Chapter 19 The Instruments of Central Banking. Learning Objectives Reserve Requirements Discount window Open market operation 19-2

Chapter 19

The Instruments of Central Banking

Learning Objectives

Reserve Requirements Discount window Open market operation

19-2

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

19-3

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

19-4


Percentage of required reserves varies with type of account

Demand Deposits Ranges between 8% to 14% For first $42.1 million: 3% Above $42.1 million: 10% (currently)

Business-owned time and savings deposits Can range between 0% to 9% Currently set at 0%

19-5


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

19-6


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

19-7


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

19-8

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

19-9


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

19-10


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

19-11


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

19-12


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

19-13


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

19-14


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”

19-15


Relationship between discount rate and other market interest rates Discount rate is an “administered” rate, set by Fed Weak linkage between discount rate and reserves and

money supply Change in the discount rate generally occurs after a change

in the Treasury bill rate or federal funds rate Also shows, after January 2003, the new primary credit rate

is now above the rate on three-month T-bill Reactive rather than proactive tool

19-16

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

19-17


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

19-18

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

19-19


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—same result, assuming the simple multiplier

19-20


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

19-21

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

19-22


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

19-23


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

19-24

Documents

Chapter 19 The Instruments of Central Banking. Learning Objectives Reserve Requirements Discount window Open market operation 19-2