Monetary Policy Tools

1. Monetary Policy Tools • Instruments that initiate monetary policy • Open Market Operations • The Discount Rate • Reserve Ratios

2. Open Market Operations • Defined as the buying or selling of bonds by the Federal Reserve in the open market. • Expansionary -- Fed buys bonds (injects reserves) • Contractionary -- Fed sells bonds (drains reserves) • Done at the Federal Reserve Bank of New York

3. Open Market Operations: How They’re Actually Done • Example -- Federal Reserve buys a $1000 bond from Salomon Brothers and pays with a check. The check in turn is deposited in checkable deposits at Chase, which is Salomon Brothers bank.

4. Balance Sheet Portrayal Salomon Brothers Bonds -$1000 D +$1000 Chase R +$1000 D +$1000 Federal Reserve Bank of NY Bonds +$1000 R +$1000

5. Characteristics of Open Market Operations • Sometimes done for temporary periods • (Fed) Repurchase Agreement -- Fed buys bond with agreement to sell it back. • Matched-Sale Purchase -- Fed sells bond with agreement to buy it back.

6. Open Market Operations -- An Effective Policy Tool • Occurs at the initiative of the Fed. • Fed is in complete control. • They are flexible: Fed can do small or large amounts. • They are reversible: Fed can undo policy mistakes. • Very low-key policy instrument: difficult to tell what Fed has done.

7. The Discount Rate (iDISC) • Defined as the rate of interest charged to banks that borrow from the Federal Reserve. • Expansionary -- Fed lowers discount rate. • Contractionary -- Fed raises discount rate.

8. Effects of Discount Rate Changes • Example -- Effect of Decrease in the Discount Rate (iDISC). iDISC DL  M2 • Increase in discount rate has the reverse effect.

9. Types of Discount Window Borrowing • Primary Credit -- borrowing for short-term reserve adjustments. • Seasonal Credit -- borrowing for seasonal needs. • Secondary Credit -- large, longer-term borrowing for banks facing financial difficulties.

10. Discount Rate Policy -- Characteristics • DL done at the discretion of banks, not the Fed. • Discount Window can be abused by banks, borrowing for profit (actively or passively). • Sometimes is regarded as signal of monetary policy, “the announcement effect.”

11. Discount Rate Policy -- Its Diminished Role • Larger volume of borrowing from other sources -- Federal Funds, RPs, Eurodollars  banks hardly use the Federal Reserve for short-term reserve adjustments. • Announcement effect now involves the Federal Funds rate target. • Recent change in procedure (generally): iDISC = Target iFF + 0.5%.

12. Reserve Ratios (rD, rT) • Designed to change the amount of required reserves. • Expansionary Policy -- Fed lowers reserve ratios. • ContractionaryPolicy -- Fed raises reserve ratios. • Affects M2 by changing the multiplier.

13. Characteristics of Reserve Ratio Policy • rT = 0 for Savings and Time Deposits (including MMDAs) • DIDMCA  Uniform Reserve Requirements (based upon deposit size)

14. Reserve Ratio Policy -- Rarely Used • Too blunt -- needs tiny changes for reasonable adjustments in money growth. • Too Disruptive -- affects all banks balance sheets.

15. The Market For Bank Reserves • Demand for Reserves(RD) -- Banks wishing to borrow reserves in the Federal Funds market, generally in response to loan demand. Downward sloping curve when plotted against iFF, (i.e. iFF  RD). It can shift rightward (increase in demand) or leftward (decrease in demand).

16. Supply of Reserves -- Banks offering reserves to the Federal Funds market + the Federal Reserve changing reserves using open market operations. Upward sloping curve when plotted against iFF, (i.e. iFF  RS). It can shift rightward (increase in supply) or leftward (decrease in supply).

17. Determination of the Federal Funds Rate • The Federal Funds Rate (iFF) is determined by equilibrium in the market for bank reserves (where RD = RS). • The Federal Funds Rate changes due to shifts in the Demand for Bank Reserves or the Supply of Bank Reserves.