Download Three policy tools the Fed use to control money supply and the

Chapter 17:
Three policy tools the Fed use to control money
supply and the interest rate:
1. OMOs
2. Discount rate
3. Reserve requirements
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.
- Supply and Demand in the market for
reserves:
A.
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
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opportunity cost: the interest rate that could have
been earned on lending these RE, which is iff.
Result: As iff decreases, the OC of holding ER falls
and the quantity of R demanded (Rd) increases.
(Negative slope)
B.
Supply Curve:
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)
(graph)
Equilibrium in the Market for Reserves
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- How Changes in tools of monetary policy affect
the (iff)?
A.
OMOs:
1. OM purchase leads to a higher level of Rs, this
will shift the supply curve to the right
lowering the (iff)
2. OM sale leads to a lower level of Rs, this will
shift the supply curve to the left rising the (iff).
3.
Result: An open market purchase causes iff to
fall while an open market sale causes iff to rise.
B.
Discount Lending:
An increase in discount lending rises quantity of
reserves supplied (cost = discount rate).
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.
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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C.
Reserve Requirements:
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.
Result: When the Fed rises the (r), iff rises, and
when (r) decreases, the iff falls.
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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.
3- Discount Policy:
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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.
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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:
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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