The Federal Reserve

Policy Tools, Objectives and

Targets.

ECO 285 – Macroeconomics – Dr. D. Foster

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 (!!)

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.

Intermediate Targets of Monetary Policy

• The key rationale for intermediate targeting:

– The limited long-term information about the economy available to policymakers.

Choosing an Intermediate Target Variable

• Characteristics:– Frequently

observable– Consistency with

ultimate goals– Definable and

measurable– Controllable

• Potential variables:– Monetary aggregates

M1, M2, MZM– Interest rates

(fed’l funds, prime …)

– Others:• Nominal GDP• Credit aggregates• Exchange rates

Getting from bond purchases to interest rates

Face value (FV)

$$$

mm/yyyy

$ $ $ $ $ $

Bond

Maturity date(in n

years)

Coupons & value

(C)

When the Fed buys bonds, their prices will ___ and interest rates will ___.

sells

• Usually, we talk of annual coupons• Market price of the bond = present value of income

stream discounted at interest rate i:

What is interest?

• Payment made to savers to compensate them for foregoing consumption.

• “The most powerful force in the universe is compound interest.”

• Interest rates embody our expectations of the future.

Some simple bond pricing problems

1. A bond has a face value (FV) of $1000, will mature in seven years, has an annual coupon of $74. The market rate of interest is 8.1%.

a) What is the current market price of this bond?

b) Suppose that the current market interest rate rises to 8.7%. What will be the new market price for this bond?

c) Suppose that when the bond was first sold, it’s market price was $1000. What must have been the market rate of interest then?

2. Consider a bond with FV=$1000, maturity = 2020, C=$81 and i=7.25%

a) What is the current price of this bond?

b) 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? What do you think about the Fed’s actions?

$963.68

$933.91

$1000

$1034.62

$1050.18

Woo hoo!!

Making Monetary Policy Transparent

FOMC - PR

March 17, 2015

Yellen’s Press Conference

March 18, 2015

Read Watch …

The Federal Reserve

Policy Tools, Objectives and

Targets.

ECO 285 – Macroeconomics – Dr. D. Foster