Principle 8: Fiscal and Monetary policies influence people’s decisions
Objectives:
List the two mandates of the Federal Reserve Bank.
Define “bank reserves.”
Distinguish between the Interest on Reserve Balances (IORB) rate, the Federal Funds Rate (FFR).
Trace the path from the IORB to changing economic conditions
Why do you want to learn this?
The dual mandate
In 1977, the Federal Reserve adopted (Fed) maximum employment” as one of its two goals. Prior to 1977, the only goal was stable prices. It’s important to recognize that “stable prices” means a stable price level as measured by the IPD, CPI, and PCE indices. It does Not mean that the Fed wants to stabilize the price of coffee or tea or funerals or weddings or lawnmowers or surgeons’ incomes or any other single good or service.
To achieve its dual mandate, the Fed provides incentives for banks and other lending institutions to increase or decrease their lending to the public. The more credit available for the public to spend, the greater the level of production and employment. To stimulate the economy, the Fed influences banks to make more credit available to the public; to reduce inflation, the Fed influences banks to make less credit available to the public.
A Bank’s decision
Reserves are simply cash in a bank’s vaults. Banks hold some cash to cover their transaction costs and to meet the requests of the public. The problem is that holding cash has an opportunity cost; banks could lend those funds to customers or other banks and earn interest, or they could send them to the Fed and earn interest. If they lend to other banks, the receiving banks are likely to lend to the public, stimulating demand, production, and employment. If they send the funds to the Fed, the money is out of circulation and pressure on the price level (inflation) is likely to lessen.
Banks try to balance their cash “needs “against the opportunity to earn interest. The question is what to do with their “excess” reserves. The Fed provides incentives to influence lending institutions’ decisions. The Fed sets the Interest on Reserve Balances (IORB) rate which is the rate the Federal Reserve pays on balances maintained with the Fed by eligible banks and other depository institutions.
The Federal funds rate (FFR) is the interest rate at which depository institutions (banks and other lending institutions) and government-sponsored entities trade funds with each other overnight. The rate that the borrowing institution pays to the lending institution is determined between the two parties; the average rate for all these types of negotiations is the effective Federal funds rate.
A bank has to make a decision – leave their reserves with the Fed and earn the IORB rate or lend to other banks (who can lend to the public) and earn the FFR. The answer is pretty simple – put your funds where they can earn the highest interest.
Fed’s implementation of monetary policy
This gets a little tricky so pay careful attention. Assume that the Fed wants to battle inflation by raising market interest rates. They raise the IORB to encourage banks to leave their surplus reserves with the FED rather than lend them to other banks where they could be loaned to the public. The FFR increases to successfully compete with the Fed. Market rates increase and the Fed has achieved its goal of higher market interest rates to combat inflation. If the Fed wants to stimulate the economy, they will lower the IORB below the FFR, encouraging banks to lend surplus reserve to other banks where they can be loaned to the public. Market interest rates fall. The FFR is an effective floor on interest rates. No banks will lend to other banks if they can earn a higher interest rate at the Fed.
To combat inflation: Fed raises IBOR, banks deposit reserves with Fed rather than with other banks taking those reserves out of circulation, credit available to the public decreases, FFR increases, market rates increase, pressure on prices falls.
To stimulate economic activity: Fed lowers the IBOR, banks loan surplus reserves to other banks rather than leaving them on deposit with the Fed, credit available to the public increases, FFR decreases, market rates fall, economic activity (production and employment) increases.
Older Fed tools
The Federal Reserve used to use three tools to influence economic activity – the discount rate, open market operations, and reserve requirements. The discount rate is the rate at which banks borrow from the Fed. It is seldom used as a policy tool. Open market operations are another way the Fed influences the money supply. The Fed holds government debt (usually U.S. Treasury bills) which it can buy or sell. If it sells Treasury bills the payment for the bills is a decrease in reserves held by banks which limits their lending ability. If it buys Treasury bills, it pays with reserves, increasing banks’ lending ability. While this was once the primary monetary policy tool, it is still used but is now a secondary tool. The reserve requirement has been set to zero which means that banks are no longer held accountable for the reserves they keep on deposit with the Fed, eliminating one of the three previous policy capabilities.
Bottom Line
The Fed has a dual mandate – maximum employment and stable prices
Bank reserves are cash on hand
The Interest on Reserve Balances (IBOR) is the rate that the Fed pays to banks and other depositors on the reserves they hold with the Fed.
The Federal Funds Rate is the rate at which banks buy and sell with each other.
To reduce inflation, the Fed raises the IORB; to stimulate the economy the Fed lowers the IORB.
1. Which of the following is a goal of the Federal Reserve?
a. Full employment
b. Fair income distribution
c. Price stability
d. Both a and c
2. Bank reserves are:
a. Gold
b. Silver
c. Cash on hand
d. All of the above
3. To fight inflation, the Fed will
a. Raise the IORB
b. Increase taxes
c. Lower the FFR
d. All of the above
4. Sierra is the manager of a bank. She has surplus reserves and is pondering what to do with them. What data should she use and how should she use them?