Chapter 19

1. Chapter 19 The Instruments of Central Banking

2. Learning Objectives • Reserve Requirements • Discount window • Open market operation

3. Introduction • Available money supply in the economy is a multiple to the level of bank reserves • Federal Reserve exercises control over bank lending and money supply: • By altering the level of reserves in the system • By influencing the deposit creation multiplier • Fed accomplishes these objectives: • By changing the reserve requirements • By changing the actual amount of reserves

4. Reserve Requirements • Reserves can be in two forms: • Vault cash • Deposits in regional bank (Earns no interest) • Within limits established by Congress, Fed can specify reserve requirements for depository institutions. • This applies even if the institution is not a member of the Federal Reserve

5. Reserve Requirements Percentage of required reserves varies with type of account • Demand Deposits • Ranges between 8% to 14% • For first $42.1 million: 3% (small banks) • Above $42.1 million: 10% (currently) • Business-owned time and savings deposits • Can range between 0% to 9% • Currently set at 0%

6. Reserve Requirements Effect of lowering the reserve requirement • Automatically increases all banks’ excess reserves • Increases demand deposit (DD) through multiple lending • However, the ultimate impact depends on banks desire to make loans • Here is an element of discretion of the lenders • Expands the money supply

7. Reserve Requirements • Effect of raising the reserve requirement • Decrease banks’ excess reserves and may force them to take steps to correct a deficit reserve position • Restrains lending and deposit creation • Contracts the money supply

8. Reserve Requirements • Even without legal reserve requirements, banks would still need to hold cash reserves as vault cash or on deposit with Federal Reserve • Cash to meet customer withdrawals • Balances at Fed to clear checks • Without legal reserve requirements, it is likely the multiplier relationship between reserves and money supply may fluctuate considerably

9. Discounting and the Discount Rate • Discount rate: amount the Federal Reserve charges banks for a temporary loan of reserves to cover a deficiency • Ability to borrow means that a bank does not need to call in loans or sell securities (reduce money supply) to deal with a deficit • All depository institutions have access to borrowing at the discount window, even if not a member of the Fed

10. Discounting and the Discount Rate • Federal Reserve influences banks’ desire to borrow reserves by changing discount rate • At a lower discount rate lenders would borrow more. • This will increase money supply • At a higher discount rate lenders would borrow less. • This will decrease money supply • Actual borrowing (changes in money supply) depends on banks’ willingness to use this facility of the FED

11. Discounting and the Discount Rate • Quantity of discount lending • Central bank is the ultimate source of liquidity in the economy • Lender of last resort—Discount provision was originally established to permit banks to borrow from the Fed when threatened with cash drains • Discount facility should not be used too often to get banks out of reserve difficulties, primarily when a bank is temporarily short of cash

12. Discounting and the Discount Rate • Quantity of discount lending • Banks should manage affairs in a way that they do not need to use discount facility very often • Discounting is a privilege, not a right • Banks are supposed to use discount facility because of need, not to make profit • Prior to 2003, the Fed used extensive administrative and surveillance procedures to prevent “abuse” of discount window

13. Discounting and the Discount Rate • Quantity of discount lending • However, under the new discount lending procedure, the Federal Reserve charges a penalty rate above short-term market rates • In return, the Fed removes conditions and restrictions for banks that qualify for primary credit • The intent of the new policy is to improve access to discount window borrowing by removing the negative connotation of borrowing from the Fed

14. Discounting and the Discount Rate • Quantity of discount lending • In March 2008, the Federal Reserve opened the discount window to investment banks • This expanded role of lender of last resort was aimed at preventing the collapse of Bear Stearns • To prevent panic withdrawals from all financial institutions

15. Discounting and the Discount Rate • Discount Rate and Market Interest Rates • Discounting is discouraged when the rate is above other short-term rates, and encouraged when it is below • In some countries, the discount rate is often kept above short-term market rates—a penalty rate as a means of restraining excessive borrowing • In US, discount rate is usually below Treasury bill rate so Fed relies on surveillance to prevent “abuse of the privilege”

16. Discounting and the Discount Rate • Relationship between discount rate and other market interest rates • Discount rate is an “administered” rate, set by Fed • The linkage between discount rate and reserves and money supply is Weak • Change in the discount rate generally occurs after a change in the Treasury bill rate or federal funds rate • Reactive rather than proactive tool

17. FIGURE 19.1 Movements in the discount rate tend to come after Treasury bill rates.

18. Discounting and the Discount Rate • Relationship between discount rate and other market interest rates • “Announcement” effect • An unexpected change in discount rate will signal that the Fed desires to change monetary policy • The public, reacting to this expectation, takes action that causes the Fed’s desire to occur • Change in the discount rate usually confirms what is happening, but does not initiate it

19. Open Market Operations • Fed’s most important tool to alter reserves • About $3,200 billion worth of marketable government securities outstanding • Held by individuals, corporations, and financial institutions • Used by the US Treasury to borrow to finance budget deficits • The sale of government securities by the Treasury is independent of the Fed and may work counter to the Fed’s monetary policy

20. Open Market Operations • Open market operations—Buying and selling government securities to influence bank reserves • Purchase securities—expand reserves (money supply) • Sell securities—contract reserves (money supply) • Does not matter whether Fed sells/purchases government securities to/from: • A bank • Other financial institution, • Or, individual

21. Open Market Operations • Modifications to the simple multiplier discussed in appendix to Chapter 19 will impact the ultimate relationship between changes in reserves and the money supply • The Federal Reserve permits the market to set the purchase/sales price of government securities and, thereby, altering the rate of interest on that class of securities

22. Conducting Open Market Operations • The Federal Open Market Committee (FOMC) in Washington decides on general aims and objectives of monetary policy and sets monetary targets (bank reserves, money supply, and interest rates) • Buying/selling of government securities takes place at Federal Reserve Bank of New York • Located in the heart of the New York financial district

23. Conducting Open Market Operations • Open Market Account manager keeps close contact with securities dealers to get the “feel of the market” and what is needed to meet targets • Uses the federal funds rate as a barometer of reserve supply relative to demand • Tries to predict expected currency movements that can affect reserve position of the banking system • Contacts the US Treasury to determine what is happening to Treasury balances in tax and loan accounts at commercial banks

24. Conducting Open Market Operations • Based on FOMC targets and projected changes in reserve position of the banking system, decides on appropriate sales/purchases of government securities • If changes in bank reserves are considered to be temporary, the open market account manager will use repurchase agreement to offset these transitory reserve movement • See Federal Fund Rate is determined using the Demand and Supply curves of Reserve.