CHAPTER 3

THE FED AND

INTEREST RATES
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The monetary base comprises the Feds 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.

Copyright 2012 John Wiley & Sons, Inc.

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.

As depository institutions lend or invest excess

reserves, M1 increases.
New loan of excess reserves increases borrowers
transactional balances.
Purchase of investment securities increases sellers
transactional balances.

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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.

Copyright 2012 John Wiley & Sons, Inc.

Copyright 2012 John Wiley & Sons, Inc.

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 return on bank reserves (most liquid of all assets);
availability of reserves to finance credit demand;
intent and effect of monetary policy.

Copyright 2012 John Wiley & Sons, Inc.

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.
Reserve effects are direct, immediate, dollar-for-dollar.
Ultimate M1 effects are substantially predictable.
Discount Rate: Cutting discount rate pressures FFR
downward, raising discount rate pressures FFR upward.
Reserve effects depend on
sensitivity of institutions to Discount Window scrutiny;
differential between discount rate & FFR.

Reserve Requirements: Cutting RR pulls FFR downward,

raising RR pushes FFR upward.
Reserve effects are direct, immediate, sustained, & too
dramatic for fine tuning.
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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
M1 may grow too rapidly
Real investment decisions may be distorted
(e.g., borrowing may just finance hoarding of assets)

Borrowing costs too high

M1 may not keep up with real sector
Economy may falter as real investment declines

Best Fed can ultimately do is try to promote stable price

levels.

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Why central banks manipulate reserves or rates: 2 schools of thought

Monetarists
Keynesians

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Monetarists: Key financial variable for changing economic activity is

the money supply.

Monetarists assume propensity to consume

rises as people perceive they have more money,
drops as people perceive they have less money,
is distorted by volatility in prices.

Thus money supply can be used to influence aggregate

demand.
Adding reserves carefully should promote economic growth.
Subtracting reserves carefully should slow the economy.
Central bank can distort price levels by over-adjusting either
way.

Short-term interest rates merely indicate monetary

policys effects.
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Keynesians: Key financial variable for changing economic activity is

interest rates.

John Maynard Keynes was influential British economist of

1930s.
Keynesians discount or disregard direct money supply
effects.
Real sector economic growth is
stimulated by falling rates as economic activity costs less to
finance,
slowed by rising rates as economic activity costs more to finance,
always and significantly susceptible to influence of monetary
policy.

To Keynesians, money supply changes reflect reactions to

interest rates.
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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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EXHIBIT 3.5
Ten-Year Treasury Rates (19602010)

Source: Federal Reserve Board of

Governors, H.15 Statistical Release.

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3 channels of the transmission process for monetary policy

Business investment in real assets

Consumer spending for durable goods and
housing
Net exports
(Gross exports less gross imports)

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Business investment in real assets

Present values of future cash flows from real assets

depend significantly on general level of interest rates.
Rates fall, PVFCF rises.
Rates rise, PVFCF drops.

Most capital expenditures are debt-financed; interest

expense is thus material in profitability of most
businesses.
Monetary policy thus always involves material incentives
or disincentives for business investment.
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.

Monetary policy can thus often affect aggregate

demand to some extent.
Fed can encourage/discourage but not necessarily
compel. Consumers dont necessarily make
financial decisions the way businesses do Businesses are mostly rational and profit-maximizing.
Consumers are partly rational and partly emotional.
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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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Monetary Policy and Economic Variables (Exhibit 3.7)

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Complications of monetary policy: controlling the money supply is

not easy.

Technical factors demand constant adjustment.

Velocity of money is difficult to predict.

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Technical factors demand constant adjustment

Cash drains
Cash holdings by public use up monetary base.
Fed must try to offset with carefully calibrated open
market purchases.

The float
DACI CIPC = Float, net extension of credit by Fed.
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.
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Velocity of money is difficult to predict

Ratio of gross domestic product to money supply
(turnover rate of unit of money in economy)
For given change in money supply, Fed
can expect general direction of change in economy.
cannot ensure particular degree of change in economy.

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The 2008 Financial Crisis

Subprime Lending Market
Deregulation
Pricing Credit Risk
Low interest rates
Increase in uncertainty
Lehman Brothers Bankruptcy

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