Tài chính doanh nghiệp - Chapter 03: The fed and interest rates

Power Point Slides for: Financial Institutions, Markets, and Money, 9th Edition Authors: Kidwell, Blackwell, Whidbee & Peterson Prepared by: Babu G. Baradwaj, Towson UniversityAndLanny R. Martindale, Texas A&M University1Copyright© 2006 John Wiley & Sons, Inc.CHAPTER 3 THE FED AND INTEREST RATES2Copyright© 2005 John Wiley & Sons, IncThe monetary base comprises the Fed’s 2 largest liabilities:Federal Reserve Notes in circulationDepository institution reserves (reserve account balances and vault cash) 3Copyright© 2006 John Wiley & Sons, Inc.The money supply involves the Monetary Aggregates4Copyright© 2006 John Wiley & Sons, Inc.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.5Copyright© 2006 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, orlowers reserve requirements 6Copyright© 2006 John Wiley & Sons, Inc.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.7Copyright© 2006 John Wiley & Sons, Inc.To influence interest rates, Fed targets but does not set Fed Funds RateFed Funds market is Fed-sponsored system in which depository institutions lend and borrow excess reserves among themselvesFed Funds Rate, set by market forces as institutions bargain with each other, is benchmark rate, measuring 8Copyright© 2006 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 upwardDiscount Rate: Cutting discount rate pressures FFR downward, raising discount rate pressures FFR upwardReserve Requirements: Cutting RR pulls FFR downward, raising RR pushes FFR upward9Copyright© 2006 John Wiley & Sons, Inc.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 highBorrowing costs too low—(e.g., borrowing may just finance hoarding of assets) Borrowing costs too high—Economy may falter as real investment declinesBest Fed can ultimately do is try to promote stable price levels 10Copyright© 2006 John Wiley & Sons, Inc.6 basic goals of monetary policy, set by the Humphrey-Hawkins Act of 1978 Full employmentEconomic growthPrice index stabilityInterest rate stabilityStable financial systemStable foreign exchange markets11Copyright© 2006 John Wiley & Sons, Inc.12Copyright© 2006 John Wiley & Sons, Inc.13Copyright© 2006 John Wiley & Sons, Inc.Business investment in real assetsFed can manipulate incentives but not compel results 14Copyright© 2006 John Wiley & Sons, Inc.Consumer spending for durable goods & housingMuch consumer spending is on credit, so it tends to vary directly with credit conditionsFalling interest rates tend to encourage spendingRising interest rates tend to discourage spendingFed can encourage/discourage but not necessarily compel; Consumers don’t necessarily make financial decisions the way businesses do - Businesses are mostly rational and profit-maximizingConsumers are partly rational and partly emotional15Copyright© 2006 John Wiley & Sons, Inc.Net exportsInterest rates affect exchange rates Falling interest rates in a country tend to “weaken” its currencyRising interest rates in a country tend to “strengthen” its currency Exchange rates affect imports and exportsAs domestic currency weakens—Domestic demand for imports drops as they become more costly butForeign demand for exports rises as they become less costlyAs domestic currency strengthens—Domestic demand for imports rises as they become less costly and Foreign demand for exports drops as they become more costlyMonetary 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 16Copyright© 2006 John Wiley & Sons, Inc.Complications of monetary policy: controlling the money supply is not easy. Velocity of money is difficult to predict 17Copyright© 2006 John Wiley & Sons, Inc.Technical factors demand constant adjustmentCash drainsFed must try to offset with carefully calibrated open market purchasesThe floatFed must try to offset float with carefully calibrated open market salesUS Treasury depositsTreasury payments cause large shifts in reservesFed and Treasury try to coordinate any large fluctuations18Copyright© 2006 John Wiley & Sons, Inc.