Upload
sabina-brooks
View
218
Download
0
Tags:
Embed Size (px)
Citation preview
Monetary Policy: Conventional and Unconventional
13Part 2
Open-Market Operations
• Which interest rate?• Fed “controls” Federal funds rate and the
Treasury bills rate (next slide)
• Fed can “influence” other interest rates such as credit cards, auto loans, mortgage rates etc.
• Normally, interest rates tend to move together
• During financial crisis relationship broke down
2
As the Fed increases or decreases the FFR, the T-bill rate follows.
Open-Market Operations
• Risk of default• The risk that the borrower may not pay in full or
on time• T-Bills are risk free• Bank to bank borrowing, federal funds rate, very
low risk
• Corporate bonds carry more risk . . .• Riskier borrowers pay higher interest rates, to
persuade lenders to accept the higher risk
4
Open-Market Operations
• Risk of default• Interest rate on a bond = Risk free rate +
Risk premium• Risk spread = Interest rate on a bond – risk
free rate• Risk spreads widen (narrow) if investors
believe there is a greater (smaller) risk of default
5
Table 2 Selected U.S. Interest Rates, September 2014 (in percent)
6
http://www.federalreserve.gov/releases/H15/update/
Open-Market Operations
• During the financial crisis risk spreads widened• Mortgages, bonds of large banks - looked far riskier than
they had before• Higher risk premiums, increasing risky interest rates
• Increased demand of U.S. T-bills – “flight to safety” • Higher T-bill price, lower T-bill interest rate
7
Risk Spreads During Financial Crisis
Commercial paper rate – 3-month T-Bill rate
Other Instruments of Monetary Policy
• Lending to banks• Fed acts as “lender of last resort”• Fed lends to banks at the discount rate, the
interest rate the Fed charges for loans to banks• This provides banks with excess reserves
• The Fed, 2007• Massive amounts of lending to banks• Helped keep the financial system functioning• Eased the panic for a time
9
Table 3 Balance Sheet Changes: Bank Borrows from the Fed
10
Fed lends reserves to banks, increasing the amount of Excess Reserves in the banking systemFed loans can increase the money supply.
Other Instruments of Monetary Policy
• Fed can influence the amount banks borrow by changing the discount rate• Lower (higher) discount rate gives banks a greater
(smaller) incentive to borrow• But Fed cannot really know how much banks will
respond• Connection between discount rate and volume of
borrowing loose• Fed normally relies on open market operations
rather than discount rate.
11
Other Instruments of Monetary Policy
• However, during financial crisis Fed lending went from• $250 million (Aug 2007) to $735 billion (Nov 2008)• Now lending back down to pre-crisis levels
• The Fed in 2007-2008 was acting as the “lender of last resort”. It was not trying to increase the money supply.
12
Other Instruments of Monetary Policy
• Changing reserve requirements• If Fed decreases
• Banks have more excess reserves• Money expansion and lower interest rates
• If Fed increase• Banks have less excess reserves• Money contraction and higher interest rates
• Reserve requirement is set at 10% of transaction deposits since 1992
13
Other Instruments of Monetary Policy
• Unconventional monetary policy• Unusual forms (or volumes) of central bank lending
and to unusual types of open-market operations• Pushing the federal funds rate down to virtually
zero• Lending to banks in unprecedented volume• Lending to some companies that are not banks• Quantitative easing
14
Other Instruments of Monetary Policy
• Quantitative easing • Open-market purchases of assets other than
Treasury bills
• Treasury bonds [longer dated]
• Other assets – in 2008 and 2009, to stabilize the mortgage market
• http://www.federalreserve.gov/releases/h41/current/h41.htm
15
How Monetary Policy Works
• Normal times• Federal funds rate is not hovering close to zero
• Risk spreads are roughly constant • Different interest rates rise and fall together
• Banks are not holding many excess reserves
16
How Monetary Policy Works
• Expansionary monetary policy• Open-market purchase of T-bills lowers interest
rates
• Contractionary monetary policy• Open-market sale of T-bills raises interest rates
17
Figure 4 The Effects of Monetary Policy on Interest Rates
18
Bank Reserves
Inte
rest
Rat
e
S0
S0D
D
S1
S1
E
A
(a)Expansionary Monetary Policy
Bank Reserves
Inte
rest
Rat
e
S0
S0
D
D
S2
S2
E
B
(b)Contractionary Monetary Policy
How Monetary Policy Works
• How do interest rates influence spending?• Y = C + I + G + (X – IM)
• Investment and Net exports and consumer spending are sensitive to interest rates
• When interest rates rise (fall), spending falls (rises)
• So expenditure falls (rises)
19
Figure 5 The Effect of Interest Rates on Total Expenditure
20
Real GDP
Rea
l Exp
endi
ture
45°
C+I+G+(X-IM)
C+I+G+(X-IM)(lower interest rate)
C+I+G+(X-IM)(higher interest rate)
How Monetary Policy Works
• Fed believes economy might slip into recession• Pursue an expansionary monetary policy• Putting it all together
21
Monetary Policy Chain of Causation
Expansionary Policy
(1) Injection of reserves into the banking system pushes down interest rates
Need to know how sensitive interest rates are to change in reserves
Monetary Policy Chain of Causation
Expansionary Policy
(1) Injection of bank reserves pushes down interest rates
Need to know how sensitive C and I are to changes in interest rates
(2) Lower r, stimulates investment and possibly consumer spending
(3) An increase in I and C causes total spending to increase
(4) GDP increases: multiplier analysis
Figure 6 The Effect of Expansionary Monetary Policy on Total Expenditure
24
Rea
l Exp
endi
ture
45°
C+I1+G+(X-IM)
C+I0+G+(X-IM)
E0
E1
6,5006,0000
Real GDP
5,500 7,000
Monetary Policy Chain of Causation
Contractionary Policy
What would occur if the Fed pursued a contractionary policy?
Money and the Price Level
• What happens to the price level when the Fed pursues an expansionary policy?• Normally, it will cause the price level to increase• How much it causes will depend on the slope of
the aggregate supply curve
26
The Inflationary Effects of Expansionary Monetary Policy
27
Pric
e Le
vel
0
Real GDP
6,4006,000
SRAS
AD0
AD0
100
E103
AD1
AD1
BAny shock that shifts the AE curve shifts the AD curve.The increase in the money supply increases Real GDP and prices.
The Inflationary Effects of Expansionary Monetary Policy
28
Pric
e Le
vel
0
Real GDP
6,4006,000
SRAS
AD0
100
E103
AD1
B
113
AD2
AD3
Impact on the price level depends on the slope of the aggregate supply curve
Complete Monetary Policy Story
Another reason the Aggregate Demand Curve Slopes Downward
• At a higher price level• The quantity of bank reserves demanded is higher• Holding the supply of reserves fixed, this will lead to
higher interest rates• Which means lower business investment and concumer
spending • Therefore, quantity demanded lower: negative slope
30
Figure 8 The Effect of a Higher Price Level on the Market for Bank Reserves
31
Bank Reserves
Inte
rest
Rat
e
S
S D0
D0
D1
D1
Effect of ahigher P
E1
E0
Unconventional Monetary Policies
• What does the Fed do when the federal funds rate is zero and the economy still needs more stimulus?• Use unconventional monetary policies• During the Financial crisis
• Massive lending to banks and non-financial firms• Open market purchase of assets other than Treasury
bills: longer term Treasury bonds and mortgage-backed securities. This is Quantitative Easing we discussed earlier.
• Objective – lower interest rates on mortgages and long-term government bonds.
32
As the Fed increases or decreases the FFR, the T-bill rate follows.
From Financial Distress to Recession
• How a financial crisis can lead to a recession• Something goes wrong in the financial
markets: loss of confidence in some financial assets• Failure of a major financial institution (e.g.,
Lehman Brothers in 2008)• Stock market crash (as in 2000)• Collapse of real estate prices (as after 2006)
34
From Financial Distress to Recession
• How a financial crisis can lead to a recession• Result: financial market distress• Risk premiums rise far above their
“normal” levels• Interest rates on risky securities are rising• Spending on the interest-sensitive components
of aggregate demand falls
35
From Financial Distress to Recession
• How a financial crisis can lead to a recession• Downward multiplier process pulls entire economy down• Worse prospects for loan repayments• Pushing risk premiums even higher• The vicious cycle continues
• Normal expansionary monetary policy may not work • Fed resorts to unconventional policies
36
From Models to Policy Debates
• How do we use this theory to address policy issues?• The debate over the conduct of stabilization policy• The debate over budget deficits• The effects of policy on economic growth• The tradeoff between inflation and unemployment