Monetary Policy
...pleasure of picking the three remaining directors. The district bank directors don’t play a role in daily procedures of the banks, but they do meet regularly to supervise bank procedures. The directors also select the president of the bank in their district. The presidents, selected by the directors take part in monetary policy making with the Board of Governors in Washington D.C. Now we look at the Federal Open Market Committee (FOMC). They are the ones who make monetary policy. The FOMC is made up of 12 members-the seven members of the Board of Governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco (federalreserve.gov/fomc). The rest of the district bank presidents take turns serving on the FOMC, because the New York Fed president actually carries out monetary policy, so this person is always on the committee. Page 4 Tools of Monetary Policy The Federal Reserve controls inflation or influence output and employment indirectly by raising or lowering interest rates. The Fed mainly affects interest rates through open market operations and the discount rate. Both of these methods work through the market for bank reserves, known as the federal funds market. Bank reserves are banks that can hold a specific amount of funds in reserve. These funds are called reserves and banks keep them as cash in their vaults or as deposits with the Fed. The major tool of monetary policy is the Fed’s open market operations, which are the buying and selling of the government bonds by the Fed to control bank reserves, the federal funds rate, and the money supply (Boyes and Melvin, 333). The Federal Reserve Bank of New York conducts these operations. If the Fed wants to lower the federal funds rate, it buys government securities, or bonds, from a bank. The Fed then pays for the securities by increasing that bank's reserves. As a result, the bank now has more reserves than it is required to hold. So the bank can lend these excess reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls. If the Fed wants to raise the federal funds rate, then it does the opposite and sells government securities, or bonds. The Fed receives payment in reserves from banks, which lowers the supply of reserves in the banking system, and the federal funds rate rises. If a bank needs more reserves to make new loans, it can borrow from the Fed. They can also borrow from other banks, but if they do borrow from the Fed, the Fed uses the discount rate. The discount rate is the interest rate the Fed charges commercial banks when they borrow from it (Boyes and Melvin, 333). The discount rate plays a role in monetary policy because, Page 5 traditionally, changes in the rate may have announcement effects, which are that they sometimes signal to markets a significant change in monetary policy. A higher discount rate can be used to indicate a more restrictive policy, while a lower rate may signal a more expansionary policy. Therefore, discount rate changes are often coordinated with FOMC decisions to change the funds rate. Foreign Exchange Market Intervention Purchases and sales of foreign currency by the Fed are directed by the FOMC, acting in cooperation with the Treasury, which has overall responsibility for these operations. The Fed does not have targets, or desired levels, for the exchange rate. Instead, the Fed gets involved to counter uncontrollable movements in foreign exchange markets, such as speculative movements that may disrupt the efficient functioning of these markets or of financial markets in general. The Foreign exchange market intervention is the buying and selling of foreign exchange by a central bank in any nation in order to move exchange rates up or down. The graph on page 6 shows the U.S. dollar and Japanese yen market exchange. At point A, the exchange rate is 100 yen per one U.S. dollar. Lets say that over a period of time, Americans buy more from Japan than Japanese buys from the U.S. Equilibrium shifts to point B as the supply of dollars increase in relation to the demand for dollars. Now the exchange rate is 90 yet per one U.S. dollar. The dollar has depreciated against the yen. Now to appreciate the U.S. dollar, the Fed must intervene in the foreign exchange market to increase the dollar value. The Fed does this by buying dollars in exchange for yen, shifting the demand curve to point C, where equilibrium is back to 100 yen per U.S. dollar. Page 6 Intervention operations involving dollars, whether initiated by the Fed, the Treasury, or by a foreign authority, are not allowed to alter the supply of bank reserves or the funds rate. The use of the domestic open market operations to offset the effects of a foreign exchange market intervention on the domestic money supply is called the "sterilization" of exchange market operations. As such, these operations are not used as a tool of monetary policy. Here is the Foreign Exchange market graph involving Japanese yen and the U.S. dollar value. Page 7 Money Demand and Supply Functions The quantity of money you want to hold in your hand is your demand for money. If we can sum the quantity of money demanded by each person, then we can find the money demanded for the whole economy. First, we must know what determines money demand, then we can take that and the money supply and observe how money influences the interest rate and the equilibrium level of income. There are three determinants for money demand and they are: transactions demand for money, precautionary demand for money, and speculative demand for money. The transactions demand is the demand to hold money to buy goods and services. The precautionary demand is the demand for money to cover unplanned transactions or emergencies. The speculative demand is the demand for money created by uncertainty about the value of other assets. The interest rate and nominal income persuade how much money people save in order to carry out these three activities. The Fed is responsible for setting the money supply. The fact that they can decide the money supply means that the money supply function is independent of the current interest rate and income. To find the equilibrium interest rate and quantity of money, we must combine the money demand and money supply functions. In the graph below, it graphs equilibrium in the money market. Equilibrium, the point where the two lines intersect, interest rate is at 9 percent and the quantity of money is at $600 billion. Let’s say that if the interest rate falls under 9%, there will be a greater demand for money. People are going to want more money but the Fed cannot supply that much. Since the money supply does not change, the demand will push the interest Page 8 rates up because people can sell stocks for money. Now that they have money, interest rates increase. However, if interest rates rise over 9%, it creates an excess supply of money, and people have more money than they should. With this excess money, people will buy non-monetary assets like bonds. Then the price of bonds will increase. The only way to restore equilibrium is to lower the interest rates. This graph shows Equilibrium in the money market and what happens to interest rates and the quantity of money. Page 9 Economic Theories There are two main economic theories in monetary policy, which are economic growth and price level stability. ...