11

Tools of Monetary Policy

Chapter 15

22

33

Tools of Monetary PolicyTools of Monetary Policy

Open market operationsOpen market operationsAffect the quantity of reserves and the Affect the quantity of reserves and the

monetary basemonetary base

Changes in borrowed reservesChanges in borrowed reservesAffect the monetary baseAffect the monetary base

Changes in reserve requirementsChanges in reserve requirementsAffect the money multiplierAffect the money multiplier

44

Tools of the Fed and Fed FundsTools of the Fed and Fed FundsOpen market purchaseOpen market purchase

Increases reservesIncreases reservesSupply upSupply upFederal funds rate downFederal funds rate down

Discount rate increaseDiscount rate increaseReduces discount loansReduces discount loansReduces reservesReduces reservesSupply downSupply downFederal funds rate upFederal funds rate up

55

Tools of the Fed and Fed FundsTools of the Fed and Fed Funds

Reserve requirement increaseReserve requirement increaseBanks scurry to find reservesBanks scurry to find reservesDemand for reserves risesDemand for reserves risesFederal funds rate upFederal funds rate up

66

Federal Funds MarketFederal Funds Market

Federal funds rate—the interest rate on Federal funds rate—the interest rate on overnight loans of reserves from one bank overnight loans of reserves from one bank to anotherto anotherPrimary indicator of the stance of monetary Primary indicator of the stance of monetary

policypolicySince the beginning of February 1994, Since the beginning of February 1994,

after every FOMC meeting, the Fed after every FOMC meeting, the Fed announced the target federal funds rate as announced the target federal funds rate as monetary policy.monetary policy.

77

Demand in the Market Demand in the Market for Reservesfor Reserves

What happens to the quantity of reserves What happens to the quantity of reserves (RR+ER) demanded by banks, holding (RR+ER) demanded by banks, holding everything else constant, as the federal everything else constant, as the federal funds rate, funds rate, iiffff, changes?, changes?

Excess reserves are insurance against Excess reserves are insurance against deposit outflowsdeposit outflowsThe cost of holding ER is the interest rate The cost of holding ER is the interest rate

that could have been earned minus the that could have been earned minus the interest rate that is paid on these reserves, interest rate that is paid on these reserves, iierer

88

Banks’ Demand for ReservesBanks’ Demand for Reserves

1. 1. RR = = RRRR + + ERER

2. 2. iiffff opportunity cost of opportunity cost of ERER, , ERER

3. Demand curve slopes down3. Demand curve slopes down

4. Downward sloping demand curve becomes 4. Downward sloping demand curve becomes flat (infinitely elastic) at flat (infinitely elastic) at iierer

55..Since the fall of 2008 Fed has paid interest on Since the fall of 2008 Fed has paid interest on reserves at a level that is below the federal reserves at a level that is below the federal funds rate target. funds rate target.

99

Banks’ Demand for ReservesBanks’ Demand for Reserves

ReservesReserves

FederalFederalFunds rateFunds rate

iiffff=i=ierer

1010

Fed’s Supply of ReservesFed’s Supply of Reserves Two components: non-borrowed and borrowed reservesTwo components: non-borrowed and borrowed reserves Cost of borrowing from the Fed is the discount rateCost of borrowing from the Fed is the discount rate Borrowing from the Fed is a substitute for borrowing Borrowing from the Fed is a substitute for borrowing

from other banksfrom other banks

If If iiffff < i < idd,, then banks will not borrow from the Fed and then banks will not borrow from the Fed and borrowed reserves are zeroborrowed reserves are zero

The supply curve will be verticalThe supply curve will be vertical

As As iiffff rises aboverises above i idd,, banks will borrow more and more at banks will borrow more and more at iidd, , and re-lend at and re-lend at iiffff

The supply curve is horizontal (perfectly elastic) at The supply curve is horizontal (perfectly elastic) at iidd

1111

Fed’s Supply of ReservesFed’s Supply of Reserves

iiffff=i=idd

NBRNBRReservesReserves

1212

Market for ReservesMarket for Reserves

Why does the Why does the federal federal funds rate funds rate converge converge to i*?to i*?

1313

1414

Discount Loans and Discount RateDiscount Loans and Discount RateThe discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates. (Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at times uses the term "discount rate" to mean the primary credit rate.) The discount rate on secondary credit is above the rate on primary credit. The discount rate for seasonal credit is an average of

selected market rates.

1515

1616

Open Market OperationOpen Market Operation

Open market purchase => iOpen market purchase => iffff down unless it is already equal to i down unless it is already equal to ierer..

1717

Advantages of Open Market Advantages of Open Market OperationsOperations

1.1. The Fed is in complete control of the The Fed is in complete control of the tool. Discount rate tool needs tool. Discount rate tool needs cooperation of the banks.cooperation of the banks.

2.2. OMO is flexible and precise; it can be OMO is flexible and precise; it can be small or large.small or large.

3.3. OMO can be reversed easily.OMO can be reversed easily.

4.4. OMO is fast. There is no time lag OMO is fast. There is no time lag between the evaluation and the impact.between the evaluation and the impact.

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Open Market OperationsOpen Market Operations

Dynamic OMO: To change the level of Dynamic OMO: To change the level of reserves and the monetary base.reserves and the monetary base.

Defensive OMO: To offset the Defensive OMO: To offset the movements in other factors.movements in other factors.

Every day New York Fed evaluates the Every day New York Fed evaluates the federal funds market and buys or sells federal funds market and buys or sells securities to hit the desired federal securities to hit the desired federal funds rate.funds rate.

1919

Open Market OperationsOpen Market Operations

Temporary OMOTemporary OMORepo: Fed purchases securities with the Repo: Fed purchases securities with the

understanding that the seller will buy them understanding that the seller will buy them back within two weeks.back within two weeks.

Reverse repo (Matched sale-purchase): Reverse repo (Matched sale-purchase): Fed sells securities with the understanding Fed sells securities with the understanding that it will buy back them back.that it will buy back them back.

Permanent OMOPermanent OMOConducted after the temporary OMO.Conducted after the temporary OMO.

2020

Change in the Discount RateChange in the Discount Rate

Discount rate down => iDiscount rate down => iff ff maymay go down go down

2121

Discount PolicyDiscount PolicyPrimary credit allowed to healthy Primary credit allowed to healthy

banks without limit.banks without limit.Secondary credit extended to banks in Secondary credit extended to banks in

trouble at 50 basis points above the trouble at 50 basis points above the primary rate.primary rate.

Seasonal credit given to small banks Seasonal credit given to small banks in tourist and agricultural areas.in tourist and agricultural areas.

2222

Discount PolicyDiscount Policy

The Fed’s discount policy is designed to The Fed’s discount policy is designed to ward off financial crises.ward off financial crises.

The Fed is the The Fed is the lender of last resortlender of last resort.. Provides unlimited funds to banks in trouble.Provides unlimited funds to banks in trouble. It creates a buffer against bank panics and It creates a buffer against bank panics and

financial meltdown.financial meltdown. Franklin National received 5% of total reserves in 1974.Franklin National received 5% of total reserves in 1974. Continental Illinois in 1984 received three times the Continental Illinois in 1984 received three times the

amount FN got.amount FN got. The possible meltdown that could have occurred in The possible meltdown that could have occurred in

Black Monday (10/19/87) was avoided through Fed’s Black Monday (10/19/87) was avoided through Fed’s lender of last resort function.lender of last resort function.

During the financial meltdown of 2008, reserves During the financial meltdown of 2008, reserves increased from 100b to 1400b.increased from 100b to 1400b.

2323

Moral Hazard ofMoral Hazard of Discount PolicyDiscount Policy

If banks believe that the Fed will bail If banks believe that the Fed will bail them out in times of trouble, they them out in times of trouble, they will take unnecessary chances and will take unnecessary chances and will engage in risky behavior.will engage in risky behavior.

The Fed allowed many small banks The Fed allowed many small banks to fail.to fail.

Too-big-to-fail policy is seen to be Too-big-to-fail policy is seen to be unfair.unfair.

2424

Change in Required ReservesChange in Required Reserves

An increase in the An increase in the reserve ratio forces reserve ratio forces banks to hold more banks to hold more reserves at each reserves at each and every federal and every federal funds rate.funds rate.

Reserve ratio up => Reserve ratio up => iiffff up up

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Reserve RequirementsReserve Requirements Depository Institutions Deregulation and Depository Institutions Deregulation and

Monetary Control Act of 1980 sets the Monetary Control Act of 1980 sets the reserve requirement the same for all reserve requirement the same for all depository institutionsdepository institutions

3% of the first $48.3 million of checkable 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over deposits; 10% of checkable deposits over $48.3 million$48.3 million

The Fed can vary the 10% requirement The Fed can vary the 10% requirement between 8% to 14%between 8% to 14%

2626

Reserve RequirementsReserve RequirementsThis is a very powerful tool.This is a very powerful tool. If deposits are around $800 billion, a 1% If deposits are around $800 billion, a 1%

change in the reserve requirement can change in the reserve requirement can have a $8 billion impact on the reserves have a $8 billion impact on the reserves of the banking system.of the banking system.

It is a blunt tool.It is a blunt tool. It can create severe liquidity problems It can create severe liquidity problems

for banks if the Fed raised the reserve for banks if the Fed raised the reserve requirement.requirement.

2727

Can Reserve Requirements Be Can Reserve Requirements Be Abolished?Abolished?

Each bank will have to keep reserves to Each bank will have to keep reserves to fulfill deposit outflows.fulfill deposit outflows.

The money supply process will work the The money supply process will work the same way except that ER/D and rd will be same way except that ER/D and rd will be combined.combined.

Many central banks have either reduced or Many central banks have either reduced or eliminated the reserve requirement.eliminated the reserve requirement.

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How the Fed Limits Fluctuations How the Fed Limits Fluctuations

2929

Monetary Policy Tools Monetary Policy Tools of the European Central Bankof the European Central Bank

Open market operationsOpen market operationsMain refinancing operationsMain refinancing operations

Weekly reverse transactionsWeekly reverse transactions

Longer-term refinancing operationsLonger-term refinancing operationsLending to banksLending to banks

Marginal lending facility/marginal Marginal lending facility/marginal lending rate (100 basis points above target)lending rate (100 basis points above target)

Deposit facility (100 basis points below target)Deposit facility (100 basis points below target)

3030

Monetary Policy Tools Monetary Policy Tools of the European Central Bankof the European Central Bank

Reserve RequirementsReserve Requirements 2% of the total amount of checking deposits and other 2% of the total amount of checking deposits and other

short-term depositsshort-term deposits

Pays interest on those deposits so cost of complying Pays interest on those deposits so cost of complying is lowis low

3131

Jiazuo Xie ApproachJiazuo Xie Approach

Federal Funds Rate is determined in the Federal Funds Rate is determined in the market where only banks appear as market where only banks appear as supplier and demander of Excess supplier and demander of Excess Reserves.Reserves.

Federal Reserve by increasing or Federal Reserve by increasing or decreasing reserves can forecast the decreasing reserves can forecast the change in ERchange in ERA constant ER/R ratio allows the Fed to A constant ER/R ratio allows the Fed to

predict the change.predict the change.

3232

Jiazuo Xie ApproachJiazuo Xie Approach Banks which are short of RR, demand Banks which are short of RR, demand

reserves from other banks.reserves from other banks. Their demand responds to the cost of Their demand responds to the cost of

reserves: ireserves: iffff..The higher the iThe higher the iffff, the lower the demand, the lower the demand

If iIf iffff exceeds i exceeds idd, they will borrow from the Fed , they will borrow from the Fed

instead of Federal Funds marketinstead of Federal Funds market Because the Fed pays iBecause the Fed pays ierer at i at iffff=i=ierer cost of cost of

borrowing is zero; infinite demand.borrowing is zero; infinite demand.

3333http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

3434

Demand for Federal FundsDemand for Federal Funds

id

ier

ER

3535

Jiazuo Xie ApproachJiazuo Xie ApproachThe The supplysupply of ER comes from banks that of ER comes from banks that

already have enough RR.already have enough RR. If iIf iffff=i=ierer, banks rather keep the ER, banks rather keep the ER

If iIf iffff>i>ierer, banks will supply the Federal , banks will supply the Federal

Funds market, the higher the difference, Funds market, the higher the difference, the higher the supplythe higher the supply

There is, however, a limited supply of ER There is, however, a limited supply of ER determined by the Feddetermined by the Fed

3636

Supply of Federal FundsSupply of Federal Funds

ER

ier

iiffff

3737

Fed Increases Nonborrowed Fed Increases Nonborrowed ReservesReserves

ER

iff

ier

NBR1 NBR2 NBR3 NBR4

3838

Fed Changes Reserve Fed Changes Reserve RequirementRequirement

idid

ier ier

ERER

Reserve Requirement Increased Reserve Requirement Decreased

3939

Discount Rate ChangedDiscount Rate Changed

Discount Rate Decreased Discount Rate Increased

iidd

iidd’’