CH15.ppt

Chapter 15Tools of Monetary Policy

2013 Pearson Education, Inc. All rights reserved. 15-*

IntroWhen the Fed conducts monetary policy, it manipulates the money supply in hopes of setting a interest rateInterest rate targeting

Specifically, the Fed targets the federal funds rateThe rate at which banks make overnight loans to one another


IntroFour Main tools of the Fed:Open market operationsDiscount policyReserve requirementsPaying interest on bank reserves held at the Fed

We will examine each of these tools


The Market For Reserves and the Federal Funds RateDemand and Supply in the Market for ReservesWeve seen how open market operations can impact reserves in the banking system

What happens to the quantity of reserves demanded by banks, holding everything else constant, as the federal funds rate changes?We will explore this


The Market For Reserves and the Federal Funds RateJust like we did in our analysis of bond markets we will develop a supply and demand analysis for reserves


The Market For Reserves and the Federal Funds RateDemand for Bank ReservesRemember bank reserves can be split up into required reserves and excess reserves

Excess reserves are insurance against deposit outflowsThe cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ierSince the fall of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target.


Demand in the Market for ReservesDemand continuedSuppose the federal funds rate is above the rate paid on excess reserves, ier, as the federal funds rate decreases, the opportunity cost of holding excess reserves (iff-ier ) falls and the quantity of reserves demanded rises


Demand in the Market for ReservesDemand Continued

Downward sloping demand curve that becomes flat (infinitely elastic) at ier Banks add to their excess reserves indefinitely

the federal funds rate will never dip below ier because banks can always earn this amount from the Fed


Supply in the Market for ReservesSupply of reserves

Two components: non-borrowed and borrowed reservesBorrowed reserves are not under direct control of the FedNon-borrowed reserves are under the control of the Fed through open market operations

Cost of borrowing from the Fed is the discount rate id (greater than federal funds rate, in general)Borrowing from the Fed is a substitute for borrowing from other banks


Supply in the Market for ReservesSupply of reserves.

If iff < id, then banks will not borrow from the Fed and borrowed reserves are zeroThe supply curve will be verticalThe total supply of reserves will be equal to the supply of non-borrowed reserves


Supply in the Market for ReservesSupply

As iff rises above id, banks will borrow more and more at id, and re-lend at iffThe supply curve is horizontal (perfectly elastic) at idlending takes place at id (id=iff) and banks borrow reserves from the fed at the fixed price of id


Reserve Market EquilibriumEquilibrium takes place where the supply of reserves equals the demand for reserves (RS = RD)

The market clearing interest rate that the Fed targets is i*ff

If iff > i*ff , more reserves are supplied than demanded, so the rate will eventually fall back to i*ff

If iff < i*ff , more reserves are demanded than supplied, so the rate will eventually rise to i*ff


Figure 1 Equilibrium in the Market for Reserves


How Changes in the Tools of Monetary Policy Affect the Federal Funds RateEffects of open an market operation depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section. An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward sloped section).


How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate (contd)Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve. Pushing thread


Figure 2 Response to an Open Market Operation


How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate (contd)Discount LendingIf 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.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


Figure 3 Response to a Change in the Discount Rate


How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate (contd)When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls. This is not ambiguous


Figure 4 Response to a Change in Required Reserves


How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate (contd)Changes on interest paid on reservesThe effect of changing the interest rate paid on reserves depends upon if the supply curve intersects the demand curve whenDemand is downward sloping (not effective)If ier is decreased/increased there is no impact on equilibrium reservesDemand is flat (effective)If ier is increased, the equilibrium quantity of reserves decreases, and iff increases


Figure 5 Response to a Change in the Interest Rate on Reserves


Figure 6 How the Federal Reserves Operating Procedures Limit Fluctuations in the Federal Funds Rate


Conventional Monetary Policy ToolsDuring normal times, the Federal Reserve uses three tools of monetary policyopen market operations, discount lending, and reserve requirementsto control the money supply and interest rates, and these are referred to as conventional monetary policy tools.


Aside: Why pay interest on reserves?In 2006 the Fed asked Congress to pass legislation to pay interest on reserves.Was supposed to go into effect in 2011, but went into effect in 2008 due to the subprime mortgage crisis Why pay interest on reserves?Removes de-facto tax on deposits, increasing economic efficiency (lowers opportunity cost of holding reserves) Before banks had a very high incentive to hold no excess reserves (dangerous)


Why pay interest on reserves?

With the Fed setting ier monetary policy is more effective as the opportunity cost of reserves (and thus the equilibrium quantity of reserves) fluctuates far lessCreates a floor for the demand curveThe Fed can expand its lending as much as it wants during times of crisis, without dramatically effecting the federal funds rate (especially important during the subprime mortgage crisis).


Open Market OperationsDynamic open market operationsIntended to change the level of reserves and monetary baseDefensive open market operationsIntended to offset movements in other factors that affect the monetary base (ex: changes in Treasury deposits)

The FOMC effectively sets the FFR and reserve requirements and operations are conducted by the open market trading desk in the NY Fed


Open Market OperationsPrimary dealersDealers with whom open market operations are conductedTRAPS (Trading Room Automated Processing System)The electronic system that conducts trades with dealers and through which operations are conducted


Open Market OperationsRepurchase agreements (repos)Type of open market purchaseTemporary sales that the Fed conducts frequently Fed purchases securities with an agreement that the seller repurchase them in a short period (ex: 15 days)Desirable way to conduct defensive open market operationsMatched sale-purchase agreementsEssentially the reverse of a repo (reverse-repo)


Advantages of Open Market OperationsThe Fed has complete control over the volumeFlexible and preciseEasily reversedQuickly implemented


Discount Policy and the Lender of Last ResortDiscount windowPrimary credit: standing lending facilityLombard facilitySecondary creditSeasonal creditLender of last resort to prevent financial panicsCreates moral hazard problem


Advantages and Disadvantages of Discount PolicyUsed to perform role of lender of last resortImportant during the subprime financial crisis of 2007-2008. Cannot be controlled by the Fed; the decision maker is the bankDiscount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target


Reserve RequirementsDepository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 millionThe Fed can vary the 10% requirement between 8% to 14%


Disadvantages of Reserve RequirementsNo longer binding for most banksCan cause liquidity problemsIncreases uncertainty for banks


Nonconventional Monetary Policy Tools During the Global Financial CrisisLiquidity provision: The Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets

Discount Window ExpansionTerm Auction FacilityNew Lending Programs

Asset Purchases: During the crisis the Fed started two new asset purchase programs to lower interest rates for particular types of credit: Government Sponsored Entities Purchase Program; QE2


Monetary Policy Tools of the European Central BankOpen market operationsMain refinancing operationsWeekly reverse transactionsLonger-term refinancing operationsLending to banksMarginal lending facility/marginal lending rateDeposit facility


Monetary Policy Tools of the European Central Bank (contd)Reserve Requirements2% of the total amount of checking deposits and other short-term depositsPays interest on those deposits so cost of complying is low

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CH15.ppt