1. 14 C h a p t e r The Tools and Goals of Central Bank Monetary Policy Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2.  Learning Objectives  To understand how the policy tools available to central banks work in carrying out a nation’s money and credit policies. To explore the strengths and weaknesses of the various monetary policy tools. To learn how the Federal Reserve System controls U.S. credit and interest rate levels. To see how central bank policy actions affect a nation’s economic goals.

3. Introduction Central banks are given the task of regulating the money and credit system in order to achieve the economic goals of full employment, a stable price level, sustainable economic growth, and a stable balance-of-payments position with the rest of the world. Although these objectives are not easy to achieve and often conflict, the central bank has powerful policy tools at its disposal.

4. General versus Selective Credit Controls General credit controls affect the entire banking and financial system. Examples: reserve requirements, the discount rate, open market operations Selective credit controls affect specific groups or sectors of the financial system. Examples: moral suasion, margin requirements on the purchase of listed securities

5. Reserve Requirements In the U.S., all depository financial institutions (including nonmembers) are required to conform to the deposit reserve requirements set by the Fed. Changes in reserve requirements are a very potent, though little-used tool. Indeed, reserve requirements have recently been reduced in the U.S., and eliminated in Canada, New Zealand, and the U.K.

6. Reserve Requirements Current Levels of Reserve Requirements for Depository Institutions in the U.S. Source: Board of Governors of the Federal Reserve System, October 2001

8. reduces the amount of excess legal reserves - institutions deficient in required legal reserves will have to sell securities, cut back on loans, or borrow reserves

11. makes borrowing from the Fed less attractive (substitution effect)

13. The Discount Rate 14 - 11 Note: Intended federal funds rate effective 12/11/2001 = 1.75% Source: http://www.frbdiscountwindow.org/, April 2002

14. Open Market Operations Open market operations in the U.S. consist of the buying and selling of U.S. government and other securities by the Federal Reserve System to affect the quantity and growth of legal reserves, and ultimately, general credit conditions. Open market operations are a most flexible policy tool, suitable for fine-tuning the financial markets.

17. Types of Federal Reserve Open Market Transactions Securities Securities Dealer Dealer Federal Reserve bank Federal Reserve bank Reserves Reserves Dealer’s bank Dealer’s bank Reserves Reserves Securities returned Securities returned RP or Reverse RP Transaction (temporary change in the level of reserves held by depository institutions) RP: Fed buys securities temporarily Reverse RP: Fed sells securities temporarily Later on: Later on:

18. Types of Federal Reserve Open Market Transactions Maturing Treasury securities Federal Reserve bank Treasury Pays cash Sells more securities to raise more cash Dealer Orders bank to pay for the new securities Reserves Dealer’s bank Run-Off Transaction (permanent reduction in the level of reserves held by depository institutions)

19. Types of Federal Reserve Open Market Transactions Places order for securities through a Federal Reserve bank which then contacts dealer Federal Reserve customer Dealer Delivers securities Orders payment to dealer Dealer’s bank Customer’s bank Reserves Agency Transaction (Type A) (no change in the total level of reserves held by all depository institutions)

20. Types of Federal Reserve Open Market Transactions Federal Reserve customer Places order for securities Federal Reserve bank Securities delivered from Fed’s own portfolio Orders payment to Fed Reserves Customer’s bank Agency Transaction (Type B) (permanent reduction in the level of reserves held by depository institutions)

21. Open Market Operations Defensive open market operations are technical adjustments in market conditions to preserve the status quo and to maintain the present pattern of interest rates and credit availability. In contrast, dynamic open market operations are designed to upset the status quo and to change interest rates and credit conditions to a level the Fed believes to be more consistent with its economic goals.

22. Selective Credit Controls Used by the Fed Moral suasion refers to the use of “arm-twisting” or “jawboning” by central bank officials to encourage lending institutions and the public to conform with the spirit of its policies.

23. Selective Credit Controls Used by the Fed Margin requirements on the purchase of stocks and convertible bonds and on short sales of securities limit the amount of credit that can be used as collateral for a loan. Since 1974, the U.S. margin requirement on stocks, convertible bonds, and short sales has been 50% of the market value of the securities.

24. Interest Rate Targeting In recent years, the Federal Reserve has given increasing weight to targeting the cost and availability of credit in the money market (in particular, the daily average interest rate on federal funds transactions). The Fed achieves its target through open market operations that impact primarily the nonborrowed reserves (and hence the total reserves) available to the banking system.

25. Interest Rate Targeting The Fed supplies more reserves When the demand for reserves  Federal Funds Interest Rate (%) D’ S’ D S Such that the federal funds rate is maintained at the desired level E’ E   Supply of Reserves ($)

26. Monetary Policy Targets Instrumental Targets (the federal funds rate & the growth of total reserves) Intermediate Targets (money & credit growth & long-term interest rates) Final Targets (low unemployment & inflation, sustainable economic growth, & a stable international balance-of-payments position) Operating Targets (borrowed & nonborrowed reserves)

27. The Federal Reserve and Economic Goals The Goal of Controlling Inflation Inflation creates undesirable distortions in the allocation of scarce resources. In the 1990s, several central banks (such as New Zealand, Canada, and U.K.) began setting target inflation rates or rate ranges. The U.S. has not set an explicit inflation rate target – it pursues price stability and full employment simultaneously.

28. The Federal Reserve and Economic Goals The Goal of Full Employment The Employment Act of 1946 committed the U.S. government to minimizing unemployment as a major national goal.

29. The Federal Reserve and Economic Goals The Goal of Sustainable Economic Growth The Federal Reserve has declared that one of its most important long-term goals is to keep the economy growing at a relatively steady and stable rate – that is, a rate high enough to absorb increases in the labor force and prevent the unemployment rate from rising but slow enough to avoid runaway inflation.

32. The Trade-offs Among Economic Goals However, there is growing research evidence that full employment and price stability (the absence of serious inflation) are compatible with each other in the longer term. This definition of sustainable long-run full employment is often referred to by economists as the NAIRU – the non-accelerating inflation rate of unemployment.

33. The Limitations of Monetary Policy Central banks cannot completely control financial conditions or the money supply. Changes in the economy feed back on the money supply and the financial markets. The structure of the economy is changing due to deregulation, internationalization, technological developments, etc., such that changes in domestic interest rates are probably not as potent a factor affecting the economy as they were a decade ago.

34. Money and Capital Markets in Cyberspace Most central banks maintain comprehensive websites, including information on what tools they normally use to carry out their money and credit policy. Visit, for example, http://www.federalreserve.gov/ http://www.bankofcanada.ca/en/ http://www.bankofengland.co.uk/ http://www.rbnz.govt.nz/ http://www.bis.org/cbanks.htm

35. Chapter Review Introduction General versus Selective Credit Controls General Credit Controls of the Fed Reserve Requirements The Discount Rate Open Market Operations Selective Credit Controls Used by the Fed Moral Suasion by Central Bank Officials Margin Requirements

36. Chapter Review Interest Rate Targeting The Federal Funds Rate The Federal Reserve and Economic Goals The Goal of Controlling Inflation The Goal of Full Employment The Goal of Sustainable Economic Growth Equilibrium in the U.S. Balance of Payments and Protecting the Dollar

37. Chapter Review The Trade-offs Among Economic Goals The Limitations of Monetary Policy