Mar 12 2008
Much hoopla is made over the US Federal Reserve’s power to affect markets through its injections of liquidity into the economy. These days, the Fed appears to have some new tricks up its sleeve, but still uses its traditionally dominant tool of Open Market Operations to affect the Federal Funds rate, and thus the interest rates that commercial banks charge borrowers financing consumption and investment.
The power of monetary policy lies in the fact that spending stimulus can be achieved without running the risk of crowding-out, wherein expansionary fiscal policy drives up interest rates, potentially off-setting any increases in aggregate demand by triggering declines in consumption and investment due to increased borrowing costs.The whole aim of expansionary monetary policy, on the other hand, is to drive interest down by increasing the reserves held by commercial banks.
The cartoon above illustrates the process that leads to lower interest rates and greater spending when the Fed undertakes expansionary open market operations. Government bonds (the blue bills above) are held as assets by both commercial banks and the public. These are illiquid, meaning they cannot be spent. In order to stimulate new spending, the Fed can take some of its reserves of money (the green bills), and buy bonds from the public and banks.
Banks receive cash from the Fed, which increases their excess reserves. Further, the public will deposit the checks they receive from the Fed into their banks, increasing checkable deposits, which add to both the banks’ required reserves and excess reserves. The result is banks now have new liquidity that they want desperately to lend out in order to earn interest (remember, banks rarely want to hold onto their excess reserves, because inflation will erode the value of any money that’s not earning interest!).
When banks’ reserves increase, due to their growing checkable deposits and the inflow of cash from the Fed’s purchase of bonds, the supply of “federal funds” shifts down, lowering the interest rates that banks charge one another for overnight loans. These are loans that banks often give and receive in order to meet their reserve requirements at the end of a business day.
For example: If Bank A has finds at the end of the day that it has received more deposits than withdrawals, and it now has $1m more in its reserves than it is required to have, it wants to lend that money out as soon as possible to earn interest on it. Bank B, it just so happens, received more withdrawals than it did deposits during the day, and is $1m short of its required reserves at day’s end. Bank B can borrow Bank A’s excess reserves in order to meet its reserve requirement. Bank A will not lend it for free, however, and the rate it charges is called the “federal funds” rate, since banks’ reserves are held predominantly by their district’s Federal Reserve Bank.
When the Fed buys bonds, all banks experience an increase in their reserves, meaning the supply of federal funds shifts out (or down in the graph above), lowering the “price” of federal funds, i.e. the federal funds rate. Lower interest rates on overnight loans will encourage banks to be more generous in their lending activity, allowing them to lower the prime interest rate (the rate they charge their most credit-worthy borrowers), which in turn should have a downward effect on all other interest rates.
Expansionary monetary policy involves the buying of government bonds on from the public and commercial banks by the Federal Reserve Bank. The result of this buying of bonds is an increase in the money supply, a decrease in real interest rates, and hopefully the stimulus of aggregate demand through new consumption and investment. Unlike expansionary fiscal policy (such as the stimulus package announced by Congress last month), crowding-out should not occur. Ideally, lowering the federal funds rate will lead to lower interest rates across the economy as a whole.
This, however, does not always transpire. In a future post, we’ll discuss why, and look at what the Fed is experimenting with today to stimulate investment and consumption, in response to the apparent failure of open market operations at providing the needed stimulus.
About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author
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