CH 17

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.

Dynamic OMO: intended to change the level of reserves and the MB.

Defensive OMO: intended to offset movements in other factors that affect reserves and the MB (i.e. changes in treasury deposits).

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.

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.

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.

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.

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:

Equal affect of all banks, but can cause immediate liquidity problems for banks with low (ER).

 However, this tool is infrequently used.