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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. 1 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. 2 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) 3 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. 4 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 5 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*. 6 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. 7 iff Rs id R1S R2S iff1 iff2 Rd R Rn1 Rn2 Open market purchase 8 iff Rs id R2S R1S iff1 Rd R Rn2 Rn1 Open market Sale 9 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. 10 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. 11 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. 12 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. 13 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. 14 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: 15 1- Equal affect of all banks, but can cause immediate liquidity problems for banks with low (ER). However, this tool is infrequently used. 16