Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
And
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 3
THE FED AND
INTEREST RATES
The monetary base comprises the Fed’s 2 largest
liabilities:
Federal Reserve Notes in circulation
Depository institution reserves
(reserve account balances and vault cash)
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The money supply involves the Monetary Aggregates
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The Fed controls the monetary base….
To meet reserve requirements, depository institutions must
transact with Fed in monetary base assets. They either deposit adequate reserves at FRB or
maintain adequate cash in vault
Either way, reserves - required or excess - earn no interest.
The more cash or reserves an institution holds above its
requirements with the Fed, the more it wants to make new
loans or investments to avoid lost interest income.
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…Thus the Fed controls the money supply….
Excess reserves appear as Fed buys securities on open market,
lends at Discount Window, or
lowers reserve requirements
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…and the Money Supply affects the economy.
Proceeds of new loans or investments not only
increase M1 but finance purchases by DSUs of
goods or services in real sector, contributing to
economic growth.
By expanding or contracting monetary base, Fed increases or decreases excess reserves, thus
raising or lowering incentive to lend or invest, thus
encouraging or discouraging expansion in real sector.
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To influence interest rates, Fed targets but does not set
Fed Funds Rate
Fed Funds market is Fed-sponsored system in
which depository institutions lend and borrow
excess reserves among themselves
Fed Funds Rate, set by market forces as
institutions bargain with each other, is benchmark
rate, measuring
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As Fed adjusts tools of monetary policy, reserve effects influence Fed Funds
rate significantly in short run
Open Market Operations: Buying pressures FFR downward,
selling pressures FFR upward
Discount Rate: Cutting discount rate pressures FFR
downward, raising discount rate pressures FFR upward
Reserve Requirements: Cutting RR pulls FFR downward,
raising RR pushes FFR upward
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Fed cannot set Fed Funds rate in long run
Ultimately, factors in real sector determine credit demand:
Fed cannot artificially sustain FFR too low or high
Borrowing costs too low—
(e.g., borrowing may just finance hoarding of assets)
Borrowing costs too high—
• Economy may falter as real investment declines
Best Fed can ultimately do is try to promote stable price
levels
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6 basic goals of monetary policy, set by the Humphrey-Hawkins Act of
1978
Full employment
Economic growth
Price index stability
Interest rate stability
Stable financial system
Stable foreign exchange markets
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Business investment in real assets
Fed can manipulate incentives but not
compel results
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Consumer spending for durable goods & housing
Much consumer spending is on credit, so it tends to
vary directly with credit conditions
Falling interest rates tend to encourage spending
Rising interest rates tend to discourage spending
Fed can encourage/discourage but not necessarily
compel; Consumers don’t necessarily make
financial decisions the way businesses do Businesses are mostly rational and profit-maximizing
Consumers are partly rational and partly emotional
Copyright© 2006 John Wiley & Sons, Inc.
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Net exports
Interest rates affect exchange rates
Falling interest rates in a country tend to “weaken” its currency
Rising interest rates in a country tend to “strengthen” its currency
Exchange rates affect imports and exports
As domestic currency weakens—
• Domestic demand for imports drops as they become more costly but
• Foreign demand for exports rises as they become less costly
As domestic currency strengthens—
• Domestic demand for imports rises as they become less costly and
• Foreign demand for exports drops as they become more costly
Monetary policy thus usually affects net exports.
Fed can weaken or strengthen dollar, but may do so
for any of numerous reasons, related or unrelated to
export effects
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Complications of monetary policy: controlling the money supply is
not easy.
Velocity of money is difficult to predict
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Technical factors demand constant adjustment
Cash drains
Fed must try to offset with carefully calibrated open
market purchases
The float
Fed must try to offset float with carefully calibrated
open market sales
US Treasury deposits
Treasury payments cause large shifts in reserves
Fed and Treasury try to coordinate any large fluctuations
Copyright© 2006 John Wiley & Sons, Inc.
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