Chapter 30.4: Interest Rates and Monetary Policy
The Federal Reserve focuses monetary policy on the federal funds rate
federal funds rate::
the rate of interest that banks pay to borrow excess bank reserves overnight from another financial institution.
an equilibrium interest rate determined by the demand and supply for reserves
the short-term interest rate that the Fed can most directly influence
Before the financial crisis, the Federal Reserve manipulated the supply of reserves that were offered in the federal funds market
the Fed could increase or decrease the overall amount of reserves in the banking system by buying and selling government bonds in open-market operations.
This affected the amount of excess reserves that banks were willing to supply in the federal funds market and thus the equilibrium federal funds rate
during the crisis, the Fed purchased so many bonds from banks through open-market operations that nearly every bank in the country ended up with a huge amount of excess reserves
the federal funds rate plunged to nearly zero due to high supply with low demand.
The number of bank-to-bank transactions in the federal funds market collapsed because banks were rarely deficient in reserves
the Fed could no longer affect the federal funds rate by using open-market operations to alter the amount of excess reserves in the banking system.
the Fed had to figure out how to conduct monetary policy when the federal funds rate was stuck near zero
in 2008, the system was adjusted
the FOMC chooses a target range for the federal funds rate rather than a value
The Fed would lower the federal funds rate to boost borrowing and spending (and increase aggregate demand and real output) by setting a lower target then either:
lower the reserve requirement
lower the discount rate
use open-market operations to alter the amount of reserves in the banking system.
the Fed relied almost exclusively on open-market operations to buy bonds and increase the supply of reserves in the banking system
this lowered the federal funds rate
It initiated a multiple expansion of the nation’s money supply
the larger supply of money would stimulate aggregate demand and real output by putting downward pressure on other interest rates (ex. the prime interest rate)
prime interest rate::
the benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses and individuals.
higher than the federal funds rate because the prime rate involves longer, riskier loans than the overnight loans extended between banks in the federal funds market.
The federal funds rate and the prime interest rate closely track one another
other than open market operations being ineffective in changing the federal funds rate, the post-crisis Fed had a zero lower bound problem:
a central bank is constrained in its ability to stimulate the economy through lower interest rates because interest rates less than zero (negative interest rates) encourage consumers to withdraw money from banks, reducing the lending capacity of the banking system.
negative interest rates mean checking account balances would shrink over time
The Fed’s response to the zero lower bound problem was quantitative easing (QE):
the goal was not to use open market purchases to lower the federal funds rate
the goal was to buy bonds solely with the intention of increasing the quantity of reserves in the banking system.
Interest rates would remain where they were (low but positive) but more excess reserves would spur banks to lend more and stimulate aggregate demand.
Another difference between QE and regular open-market operations is that QE can involve the purchase of not only U.S. government bonds but also debt issued by U.S. government agencies or government-backed corporations (known as government-sponsored entities or GSEs).
Fed wanted to “normalize” monetary policy by returning short-term interest rates to their historically normal range of 3% or higher
they did this by raising the IOER rate to get banks to raise other interest rates.
the higher the IOER rate, the more banks would charge to lend money
they also used reverse repos to make sure the Fed could raise the federal funds rate
after 2008, the federal funds market was dominated not by bank-to-bank lending but by nonbank-to-bank lending
banks were willing to borrow money at any rate below the IOER rate because they could deposit the borrowed money at the Fed, increase their excess reserves, and earn the higher IOER rate on whatever they had borrowed from the nonbanks.
this was bad b/c the Fed could only pay IOER to banks
b/c the Fed couldn’t pay them IOER, nonbanks were willing to lend cash to banks at a federal funds rate less than the IOER rate that banks could get from the Fed.
this meant the Fed could not fully control the federal funds rate
So the Fed would perform a reverse repo with nonbanks, borrowing away the cash that the nonbanks would’ve otherwise lent to banks in the federal funds market.
If the Fed did enough reverse repos with nonbanks while raising the IOER, the federal funds rate would always rise up to the IOER rate.
These 2 actions would reduce the supply of money and credit to the economy, reduce aggregate demand, and lower inflation.
The FOMC sets the target federal funds rate (or range) with the goal of low inflation and full employment
The Taylor Rule builds on the belief held by many economists that central banks will tolerate a small positive rate of inflation if it will help the economy produce at potential output.
assumes the Fed has a 2% “target rate of inflation” that it is willing to tolerate
Taylor rule::
a) When real GDP equals potential GDP and inflation is at its target rate of 2 percent, the federal funds target rate should be 4 percent
implying a real federal funds rate of 2 percent (= 4 percent nominal federal funds rate - 2 percent inflation rate).
b) For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real federal funds rate by 1/2 percentage point.
c) For each 1 percent increase in the inflation rate above its 2 percent target rate, the Fed should raise the real federal funds rate by 1/2 percentage point.
in this case each percentage point increase in the real rate will require a 1.5 percentage point increase in the nominal rate to account for the underlying 1 percent increase in the inflation rate.
The last two rules are applied independently of each other so if real GDP is above potential output and at the same time inflation is above the 2 percent target rate, the Fed will apply both rules and raise real interest rates in response to both factors.
ex.
if real GDP is 1 percent above potential output and inflation is 1 percent above the 2 percent target rate
the Fed will raise the real federal funds rate by 1 percentage point (= 1/2 percentage point for the excessive GDP + 1/2 percentage point for the excessive inflation).
the last two rules are reversed for situations in which real GDP falls below potential GDP or inflation falls below 2 percent:
Each 1 percent decline in real GDP below potential GDP or fall in inflation below 2 percent calls for a decline of the real federal funds rate by 1/2 percentage point.
the Fed doesn’t strictly follow the Taylor rule
It changes the federal funds rate to any level (or range) that it deems appropriate
The Federal Reserve focuses monetary policy on the federal funds rate
federal funds rate::
the rate of interest that banks pay to borrow excess bank reserves overnight from another financial institution.
an equilibrium interest rate determined by the demand and supply for reserves
the short-term interest rate that the Fed can most directly influence
Before the financial crisis, the Federal Reserve manipulated the supply of reserves that were offered in the federal funds market
the Fed could increase or decrease the overall amount of reserves in the banking system by buying and selling government bonds in open-market operations.
This affected the amount of excess reserves that banks were willing to supply in the federal funds market and thus the equilibrium federal funds rate
during the crisis, the Fed purchased so many bonds from banks through open-market operations that nearly every bank in the country ended up with a huge amount of excess reserves
the federal funds rate plunged to nearly zero due to high supply with low demand.
The number of bank-to-bank transactions in the federal funds market collapsed because banks were rarely deficient in reserves
the Fed could no longer affect the federal funds rate by using open-market operations to alter the amount of excess reserves in the banking system.
the Fed had to figure out how to conduct monetary policy when the federal funds rate was stuck near zero
in 2008, the system was adjusted
the FOMC chooses a target range for the federal funds rate rather than a value
The Fed would lower the federal funds rate to boost borrowing and spending (and increase aggregate demand and real output) by setting a lower target then either:
lower the reserve requirement
lower the discount rate
use open-market operations to alter the amount of reserves in the banking system.
the Fed relied almost exclusively on open-market operations to buy bonds and increase the supply of reserves in the banking system
this lowered the federal funds rate
It initiated a multiple expansion of the nation’s money supply
the larger supply of money would stimulate aggregate demand and real output by putting downward pressure on other interest rates (ex. the prime interest rate)
prime interest rate::
the benchmark interest rate used by banks as a reference point for a wide range of interest rates charged on loans to businesses and individuals.
higher than the federal funds rate because the prime rate involves longer, riskier loans than the overnight loans extended between banks in the federal funds market.
The federal funds rate and the prime interest rate closely track one another
other than open market operations being ineffective in changing the federal funds rate, the post-crisis Fed had a zero lower bound problem:
a central bank is constrained in its ability to stimulate the economy through lower interest rates because interest rates less than zero (negative interest rates) encourage consumers to withdraw money from banks, reducing the lending capacity of the banking system.
negative interest rates mean checking account balances would shrink over time
The Fed’s response to the zero lower bound problem was quantitative easing (QE):
the goal was not to use open market purchases to lower the federal funds rate
the goal was to buy bonds solely with the intention of increasing the quantity of reserves in the banking system.
Interest rates would remain where they were (low but positive) but more excess reserves would spur banks to lend more and stimulate aggregate demand.
Another difference between QE and regular open-market operations is that QE can involve the purchase of not only U.S. government bonds but also debt issued by U.S. government agencies or government-backed corporations (known as government-sponsored entities or GSEs).
Fed wanted to “normalize” monetary policy by returning short-term interest rates to their historically normal range of 3% or higher
they did this by raising the IOER rate to get banks to raise other interest rates.
the higher the IOER rate, the more banks would charge to lend money
they also used reverse repos to make sure the Fed could raise the federal funds rate
after 2008, the federal funds market was dominated not by bank-to-bank lending but by nonbank-to-bank lending
banks were willing to borrow money at any rate below the IOER rate because they could deposit the borrowed money at the Fed, increase their excess reserves, and earn the higher IOER rate on whatever they had borrowed from the nonbanks.
this was bad b/c the Fed could only pay IOER to banks
b/c the Fed couldn’t pay them IOER, nonbanks were willing to lend cash to banks at a federal funds rate less than the IOER rate that banks could get from the Fed.
this meant the Fed could not fully control the federal funds rate
So the Fed would perform a reverse repo with nonbanks, borrowing away the cash that the nonbanks would’ve otherwise lent to banks in the federal funds market.
If the Fed did enough reverse repos with nonbanks while raising the IOER, the federal funds rate would always rise up to the IOER rate.
These 2 actions would reduce the supply of money and credit to the economy, reduce aggregate demand, and lower inflation.
The FOMC sets the target federal funds rate (or range) with the goal of low inflation and full employment
The Taylor Rule builds on the belief held by many economists that central banks will tolerate a small positive rate of inflation if it will help the economy produce at potential output.
assumes the Fed has a 2% “target rate of inflation” that it is willing to tolerate
Taylor rule::
a) When real GDP equals potential GDP and inflation is at its target rate of 2 percent, the federal funds target rate should be 4 percent
implying a real federal funds rate of 2 percent (= 4 percent nominal federal funds rate - 2 percent inflation rate).
b) For each 1 percent increase of real GDP above potential GDP, the Fed should raise the real federal funds rate by 1/2 percentage point.
c) For each 1 percent increase in the inflation rate above its 2 percent target rate, the Fed should raise the real federal funds rate by 1/2 percentage point.
in this case each percentage point increase in the real rate will require a 1.5 percentage point increase in the nominal rate to account for the underlying 1 percent increase in the inflation rate.
The last two rules are applied independently of each other so if real GDP is above potential output and at the same time inflation is above the 2 percent target rate, the Fed will apply both rules and raise real interest rates in response to both factors.
ex.
if real GDP is 1 percent above potential output and inflation is 1 percent above the 2 percent target rate
the Fed will raise the real federal funds rate by 1 percentage point (= 1/2 percentage point for the excessive GDP + 1/2 percentage point for the excessive inflation).
the last two rules are reversed for situations in which real GDP falls below potential GDP or inflation falls below 2 percent:
Each 1 percent decline in real GDP below potential GDP or fall in inflation below 2 percent calls for a decline of the real federal funds rate by 1/2 percentage point.
the Fed doesn’t strictly follow the Taylor rule
It changes the federal funds rate to any level (or range) that it deems appropriate
