Global financial markets Global financial markets Hult international business school Frédéric Chartier 1 Session 5 Central banks and monetary policy Governments and fiscal policy 2 The federal reserve...

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Global financial markets Global financial markets Hult international business school Frédéric Chartier 1 Session 5 Central banks and monetary policy Governments and fiscal policy 2 The federal reserve bank central banking 3 3 Functions of central banks 4 Conduct monetary policy to ensure the right amount of money in the economy. Perform supervisory and regulatory functions over the banking system. Lender of last resort function: Lend to banks experiencing temporary liquidity problems. Provide check clearing services to on behalf of banks. (Depending on the country) Ensure that the local currency is at its desirable value against other currencies. 4 central bank independence 5 The degree of central bank independence varies greatly from country to country. In the United States, board members serve longer terms than in other countries, implying greater independence. In other countries, the head of the central bank serves a longer term, implying somewhat less political control. An independent central bank is free to pursue its goals without direct interference from government officials and legislators. An independent central bank can more freely focus on keeping inflation low. The European Central Bank is, in principle, extremely independent, and the Bank of Japan and the Bank of England traditionally have been less independent. By the late 1990s, both had become more independent and more focused on price stability. 5 central bank independence 6 What conclusions should we draw from differences in central bank structure? Many analysts believe that an independent central bank improves the economy’s performance by lowering inflation without raising output or employment fluctuations. The most independent central banks had the lowest average rates of inflation during the 1970s and 1980s. The central bank also must be able to set goals for which it can be held accountable. The leading example of such a goal is a target for inflation. Central banks in Canada, Finland, New Zealand, Sweden, and the United Kingdom have official inflation targets, as does the European Central Bank. The U.S. Fed has only an informal inflation target. 6 The European central bank 7 The European Central Bank (ECB) is charged with conducting monetary policy for the 19 countries that participate in the European Monetary Union, and use the euro as their common currency. The ECB’s organization is similar to that of the U.S. Fed. The ECB’s executive board has six members who work exclusively for the bank. Board members are appointed by the heads of state and government, after consulting the European Parliament and the Governing Council of the ECB. Executive board members serve nonrenewable eight-year terms. The governors of each of the member national central banks serve a term of at least five years. The long terms board members and governors of are designed to increase the political independence of the ECB. 7 Central bank balance sheet the monetary policy process 8 8 9 Notes: In most years, the Fed’s most important assets are its holdings of U.S. Treasury securities—Treasury bills, notes, and bonds—and the discount loans it has made to banks. In 2012, the Fed’s balance sheet reflects the unusual policy actions it took during the financial crisis of 2007–2009. The Fed had purchased large amounts of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac. The Fed took this action to aid the ailing housing market. The Fed participated in actions to save the investment bank Bear Stearns and the insurance company AIG from bankruptcy, and securities related to those actions remained on the Fed’s books. Third, the Fed had participated in liquidity swaps with foreign central banks and had accumulated assets related to those swaps. Finally, the Fed had participated in a program to help the market for asset-backed securities, which are securitized loans backed by assets other than property. 9 The model of how the money supply is determined includes three actors: 1. The Federal Reserve: responsible for controlling the money supply and regulating the banking system. 2. The banking system: creates the checking accounts that are a major component of M1. 3. The nonbank public (all households and firms): decides the form in which they wish to hold money (e.g., currency vs. checking deposits). 10 The Federal Reserve’s Balance Sheet and the Monetary Base 10 The importance of bank reserves 11 Required reserves are reserves that the Fed requires banks to hold. Excess reserves are reserves that banks hold above those the Fed requires to hold. Reserves = Required reserves + Excess reserves. Required reserve ratio is the percentage of checkable deposits that the Fed specifies that banks must hold as reserves. Note: Remember from our previous class that bank reserves represent the two most liquid assets held by commercial banks, i.e., cash in the vault + deposits with the central bank. 11 12 Monetary Aggregates M1 Money Supply = Currency in circulation + Checking Deposits M2 Money supply = Currency in circulation + Checking Deposits + Near-Money Deposits Monetary Base = Currency in circulation + Bank Reserves Bank Reserves = Vault Cash (cash inside banks) + Deposits with Central Bank (Total) Bank Reserves = Required Reserves + Excess Reserves Required Reserves Ratio: a % of customer deposits that must be kept in reserves. Ratio is determined by the central bank. 12 13 Monetary base The process starts with the monetary base. Monetary base (or high-powered money) is the sum of bank reserves and currency in circulation. Monetary base = Currency in circulation + Bank Reserves. The money multiplier links the monetary base to the money supply. When the money multiplier is stable, the Fed can control the money supply by controlling the monetary base. There is a close connection between the monetary base and the Fed’s balance sheet. 13 14 The money supply process Three actors determine the money supply: the Fed, the nonbank public, and the banking system. 14 15 How the fed changes the monetary base The Fed changes the monetary base by changing the levels of its assets— through buying and selling Treasury securities or making discount loans to banks. Open market operations are the Fed’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. Open market purchase is the Fed’s purchase of securities. Open market sale is the Fed’s sale of securities. 15 16 The tools of monetary policy The Fed (and central banks in general) has set six monetary policy goals: 1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign-exchange market stability 16 17 Main tools of Monetary policy The Fed’s three traditional policy tools are: 1. Open market operations Open market operations are the Fed’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. 2. Discount loans Discount policy is the policy tool of setting the discount rate and the terms of discount lending. Discount window is the means by which the Fed makes discount loans to banks. This serves as the channel for meeting the liquidity needs of banks. 3. Reserve requirements Reserve requirement is the regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed. 18 other tools of Monetary policy During the financial crisis, the Fed introduced two new policy tools connected with bank reserve accounts that are still active: 1. Interest on reserve balances By raising the interest rate it pays, the Fed can increase banks’ holdings of reserves, potentially increasing the money supply. By reducing the interest rate, the Fed can have the opposite effect. 2. Term deposit facility Similar to certificates of deposit, the Fed’s term deposits are offered to banks in periodic auctions. The interest rates have been slightly above the interest rate the Fed offers on reserve balances. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply. 19 The Federal Funds Market and the Fed’s Target Federal Funds Rate The Federal funds rate is the interest rate that banks charge each other on very short-term loans. The federal funds rate is determined by the demand and supply for reserves in the federal funds market. The target for the federal funds rate is set at FOMC meetings. The federal funds rate is influenced by the demand for and the supply of reserves. Demand for Reserves: determined the banking system. Supply of Reserves: controlled by the Fed. 20 Quantitative easing Quantitative easing is the central bank policy that attempts to stimulate the economy by buying long-term securities. During 2009 and early 2010, the Fed bought more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities. In November 2010, the Fed announced a second round of quantitative easing (QE2), which involved buying $600 billion in long-term Treasury securities. In September 2011, the Fed announced its policy of Operation Twist, which involved buying $400 billion of long-term securities (lowering long-term interest rates) while selling $400 billion of short-term securities (raising short-term interest rates). In September 2012, the Fed announced a third round of quantitative easing (QE3) that focused on purchases of mortgage-back securities. 21 Quantitative easing (2020) 22 Inflation targeting Before the financial crisis, there was significant interest in using inflation targeting as a framework for monetary policy. With inflation targeting, a central bank publicly sets an explicit target for the inflation rate over a period of time. In 2010, the Fed announced that it would attempt to maintain an average inflation rate of 2% per year. In the summer of 2020, the Fed announced that it would no longer pursue inflation targeting for the time being. Fiscal policy 23 23 24 The Business cycle Alternating increases and decreases in economic activity over time Phases of the business cycle Peak Recession Trough Expansion Business cycles are alternating increases and decreases in economic activity over time. Each business cycle consists of four phases. A peak is when business activity reaches a temporary maximum with full employment and near-capacity output. A recession is a decline in total output, income, employment, and trade lasting six months or more; this is sometimes referred to as an economic contraction. The trough is the bottom of the recession period and the expansion is when output and employment are recovering and expanding toward the full employment level. 24 Level of real output Time Peak Peak Peak Recession Recession Expansion Expansion Trough Trough Growth Trend LO1 9-25 The business cycle 25 This figure shows the business cycle. Economists distinguish four phases of the business cycle; the duration and strength of each phase may vary. Additionally, individual cycles vary in duration and intensity. You can see that the long run trend is economic growth. 26 Causation: a first glance Business cycle fluctuations Economic shocks Prices are
Answered 1 days AfterOct 27, 2021

Answer To: Global financial markets Global financial markets Hult international business school Frédéric...

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