- Study Guide (Course-wide Content)
A. Central Banking and the Federal Reserve System
- Every modern country has a central bank. The U.S. central bank is made up of the Federal Reserve Board in Washington, together with the 12 regional Federal Reserve Banks. Its primary mission is to conduct the nation's monetary policy by influencing financial conditions in pursuit of low inflation, high employment, and stable financial markets.
- The Federal Reserve System (or "the Fed") was created in 1913 to control the nation's money and credit and to act as the "lender of last resort." It is run by the Board of Governors and the Federal Open Market Committee (FOMC). The Fed acts as an independent government agency and has great discretion in determining monetary policy.
- The Federal Reserve has four major functions: conducting monetary policy by setting short-term interest rates, maintaining the stability of the financial system and containing systemic risk as the lender of last resort, supervising and regulating banking institutions, and providing financial services to banks and the government.
- The Fed has three major policy instruments: (a) open-market operations, (b) the discount window for borrowing by banks and, more recently, primary dealers, and (c) legal reserve requirements for depository institutions.
- The Federal Reserve conducts its policy through changes in an important short-term interest rate called the federal funds rate. This is the short-term interest rate that banks charge each other to trade reserve balances at the Fed. The Fed controls the federal funds rate by exercising control over its instruments, primarily through open-market operations.
- Remember the important monetary transmission mechanism, the route by which monetary policy is translated into changes in output, employment, and inflation:
- The central bank announces a target short-term interest rate chosen in light of its objectives and the state of the economy.
- The central bank undertakes daily open-market operations to meet its interest-rate target.
- The central bank's interest-rate target and expectations about future financial conditions determine the entire spectrum of short- and long-term interest rates, asset prices, and exchange rates.
- The level of interest rates, credit conditions, asset prices, and exchange rates affect investment, consumption, and net exports.
- Investment, consumption, and net exports affect the path of output and inflation through the AS-AD mechanism.
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We can write the operation of a monetary policy change as follows:
Change in monetary policy
→ change in interest rates, asset prices, exchange rates
→ impact on I, X, C
→ effect on AD
→ effect on Q, P
- Although the monetary transmission mechanism is often described simply in terms of "the interest rate" and "investment," this mechanism is in fact an extremely rich and complex process whereby changes in all kinds of financial conditions influence a wide variety of spending. The affected sectors include: housing, affected by mortgage interest rates and housing prices; business investment, affected by interest rates and stock prices; spending on consumer durables, influenced by interest rates and credit availability; state and local capital spending, affected by interest rates; and net exports, determined by the effects of interest rates upon foreign exchange rates.
- Monetarism holds that the money supply is the primary determinant of short-run movements in both real and nominal GDP as well as the primary determinant of long-run movements in nominal GDP. The income velocity of money (V) is defined as the ratio of the dollar-GDP flow (PQ) to the stock of money (M): V ≡ PQ/M. With constant velocity, prices move proportionally to the money supply. Monetarists propose that the money supply should grow at a low fixed rate. Statistical studies indicate that velocity tends to be positively correlated with interest rates, a finding that undermines the monetarist policy prescription.
- In an open economy, the international-trade linkage reinforces the domestic impacts of monetary policy. In a regime of flexible exchange rates, changes in monetary policy affect the exchange rate and net exports, adding yet another facet to the monetary mechanism. The trade link tends to reinforce the impact of monetary policy, which operates in the same direction on net exports as it does on domestic investment.