Unit 8

1. Unit 8 Tools of Monetary Policy

2. The Federal Reserve Goals and Tools • Goals • influence greater output • lower the unemployment rate • prices level stability • tools of monetary policy or instruments of monetary policy • open market operations • reserve requirement policy • discount window policy • intermediate target variables • short-term interest rates • monetary aggregates (M1, M2, M3)

3. More on Tools of Monetary Policy • Open market operations • Affect the quantity of reserves and the monetary base • Changes in borrowed reserves • Affect the monetary base • Changes in reserve requirements • Affect the money multiplier • Federal funds rate—the interest rate on overnight loans of reserves from one bank to another • Primary indicator of the stance of monetary policy

4. Open Market Operations: Fundamental Considerations • Open market operations • Buying and selling of securities in the open market • The Fed is empowered to buy or sell • U.S. Treasury securities • federal agency securities • banker's acceptances • other securities • If the Fed sells $225 million in U.S. Treasury bills to a government securities dealer

5. Discovery Of Open Market Operations And The Banking Act Of 1935 • Discovery • Prior to 1920,the discount window was the only Fed policy tool, • The Fed's revenues were only the interest received on the Fed's discounts loans. • An early 1920s recession led to a drop in revenue, so individual Fed banks bought U.S. government securities. • When Fed purchased securities, member bank’s reserves increased, interest rates fell, and credit conditions eased. • The Banking Act of 1935: • eliminated individual Fed banks’ power to conduct separate policies, and • shifted a significant amount of power to the Board of Governors in Washington, D.C.

6. Domain of the Fed's Open Market Activity • Federal Reserve's open market operations could be carried out in any asset. • To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances. • When the Fed buys $400 million in Treasury bonds and bills frombanks, • reserves and the monetary base expand dollar-for-dollar, but • the money supply is not directly or immediately affected. • This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.

7. Outright Transactions versus Repurchase Agreements • Outright transactions • The Fed uses outright purchases to bring about long-run or permanent growth in reserves and the monetary aggregates. • Repurchase agreements (and reverse repurchase agreements) • The Fed uses repurchase agreements (repos) and reverse repurchase agreements to neutralize the impact on reserves and the monetary base of transitory changes. • Recall a repurchase agreement is a money market instrument wherein one party sells securities with an explicit agreement to buy them back at a specified future date and price.

8. The Effectiveness Of Open Market Operations • Impacts of Open Market Operations • Impact on Bank Reserves, the Monetary Base, and the Monetary Aggregates: • The Fed can exert relatively accurate control over bank reserves and the monetary base by manipulating its security portfolio. • Impact on Security Prices and Interest Rates (Yields): • When the Fed buys government securities in the open market, it bids up security prices and therefore reduces their yields. • Marketable securities are substitutable, so a decline in government security yields spills over to yields on other assets.

9. Advantages of Open Market Operations • Precision: • firm and accurate control over aggregate bank reserves and the monetary base, while • a high degree of accuracy cannot be achieved through changes in the discount rate or reserve requirements. • Flexibility: • in the market each day, buying and selling large quantities of securities • very easy for the Fed to alter course • Source of Initiative: • The Fed is able to dominate aggregate bank reserves and the monetary base.

10. Early Disadvantages of Open Market Operations • Signaling: • Changes in the discount rate and reserve requirements are superior to open market operations in signaling policy changes to the public. • Regional Bias: • Prior to well-developed financial markets, a regional bias operated in open market operations, because the effects were concentrated in select urban areas where security dealers were located; open market operations did not disperse across the nation.

11. Open Market Operations and the Federal Funds Rate • The effects of the Fed's open market operations transmit very quickly throughout the nation through the federal funds market. • The supply of reserves is determined by Federal Reserve policy. • When the Fed purchases securities, bank reserves are boosted dollar-for-dollar. • When the Fed sells securities, bank reserves decline dollar-for-dollar.

12. Demand in the Market for Reserves • What happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes? • Two components: required reserves and excess reserves • Excess reserves are insurance against deposit outflows • The cost of holding these is the interest rate that could have been earned • As the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises • Downward sloping demand curve

13. Supply in the Market for Reserves • Two components: non-borrowed and borrowed reserves • Cost of borrowing from the Fed is the discount rate • Borrowing from the Fed is a substitute for borrowing from other banks • If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero • The supply curve will be vertical • As iffrises above id, banks will borrow more and more at id, and re-lend at iff • The supply curve is horizontal (perfectly elastic) at id

15. Affecting the Federal Funds Rate • An open market purchase causes the federal funds rate to fall; an open market sale causes the federal funds rate to rise shifting the supply curve • If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate

16. Affecting the Federal Funds Rate (cont’d) • If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate • When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls shifting the demand curve

20. Discount Window Policy • The discount window is a facility through which the Federal Reserve district banks lend reserves directly to depository institutions. • Discount policy is the set of conditions under which banks are permitted to borrow reserves and the interest rate charged (discount rate). • Categories of Conditions: • Primary credit-- • granted to banks in good condition who are permitted to borrow as much as they want • discount rate > fed funds rate • Secondary credit • provided to troubled banks that are experiencing liquidity problems • ½ percentage point higher rate • Seasonal credit • provided to banks subject to seasonal fluctuations in loan demand—like agricultural activity

21. Discount Policy • Discount window • Primary credit—standing lending facility • Secondary credit • Seasonal credit • Lender of last resort to prevent financial panics • Creates moral hazard problem

23. The 2003 Federal Reserve Change in Discount Window Policy • Prior to 2003, • discount rate < fed funds; • the Fed had to create policies to discourage overuse of the discount window, and • Use was a “privilege” not a “right.” • After 2003, • Lombard system • discount rate > fed funds rate; • use became a right rather than a privilege, so • So relatively high discount rate naturally discouraged overuse of the discount window.

24. Advantages and Disadvantages of Discount Policy • Used to perform role of lender of last resort • Cannot be controlled by the Fed; the decision maker is the bank • Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target

25. The Reserve Requirement Instrument • Since 1935, the Fed has had the authority to set and change reserve requirements or required reserve ratios that banks must maintain. • Before 1980, reserve requirements only existed for member banks, now enforced for all banks. • The Monetary Control Act of 1980 established a new structure of reserve requirements for all banks and thrift institutions.

26. Institutional Aspects of Bank Reserve Management Reserve Averaging • Banks must meet the required reserve ratio (on a daily average) over the settlement period, a two-week period that ends on a Wednesday. • Carryover Allowance • 2% leeway may be carried over one settlement period.

27. Reserve Requirements • Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions • 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million • The Fed can vary the 10% requirement between 8% to 14%

28. Advantages of the Reserve Requirement Tool • Speed of Impact: • When the Fed changes reserve requirements, all institutions experience an immediate change in their excess-reserve position. • Neutrality: • Unlike open market operations and discount rate changes, the impact of reserve requirement changes is spread across all banks and thrift institutions uniformly. • Potential Use in an Emergency: • At rare times when other tools cannot do the job, changes in reserve requirements may be needed to neutralize major changes in the monetary base.

29. Disadvantages of the Reserve Requirement Tool • Bluntness: • A one percentage point reduction (increase) in the reserve requirement would release (absorb) $7 billion of excess reserves. • Such large changes make this tool too clumsy to be used regularly. • Lack of Flexibility: • Unlike other tools, an early reversal of a previous position would constitute the Fed making a significant and obvious admission of error. • Frequent changes in reserve requirements create uncertainty for banks. • Raising the reserve requirement level can trigger liquidity problems for many banks.

30. Disadvantages of Reserve Requirements • No longer binding for most banks • Can cause liquidity problems • Increases uncertainty • Recommendations to eliminate

31. The Channel/Corridor System • Sets up a standing lending facility (lombard facility) and stands ready to loan overnight any amount banks ask for at a fixed interest rate (lombard rate) • The supply of reserves is infinitely elastic at this interest rate • Another standing facility is set up that pays banks a fixed interest rate on any deposits they would like to keep at the central bank

32. The Channel/Corridor System (cont’d) • The supply of reserves is also infinitely elastic at this interest rate • In between these two interest rates the quantity supplied is equal to the non-borrowed reserves • The demand curve has its usual downward slope

34. Monetary Policy Tools of the European Central Bank • Open market operations • Main refinancing operations • Weekly reverse transactions • Longer-term refinancing operations • Lending to banks • Marginal lending facility/marginal lending rate • Deposit facility

35. Monetary Policy Tools of the European Central Bank (cont’d) • Reserve Requirements • 2% of the total amount of checking deposits and other short-term deposits • Pays interest on those deposits so cost of complying is low