5 Sept 30

• Open Market Operations (Review)• Money Supply and Money Demand (Review)• Interest Rates• Economic Consequences of Fed Actions• Fed Responses to the Financial Crisis and Great

Recession: Quantitative Easing I, II and III

Monetary Policy

• Expansionary Monetary Policy—actions which increase the money supply

Monetary Policy

• Expansionary Monetary Policy—actions which increase the money supply

• Contractionary Monetary Policy—actions

which decrease the money supply

Tools of the Fed

• Open Market Operations• The Fed Buys or Sells T-Bonds

An Open Market Operation

• The Fed buys a $100,000 T-Bond from a bond dealer, and pays for it by electronic transfer of $100,000 to the bond dealer’s checking account

Fed Buys $100,000 BondBond Trader’s Balance Sheet

Assets (A) Liabilities (L)

T-Bonds −100,000

Deposits +100,000

An Open Market Operation

• The Fed buys a $100,000 T-Bond from a bond dealer, and pays for it by electronic transfer of $100,000 to the bond dealer’s checking account

• Consequently, the bond dealer’s bank’s balance sheet shows a $100,000 increase in reserves

Fed Buys $100,000 BondBank’s Balance Sheet

Assets (A) Liabilities (L)

Reserves +100,000 Deposits +100,000

Fed Buys $100,000 Bond

Δ Total Deposits

= Initial Δ in Reserves1

(R + E)

= $100,0001

(.1 + 0)

= $100,0001

(.1)

= $100,000 × 10

= $1,000,000

Fed Buys $100,000 Bond

Δ Total Deposits

= $1,000,000

Δ Money Supply = Δ Total Deposits

+ Δ Cash held by the public

= $1,000,000 + $0

= $1,000,000

Buying bonds is expansionary monetary policy

An Open Market Operation

• The Fed sells a $100,000 T-Bond to a bond dealer, and the bond dealer pays for the bond by an electronic transfer of $100,000 from their checking account

Fed Sells $100,000 BondBond Trader’s Balance Sheet

Assets (A) Liabilities (L)

T-Bonds +100,000

Deposits −100,000

An Open Market Operation

• The Fed sells a $100,000 T-Bond to a bond dealer, and the bond dealer pays for the bond by an electronic transfer of $100,000 from their checking account

• Consequently, the bond dealer’s bank’s balance sheet shows a $100,000 decrease in reserves

Fed Sells $100,000 BondBank’s Balance Sheet

Assets (A) Liabilities (L)

Reserves −100,000 Deposits −100,000

Fed Sells $100,000 Bond

Δ Total Deposits

= Initial Δ in Reserves1

(R + E)

= −$100,0001

(.1 + 0)

1

(.1)

× 10

= −$1,000,000

= −$100,000

= −$100,000

Fed Sells $100,000 Bond

Δ Total Deposits

= $−1,000,000

Δ Money Supply = Δ Total Deposits

+ Δ Cash held by the public

= −$1,000,000 + $0

= −$1,000,000

Selling bonds is contractionary monetary policy

Tools of the Fed

• Open Market Operations• The Fed Buys or Sells T-Bonds in the SOMA

• Changing the Reserve Requirement

Tools of the Fed

• Open Market Operations• The Fed Buys or Sells T-Bonds

• Changing the Reserve Requirement• Reserve Lending from the “Discount Window”

• Three Programs:• Primary Credit• Secondary Credit• Seasonal Credit

• Role as “Lender of Last Resort”

• Main policy tool: The Discount Rate

Money Supply Curve

MS

i MS

M

Assumptions:

E constant for all banks

No change in cash held by the public

Fed Buys Bonds

MS

i MS

M

MS′

MS′

Fed Sells Bonds

MS

i MS

M

MS

MS

′

′

Money Demand Curve

i

M

MD

Equilibrium in the Money Market

i

M

MD

MS

i*

M*

Equilibrium in the Money MarketWhat if the Fed buys bonds?

i

M

MD

MS

i*

M*

Equilibrium in the Money MarketWhat if the Fed buys bonds?

i

M

MD

MS

i1*

M1*

i2*

M2*

Equilibrium in the Money MarketWhat if the Fed sells bonds?

i

M

MD

MS

i*

M*

Equilibrium in the Money MarketWhat if the Fed sells bonds?

i

M

MD

MS

i2*

M2*

i1*

M1*

Target Fed Funds RateSince Jan. 1, 2005

Effective Fed Funds RateSince Jan. 1, 2005

Target and Effective Fed Funds RateSince Jan. 1, 2005

Target and Effective Fed Funds RateSince Jan. 1, 1985

Why Does the Fed Target i Instead of M?

• i is easier to control than M

Why Does the Fed Target i Instead of M?

• i is easier to control than M• i is more closely related to the economic variables the Fed ultimately cares about, like

• Inflation• Unemployment

Five Interest Rates Since 1980

Real vs. Nominal Interest Rates

• Nominal interest rate = i

• Real interest rate = r

• Inflation rate = π

i = r + π

r = i – π So, if i = 4%, π = 3%, then r = 1%

If forecasting, use πe, expected inflation:

i = r + πe

Bank wants r = 5%, and πe = 3%, sets i at 8%

Finance Jargon:Basis Points (bps)

What is a “basis point”?

A basis point is 1/100 of a percentage point

Advantage:Avoids the ambiguity between relative and absolute discussions about rates. For example, a "1% increase" in a 10% interest rate could mean an increase from 10% to 10.1%, or from 10% to 11%.

10% to 10.1% = 10 basis points10% to 11% = 100 basis points

Economic Consequences of Fed Actions

Fed buys bonds

Economic Consequences of Fed Actions

Fed buys bonds i↓

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Investment ↑

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Investment ↑

Net Exports ↑

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Investment ↑

Net Exports ↑

Aggregate Demand ↑

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Investment ↑

Net Exports ↑

Aggregate Demand ↑

National Income ↑

Economic Consequences of Fed Actions

Fed buys bonds i↓

Consumption ↑

Investment ↑

Net Exports ↑

Aggregate Demand ↑

National Income ↑

Inflation ↑ (sooner or later)

Economic Consequences of Fed Actions

Fed sells bonds

Economic Consequences of Fed Actions

Fed sells bonds i↑

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Investment ↓

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Investment ↓

Net Exports ↓

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Investment ↓

Net Exports ↓

Aggregate Demand ↓

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Investment ↓

Net Exports ↓

Aggregate Demand ↓

National Income ↓

Economic Consequences of Fed Actions

Fed sells bonds i↑

Consumption ↓

Investment ↓

Net Exports ↓

Aggregate Demand ↓

National Income ↓

Inflation ↓ (sooner or later)

Tools of the Fed

• Open Market Operations• The Fed Buys or Sells T-Bonds

• Changing the Reserve Requirement

• Reserve Lending from the “Discount Window”

______________________

New Fed Tools

Called collectively—”Quantitative Easing”

Quantitative Easing

Conventional monetary policy

Central bank uses open market operations—buying and selling short-term government bonds-- or loans from the discount window to bring short-term interest rates (the Fed Funds rate in the U.S.) in line with a target

Quantitative Easing

When short-term interest rates are already at or near zero, the central bank buys other financial assets from financial institutions in order to inject reserves into the system, lower interest rates on longer-term financial instruments, and stimulate the economy.

In order to be effective, banks must be willing to lend their excess reserves.

Recent Quantitative Easing

Japan Early 2000s

Financial Crisis (2007 – 2009)

Eurozone

Britain

U.S.

QE 1 (Nov. 25, 2008 – March 31, 2010)

QE 2 (Nov. 3, 2010 – June 30, 2011)

QE 3 (Announced Sept. 13, 2012)

Recent Quantitative Easing

QE 1 (Nov. 25, 2008 – March 31, 2010)

Fed bought $1.2T in MBS

Fed bought $175B in bonds from Fannie Mae, Ginnie Mae, and Freddie Mac

Impact: Lower mortgage interest rates

Impact of QE1 on Mortgage Rates

Recent Quantitative Easing

QE 1 (Nov. 25, 2008 – March 31, 2010)

Fed bought $1.2T in MBS

Fed bought $175B in bonds from Fannie Mae, Ginnie Mae, and Freddie Mac

QE 2 (Nov. 3, 2010 – June 30, 2011)

Fed began the purchase of $600B of longer-term T-Bonds

Goal Keep longer-term interest rates, esp. mortgage rates,

low

Impact: Mortgage rates increased, despite the program

Impact of QE2 on Mortgage Rates

Recent Quantitative Easing

QE 3 (Announced Sept. 13, 2012)

Fed announced it would buy $40B/mo. in MBSIncreased buying to $85B/mo. in Dec. 2012

Publicly committed to keep interest rates low through 2015

ECB announced a similar program

Impact

Impact on Banks

Impact on Savers

The “Taper”

• Fed began to reduce, or “taper,” it’s bond buying by $10B with each FOMC meeting since Dec., 2013.

• QE3 is scheduled to end in October with a final $15B/mo. reduction.

• Concerns for the financial markets

The “Taper”

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