Chapter 14 The Federal Reserve and the Interest Rates

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Chapter 14The Federal Reserve and the Interest
Rates
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The Federal Funds Market

• The federal funds market Where banks lend
  reserves overnight
• The federal funds rate is the nominal interest
  rate on overnight loans between commercial banks.
• The Fed's FOMC sets a target for the federal
  funds rate, however, the federal funds rate is
  determined by the supply and demand for federal
  funds, or reserves.

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The Feds Target

• The actual federal funds rate follows closely the
  Feds target funds rate.

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The Demand for Reserves

• Like all demand curves the demand for reserves is
  downward sloping.
• The higher the fed funds rate, the more costly it
  is for banks to borrow and banks will borrow less.

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Shifts in the Demand for Reserves

• The demand for federal funds shifts right when
• The demand for loans is high
• When income (or GDP) is high
• Investment increases
• Prices increase

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The Supply of Reserves

• Total reserves borrowed reserves nonborrowed
  reserves
• Borrowed reserves are borrowed directly from the
  Fed (very small amount).
• Non-borrowed reserves are under the direct
  control of the Fed.

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Open Market Operations (a)

• The Fed controls the supply of non-borrowed
  reserves through Open Market Operations (OMOs).
• This is the Fed's most important monetary policy
  tool.
• The Fed owns government bonds it has bought from
  the public.

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Open Market Operations (b)

• When the Fed buys a government bond it pays for
  the bond by increasing the banks non-borrowed
  reserves.
• This bank now has excess reserves.
• In this way the Fed creates new reserves.
• Since excess reserves earn the bank no interest,
  the bank will lend these out.
• The money multiplier then goes to work, creating
  more and more deposits, that is, more money
  within the banking system.
• In this way the Feds control of total reserves
  influencing and of the fed funds rate also
  affects the money supply.

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Equilibrium in the Funds Market

• The Fed controls total reserves borrowed
  reserves nonborrowed reserves.
• Suppose investment increases, so the demand for
  loans and reserves increases.
• The demand curve for reserves shifts rightward.
• If the Fed does nothing, the federal funds rate
  increases.
• If the Fed wants to keep the federal funds rate
  constant, it can increase the supply of reserves
  (by performing an OMO of buying government bonds
  in the bond market).

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Interest Rate Operation Procedure

• The Fed uses an interest rate operation
  procedure.
• It chooses a target for the federal funds rate,
  then conducts OMOs to keep the market-determined
  rate close to the target.
• In the early 1980s the Fed followed a money
  supply procedure where it kept track of M1 (or
  M2).
• The Fed and most other rich countries' central
  banks have changed to an interest rate operating
  procedure since the 1980s.

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Velocity of Money

• The reason for the change to an interest rate
  operation procedure is that velocity is no longer
  predictable.
• V PY/Ms.
• Velocity became unstable because of the
  deregulation of the banking sector and financial
  innovation.