Federal Fiscal and Monetary Policy PDF

Federal Fiscal and 2 Monetary Policy Learning Objectives After completing this lesson, students should be able to... Recall the two ways in which the federal government influences the cost of borrowing money Define fiscal p...

Federal Fiscal and 2 Monetary Policy Learning Objectives After completing this lesson, students should be able to... Recall the two ways in which the federal government influences the cost of borrowing money Define fiscal policy and the branches of government that determine and implement it Describe how government spending and the federal deficit are covered using debt financing Explain how taxation is used to carry out social policy with respect to real property ownership Summarize the historical reasons for government regulation of depository institutions Outline the organization of the Federal Reserve System Discuss the relationship between the Federal Reserve’s actions, inflation, and the health of the economy List the tools used by the Federal Reserve to implement monetary policy Suggested Lesson Plan 1. Give students Exercise 2.1 to review the previous chapter, “Finance and Investment.” 2. Provide a brief overview of Chapter 2, “Federal Fiscal and Monetary Policy,” and review the learning objectives for the chapter. © 2018 Rockwell Publishing  Financing Residential Real Estate Instructor Materials 3. Present lesson content: Government Influences on Finance Fiscal Policy Spending and Debt Financing EXERCISE 2.2 The federal deficit and interest rates Taxation EXERCISE 2.3 Tax code provisions and real estate Monetary Policy – Federal Reserve System – Economic growth and inflation Tools for Implementing Monetary Policy – Reserve requirements – Key interest rates – Open market operations Changes in Monetary Policy EXERCISE 2.4 Tools for implementing monetary policy 4. End lesson with Chapter 2 Quiz. Chapter 2 Outline: Federal Fiscal and Monetary Policy I. Government Influences on Finance A. The federal government influences real estate finance by influencing the cost of mortgage funds B. Market interest rates represent the cost of borrowing money, which is subject to the rules of supply and demand C. The federal government affects the cost of borrowing through fiscal policy (spending and debt financing, and taxation) and monetary policy II. Fiscal Policy A. Federal government fiscal policy is determined by both the legislative and executive branches, and is carried out by the U.S. Treasury Department B. If the federal government spends more money than it receives in a year, a deficit occurs C. To finance the shortfall, the government sells interest-bearing securities to investors 2  Chapter 2: Federal Fiscal and Monetary Policy D. When private investors lend money to the government to cover a deficit, less money is available to private borrowers 1. Some economists believe federal deficits have little effect on interest rates 2. Other economists believe deficit spending pushes interest rates up be- cause government borrowing takes funds out of the money market and increases demand for funds EXERCISE 2.2 The federal deficit and interest rates III. Taxation A. Taxation affects mortgage rates by affecting how much money taxpayers have available to lend or invest B. Taxation also affects mortgage rates through tax exemptions, deductions, and exclusions, which may affect demand for mortgages C. Taxpayers are allowed to deduct home mortgage interest, which reduces the amount of taxes they pay 1. Interest on loans for the purchase, construction, or improvement of a home is deductible; if the loans (obtained after December, 2017) total more than $750,000 interest paid on the excess is not deductible 2. Interest on home equity loans is deductible if the funds were used for substantial home improvements D. Taxpayers may exclude from taxation the gain received from selling a princi- pal residence 1. A gain of up to $250,000 for an individual or $500,000 for a married couple filing jointly may be excluded 2. To qualify for exclusion, the taxpayers must have owned the property and used it as a principal residence for at least two of the previous five years E. Investors may take depreciation deductions EXERCISE 2.3 Tax code provisions and real estate IV. Monetary Policy A. Federal monetary policy refers to the government’s control over the money supply, which is implemented by the Federal Reserve System (or the “Fed”) B. Historical background 1. Banks were first regulated in 1863 through the National Bank Act, which created basic procedures for supervising banks 2. The Federal Reserve Acts of 1913 and 1916 created the modern banking system 3. The Federal Reserve System imposes reserve requirements, specifying what amount of a bank’s deposits must be kept in reserve to be available for withdrawal 3  Financing Residential Real Estate Instructor Materials 4. The Federal Reserve acts as a lender of last resort, providing short-term loans to banks running low on funds 5. The stability of the banking industry was bolstered in the 1930s by the creation of the Federal Deposit Insurance Corporation C. Organization of the Federal Reserve 1. The Federal Reserve System is decentralized into 12 regional Federal Reserve Banks D. Economic growth and inflation 1. If economic growth occurs too quickly, inflation results, causing price increases that hamper further growth 2. In times of inflation, the Fed will take action to slow growth in order to limit infla- tion V. Tools for Implementing Monetary Policy A. Reserve requirements: a percentage of deposits that each bank must maintain either in its own vaults or on deposit with the Federal Reserve Bank 1. Reserve requirements were originally intended to avert financial panic by making sure that depositors were always able to withdraw deposits 2. Reserve requirements also allow the Fed to control the money supply 3. An increase in reserve requirements reduces the amount of money banks have available to lend and therefore increases interest rates B. Interest rates: the Fed controls two key interest rates, the federal discount rate and federal funds rate 1. The discount rate is the rate charged to member banks when they borrow money from the Fed to cover a shortfall in funds 2. The federal funds rate is the rate banks charge each other for loans to cover short- falls 3. Lenders’ market interest rates will usually rise or fall in response to changes in the federal rates, although long-term rates (such as mortgages) are not immedi- ately affected C. Open market operations: the Fed controls the money supply by buying and selling government securities 1. If the Fed buys government securities, it puts more money into the money supply, which by itself will decrease interest rates 2. If the Fed sells government securities, it takes money from investors out of the money supply, which will increase interest rates 4  Chapter 2: Federal Fiscal and Monetary Policy VI. Changes in monetary policy A. The Fed modifies its monetary policy in response to changing economic indicators B. After the 2007 financial crisis, the Fed tried to spur economic growth by lowering interest rates without allowing inflation to become a problem; more recently, the Fed has begun gradually increasing interest rates EXERCISE 2.4 Tools for implementing monetary policy 5  Financing Residential Real Estate Instructor Materials Exercises EXERCISE 2.1 Review exercise To review Chapter 1, “Finance and Investment,” have students match the following terms with one of the descriptions below: Interest rate risk Prepayment risk Safety Risk of default Securities Liquidity Debt investment Ownership investment Yield ______ 1._Adjustable-rate mortgages help lenders manage this type of risk. ______ 2._This investment characteristic concerns how easily an investment can be converted into cash. ______ 3._A purchase of real estate is this type of investment. ______ 4._Underwriting standards are the tool lenders rely on most in order to manage this type of risk. ______ 5._If this investment characteristic is most important to an investor, he’ll generally have to accept a greater degree of risk. ______ 6._Making a mortgage loan is this type of investment. Answers: 1. INTEREST RATE RISK. A lender takes on less interest rate risk with an adjustable-rate mortgage than with a fixed-rate mortgage, because the ARM allows the lender to increase the loan’s interest rate periodically to reflect an increase in market rates. 2. LIQUIDITY. A very liquid investment is one that can easily be converted into cash. 3. OWNERSHIP INVESTMENT. The purchase of an asset (such as real estate) is an ownership investment. The owner’s return on the investment may take the form of appreciation in the value of the asset, rents collected from tenants, or both. 4. RISK OF DEFAULT. Underwriting standards help lenders evaluate how likely it is that a potential borrower would eventually default if the proposed loan were made. 5. YIELD. As a general rule, the riskier the investment, the higher the potential yield. The yield is the investor’s return or profit. 6. DEBT INVESTMENT. When a lender loans money to a borrower and then collects interest on the loan, it’s a debt investment. 6  Chapter 2: Federal Fiscal and Monetary Policy EXERCISE 2.2 The federal deficit and interest rates Discussion Prompt: When the money supply increases, what is the expected effect on interest rates? Does the federal deficit trigger an increase or decrease in the money supply? How does the U.S. Treasury finance the deficit? Analysis: According to the law of supply and demand, prices rise when demand exceeds supply, and they fall when supply exceeds demand. So interest rates (the cost of money) tend to fall when the money supply increases, because more money is available to meet borrower demand. Economists disagree about what effect the federal deficit has on the money supply and interest rates. The federal deficit results from the federal government spending more money than it has in revenues (thus adding money to the economy). On the other hand, the government has to cover the shortfall, and the Treasury does this by issuing interest-bearing securities and selling them to investors. In effect, the Treasury is borrowing money from private investors to cover the deficit. That means the Treasury is competing for investors’ funds with private borrowers in the market, so that less money is available for those borrowers. If this analysis is correct, an increase in the federal deficit reduces the money supply and drives interest rates up. EXERCISE 2.3 Tax code provisions and real estate Discussion Prompt: We’ve looked at several tax provisions related to real estate, includ- ing exclusion of gain on the sale of a home and depreciation deductions. Can you construct a scenario in which a taxpayer could use both of those for a single property? Analysis: Depreciation deductions are only available for investment or business prop- erty. Exclusion of gain is allowed only on the sale of a principal residence property (occupied two of the past five years by the taxpayer). However, a taxpayer might be able to claim both kinds of tax benefits if she converts a property from a resi- dence to a rental, or vice versa. (Note that a tax attorney or accountant should be consulted about this. The conversion of a rental property to a residence may trigger depreciation recapture.) 7  Financing Residential Real Estate Instructor Materials EXERCISE 2.4 Tools for implementing monetary policy From the following list, choose the action the Federal Reserve would be most likely to take in order to achieve each of the goals below. Buy government securities Decrease reserve requirements Increase the discount rate Lower the federal funds rate target Sell government securities ______ 1._Slow down economic growth to fight inflation. ______ 2._Stimulate activity in a weak economy. ______ 3._Take money out of circulation. ______ 4._Make more money available for lending or investment. ______ 5._Increase the money supply. Answers: 1. INCREASE THE DISCOUNT RATE. An increase in the discount rate normally indi- cates that the Fed is concerned about an overheated economy producing inflation. 2. LOWER THE FEDERAL FUNDS RATE TARGET. While the federal funds rate is not set directly by the Fed, its target does signal the Fed’s overall view of the economy. 3. SELL GOVERNMENT SECURITIES. When the Fed sells government securities, the money supply decreases, because the money paid by the buyer is taken out of circulation. 4. DECREASE RESERVE REQUIREMENTS. Reduced reserve requirements mean that banks have more of their money free for investment or lending. 5. BUY GOVERNMENT SECURITIES. However the Fed pays for the securities (cash, check, or crediting a bank’s reserves), the purchase puts more money into circu- lation. 8  Chapter 2: Federal Fiscal and Monetary Policy Chapter 2 Quiz 1. Which of the following is not an aspect of the 6. Which of the following is not a responsibility federal government’s fiscal policy? of the Federal Reserve System? A. Debt financing A. Imposing reserve requirements B. Government spending B. Issuing interest-bearing securities C. Setting key interest rates C. Performing periodic bank examinations D. Taxation D. Regulating commercial banks 2. In a given year, the federal government receives 7. Economic growth that is too strong and too fast $4 trillion in revenues, but incurs $4.2 trillion in is usually accompanied by: expenditures. The $200 billion shortfall is the: A. deficit spending A. federal debt B. deflation B. federal deficit C. inflation C. reserve requirement D. unemployment D. trade deficit 8. Which of the following is not a tool the Federal 3. An unmarried taxpayer may deduct: Reserve uses to implement federal monetary A. capital gains on the sale of a residence up policy? to $250,000 A. Interest rates B. depreciation of income-earning property B. Open market operations C. mortgage interest on a loan for a first or C. Reserve requirements second residence of up to $750,000 D. Taxation D. Both B and C 9. The interest rate that the Federal Reserve Sys- 4. A married couple filing a joint return sell their tem charges member banks who borrow funds primary residence for a profit. How much of to cover shortfalls is the: their capital gain from the sale of the house A. discount rate may be excluded from taxation? B. federal funds rate A. $100,000 C. open market rate B. $250,000 D. reserve rate C. $500,000 D. $1,000,000 10. The federal funds rate is the: A. percentage of deposits that lenders must 5. Because the Federal Reserve will provide short- maintain in their vaults or on deposit at a term emergency loans to banks who can’t meet Federal Reserve Bank reserve requirements, it is known as a: B. prevailing rate charged to mortgage bor- A. lender of last resort rowers by commercial banks B. primary market lender C. rate charged by the Federal Reserve for C. secondary market entity short-term loans to lenders facing a short- D. wholesale lender fall in funds D. rate that banks charge each other for over- night, unsecured loans 9  Financing Residential Real Estate Instructor Materials 11. A commercial bank is required by the Federal Reserve to keep between 3% and 12% of its deposits either in its own vaults or on deposit at the Federal Reserve Bank in its district. This is an example of: A. fiscal policy B. open market operations C. reserve requirements D. the discount rate 12. To lower interest rates, the Federal Reserve would: A. decrease reserve requirements and buy government securities B. decrease reserve requirements and sell government securities C. increase reserve requirements and buy government securities D. increase reserve requirements and sell government securities 13. In the early 1980s, the problem facing the economy that the Federal Reserve tried to resolve was: A. budget deficits B. inflation C. high and volatile interest rates D. stagnant growth 14. How many Federal Reserve Banks are there? A. 3 B. 12 C. 50 D. 100 15. One way that the government controls the money supply is by: A. changing the discount rate B. increasing the federal deficit C. engaging in open market operations D. adjusting the federal funds rate 10  Chapter 2: Federal Fiscal and Monetary Policy Answer Key 7. C. Inflation is a trend of general price 1. C. The government’s fiscal policy in- increases throughout the economy, cludes government spending, debt which usually occurs as a result of too financing, and taxation. Setting of much economic growth too quickly. interest rates is an aspect of monetary The Federal Reserve attempts to pro- policy. mote economic growth while limiting inflation. 2. B. If the federal government spends more money than it receives as revenue, the 8. D. The Federal Reserve System does not shortfall in a particular year is known have control over taxation, which is an as the federal deficit. The Treasury aspect of fiscal policy. Laws and rules covers the shortfall by issuing interest- concerning taxation are established by bearing securities to investors. the legislative and executive branches of the government. 3. D. Depreciation of income-earning prop- erty and mortgage interest are both 9. A. The discount rate is the interest rate deductible. Capital gains from the sale charged for short-term loans to lend- of a home are excluded from taxation, ers with a shortfall in funds that leaves not deducted from income. them unable to meet Fed reserve re- quirements. 4. C. For married taxpayers filing a joint re- turn, up to $500,000 of the gain on the 10. D. The federal funds rate is the inter- sale of a principal residence may be est rate that banks charge each other excluded from taxation. for short-term loans, such as loans to obtain funds necessary to meet Fed re- 5. A. The Federal Reserve System is known serve requirements. as a “lender of last resort,” since it makes short-term loans to other lend- 11. C. The Federal Reserve uses reserve re- ers that run low of funds and cannot quirements to make sure that banks meet the reserve requirements set by have enough funds easily accessible to the Fed. depositors, in order to prevent “runs on the bank.” By adjusting reserve 6. B. The Treasury Department finances requirements, the Fed is also able to government debt by issuing interest- adjust the amount of money in circula- bearing securities. (The Fed may buy tion. and sell government securities in open market operations, but it does not issue the securities.) 11  Financing Residential Real Estate Instructor Materials 12. A. Decreasing reserve requirements would increase funds available for lending and decrease interest rates. Likewise, buying back government securities increases the money supply and decreases interest rates. 13. C. By the early 1980s, the Federal Re- serve’s efforts to rein in the inflation problem of the 1970s had succeeded, but the result was very high, extremely variable interest rates. The Federal Reserve was then able to lower and stabilize interest rates. 14. B. There are 12 Federal Reserve Banks, though some of these banks have branches. 15. C. The Fed adjusts the money supply by engaging in open market operations. As it buys and sells government secu- rities, it changes the amount of money in circulation. 12  Chapter 2: Federal Fiscal and Monetary Policy PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Financing Residential Real Estate Lesson 2: Federal Fiscal and Monetary Policy © 2018 Rockwell Publishing Introduction This lesson will cover: ⚫ federal government’s fiscal policy ⚫ taxation ⚫ federal government’s monetary policy ⚫ Federal Reserve system ⚫ tools for implementing monetary policy © 2018 Rockwell Publishing Introduction Federal government affects real estate finance by influencing cost of borrowing mortgage funds. Major cost of borrowing money is interest charged by lender. ⚫ Market interest rates = current cost of $ © 2018 Rockwell Publishing 13  Financing Residential Real Estate Instructor Materials Introduction Cost of borrowing money is influenced by federal government in two ways: ⚫ fiscal policy ⚫ monetary policy © 2018 Rockwell Publishing Introduction Fiscal policy: government’s actions in raising revenue, spending money, and managing its debt. Monetary policy: government’s direct efforts to control money supply and cost of money. © 2018 Rockwell Publishing Fiscal Policy Set by executive and legislative branches (president and Congress), who establish federal tax laws, budget. ⚫ U.S. Treasury Department manages government’s finances, carrying out fiscal policy. © 2018 Rockwell Publishing 14  Chapter 2: Federal Fiscal and Monetary Policy Fiscal Policy Spending and debt financing Federal deficit: shortfall when government spends more than it collects. ⚫ Treasury gets funds to cover shortfall by issuing interest-bearing securities. ⚫ By selling securities to investors, government is borrowing money from private sector. ⚫ Leaves less money for private borrowers. © 2018 Rockwell Publishing Fiscal Policy Spending and debt financing Some economists believe federal deficit has little effect on interest rates. Others believe federal borrowing pushes interest rates up. © 2018 Rockwell Publishing Fiscal Policy Taxation Tax policies affect how much taxpayers have left for other purposes: ⚫ ↓ taxes = more $ to lend/invest ⚫ ↑ taxes = less $ to lend/invest © 2018 Rockwell Publishing 15  Financing Residential Real Estate Instructor Materials Fiscal Policy Taxation Tax policies also affect investment choices: ⚫ ↑ taxes = tax-exempt securities preferred ⚫ ↓ taxes = taxable investments attractive Real estate, MBS are taxable. © 2018 Rockwell Publishing Fiscal Policy Taxation Taxes implement social policy by providing benefits and incentives: ⚫ mortgage interest deductions ⚫ exclusion of gain on sale of principal residence © 2018 Rockwell Publishing Fiscal Policy Deduction of mortgage interest Taxpayer can deduct (from taxable income) interest paid on one or more mortgages: ⚫ loans for buying, building, or improving 1st or 2nd residence ⚫ home equity loans ⚫ purchase loans on investment property © 2018 Rockwell Publishing 16  Chapter 2: Federal Fiscal and Monetary Policy Fiscal Policy Deduction of mortgage interest Loans for buying, building, or improving 1st or 2nd residence. ⚫ Can deduct all interest on loans up to $750,000. ⚫ If loan amount exceeds that limit, interest on excess not deductible. © 2018 Rockwell Publishing Fiscal Policy Deduction of mortgage interest Home equity loans – can deduct interest only if loan funds are used for substantial home improvements. © 2018 Rockwell Publishing Fiscal Policy Gain on sale of home Homeowners allowed to exclude from taxation a gain (profit) on sale of principal residence. ⚫ May exclude up to $250k ($500k for married couple filing jointly). ⚫ Excess taxed at capital gains rate. © 2018 Rockwell Publishing 17  Financing Residential Real Estate Instructor Materials Fiscal Policy Gain on sale of home Taxpayer must have owned and used property as principal residence for two of last five years. ⚫ If married, one spouse must meet ownership test; both must meet use test. ⚫ If only one spouse meets both tests, maximum exclusion is $250k (if filing jointly). © 2018 Rockwell Publishing Fiscal Policy Gain on sale of home Reduced exclusions allowed under special circumstances when taxpayers have owned house for less than 2 years. For example, if home sold because of: ⚫ change in health ⚫ change in place of employment ⚫ unforeseen circumstances © 2018 Rockwell Publishing Fiscal Policy Depreciation deductions for investors Owners of income property allowed to take depreciation deductions. ⚫ Deduct cost of buildings and property improvements that will eventually have to be replaced. ⚫ Cost spread out over number of years, not deducted all at once. © 2018 Rockwell Publishing 18  Chapter 2: Federal Fiscal and Monetary Policy Summary Fiscal Policy Fiscal policy Federal deficit Taxation Deduction of mortgage interest Exclusion of gain on sale of home Depreciation deductions © 2018 Rockwell Publishing Monetary Policy Government uses its control over money supply to keep national economy running smoothly. © 2018 Rockwell Publishing Monetary Policy Federal Reserve System Monetary policy is set and implemented by Federal Reserve System (“the Fed”). © 2018 Rockwell Publishing 19  Financing Residential Real Estate Instructor Materials Federal Reserve System Historical background In early 19th century, there was little government regulation of depository institutions. ⚫ Security of bank deposits depended on integrity of bank managers. © 2018 Rockwell Publishing Federal Reserve System Historical background In 1863, Congress passed National Bank Act. ⚫ Established basic banking regulations/procedures for supervising commercial banks. © 2018 Rockwell Publishing Federal Reserve System Historical background Economic downturns led to financial panics (bank depositors withdrew all their money at once). ⚫ Caused even financially sound banks to fail. Public previously resistant to idea of central national bank, but losses from panics of 1907 changed public opinion. © 2018 Rockwell Publishing 20  Chapter 2: Federal Fiscal and Monetary Policy Federal Reserve System Historical background Federal Reserve Acts of 1913 and 1916 created Federal Reserve System and established modern banking system. Reserve requirements: certain proportion of bank’s deposits must be held in reserve, available for immediate withdrawal on demand. © 2018 Rockwell Publishing Federal Reserve System Historical background Fed is “lender of last resort,” providing short-term backup loans to banks that run low on funds. © 2018 Rockwell Publishing Federal Reserve System Historical background Creation of Fed helped, but did not solve, problem of financial panics. ⚫ In 1930s, Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) created to boost depositor confidence. © 2018 Rockwell Publishing 21  Financing Residential Real Estate Instructor Materials Federal Reserve System Organization Federal Reserve System is made up of: ⚫ 12 regional Federal Reserve Banks in 12 Federal Reserve Districts ⚫ Federal Reserve Board ⚫ Federal Open Market Committee ⚫ advisory councils ⚫ over 3,000 member banks © 2018 Rockwell Publishing Federal Reserve System Organization Board of Governors: controls Federal Reserve system. ⚫ 7 members, appointed by President, confirmed by Senate for 14-year terms. ⚫ Members chosen from different Federal Reserve Districts. © 2018 Rockwell Publishing Federal Reserve System Organization Board of Governors, cont. ⚫ Chairman chosen for 4-year term from among governors. ⚫ Sets reserve requirement for commercial banks. ⚫ Controls discount rate (interest rate set by Federal Reserve Banks). © 2018 Rockwell Publishing 22  Chapter 2: Federal Fiscal and Monetary Policy Federal Reserve System Organization Federal Reserve Banks: each district has one main Federal Reserve Bank. Some districts also have branch banks. ⚫ Each reserve bank appoints a banker to Federal Advisory Council. © 2018 Rockwell Publishing Summary Federal Reserve System Monetary policy Federal Reserve System Reserve requirements Lender of last resort Board of Governors Federal Reserve Board Federal Open Market Committee © 2018 Rockwell Publishing Federal Reserve System Economic growth and inflation Fed’s goal: maintain healthy U.S. economy. ⚫ Economic growth that is too strong or too fast results in inflation. ⚫ Inflation: trend of general price increases throughout economy. © 2018 Rockwell Publishing 23  Financing Residential Real Estate Instructor Materials Federal Reserve System Tools for implementing policy The Fed uses three tools to implement its monetary policy and influence economy: ⚫ reserve requirements ⚫ interest rates ⚫ open market operations © 2018 Rockwell Publishing Tools for Implementing Policy Reserve requirements Banks required to maintain percentage of deposits on reserve in own vaults or at district Federal Reserve Bank. ⚫ May be as much as 10% depending on amount of deposits at bank. © 2018 Rockwell Publishing Tools for Implementing Policy Reserve requirements Depository Institutions Deregulation and Monetary Control Act of 1980 subjected all commercial banks to same reserve requirements as Federal Reserve members. © 2018 Rockwell Publishing 24  Chapter 2: Federal Fiscal and Monetary Policy Tools for Implementing Policy Reserve requirements Increase in reserve requirements = decrease in funds available for investment and increase in interest rates. Decrease in reserve requirements = increase in supply of funds and decrease in interest rates. © 2018 Rockwell Publishing Tools for Implementing Policy Interest rates Fed has control over two key interest rates: ⚫ federal discount rate ⚫ federal funds rate © 2018 Rockwell Publishing Tools for Implementing Policy Federal discount rate Interest rate charged when bank borrows money from Federal Reserve Bank to cover shortfall in funds. © 2018 Rockwell Publishing 25  Financing Residential Real Estate Instructor Materials Tools for Implementing Policy Federal funds rate Interest rate banks charge each other for overnight, unsecured loans. ⚫ Banks borrow from other banks to meet reserve requirements. ⚫ Rate set by banks. ⚫ Federal Open Market Committee sets target for federal funds rate. © 2018 Rockwell Publishing Tools for Implementing Policy Interest rates When Fed raises or lowers either rate, it’s an indication of overall view of economy. Lenders often make corresponding changes to interest rates they charge customers. ⚫ Some lenders change rates in anticipation of rate changes by Fed. © 2018 Rockwell Publishing Tools for Implementing Policy Interest rates Short-term interest rates most affected by changes in discount and federal funds rates. Long-term interest rates (mortgage rates) don’t respond directly to Fed’s rate adjustments. © 2018 Rockwell Publishing 26  Chapter 2: Federal Fiscal and Monetary Policy Tools for Implementing Policy Open market operations Fed also buys and sells government securities in transactions called open market operations. ⚫ Conducted by Securities Dept. of Federal Reserve Bank of New York (“Trading Desk”). ⚫ Federal Open Market Committee (FOMC) directs transactions. © 2018 Rockwell Publishing Tools for Implementing Policy Open market operations FOMC is most important policy-making organization in Fed. ⚫ 8 regularly scheduled meetings per year. ⚫ 12 members: ⚫ 7 members of Federal Reserve Board ⚫ president of NY Federal Reserve Bank ⚫ 4 other Reserve Bank presidents © 2018 Rockwell Publishing Tools for Implementing Policy Open market operations Open market operations are Fed’s primary means of controlling money supply. Money supply: ⚫ increases when Fed buys government securities ⚫ decreases when Fed sells government securities © 2018 Rockwell Publishing 27  Financing Residential Real Estate Instructor Materials Tools for Implementing Policy Open market operations Increased money supply is supposed to lower interest rates. ⚫ But other factors can put pressure on rates. The Fed uses open market operations and other tools to balance complicated forces. © 2018 Rockwell Publishing Federal Reserve System Changes in monetary policy Monetary policy is experimental, and Fed changes strategies from time to time. ⚫ 1970s: Fed moderated interest rates by increasing money supply when interest rates rose. ⚫ When inflation became a concern, Fed tried to control it by restricting growth of money supply. ⚫ Then interest rates soared. © 2018 Rockwell Publishing Federal Reserve System Changes in monetary policy ⚫ By 1982, inflation under control. ⚫ Fed then focused on preventing large fluctuations in interest rates. ⚫ Remainder of 20th century: ⚫ moderate inflation ⚫ lower, stable interest rates © 2018 Rockwell Publishing 28  Chapter 2: Federal Fiscal and Monetary Policy Federal Reserve System Changes in monetary policy ⚫ New century: economy slowed. ⚫ Fed lowered interest rates sharply to stimulate growth. ⚫ Growth led to inflation concerns again, so Fed gradually increased rates. ⚫ 2007: as credit crisis began, Fed started lowering interest rates again. ⚫ Rates stayed low for many years, but began to rise in the last few years. © 2018 Rockwell Publishing Summary Implementing Monetary Policy Interest rates Discount rate Federal funds rate Federal Open Market Committee Open market operations Inflation © 2018 Rockwell Publishing 29