Module 6 Note on Money and Monetary Policy Case Study Paper Note on Money and Monetary PolicyUsing the Harvard Business Case Study, Note on Money and Monet

Module 6 Note on Money and Monetary Policy Case Study Paper Note on Money and Monetary PolicyUsing the Harvard Business Case Study, Note on Money and Monetary Policy, answer the following questions by creating and submitting a Word document. Your answers should be a maximum of 1 page per question (and very possibly less).Following the stock market crash in October 1987 and the terrorist attack in September 2001 the Federal Reserve rapidly increased the amount of money in circulation and lowered interest rates. Why did the Federal Reserve take these actions and what impact do you believe they had?From early 2005 through August 2006, the Federal Reserve steadily raised short term interest rates, being concerned about potential inflationary pressures. It then held short term rates steady through August 2007, saying that it remained very watchful about possible inflationary dangers. However in September 2007 it suddenly dropped rates and took other steps to aid capital market liquidity. Recently short term rates have been maintained at extremely low rates (effectively zero percent for a while). Now there are fears of a double-dip recession and potential deflation on one hand and other fears of potential high inflation in the foreseeable future. If you were sitting on the Open Market Committee today, how would you go about deciding what policy path to take, particularly given the lag in the effect of some monetary policies on the real economy?Please search this case online and when you complete,offer me this case. Financial Markets & Institutions
Case Study 4
Note on Money and Monetary Policy
Using the Harvard Business Case Study, Note on Money and Monetary Policy, answer the
following questions by creating and submitting a Word document. Your answers should be a
maximum of 1 page per question (and very possibly less).
1. Following the stock market crash in October 1987 and the terrorist attack in September
2001 the Federal Reserve rapidly increased the amount of money in circulation and
lowered interest rates. Why did the Federal Reserve take these actions and what impact
do you believe they had?
2. From early 2005 through August 2006, the Federal Reserve steadily raised short term
interest rates, being concerned about potential inflationary pressures. It then held short
term rates steady through August 2007, saying that it remained very watchful about
possible inflationary dangers. However in September 2007 it suddenly dropped rates and
took other steps to aid capital market liquidity. Recently short term rates have been
maintained at extremely low rates (effectively zero percent for a while). Now there are
fears of a double-dip recession and potential deflation on one hand and other fears of
potential high inflation in the foreseeable future. If you were sitting on the Open Market
Committee today, how would you go about deciding what policy path to take,
particularly given the lag in the effect of some monetary policies on the real economy?
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Module 6 Compiled
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Module 6 Study Guide and
Deliverables
Lecture
Central Banking and the Conduct of
Topics:
Monetary Policy
Readings:
Madura: Ch. 4, 5, UVA #1, and HBS #3
Discussions: 6: What’s the correct orientation of
monetary policy?
Initial post due by Wednesday, April 24
at 11:59 PM ET
Reply posts due by Sunday, April 28 at
11:59 PM ET
Activities:
Case Study #3 Geithner & Bernanke
Amid the Global Financial Crisis due by
Sunday, April 28 at 11:59 PM ET
Case Study #4 Note on Money and
Monetary Policy due by Sunday, April
28 at 11:59 PM ET
Changes in Financial Institutions &
Markets Term Paper due by Sunday,
April 28 at 11:59 PM ET
Week 6 Introduction
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The Federal Reserve and Monetary Policy
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Perhaps even more important than its regulatory role, the Federal Reserve determines and implements U.S.
monetary policy. This is similar to most countries where the central bank performs this function. Monetary policy is
at the core of the efficient operation of the nation’s economy. It is importance in setting not just interest rates, but
in determining the whole framework in which the economy functions cannot be overstated.
Organization of the Federal Reserve
The Fed undertakes three principal functions – the carrying out of monetary policy, bank supervision and regulation
and the delivery of financial services to both the government and the nation’s financial institutions. The Dodd-Frank
Act will give the Fed a fourth clear mandate – consumer protection.
The Fed has five major components:
The Board of Governors oversees and serves as a “board of directors” for the Fed
The Federal Reserve district banks provide a variety of services for the banks in their areas. Some, such as
the New York Fed, carry out system-wide functions such as the administration of open market operations
The Federal Open Market Committee (FOMC) sets the course of monetary policy, particularly, the level of
money supply and interest rates
Member banks undertake their own operations and advise the district banks of conditions that are affecting
the economic environment.
Advisory committees provide expert advice in key policy issues.
The Board of Governors
The Board of Governors consists of seven members appointed by the President of the U.S. and confirmed by the
Senate. One of those members is appointed as the Chairman. The members serve 14-year terms. The long terms
are intended to reduce political pressure, and the appointments are made on a non-partisan basis. Terms are
staggered so that one term expires in every even-numbered year.
Federal Reserve District Banks
There are twelve Federal Reserve district bank s. The New York bank is the most important. Commercial banks
that become members of the Fed must purchase stock in their district banks. The district banks pay a dividend to
the member banks with a maximum dividend of 6% annually. Each district bank has nine directors with six elected
by member banks and three appointed by the Board of Governors. The nine directors appoint the president of the
district bank. District banks clear checks, replace old currency, provide loans to depository institutions and
conduct research.
Federal Open Market Committee (FOMC)
The FOMC consists of the seven members of the Board of Governors plus the presidents of five Fed district banks,
that of the New York Fed plus four others on a rotating basis. Its goals are to promote high employment, economic
growth, and price stability, achieved through control of the money supply. Its decisions on changes in monetary
policy are forwarded to the Trading Desk (Open Mark et Desk ) at the NY Fed district bank which carries out the
intended policy.
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Member Banks
All national banks are required to be members of the Fed. State-chartered banks are not required to be members
but may choose to do so. Nationally, about 35% of all banks are members, but they control the vast majority of
banking assets.
Advisory Committees
The Federal Advisory Council consists of one member from each district. It makes recommendations to the Fed
about economic and banking issues. The Consumer Advisory Council consists of up to 30 members and
represents the financial institutions industry and its consumers. The Thrift Institutions Advisory Council consists of
representatives of savings banks, S&Ls and credit unions and offers views on issues specifically related to thrift.
The Organization of the Federal Reserve and Member Banks
Open Market Operations
The FOMC meets eight times a year. At each meeting, the target money supply growth-level and interest-rate level
are determined. Two weeks prior to the FOMC meeting, the members receive the Beige Book. This contains a
detailed compilation of currently-available economic data. The meeting is attended by the Board of Governors, the
12 presidents of the district banks, and staff members. Staff members begin with presentations about current
economic conditions and recent economic trends. Next, each FOMC member can offer recommendations about
whether monetary-growth and interest-rate target levels should be changed. Finally, voting members vote on
monetary policy and interest rates.
The FOMC’s decision on target money supply levels is forwarded to the Trading Desk at the NY district bank
through a policy directive. FOMC objectives are specified in a target range for the money supply growth. The FOMC
also specifies a desired target for the federal funds rate. The manager of the Trading Desk instructs traders on the
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amount of government securities to buy or sell in the secondary market. This is called open mark et operations.
The Trading Desk continuously conducts open market operations in response to ongoing changes in bank deposit
levels.
Fed Purchases and Sales of Securities
Traders at the Trading Desk call government securities dealers to purchase securities. Dealers provide a list of
securities for sale, and the traders purchase those that are at the most attractive rates. The total funds of
commercial banks increase by the dollar amount of securities purchased by the Fed, resulting in a loosening of the
money supply. To force a decline in the Fed funds rate, the Trading Desk can also purchase Treasury securities,
and the Fed funds rate will decline along with other interest rates.
To decrease the money supply, traders sell government securities to government securities dealers. These are sold
to the dealer submitting the highest bid. As dealers pay, their account balances are reduced, and the total amount
of funds at commercial banks is reduced, resulting in a tightening of the money supply. To force an increase in the
Fed Funds rate, the Trading Desk can also sell Treasury securities.
The Fed also uses repurchase agreements to increase the aggregate level of bank funds on a temporary basis.
These are often used during holidays to correct temporary imbalances.
How Open Market Operations Affect Interest Rates
When the Fed uses open market operations to increase bank funds, the yield on Treasury securities will tend to
decline, and the Fed Funds rate may decline since banks with excess funds may offer new loans at a lower
interest rate. Banks may also lower interest rates on deposits. As yields on bank deposits and Treasuries decline,
investors look for alternative securities, and the yields on the alternative investments will decline as more money is
invested in them. The reduction in yields on debt securities lowers the cost of borrowing for the issuers of debt
securities, and this can encourage potential expenditures.
The application of open market operations can be seen most clearly in the wake of major events, such as the 1987
market crash, in the wake of 9/11, and the like. The effects can be traced also, although with less precision, during
more extended periods of expansion or contraction. In times of crisis, such as the 1987 Crash or 9/11, the Fed
acts to provide additional liquidity to the market, sometimes in massive amounts. During more general times of
economic weakness, it has provided additional funds to the market, keeping interest rates low and encouraging
new investment. During periods of economic buoyancy, the Fed generally acts in a contractionary way, pulling
funds out of the market, raising interest rates and discouraging lending and investment. During the financial crisis,
the Fed has pumped additional liquidity into the market, particularly during times like the threatened freezing of the
commercial paper and Fed Funds markets in 2007 and following the collapse of Lehman Brothers. During the
whole period, it has pumped additional money into the system, purchasing securities, especially MBS, in large
quantities (deemed “quantitative easing”) and kept short-term interest rates at extremely low levels.
Setting the Fed Funds Rate
The Fed Funds market is a Fed-sponsored system in which depository institutions lend and borrow excess
reserves among themselves. The actual Fed Funds Rate (FFR) is set by market forces as institutions bargain with
each other. The Fed however suggests an indicated level for the FFR which is taken as a signal as to the intent
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and effect of monetary policy. Ultimately, factors in real sector determine credit demand: Fed cannot artificially
sustain FFR too low or high.
Adjusting the Discount Rate
Another highly visible indicator of Fed policy is the discount rate, the rate it charges banks when they borrow at the
Fed discount window. To increase the money supply, the Fed can authorize a reduction in the discount rate that
encourages depository institutions to borrow from the Fed. To decrease the money supply, the Fed can increase
the discount rate, discouraging borrowing from the Fed. Often, a change in the discount rate is the “public
announcement” of a change in monetary policy which is then reinforced through open market operations.
In recent years, the Fed has often adjusted the discount rate to keep it in line with changes in the targeted Federal
Funds Rate. During the recession of 2000-2001 and the following recovery, the Fed kept the discount rate low.
When the economy began to grow vigorously and there were signs of overheating in some sectors like housing, the
Fed steadily increased the discount rate. With the advent of the financial crisis in 2007, the Fed commenced to
lower the discount rate. In almost every instance, there will be arguments that, with great hindsight, the Fed
“should have” raised or lowered the rate more rapidly, but as we’ll note later, the ability to fine tune monetary policy
is challenging at best.
Adjusting the Reserve Requirement
The reserve requirement ratio is the proportion of bank deposits that must be held as reserves. It is set by the
Board of Governors and historically has been set between 8 and 12 percent. Currently the Reserve Requirement is
10% of transaction accounts. The requirement is sometimes changed to adjust the money supply, but it is such a
blunt instrument that the Fed generally chooses to use more subtle and gradated means to accomplish its
policies.
For any given amount of reserves which banks hold, the reserve requirement determines the potential money
supply. Increasing the requirement will result in a reduction of the money supply, and vice versa. The ratio of
1/reserve requirement ratio is termed the money multiplier. To loosen the money supply, an initial increase in
reserves (arising from the purchases in open market operations) will result in an increase in the money supply:
Increase in Money Supply = Increase in Reserves x Money Multiplier
Consequently, even a small change in the reserve requirement could have a dramatic impact on the total money
supply. In contrast, changes in the actual amount of reserves, through open market operations, are easier to
control.
Comparison of Monetary Tools
The most frequently used monetary policy tool is open market operations. Since they involve buying and selling
securities, open market operations can be used without necessarily signaling the Fed’s intentions and can be
easily reversed. Adjustments in the discount rate or the indicated Fed Funds Rate only work if depository
institutions respond to the adjustment. Adjustments in the reserve requirement ratio can cause erratic shifts in the
money supply.
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The following chart, which we’ve seen in the earlier lecture on interest rates, highlights the level of interest rates,
both long and short term and inflation with changes in the money supply. It is clear that while there are some
general effects as to the trends – such as a higher rate of money supply growth tends to be associated with lower
interest rates—there is no simple one-to-one relationship between the various elements. We live in just too
complex a world for that.
As powerful as open market operations are, there are other factors that affect the money supply, and the volume of
funds available in the marketplace can change without the Fed’s intervention because of the Federal Reserve float,
the amount of checks credited to the banks’ funds that have not yet been collected and the amount of currency in
circulation. Staff at the NY Fed and the Board of Governors provides daily forecasts of how technical factors will
affect the level of funds.
Definition of the Money Supply
Monetary policy employs several definitions of money (and money equivalents). The question regarding relevancy is
how the public really treats/uses/regards different instruments:
M1 includes currency held by the public and checking deposits. M1 is the most narrow form of money
M2 includes everything in M1 plus savings accounts and small-time deposits, money market deposit
accounts (MMDAs), and other items
M3 includes everything in M2 plus large-time deposits and other item. Other, still broader definitions include
things such as credit card balances.
The Fed must decide what form of money to manipulate. The optimal form of money should be controllable by the
Fed and have a predictable impact on economic variables. However, other factors outside of the direct control of the
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Fed can affect the supply numbers. For example, if consumers choose to undertake more transactions using a
credit card as opposed to cash, then the effect of a given amount of cash in the marketplace can be quite different.
It may be difficult for the Fed to simultaneously control money supply growth and the FFR. For example, during the
financial crisis, short-term rates were reduced to effectively zero but longer-term rates remained largely stationary.
Central banks of other countries use open market operations, reserve requirement adjustment and adjustments in
the interest rate they charge on loans. Central bankers in various countries will sometimes act in concert, but this
is purely voluntary. Regardless, the Fed must consider economic conditions in other major countries when
assessing the U.S. economy. Coordinating monetary policy may be difficult because of conflicting interests. After
September 11, 2001, central banks of various countries injected money into the banking system to provide more
liquidity, and several central banks reduced their interest rates. Similarly, the (nearly) universal response to
financial crisis was to lower interest rates and increase money supply by purchasing securities to stimulate the
economy.
The Bank of International Settlements (BIS) serves as a “club” for central bankers and as a consultative body (as in
the developments of the Basel Accord). However, participation in and compliance with BIS suggestions is purely
voluntary, and the BIS has no ability to actually make policy for any country.
Some of these conflicts can be seen in the history of the euro. On June 1, 2002, the euro replaced the currencies
of twelve European countries. The European Central Bank (ECB) sets monetary policy for all participating countries
with an objective to control inflation and to stabilize the value of the euro. By joining in a common currency,
individual countries no longer had the ability to manipulate monetary policy to support their individual countries, as
the interest rate offered on government securities must be similar across participating countries. Countries whose
economies were lagging would like to see a looser, more stimulative monetary policy. Countries whose economies
are showing signs of overheating might desire a more restrictive policy.
Monetary Theory
Keynesian economics is one of the most popular theories influencing the Fed. Developed by John Maynard Keynes
during the Great Depression, it suggests how the Fed can affect the interaction between the demand for money
and the supply of money to influence interest rates, the aggregate level of spending and economic growth.
Keynesian philosophy advocates an active role for the government in correcting economic problems.
The Keynesian approach can be explained by using the loanable funds framework. Demand for and supply of
loanable funds determine the equilibrium interest rate. The business investment schedule illustrates the inverse
relationship between interest rates on loanable funds and the level of business investment – at lower interest rates,
businesses will borrow more money to invest in expanding …
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