This chapter discusses monetary policy. You likely dealt with monetary policy in the introductory course, but now it is examined in the context of both ISLM and ADAS
The Federal Reserve changes the money supply. The reason they change the money supply is because it affects short term interest rates. The key is not the money supply, the key is interest rates.
Background of Banks and the Financial Sector:
The origins of money are described, including the origins of paper money.
Money is money if it fulfills three functions:
medium of exchange: people use it and accept it
store of value: How much an items cost cannot wildly vary day to day (it must be relatively stable in value over time)
unit of account: It be able to easily break into smaller units to pay for cheap items and accumulate to pay for expensive items
The role of banks is to make loans (fractional banking). They pay depositors a savings rate. To make money, the bank must charge borrows more money.
The bank spread is the difference between what the bank pays its depositors vs. what they charge borrowers. The spread is how banks make money. It is stable and changes little as interest rates move higher. Banking is a volume business and more loans are made at lower interest rates. Banks are usually more profitable at lower interest rates. The need for volume explains why banks constantly desire to consolidate and get bigger.
Videos in sequence:
Fractional banking implies the bank only holds a small fraction of deposits and lends most of the deposited money to people seeking loans.
Loaning money (Fractional Banking) means that there is less money at banks than deposits:
This causes concerns about bank runs.
As a side note, George Bailey would go to jail today in Itâ€™s A Wonderful Lifeâ€¦.he repeatedly mixes personal money with bank money. This is a big NO NO in the current legal environment
FDIC and Federal Reserves were created to prevent bank runs (deposits guaranteed by government and the Federal Reserve acts as lender of last resort)
The loan of one bank is the deposit of another bank, which make more loans (the loan process)
The loan process increases the money supply
The loan process in reverse reduces the money supply
The cost of creating too much money is inflation. When inflation gets too high it is call hyperinflation.
The opposite is called deflation
The money supply is affected by:
Federal Reserve (Open Market Operations)
In the introductory class, you likely learned that when the Federal Reserve created cash, it multiplied the money supply by a factor. The factor was the deposit multiplier which equaled (1/rr). The rr equaled the reserve requirement.
Example, the reserve requirement in the U.S. is 10% (or 0.10). If the Fed increases the money supply (buys treasures from banks) of $50 billion, it will increase the money supply by $500 billion.
$50 X (1/0.10) = $500
However, this assumes that everyone will immediate take all cash and deposit it in the bank. The banks will then lend out as much as they can. However this assumption never holds. People stick some money in their pockets to buy things. Banks hold a little more cash back than required by law. Therefore the formula is more complicated. We are not going to spend much time on this in the remote format (one of the casualties of the change), but I did want to highlight that the formula is more complicated and depends on the actions of individuals and banks.
The Federal Reserve (specifically the Federal Open Market Committee within the Fed) conducts monetary policy by buying and selling Treasury bonds from banks
Monetary boils down to 2 actions
#1 The Fed buys treasuries = gives money to banks = banks makes loans after loans after loans = money supply increases = interests rates reduce (money market graph) = stimulates the economy
#2 The Fed sells treasuries = takes money from bank = reduction in loans after loans after loans = money supply decreases = interest rates rise (money market graph) = pulls back the economy
In recessions = Fed buys treasuries to reduce interest rates and stimulate the economy
This will shift LM to the right â€“ an increase in money supply shifts LM right and causes interest rates to decrease
This will shift AD to the right – this is because lower interest rates (see above) drive more consumption, investment and exports
In expansions = Fed sell treasuries to increase interest rates and reduce potential of inflation.
This will shift LM to the left â€“ a decrease in money supply shifts LM left and causes interest rates to increase
This will shift AD to the left – this is because higher interest rates (see above) drive less consumption, investment and exports
As we are currently at zero interest rates (at the time of this writing, we may go negative). As an added thought, what would happen if interest rates go negative?
Fed Sticks To Coronavirus Plan: Zero Rates And QE
The headline above references the attached article.
Use your knowledge of monetary policy to defend or rebut the actions of the Federal Reserve. The brief should be a maximum of 2 pages.
Please make sure to describe what was happening in the U.S. economy using both ISLM and ADAS. You may ignore the section on Quantitative Easing as these are special tools used in unique circumstance. However, you should reference the rest of the article in your argument. Please explain whether you believe this will be effective and how your approach might differ if you were the Federal Reserve Chairperson. What will all this mean for output, prices, interest rates, and employment?
Fed Sticks To Coronavirus Plan: Zero Rates And QE
Â· JED GRAHAM
Â· 04:18 PM ET 04/29/2020
The Federal Reserve signaled Wednesday that it will anchor its benchmark interest rate near zero for a year and perhaps much longer. The meeting statement also affirmed the Fed’s stance of unlimited quantitative-easing asset buys. Fed chief Jerome Powell’s press conference did nothing to spoil the mood on Wall Street as the Dow Jones surged to a post-coronavirus-crash high on good news about Gilead’s Covid-19 treatment.
ke a look at the major
With the coronavirus shutdown costing the U.S. economy 24 million jobs, the Fed statement noted “a surge in job losses” and “tremendous human and economic hardship” due to the coronavirus crisis. Policymakers said the health crisis will weigh heavily in the near term and “poses considerable risks to the economic outlook over the medium term.”
The Fed said it will keep rates in the 0%-0.25% range until the “economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
Powell said at his post-meeting press conference that the Fed would continue to act “forcefully proactively and aggressively” to try to assure a robust recovery.
But he indicated that the road would likely be a long one. “It will take some time” to reach “anything that resembles maximum employment,” he said.
Dow Jones, Treasury Yields React To Fed Meeting
The Dow Jones Industrial Average and other major indexes initially came off intraday highs after the Fed meeting, then strengthened, before paring gains slightly at the close. The Dow Jones climbed 2.2%, the S&P 500 rose 2.7%, and the Nasdaq composite added 3.6%.
Meanwhile, the 10-year Treasury yield, which dipped to 0.6% ahead of the Fed’s 2 p.m. ET statement, ticked up slightly to 0.62%.
Fed Chief Powell: The $6 Trillion Dollar Man?
The Fed didn’t announce major new actions because it’s already committed an unprecedented amount of support to keep the U.S. economy from imploding due to the coronavirus shutdown.
In March, without waiting for its regularly scheduled meeting, the Fed slashed rates close to zero in two steps, launched unlimited quantitative easing and scooped up more than $2.4 trillion in assets, primarily Treasuries and mortgage securities.
The bottom for the Dow Jones and broader stock market came on March 23, the day the Federal Reserve launched unlimited QE. While the $2 trillion federal aid package also played a role in shifting sentiment, “Don’t fight the Fed” has proved to be good advice.
Under Fed chief Powell, the central bank has announced a series of programs that could see it provide $4 trillion in funding to businesses hurt by the coronavirus, as well as states and municipalities. The Cares Act coronavirus rescue set aside $454 billion for the Treasury Department to backstop the programs, with the Fed supplying the bulk of the liquidity.
How Big Will The Fed’s Balance Sheet Get?
Some Wall Street firms expect the Fed balance sheet to keep surging, from $6.6 trillion last week to about $11 trillion in coming months. That will be driven by Fed lending programs and purchases of corporate and municipal bonds.
But there’s a pretty big wild card, says UBS chief economist Seth Carpenter. “Demand for the credit facilities could be less than we think if the terms are not attractive,” he wrote. He sees the Fed balance sheet ending the year at about $8.5 trillion.
Powell gave an update on the lending programs to business. The programs aren’t up and running yet. The big business lending facilities should be ready soon, he said. But it will take a little longer to ready the Main Street Lending Program for small and midsize firms.
Powell noted that the Fed program isn’t limited by a dollar ceiling, like the Small Business Administration’s Paycheck Protection Program that temporarily ran out of funds. However, he did signal some doubt about how much demand there will be.
There’s a “tremendous amount of financing going on” for companies that might have tapped Fed facilities. His view is that the announcement of the Fed programs “got the (credit) market functioning again.”
What’s Next For Fed Quantitative Easing
The Fed restarted quantitative easing with a March 15 announcement, saying it would buy “at least” $700 billion in Treasuries and mortgage securities to assure the smooth functioning of markets. A week later, the Fed said it was all in and would buy “the amounts needed” to get the job done.
At the peak, it took daily purchases of $75 billion in Treasuries and $50 billion in mortgage-backed securities, or $625 billion in a week. But the Fed has gradually dialed back those amounts. This week, it’s buying $10 billion in Treasuries each day and $8 billion in MBS.
The thrust of the Fed’s intervention has shifted to its new credit facilities. But economists are beginning to think about what will happen after those have been tapped.
A key question: What will the Fed do to keep long-term interest rates low as multitrillion-dollar deficits create a flood of issuance?
Yield Curve Control?
Wall Street economists think the answer may be something the Federal Reserve last tried in the 1940s: yield curve control. Many expected at least a preliminary discussion on Wednesday, though not necessarily an announcement.
“When the economy starts to recover with very large federal debt issuance, there is some risk of an unwelcome jump in Treasury yields,” wrote Lewis Alexander, Nomura’s chief U.S. economist. “Ultimately we think the FOMC will adopt some form of yield curve control.” He expects such an announcement by June.
Yield curve control could be a way for the Fed to conserve its balance-sheet ammunition. One way it might work is for the Fed to set interest rates, rather than market forces, up to perhaps two-year Treasuries. While longer-term yields might still float, the Fed could use all of its QE power at the longer end of the Treasury curve to hold rates in check.
But that’s a subject for another day. Fed chief Powell didn’t touch on the possibility on Wednesday.