• Continued volatility of monetary aggregates