Study Session 6
Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy
KEy CONCEPTS
LOS 27.a
The goals of the Federal Reserve are ro promore full employment, stable prices, and moderate long-term interest rates. The Fed's mandate is to achieve these goals by keeping the long-term growth rate of the monetary aggregates consistent with the potential longterm growth rate of CDP.
The Fed operationalizes its goals by focusing on the core rate of inflation in consumer prices and the difference between potential and actual real CDP growth.
LOS 27.b
The Fed conducts monetary policy primarily by influencing the federal funds rate, the rate at which member banks make overnight loans of reserves to each other.
Under an inStrUlllcnr rule. such as the Ta\·lor rule, the target federal funds r~ltt' is based on rl1l'current perforlllanu: of the econom\. Linder a targeting rule. the target federal funds rate is chosen so as to keep the expccted future inflation rJ.te equal [() the tJ.rgct rate of inflation.
The Fed uses open market operations to inAucnce the federal funds rate (FFRL In order to decrease (increase) the FFR, the fed buys (sells) Treasurv securities in the open market. which increases (decreases) bank reserves, the money supply. and the supply of loanable funds.
LOS 27.c
The transmission mechan ism through which changes in the FFR affeer the economy can be described as follows:
1.The Fed buys (sells) Treasury securities, which increases (decreases) bank reserves.
2.The FFR decreases (increases) as banks are more (less) willing ro lend each other reserves.
3.Other short-term rates decreJ.se (increase) as the increase (decrease) in the supply of loanable funds decreases (increases) the equilibrium rate for loans.
4.Longer-term interest rates also decrease (increase).
5.The decrease (increase) in rates causes the dollar to depreciate (appreciate) in the foreign exchange market.
6. The decrease (increase) in long-term rates increases (decreases) business investment in plant and equipment.
"'7 Lower (higher) interest rates cause consumers to increase (decrease) their purchases of houses. autos, and durable goods.
8.Depreciation (appreciation) of the dollar increases (decreases) foreign demand for U.S. exports.
9.These increases (decreases) in consumption. investmenr, and net exports all increase (decrease) aggregate demand.
10.The increase (decrease) in aggregate demand increases (decreases) inflation, employment, and real CDP.
©2008 Kaplan Schweser |
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Study Session 6
Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy
The link between changes in the FFR and changes in long-term interest rates is actually rather loose, and monetary policy changes only affect the economy with a time lag. As a result, policy decisions do not always have their intended effects at appropriate times.
LOS 27.d
Alternative monetary policy strategies not currently used by the Fed include:
•The McCallum rule, which is focused on the growth rate of the monetary base. Its main drawback is that shifts in the demand for money can cause fluctuations in
interest rates and aggregate demand.
• A rule that targets the growth rate of the money supply may also present problems in that changes in both money demand and money velocity can cause volatility in aggregate demand and interest rates.
•Conducting monetary policy to keep the foreign exchange rate with other countries' currencies stable would cause the domestic inflation rate to match that of the other
countries, over which the Fed has no control.
•Inflation rate targeting is used by many central banks. the notable exceptions being
those of the U.S. and Japan. The performance of strict inflation targeting, compared to the Fed's method of ll10ncrary polic:' determination, is still subject to debate.
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©2008 Kaplan Schweser |
Scudy Session 6
Cross-Reference to CFA Institute Assigned Reading #27 - Monetary Policy
CONCEPT CHECKERS
1.The Federal Reserve's policy goals least likely include:
A.price stability.
B.minimizing long-term interest rates.
C. maximizing the sustainable growth rate of the economy.
2.The Fed operationalizes its goals by focusing on:
A.core inflation and the output gap.
B.expected inflation and U.S. dollar exchange rates.
C. food and energy prices and the growth rate of real GOP.
3.The Fed conducts monetary policy primarily by targeting the:
A.inflation rate.
B.federal funds rate.
C. 1O-\'ear Treasury |
note \'idJ. |
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.1. Implementing mOnL'LH\ polic\' in such J \vay as [0 keep the !C)reC1S[ rate or inflarion a[ a certain level is besT Jescribed as a(n):
A.Taylor rule.
B.instrumcIll rule.
C.targeting rule.
S.Purchase, ofTreasulT securities in the open market [)\' rhe Fed are leasT !ike~)' to lI1crease:
A.excess reserves.
B.the federal funds rate.
C.cash in investor accounts.
6.An increase in the target federal funds rate will most like~J' lead ro an increase in:
A.business investment in fixed assets.
B.consumer spending on durable goods.
C. the foreign exchange value of the U.S. dollar.
7.A strategy designed to match the growth rate of the monetary hase to the long-
term growth rate of real GOP plus the target inflation rate is:
A.the McCallum rule.
B.inflation targeting.
C. exchange rate targeting.
©2008 Kaplan Schweser |
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Srudy Session 6
Cross-Reference ro CFA Insurute Assigned Reading #27 - Monetary Policy
ANSWERS - CONCEPT CHECKERS
1.B The Fcd's goals include maximum employment, which is interpreted as the maximum
sustainable growth ratc of the cconomy; stable prices; and moderate (not minimal) longterm III terest r,nes.
AThe Fed focuses on the core rate of inflation (the rate of incrcase in the CPJ excluding food and energy prices) and the output gap (the difference between the actual and potenriaJ rates of real GDP growth).
3.B The primary mcthod by which the Fed conducts monetary policy is through changcs in the target fedcral funds rate.
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C |
An inflation targeting rule would call for the Fcd to base its decisions on a forecast |
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rate of inflation and to set its fedcral funcls rate targct at a level that makes thc forecast |
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inflation rate equal its targc!, \X!ith '111 instrument rule. polin' dccisions :He basL'(J on the |
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!)erl,Orlll:lIlCL' of rhL' econom\', Thl' TlI'lor ruleis Jil t'xampIL' of an |
instrUI1lL'nl ruk, |
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()pL'11 markct purchases bv tilt' reJ will ril'O"n/sl' rhe federal funds |
r'ltc h\' increasinf' |
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excc,s rcsn\'<:, thaI hanks caf) knJ ro one another and, therefore. their willingncss to |
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lend. |
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C |
An increase in thc target federal funds rate \\'()uld also bc likel:' [(l increase longer-lt'l'l1l |
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iIHL'resr races. \\'hich would CIUS,'consumption spcnding on (!urabic goods and huslness |
investment in plant and equipment to decrease, The increase in rates would, howevn. make foreign investment in tL~ l',\, more arrraerive, which would increase demand for
U,S, dollars and cause the clol;,",r [C apprcciate.
AThe McCallum rule is designed to set the growth rate of the monctar:' base at the longterm growth ratc of real GDP plus the target rate of inflation, with an adjustment for changes in thc velocity of money,
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©2008 Kaplan Schweser |
The following is a review of the Economics principles designed to address the learning outcome statements set forth by CFA Institute(!<). This topic is also covered in:
AN OVERVIEW OF CENTRAL BANKS
Study Session 6
EXAM FOcus
This review has only two LOS. While
it primarily concerns cemral banks of coumries other than the U.S., the policy roo Is and goals of central banks around rhe world are quire similar. The policy rools of cemral banks were covered in rhe previous ropic review and are covered agal11 in rhe
Fixed Income topic area. Suffice to say, a candidate should be quite familiar with central bank funnions, monerary policy r(lOls, and how rhe goals of economic growth and price srabiliry somerimes conAicr in rhe shorr run.
~u~, 28.;:: ldclltir} the flinctiom of;: central ballk.
The primar}' funcrion of central banks is to control a cOllllln"s mone}' supply. The goals are rypicall}' price level srabiJin' and maximum sust:linable growrh of real CDP. ivlosl believe that rhest: goals an: compatible in rhe long run. That is. a low. Hable. and predicr:lble rare or price inflarion supports maximum economic growrh. In rhe shorr run. however. anions raken to reduce inflarionar}' pressures in rhe economy may slow economic growrh or even le:ld to a recession. Cemral banks of differem countries have different mandares, bur rhe differences rypically are in how much emphasis is placed on promoting economic growrh. since all cemral banks an: required to mainrain srable prices, ofren within some prescribed range.
Central banks also rypically issue a counrr}''s currenc}' and regulare irs banking sysrem.
LOS 28.b: Discuss monetary policy and the tools utilized by central banks to carry out monetary policy.
In the U.S., rhe rhree policy tools of the central bank (rhe Federal Reserve) are:
1.B;l11ks can borrow funds from the Fed if rhey have remporary shorrfalls in reserves. The discount rate is rhe rate at which banks can borrow reserves from rhe Fed. A lower rate makes reserves less costly to banks, encourages bank lending, and rends ro decrease inreresr rates. A higher discount rate has the opposire effecr, raising inrerest ra res.
2.Bank reserve requirements arc the percentage of deposirs thar banks must retain
(nor loan our). By increasing rhe percentage of deposirs rhar banks are required ro retain as reserves, the Fed effecrively decreases the funds thar are available for lending. This decrease in rhe amount available for lending will tend ro increase interest rares. A decrease in rhe percentage reserve requirement will increase rhe
funds available for loans, which rends ro decrease interesr rares. This rool only works well if banks are willing to lend, and rheir cusromers are willing ro borrow, rhe addirional funds made available by reducing the reserve requirement.
©2008 Kaplan Schweser |
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Scud}' Session,6
Cross-Referenfe to CPA Institute Assigned Reading #28 - An Overview of Central Banks
3, Open market operations are the buying or selling of Treasury securities by the Fed in rhe open marker. When the Fed buys securities, cash replaces securities in investor accounts, banks have excess reserves, more funds are available for lending, and interest rates decrease. Sales of securities by the Fed have the opposite effect,
reducing cash balances and funds available for lending, and increasing interest rates, This is the Fed's most commonly used rool and is important in achieving rhe federal funds target rate.
In other countries, the tools are essen tially the same, but the names may be differen t. In the Unired Kingdom, the interbank rate for overnight loans is referred to as the repo rate or repurchase rate, and this terminology is common in other countries as well. In Australia the central bank refers to this rate as the cllSh raU and in Canada it is referred to simply as the overnight rate,
\Xlhen you read that the US Fed has "decreased interest rates," this typically means that they' have reduced the federal funds rate, the average rate at which hanks loan resen'("s
to each other. usualhovernight. Note that the federal funds rate is a market dctermillc'd rate, Howcver. the cl'nrral h~lllk usual'" decreases the discolillt r~!;l' ,l[ the saml' lime:.
To decrease the federal funds LItC. the cclltral bank will increase thl' mOlln' supplv. increasing banks' excess reSCI'ves and their willingness to knd.
\x:rhile the centra) hanks of mall\' countries use cither the discount ratl' or the overnight rate as their primarv poliC\' rool. the goal is to keep inflation within hounds, i\'1anagins the money suppl!' in such a wa\' as to keep inflation within prescribed hounds is rermed inflation targeting. This is till' most common monerary policy goal and over the last
20 years most countries have i110ved to inflation targeting, Exceptions are the U.S. and Japan. The U.S. Fed does not rarget inflation rares specifically. hut has a dual mandatc of full employment and stable prices. The Bank of Japan does not specifically target
an inflation rate, but faces different problems than other countries in this regard as deflation has been seen as a significant threat in recent years, while inflation that is too high has not.
Countries that target inflation typically have a target of 2% annual inflation with an acceptable range of IOlb to ,1°;(1. .lusr as cenual hanks USl' slightly djfferl'nr interesr ratcs j~)f policy making, the\' also USl' different measures of price inflation. All usc some measure of changes in consumer prices. However, there are differences based on whether some measure of "core" inflation is used. A measure of core inflation is constructed b!' taking some of the most volatile components of overall prices, such as food and energy, au t of the cpr calculation.
To promote economic growth. central banks can, in theory, simpl!' increasc targer rates when the cconomy is growing at an unsustainably rapid rate and decrease ratcs when economic growth is deemed roo slow, 1n pracrice the management of a complex economy in a global context is actually guite difficult. Policy changes designed to
promote growth may also increase inflation, and changes in interest rates also affect asset prices, income from saving and lending, investment flows between countries, foreign exchange rates, and import and export levels.
©2008 Kaplan Schwcser
Smdy Session 6
Cross-Reference to CFA Institute Assigned Reading #28 - An Overview of Central Banks
KEy CONCEPTS
LOS 28.a
Central banks manage a country's money supply in order to maintain price stability and, with varying emphasis, promote full employment and maximum sustainable long-term growth of the economy. Central banks also issue a country's currency and regulate its banking system.
LOS 28.b
There are three primary cools that central banks use to carry out monetary policy and affect inRation and the rate of economic growth.
•They can reduce (increase) inflation and the growth rate of the economy through open market operations, selling (buying) government securities in order to increase (decrease) shore-term interest rates.
•The\' can reduce (increase) inflation and the growth rate of the econom" hy increasin~ (decreasing) the hank reserve requiremellt, whiL'h \"ill decrease (increase)
lhe mone" SUpf)J.I' and inL'rease (decrease) s!lUrl-terIll iI1lLTl'S[ r~ltes,
•The~' can increase (decrease) [he interest rate at which [!In'lend reserves to memher
banks, which will decrease (increase) hanks' willingness to lend and redUCt: (increase)
lhe mone\' supp!v.
©2008 Kaplan Schweser |
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Self-Test: Economics
8.A Real business cycle theory holds that economic cycles are driven by fluctuations in the growth rate of productivity that result from changes in technology. Keynesian cycle theory attributes the business cycle ro changes in business confidence, while new classical cycle theory suggests business cycles are driven by unexpected changes in aggregate demand.
9.A Changes in the U.S. federal funds rate and changes in long-term interest rates are unlikely to be proporrionate. Long-term rates are the sum of short-term rares and a premium fOf the expected rate of inflation. If a decrease (increase) in rhe target federal funds rate by the Fed causes economic agents ro increase (decrease) their inflation expectations, the change in long-term rates will be less than the change in the federal funds rate. Increases in spending on consumer durables and a decrease in the foreign exchange value of the U.S. dollar ate among the expected results of a decrease in the target U.S. federal funds rate.
10.A An increase in aggregate demand will cause shorr-run equilibrium ro move along the
shorr-run aggregare supply curve (SAS). This will tend !O increase both real GOP and the price level in the shorr run.
I ]. C :\n incrci'c in the nlOnlT \\'a~l' rate WIlUlll not inerc:asl' lllni:!-run aggrci:!Jll sUrf,I:'
(porcnrial real CUP). hur instead would decrease rhe shOll-run 'lggregall" Sllppl:' (urn'.
An improvement in technology would tend (() increase porential real CDP. Decreasing rhe income tax rale narrows the tax wedge herween prerax and after-tax income. which increase:.' the: full-emplovment quantin' or lahor supplied and potential real GOP.
12.C Cvcl ical unemplovment is zero at full emplovment, while structural and frierionJ.1 unemployment arc always grearer than zero so that rotal unemplovment is greater than
zero at full-employment real GOP.
©2008 Kaplan Schweser |
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FORMULAS
percent change in quantiry demanded %6Q
price e1asticiry of demand '" |
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%6P |
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percent change in price |
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change in value |
ending value - |
beginning value |
where: percent change '" |
( ending value + ~eginning value) |
average value - |
percent change in quantiry demanded |
cross elasticity of demand", --- " -------- |
"' ---- |
' ---- |
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' --------- |
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percent change in price of substiture or complement |
11<:rce[1[ change in quanriry demanded percenr change in income
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f |
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percent change in quantity supplied |
prIce e JStlCIrY 0 |
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supp y = |
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percent change In price |
rotal cost", total fixed cost + total variable coSt |
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change in total cost |
L\TC |
marOlna cost = |
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= -- |
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change in output |
L\Q |
average fixed COSt'" TFC / Q
average variable cost'" TVC / Q
average total coSt'" AFC + AVe
unemployment rate = number of unemployed x 100
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labor force |
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e·· . |
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labor force |
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1abor lOrce partiCipation rate = |
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working-age population |
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number of employed |
xl 00 |
employmenr-to-populatlOn raoo = . |
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working-age population |
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ePI = cost of basket at current prices |
xl 00 |
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cost of basket at base period prices |
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©2008 Kaplan Schweser |
X 100
" fl .
Book 2 - Economics
Formulas
In atlon rate = current CPI - year-ago CPI year-ago CPI
aggregate demand = consumption + investment + government spending + net exports
potential deposit expansion multiplier = 1 / (required reserve ratio)
potential increase in money supply = potential deposit expansion multiplier x increase in excess reserves
money multiplier = (l + c) (r + c)
change in quantity of money = change in monetary base x monel" multiplier
equation of exchange:
money supply x velocity = GOP = price x real output
quantity theory of money: price = M( ~)
©2008 Kaplan Schweser |
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