Download CH 17: Tools of Monetary policy

CH 17: Tools of Monetary policy
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Three policy tools the Fed use to
control money supply and the interest
rate:
OMOs
Discount rate
Reserve requirements
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The market for reserves and the Federal
Funds Rate (iff):
OMOs and Discount lending affect the
Fed's balance sheet and the amount of
reserves (R).
 The market for reserves is where the (iff) is
determined.
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Supply and Demand in the market for
reserves:
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Demand Curve for Reserves:
What happens to the quantity of reserves
demanded as (iff) changes?
R= RR + ER
Recall that ER are insurance against deposit
outflow, and the cost of holding ER is their
opportunity cost: the interest rate that could have
been earned on lending these ER, which is iff.
Result: As iff decreases, the OC of holding ER
falls and the quantity of R demanded (Rd)
increases. (Negative slope)
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Supply Curve:
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As discount lending increases, the quantity of
reserves supplied (Rs) to the banking system
also increases.
When the bank borrows from the Fed, the bank
is not having to borrow from the FED market.
Thus: Discount lending is a substitute for
borrowing Federal Funds.
Result: when (iff) increases, banks will borrow
more from the Federal Reserve, and the
resulting increase in discount lending means that
the quantity of reserves supplied rises. (Positive
slope)
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FFR
(iff)
i*ff
RS
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RD
Quantity of Reserves (R)
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Equilibrium in the Market for Reserves
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How Changes in tools of monetary policy affect
the (iff)?
OMOs:
OM purchase leads to a higher level of Rs, this
will shift the supply curve to the right lowering
the (iff)
OM sale leads to a lower level of Rs, this will
shift the supply curve to the left rising the (iff).
Result: An open market purchase causes iff
to fall while an open market sale causes iff to
rise.
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FFR
(iff)
RS
i*ff
RD
Quantity of Reserves (R)
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Discount Lending:
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An increase in discount lending rises quantity of
reserves supplied (cost = discount rate).
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Banks borrow more from the Fed as the discount
rate falls. Thus, a lower discount rate leads to a
greater quantity of reserves supplied and shifts
the supply curve to the right, and the iff falls.
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Result: When the Fed lowers the discount
rate, iff falls and when the Fed raises the
discount rate, the iff rises.
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Reserve Requirements:
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When the required reserve ratio (r)
increases, required reserves increase and
thus, the quantity of reserves demanded
increases, and the demand curve shifts to
the right, increasing the iff.
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Result: When the Fed rises the (r), iff
rises, and when (r) decreases, the iff
falls.
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FFR
(iff)
RS
i*ff
RD
Quantity of Reserves (R)
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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.
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Types of OMOs:
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Dynamic OMO: intended to change the
level of reserves and the MB.
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Defensive OMO: intended to offset
movements in other factors that affect
reserves and the MB (i.e. changes in
treasury deposits).
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Advantages of OMOs:
 The Fed has complete control over the
size of the operations.
 OMOs are flexible and exact, and can be
used to any extent (small or large).
 OMOs are easily reversed when a
mistake is made.
 Quick effect.
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2. Discount Policy:
Made at the discount window, and used
to influence reserves, MB, and MS:
 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.
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Secondary credit: is given to banks that are
in a financial trouble and with sever liquidity
problems(0.5% above discount rate)
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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.
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Discount loans are also important in
preventing financial panics. The Fed is the
“Lender of Last Resort”;
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To prevent bank failures from spinning out of
control.
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The Fed provide reserves to banks where no
others would do.
Announcement Effect:
Discount policy can be used to signal the Fed’s
intentions about future monetary policy.
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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.
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Advantages and disadvantages of discount
policy:
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Lender of last resort, but even if discount
rate is changed, no guarantee that banks will
follow.
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3- Reserve Requirements:
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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.
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A rise in (r) will also increase the
demand for reserves and raises the
federal funds rate.
 Advantages and disadvantages:
 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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