Essay Preview: Federal Reserve
Report this essay
The key to the Feds power, says Laffer, is its total control over the monetary base — the sum of currency in circulation, vault cash and member-bank deposits at the Fed. It increases or decreases the monetary base by buying or selling bonds in the open market. The monetary base, in conjunction with reserve requirements, determines bank liabilities, and bank liabilities along with real output give us the overall price level. The discount rate follows the three-month Treasury bill. If the discount rate goes below the T-bill rates, the banks will profit from the Fed for selling the T-bills at a discounted price. And if the discount rate far exceeds the three-month T-bill rate, only those banks in desperate straits would ever borrow.
Hilton disagrees with Laffer that the Fed is not influential or important. On slide 2 of Spence Hiltons Framework for Implementing Monetary Policy, he gives a simple example that illustrates how The Three Tools of Domestic Monetary Policy work. This includes the discount window, reserve requirements and open market operations. Another example would be on slide 4. Because large banks can trade in either the federal funds market or the Eurodollar market and because fed funds and Eurodollars are easily substitutable forms in which to hold short-term liquidity, it should not be surprising that overnight Eurodollar interest rates line up closely with the funds rate, even within the day. If monetary policy can affect Treasury yields, then clearly it can affect other yields and asset prices as well. For example, mortgage rates are closely linked to long-term Treasury yields, the spread between the two rates being explained largely by factors such as the risk of default on mortgage loans and the so-called prepayment risk (that is, the risk that homeowners will choose to pay off their mortgages early). Likewise, changes in Treasury yields affect stock prices by affecting both the profit prospects of publicly traded