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DAY 4 PROBLEM SET Monetary Policy and the Interest Rate.doc

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DAY 4 PROBLEM SET Monetary Policy and the Interest Rate (ANSWERS).pdf

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APMac U4 L6 banking and the money supply

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Define monetary policy and related terms.

Explain (using graphs as appropriate) the short-run effects of a monetary policy action.

Calculate (using data and balance sheets as appropriate) the effects of a monetary policy action.

Define why there are lags to monetary policy.

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Fiscal and monetary policy have short-run effects on macroeconomic outcomes.

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Central banks implement monetary policies to achieve macroeconomic goals, such as price stability.

The tools of monetary policy include open-market operations, the required reserve ratio, and the discount rate. The most frequently used monetary policy tool is open-market operations.

When the central bank conducts an open-market purchase (sale), reserves increase (decrease), thereby increasing (decreasing) the monetary base.

The effect of an open-market purchase (sale) on the money supply is greater than the effect on the monetary base because of the money multiplier.

Many central banks carry out policy to hit a target range for an overnight interbank lending rate. (In the United States, this is the federal funds rate.)

Central banks can influence the nominal interest rate in the short run by changing the money supply, which in turn will affect investment and consumption. [See also the influence on net capital inflows.]

Expansionary or contractionary monetary policies are used to restore full employment when the economy is in a negative (i.e., recessionary) or positive (i.e., inflationary) output gap.

Monetary policy can influence aggregate demand, real output, the price level, and interest rates. [See also the effect on exchange rates.]

A money market model and/or the AD–AS model are used to demonstrate the short-run effects of monetary policy.

In reality, there are lags to monetary policy caused by the time it takes to recognize a problem in the economy and the time it takes the economy to adjust to the policy action.

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The security system for this website has been triggered. Completing the challenge below proves you are a human and gives you temporary access.

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1. Can you describe the money market?

2. Can you graph the money market?

3. Can you explain why the demand curve is downward sloping?

4. Can you explain why the supply curve is vertical?

5.  How do banks create money?

6. Can you use the money multiplier to figure out how much a deposit will: (a) maximally change the potential new loans by the bank; (b) maximally change the potential new loans by the banking system; (c) maximally change the money supply, and; (d) maximally change demand deposits?

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Here is the answer key to the practice set that we worked on in class.

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Here is the practice set that we worked on in class. The next document is the answer key.

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You've most likely heard that the Federal Reserve has a dual mandate regarding monetary policy. But do you know what that means? The Fed's dual mandate is commonly understood as pursuing the economic goals of:

1. Maximum employment: Maximum sustainable employment is the level at which cyclical unemployment-the type of unemployment that rises during economic downturns-is eliminated.

2. Price stability: If prices for goods and services are stable, that preserves the purchasing power of money. The Federal Open Market Committee, or FOMC, has equated price stability with a low, measured rate of inflation. (Inflation is a general, sustained upward movement of prices for goods and services in an economy.) To achieve this part of the mandate, the FOMC targets an inflation rate of 2 percent over the longer run.

As the central bank, the Fed works toward this dual mandate by influencing the supply of money and interest rates in the economy.

A Bit of History

When Congress created the Fed in 1913, there was no mandate carved in stone, although the goal for our nation's new central bank was to promote badly needed economic and financial stability for the country.

As detailed in the St. Louis Fed's 2017 annual report, the Fed in the 1940s inched closer to an explicit mandate when Congress required the federal government to promote:

Then, in the late 1970s, during a period of high unemployment and high inflation, Congress directed the Fed "to increase production, so as to promote effectively the goals of":

The Countdown

But wait a minute: None of this sounds like a dual mandate. Rather, it sounds as if Congress has given the Fed three mandates-if not four. Over the years, the mandates were boiled down to two: maximum employment and price stability. And now, some say the central bank can focus on price stability. Count the St. Louis Fed's president, James Bullard, among this group.

And Then There was One

Why not keep maximum employment as a key mandate? For one thing, the links between monetary policy and employment are weak and inexact. Because of this, the Fed has no explicit numerical target for the unemployment rate or for the growth of employment.

In contrast is the mandate for price stability, which is usually interpreted as low and stable inflation. The connections between monetary policy and price stability are strong in the medium to long run. Therefore, the Fed can and does set a target goal for inflation (that 2 percent target mentioned earlier). This is measured as the year-over-year percentage change in the price index for personal consumption expenditures.

Over the years, many policymakers across the globe have found that price stability is the only mandate needed. For example, the European Central Bank has had this single mandate since that bank got off the ground in the 1990s. Central bankers have found that other goals fall into line when the target for inflation is being met.

James Bullard, president and CEO of the St. Louis Fed and a participant on the Federal Open Market Committee, said recently, "The central bank can control the inflation rate over the medium term, and because of that, I think it'd be better to have a single mandate. The optimal way to deliver on the dual mandate is to pursue low and stable inflation, which in turn helps the real economy."

Notes and References

¹ For further reading, see:

Additional Resources

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Fed's Dual Mandate: Maximum Employment, Price Stability

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You've most likely heard that the Federal Reserve has a dual mandate regarding monetary policy. But do you know what that means? The Fed's dual mandate is commonly understood as pursuing the economic goals of: Maximum employment: Maximum sustainable employment is the level at which cyclical unemployment-the type of unemployment that rises during economic downturns-is eliminated.

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Federal Reserve Bank Purposes and Functions

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Federal Reserve Bank Purposes and Functions

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This is perhaps the single best site detailing the importance of the Fed.

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board of governors of the federal reserve system

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The Federal Reserve Board of Governors in Washington DC.

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For a longer overview of the Fed, check out this series produced by the Philadelphia Fed.

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For a longer overview of the Fed, check out this series produced by the Philadelphia Fed.

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This chapter provides an overview of the Federal Reserve System. Learn about the Fed's structure and the three areas in which it operates - payments, supervision and regulation of financial institutions, and monetary policy. Learn about the two goals of Federal Reserve monetary policy - price stability and maximum employment.

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The Fed's decentralized structure was put in place nearly 100 years ago. Does it still make sense? The latest in the Atlanta Fed's animated video series explains how the U.S. central bank's regional structure helps gather grassroots information about economic conditions across the nation.

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The Fed Today The Fed TodayJoin radio and television journalist Charles Osgood as he explains the workings of the Federal Reserve System. This 13-minute video covers the Fed's history from its creation in 1914 to the technological innovations of 21st century banking.

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The fourth in a series of animated videos about the Federal Reserve focuses on the origins, structure, and functions of the U.S. central bank. The video uses lively graphics and straightforward examples to explain the history of the Federal Reserve System and how its three main functions help foster a stable financial system and a growing economy.

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The money multiplier describes how an initial deposit leads to a greater final increase in the total money supply. Also known as "monetary multiplier," it represents the largest degree to which the money supply is influenced by changes in the quantity of deposits. It identifies the ratio of decrease and/or increase in the money supply in relation to the commensurate decrease and/or increase in deposits.

Let's explain this another way, in terms of our banking system: in a system of fractional reserve banking, commercial banks must only retain a particular fraction of their deposits in reserves. The reserve ratio is whatever that fraction is.

In this system, the majority of the money supply is generated by such banks, because they only have to hold some of their deposits as reserves; when these banks make loans using the rest of their deposits, this results in the creation of new money. The money multiplier is the greatest amount of money that can be created through this kind of banking.

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Money Multiplier | Intelligent Economist

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The money multiplier describes how an initial deposit leads to a greater final increase in the total money supply. Also known as "monetary multiplier," it represents the largest degree to which the money supply is influenced by changes in the quantity of deposits.

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The neutral rate of interest (also called the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*) is the short-term interest rate that would prevail when the economy is at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. It is a function of the economy's underlying characteristics and is not set by the Federal Reserve. It's usually discussed in real terms, that is, with inflation subtracted out. The neutral rate cannot be observed directly; it can only be estimated.

Why does it matter?

It matters because it affects how the Fed judges whether the interest rates it sets are stimulating or restraining the economy. The Fed may temporarily set the benchmark federal funds rate, the rate at which banks borrow from each other overnight, above the neutral rate to cool the economy or below the neutral rate to stimulate it. The neutral rate is essentially a guidepost for monetary policy.

People have been talking more about the neutral rate in recent years. The chart below shows the number of news stories mentioning the term 'neutral rate' according to a metric from Bloomberg that aggregates news trends across over 100 sources. The number of news stories mentioning the term "neutral rate" rose sharply after the Fed began raising rates in December of 2015, and rose further in 2018.

How has the level of the neutral rate changed?

Economists use different models to estimate the neutral rate. Widely cited estimates from Federal Reserve economists Kathryn Holston, Thomas Laubach and John Williams put the real (or inflation-adjusted) neutral rate at about 0.6% in the United States as of the second quarter of 2018. This measure has declined over time. The chart below shows the Holston, Laubach, Williams (HLW) estimate of the long-run neutral rate for the US since the 1970s. Since 1972, the estimated neutral rate has declined by 2.8 percentage points.

The trend is similar for other advanced economies, indicating that the decline in the neutral rate is not due only to specific factors in the United States. Across the UK, Canada, and Europe, the HLW estimate of the neutral rate of interest has fallen by an average of 2.7 percentage points since 1972.

The median projection of members of the Federal Open Market Committee-the Fed governors in Washington and the presidents of the regional Fed banks-puts the long run real neutral interest rate at 1.0% as of September 2018. The median projection of the long-run fed funds rate-essentially, an estimate of the neutral rate-has declined over time. It is now 1.3 percentage points lower than it was back in January 2012 when the FOMC started publishing this metric.

What determines the neutral rate of interest in the long term?

In the long run, the neutral rate of interest is determined by the supply of and demand for savings. For example, for firms to make new investments, they need households and other savers to supply the capital to finance that investment. Therefore, total investment in the economy must be equal to the pool of available capital or savings. For that to happen, interest rates need to be high enough to convince savers to save and low enough to incentivize borrowers to borrow. The interest rate that does this in the long run is the neutral rate of interest. Over time, there are several factors that can affect the supply of and demand for saving.

Productivity growth - If firms are more productive, they are able to produce more from a finite set of resources. Higher productivity growth is generally associated with new investment opportunities that increase the demand for capital, driving up interest rates. In recent years, productivity growth has been quite low, driving down the neutral rate.

Secular Stagnation - One view that focuses on factors related to aggregate demand is the secular stagnation hypothesis, a view advanced most prominently by former Treasury Secretary Larry Summers. Summers believes that savings has increased while desired investment has fallen due to a change in economic fundamentals-in particular, modern business requires less capital to function. As a result, he sees low real interest rates as an enduring phenomena. He reads recent interest-rate trends as evidence that the world economy has a chronic shortfall of aggregate demand for new investment and that, barring significant fiscal stimulus, interest rates will remain low for some time.

The Global Savings Glut - As the world becomes more connected, the pool of available savings becomes global, making interest rates more sensitive to capital flows in foreign economies. Former Fed Chair Ben Bernanke argues that, as a result of these forces, a ' Global Savings Glut' has driven down the neutral rate of interest. The theory contends that the export-oriented policies of emerging market economies like China flooded capital markets with an increased supply of global savings in the early 2000s. Particularly, after a wave of emerging market currency crises in the 1990s, Central Banks around the world accumulated large foreign exchange reserves to better manage capital flows. This accumulation of foreign reserves, mostly invested in US treasury bills, dramatically increased the supply of savings and drove down the neutral rate. Some research has given credibility to this hypothesis, particularly in the lead up to the Great Recession.

Should these savings and investment trends reverse, the neutral rate of interest could go back up. In April 2015 for example, Bernanke predicted that interest rates would tend to rise if trends in global capital flows reversed. Indeed recent research suggests that the global savings glut may be moderating. This differs from the secular stagnation theory, which implies a more permanent situation.

Safe Assets and Risk Aversion - Other explanations for the decline in the neutral rate focus on the demand for safe assets. If people become more risk averse, they may save more as a buffer against a future economic downturn. This could increase demand for ultra-safe U.S. Treasury bills, which are very easy to buy and sell and have a very low chance of default - the modern equivalent of stuffing cash under your mattress. Some economists argue that investors became more risk averse after the global financial crisis of 2008, and put more of their money into safe assets instead of riskier (but potentially more productive) investment projects. Some research suggests that increased risk premiums and a greater demand for safe assets is the primary force driving down the neutral rate of interest in recent years.

Demographics- For many, the biggest reason to save is to prepare for retirement. Therefore, the longer people expect to live, the more they should save. As a result, increases in life expectancy in advanced economies have increased the supply of savings and driven down the neutral rate of interest. Of course, once people retire, they draw down their savings. But at the same time, lower fertility rates mean that the US labor force is growing more slowly so there are fewer workers to supply with capital and, thus, less demand for new investment. That pushes down the neutral rate of interest. Researchers in the US, Europe and Japan have shown that demographic trends have had a large downward effect on interest rates in advanced economies. .

What are Fed officials saying about the neutral rate?

Fed officials talk a lot about the neutral rate. As the Fed increases interest rates, many have debated when they'll reach 'neutral' and if they should go beyond neutral to cool the economy. Chicago Fed President Charles Evans, Boston Fed President Eric Rosengren, and Cleveland Fed President Loretta Mester have argued for bringing the fed funds rate above neutral, to slow the economy. However, St. Louis Fed President James Bullard and Minneapolis Fed President Neel Kashkari have argued that it's not yet necessary to slow the economy because it's not yet at full capacity; being preemptive, they argue, could tip the economy into recession.

At the Fed's 2018 Jackson Hole conference, Fed Chair Jay Powell downplayed the use of the neutral rate. Because it can't be directly observed, he reasoned, estimates are uncertain and monetary policy has to be cautious about using it as a benchmark. For example, Powell pointed out that estimates of the neutral rate have been revised downwards several times. Referring to the neutral rate as r-star, as insiders often do, he said.

"[...] These assessments of the values of the stars are imprecise and subject to further revision...[T]he FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides."

In a recent speech, New York Fed President John Williams (the same Williams from the Holston, Laubach, Williams estimate of the neutral rate) similarly downplayed the use of the neutral rate. He emphasized that the neutral rate is a good benchmark as a general concept, but is less useful as a precise estimate of what rates should be in the near-term.

"[...] as we have moved far away from near-zero interest rates, it makes sense to shift away from a focus on normalizing the stance of monetary policy relative to some benchmark 'neutral' interest rate, often referred to as 'r-star.' Now, I have spent a good deal of my career studying r-star and I find it to be a useful concept for describing the economy's longer-run behavior. Having said that, at times r-star has actually gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star. More than that, r-star is just one factor affecting our decisions, alongside economic and labor market indicators, wage and price inflation, global developments, financial conditions, the risks to the outlook... I think you get the point."

What are the dangers of a low neutral rate?

A low neutral rate of interest leaves monetary policy with less room to cut interest rates in a recession. As Larry Summers noted at a Hutchins Center conference in 2017, the Fed's response to past recessions has been to cut nominal interest rates by 5.3 percentage points on average. If inflation is 2% and the neutral real rate is 1%, the normal level of nominal interest rates would hover around 3%. In that case, the Fed won't be able to cut rates by anywhere near 5 percentage points in a recession before hitting zero. Research by Fed economists Michael Kiley and John Roberts shows that with a very low neutral rate of interest, the Fed might have to lower interest rates to zero up to 40% of the time. There are several proposals for how to deal with the problem of the so-called zero-lower bound on interest rates. Some include use of the Fed's unconventional monetary tools such as quantitative easing and forward guidance. Others focus on a change in the Fed's monetary policy framework. In any case, as long as the neutral rate remains low, the Fed will have to be creative in conducting monetary policy when the next recession arrives.
This post is an updated version of a 2015 post by Peter Olson and David Wessel.

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The Hutchins Center Explains: The neutral rate of interest

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The neutral rate of interest (also called the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*) is the short-term interest rate that would prevail when the economy is at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary.

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What is the 'Discount Rate'

The discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve's discount window.

The discount rate also refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows.

BREAKING DOWN 'Discount Rate'

The Fed's discount rate is an administered rate set by the boards of the Federal Reserve Banks and approved by the Board of Governors; it is not a market rate. The Fed's 12 regional branches offer very short-term - generally overnight - loans to banks that are experiencing funding shortfalls in order to prevent liquidity problems or, in the worst-case scenario, bank failures. This lending facility is known as the deposit window; it is different from the interbank borrowing that institutions with deposits at the Fed do among themselves, which is governed by the federal funds rate.

The discount rate is actually three separate but related rates. The primary credit rate, which is sometimes referred to simply as the "discount rate" and should not be confused with the prime rate, is available to institutions with good credit. The secondary credit rate is available to institutions that do not qualify for the primary rate and is set 50 basis points higher than the primary rate. Both of these rates are set without regard to market rates. The seasonal credit rate is available to institutions that experience predictable seasonal fluctuations, such as banks serving agricultural and tourist communities. It is set every 14 days at the average of the daily effective federal funds rate and the three-month CD rate over the previous 14 days, meaning it's affected by market interest rates.

Discount window loans are collateralized ​, unlike overnight loans at the federal funds rate.

Use of the Fed's discount window soared in late 2007 and 2008, as financial conditions deteriorated sharply and the central bank took steps to inject liquidity into the financial system. In August 2007 the Board of Governors cut the primary discount rate from 6.25% to 5.75%, reducing the spread over the fed funds rate from 1 percentage point to 0.5, where it currently sits (from early 2008 to 2010 the spread was 0.25 percentage points). The board also extended the lending period from overnight to 30 days, then to 90 days in March 2008. Those measures were temporary, and the discount rate is once again used for overnight lending.

In October 2008, the month after Lehman Brothers' collapse, discount window borrowing peaked at $403.5 billion; that compares to a monthly average of $0.7 billion from 1959 to 2006.

Other central banks have lending facilities similar to the Fed's discount window. The European Central Bank's are known as standing facilities, for example.

Discounted Cash Flow Analysis

The discount rate also refers to the rate used to determine the present value of cash flows in discounted cash flow analysis. For example, to determine the present value of $1,000 a year from now, you need to discount it by a particular interest rate. Assuming a discount rate of 10%, the present value would be $909.09, according to the formula below:

=1000/(1+0.1)

If you expect to receive $1,000 in two years, the present value would be $826.45 at a 10% discount rate.

What is the appropriate discount rate to use for a project? Many companies use their weighted average cost of capital (WACC) if the project's risk profile is similar to that of the company. If the project's risk profile is substantially different from that of the company, the Capital Asset Pricing Model (CAPM) is often instead.

The discount rate can also refer to the rate at which pension plans and insurance companies discount their liabilities.

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The discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve's discount window. The discount rate also refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows.

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Federal Reserve Manages U.S. Monetary Policy

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Monetary Policy and the FED- EconMovies #9: Despicable Me

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EconMovies explain economic concepts through movies. In this episode, I use Despicable Me to explain monetary policy, interest rates, and the role of banks in the economy. Good luck studying economics. Oh, and don't mess with Janet Yellen. Thanks for watching. Please subscribe. Watch ALL episodes of Econmovies https://www.youtube.com/playlist?list...

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Macro 4.5- The Federal Reserve System- Quick Overview

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A quick overview of the FED and monetary policy. Enjoy! For more econ videos and resources visit www.ACDCecon.com. Please comment and subscribe. More information about the Money Supply https://www.youtube.com/watch?v=vc7wmTT8m0M

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In this video I explain the money market graph with the the demand and supply of money. The graph is used to show the idea of monetary policy and how changing the money supply effects interest rates. Thanks for watching.

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Mr. Clifford explains how to connect the supply and demand for money to aggregate demand and supply.

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Money Supply Shifters- Macroeconomics 4.7

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Video moving through open market operations slowly and thoroughly

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Video moving through open market operations slowly and thoroughly

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Money creation and monetary policy (part 2)