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Chapter 17
Tools of Monetary Policy
There are three policy tools the Fed can use to
control MS (and interest rates):
1- OMOs  (reserves and MB)
2- Discount lending  (MB)
3- R  (m).
- How the Fed use these tools in practice and
how effective each tool is?
- Its important to understand the importance of
“federal fund rate”:
The interest rate on overnight loans of reserves
from one bank to another. It’s an indicator of
position (viewpoint) of monetary policy, and it
affects the interest rates.
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The Market for Reserves and the Federal Funds
Rate:
OMOs and discount lending affect the Fed’s
balance sheet and the amount of reserves.
The Market for reserves: is where the federal
funds rate is determined.
Supply and Demand in the market for reserves:
The demand curve for reserves:
Q: What happens to the quantity of reserves
demanded, everything been equal, as the federal
fund rate changes?
R= RR + ER
R= (r . D) + ER, therefore,
The quantity of reserves demanded = RR + ER
ER are insurance against deposit outflows, and
the cost associated with holding ER is the
opportunity cost: the interest rate that could have
been earned on lending these reserves = federal
funds rate.
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As the federal funds rate falls, the opportunity
cost of holding ER falls, and the quantity of
reserves demanded rises.
The demand curve for reserves (Rd) slopes
downward:
The supply curve of reserves:
Two components:
1- the amount of reserves supplied by the Fed’s
OMO:
Non-borrowed reserves (Rn)
2- the amount of reserves borrowed from the
Fed:
Discount loans (DL),
The cost of borrowing discount loans = the
discount rate (id)
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Federal
Fund Rate
(iff)
id
Rs
iff*
Rd
Rn
If the federal funds rate (iff) < The discount rate
(id):
Then the bank will not borrow from the Fed and
discount loans = zero
This is true since borrowing in the federal funds
market is cheaper.
Result: if id > iff, the supply of reserves = the amount of
non-borrowed reserves supplied by the fed Rn,
and the supply curve is vertical.
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As the federal funds rate rise above the discount
rate, banks want to keep borrowing more at (id),
and then lending out the proceeds in the federal
funds market at the higher rate (iff). Therefore,
the supply curve becomes flat at (id):
iff
Rs
id
iff2
iff*
iff1
Rd
R
Rn
Market Equilibrium:
Occurs where quantity of reserves demanded =
quantity supplied:
Rs = R d
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When the federal funds rate is (iff2), there are
more reserves supplied than demanded (excess
supply) so the federal funds rate falls to (iff*).
When the federal funds rate is (iff1), there are
more reserves demanded than supplied (excess
demand) so the federal funds rate rises to (iff*).
Therefore, the federal funds rate is determined
through the equilibrium between quantity of
reserves demanded and quantity of reserves
supplied, and the equilibrium federal funds rate is
iff*.
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How Changes in the Tools of Monetary Policy
Affect the Federal Funds Rate:
- How changes in the three tools of monetary
supply (OMOs, DL, RR) affect the market for
reserves and the equilibrium federal funds
rate?
A) Open Market Operations:
At any given federal funds rate, an open market
purchase will increase reserves supplied.
This is true since a higher amount of
borrowed reserves (rises from Rn1 to Rn2).
non-
Result:
1- Open market purchase shifts the supply curve
to the right (from Rs1 to Rs2): federal funds rate
fall,
2- Open market sale shifts the supply curve to the
left (from Rs1 to Rs3): Federal funds rate rises.
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iff
Rs
id
R1S
R2S
iff1
iff2
Rd
R
Rn1
Rn2
Open market purchase
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iff
Rs
id
R2S
R1S
iff1
Rd
R
Rn2
Rn1
Open market Sale
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B) Discount Lending:
- discount lending is lowered by the Fed:
(iff)
i1d
i2d
iff*
R1s
R 2s
Rd
Rn
The equilibrium remains the same
Result: if the intersection (the equilibrium or the
Rd intersects Rs) is below the horizontal section of
the Rs, then changes in the discount lending will
lead to no changes in the equilibrium federal
funds rate (remains at iff*).
As long as iff remains below id, Rs =Rn and the
supply curve is vertical.
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But what if (id) > (iff)?
Now banks want to keep borrowing more at (id)
and then lending out the proceeds in the federal
funds market at rate equals (iff).
(iff)
id
iff1=i1d
R1s
R2s
iff2=i2d
Rd
R1n
R
Lowering Discount Rate: Fall in Rs and then fall in
iff
The demand intersects on the flat section so there
is discount lending. Changes in the in the discount
rate do affect federal funds rate.
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C) Reserve requirements:
As the (r) increases, RR increases, quantity of
reserves demand increases. Thus there is a shift in
demand curve to the right, and (iff*) increases too.
(iff)
Rs
id
i2ff
iff*
Rd
Rn
Result: When the Fed raises reserves
requirements, the federal funds rate rises.
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1- Open market Operations:
- The most important monetary policy tool.
- The primary determinants of changes in
interest rate and the MB.
- OMO expand reserves and the MB, thus
raising MS and lowering short-term interest
rate.
- Open market sale lower reserves and MB,
lowering MS and raising interest rate.
Types of OMO:
1- Dynamic OMO: intended to change the level
of reserves and the MB.
2- Defensive OMO: intended to offset
movements in other factors that affect
reserves and the MB (i.e. changes in treasury
deposits).
Advantages of OMOs:
1- The Fed has complete control over the size of
the operations.
2- OMOs are flexible and exact, and can be
used to any extent (small or large).
3- OMOs are easily reversed when a mistake is
made.
4- Quick effect.
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3- Discount Policy:
Made at the discount window, and used to
influence reserves, MB, and MS:
A)
B)
C)
Primary credit: is the discount lending that
plays the most important role in monetary
policy (good credit banks are allowed to
borrow all they want from the primary
credit). Interest rate charged is the discount
rate.
Secondary credit: is given to banks that are in
a financial trouble and with sever liquidity
problems(0.5% above discount rate)
Seasonal credit: is given to meet the needs of a
limited number of small banks that have s
seasonal patterns of deposits. The interest
rate charged is linked to federal funds rate.
Discount loans are also important in preventing
financial panics. The Fed is the “Lender of Last
Resort”;
To prevent bank failures from spinning out of
control.
The Fed provide reserves to banks where no
others would do.
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Announcement Effect:
Discount policy can be used to signal the Fed’s
intentions about future monetary policy.
If the Fed decided to slow the expansion of the
economy, can “announce” that the discount rate
will increase = the public will expect the monetary
policy to be less expansionary in the future.
Advantages and disadvantages of discount policy:
Lender of last resort, but even if discount rate is
changed, no guarantee that banks will follow.
3- Reserve Requirements:
Changes in (r) affect MS through (m). A rise in (r)
reduces the amount of deposits that can be
supported by a given level of the MB, leading MS
to fall.
A rise in (r) will also increase the demand for
reserves and raises the federal funds rate.
Advantages and disadvantages:
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1- Equal affect of all banks, but can cause
immediate liquidity problems for banks with
low (ER).
However, this tool is infrequently used.
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