Chapter 17

Tools of Monetary Policy

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The Market for Reserves and the Federal Funds RateDemand Curve for Reserves

1. R = RR + ER2. i→ opportunity cost of ER→ ER3. Demand curve slopes down

Supply Curve for Reserves1. If iFF is below iD, then no discount borrowing, RS =

Rn

2. Supply curve flat (infinitely elastic) at iD because as iFF starts to go above iD, banks borrow more at iD

Market Equilibrium where RD = RS at i*FF

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Supply and Demand for Reserves

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Response to Open Market Operations

Open Market Purchase

Non-borrowed reserves, Rn and shifts supply curve to right RS

2: i to i2ff

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Response to a Change in the Discount Rate

(a) No discount lending Lower Discount RateHorizontal section and supply curve just shortens, iff stays same

(b) Some discount lendingLower Discount RateHorizontal section , iff to i2

ff = i2d

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Required Reserves Demand for Reserves , RD shifts right and iff to i2

ff

Response to Change in Required Reserves

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Open Market Operations

2 Types1. Dynamic to change MB

2. Defensive to offset other changes to MB using Repurchase Agreements (repos).

Advantages of Open Market Operations1.Completely controlled by Fed

2.Flexible and precise

3.Easily reversed

4. Implemented quickly

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Discount Operations (Discount Loans)

3 Types1. Primary Credit

Backup source of liquidity for banks

Puts a ceiling on iFF

2. Secondary Credit

3. Seasonal Credit

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Rightward shift of RS to RS

2 moves equilibrium to point 2 where i2

ff = id and discount lending rises from zero to DL2

How the Primary Credit Facility Puts Ceiling on iff

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Discount Operations

Advantages1. Fed as Lender-of-Last Resort to Banks 1. To prevent bank panics

Example: Continental Illinois

2. To prevent non-bank financial panics.

Examples: 1987 stock market crash.

Disadvantages1. Not fully controlled by Fed

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Reserve Requirements (Have been declining worldwide)

Advantages1. Powerful effect on the money supply

Disadvantages1. Tax on banks makes them less competitive and

weak.

2. Small changes have very large effect on the money supply.

3. Expensive to administer.

4. Can cause liquidity problems for banks.

5. Frequent changes cause uncertainty for banks and make liquidity management more difficult.

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Channel/Corridor System for Setting Interest Rates

In the channel/corridor system standing facilities result in a step function supply curve, RS. If demand curve shifts between RD

1 and RD

2, iff always remains between ir and il