Tài chính doanh nghiệp - Chapter 3: 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 As depository institutions lend or invest excess reserves, M1 increasesnew loan of excess reserves increases borrower’s transactional balances purchase of investment securities increases seller’s transactional balances6Copyright© 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.8Copyright© 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 - return on bank reserves (most liquid of all assets)availability of reserves to finance credit demandintent and effect of monetary policy 9Copyright© 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 upwardReserve effects are direct, immediate, dollar-for-dollarDiscount Rate: Cutting discount rate pressures FFR downward, raising discount rate pressures FFR upward Reserve effects depend on—sensitivity of institutions to “Window scrutiny”differential between Discount Rate & FFR Reserve Requirements: Cutting RR pulls FFR downward, raising RR pushes FFR upwardReserve effects are direct, immediate, sustained, & too dramatic for “fine tuning”10Copyright© 2006 John Wiley & Sons, Inc.11Copyright© 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—M1 may grow too rapidlyReal investment decisions may be distorted (e.g., borrowing may just finance hoarding of assets) Borrowing costs too high—M1 may not “keep up with” real sectorEconomy may falter as real investment declinesBest Fed can ultimately do is try to promote stable price levels 12Copyright© 2006 John Wiley & Sons, Inc.Why central banks manipulate reserves or rates: 2 schools of thought MonetaristsKeynesians13Copyright© 2006 John Wiley & Sons, Inc.Monetarists: Key financial variable for changing economic activity is the money supply. Monetarists assume propensity to consume—rises as people perceive they have “more money”drops as people perceive they have “less money”is distorted by volatility in pricesThus money supply can be used to influence aggregate demandadding reserves carefully should promote economic growthsubtracting reserves carefully should slow the economycentral bank can distort price levels by over-adjusting either way Short-term interest rates merely indicate monetary policy’s effects14Copyright© 2006 John Wiley & Sons, Inc.Keynesians: Key financial variable for changing economic activity is interest rates. John Maynard Keynes was influential British economist of 1930sKeynesians discount or disregard direct money supply effectsReal sector economic growth is—Stimulated by falling rates as economic activity costs less to financeSlowed by rising rates as economic activity costs more to financeAlways and significantly susceptible to influence of monetary policy To Keynesians, money supply changes reflect reactions to interest rates15Copyright© 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 markets16Copyright© 2006 John Wiley & Sons, Inc.17Copyright© 2006 John Wiley & Sons, Inc.18Copyright© 2006 John Wiley & Sons, Inc.19Copyright© 2006 John Wiley & Sons, Inc.3 channels of the transmission process for monetary policy Business investment in real assetsConsumer spending for durable goods and housingNet exports (Gross exports less gross imports)20Copyright© 2006 John Wiley & Sons, Inc.Business investment in real assetsPresent values of future cash flows from real assets depend significantly on general level of interest rates Rates fall, PVFCF rises Rates rise, PVFCF dropsMost capital expenditures are debt-financed; interest expense is thus material in profitability of most businessesMonetary policy thus always involves material incentives or disincentives for business investmentFed can manipulate incentives but not compel results 21Copyright© 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 spendingMonetary policy can thus often affect aggregate demand to some extentFed 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 emotional22Copyright© 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 23Copyright© 2006 John Wiley & Sons, Inc.Complications of monetary policy: controlling the money supply is not easy. Technical factors demand constant adjustmentVelocity of money is difficult to predict 24Copyright© 2006 John Wiley & Sons, Inc.Technical factors demand constant adjustmentCash drainsCash holdings by public “use up” monetary baseFed must try to offset with carefully calibrated open market purchasesThe floatDACI – CIPC = Float, net extension of credit by FedFed 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 fluctuations25Copyright© 2006 John Wiley & Sons, Inc.Velocity of money is difficult to predictRatio of gross domestic product to money supply (turnover rate of unit of money in economy)For given change in money supply, Fed—can expect general direction of change in economycannot ensure particular degree of change in economy26Copyright© 2006 John Wiley & Sons, Inc.