Federal Reserve

Tools and Targets

Open Market Operations

• Types:– Dynamic

• Designed to change base

– Defensive• Meant to offset other factors affecting base

• Purpose:– Change the monetary base.

Open Market Operations

• Advantages:– Controlled by the Fed– Flexible and precise– Easily reversed– Implemented quickly

Discount Loans

• Purpose:– Influence reserves in the banking system– Lender of Last Resort

• Prevent bank panics

• Prevent non-bank financial panics

Types of Discount Loans

• Primary Credit– Restricts eligibility to generally sound

institutions.• The goal is to eliminate institutions’ incentive to

borrow to exploit the positive spread of money market rates over the discount rate.

• The Fed expects that the restriction of eligibility will reduce its need to review borrowers’ funding situations; thereby, encouraging banks to use the discount window during tight markets.

Types of Discount Loans

• Primary Credit– Primary credit is extended at a rate that is above

the usual level of short term market interest rates, including the federal funds rate.

Types of Discount Loans

• Secondary Credit– Secondary credit is available in appropriate

circumstances to depositary institutions that do not qualify for primary credit.

– Secondary credit is extended at an interest rate that is 50 basis point above the primary discount rate.

Changes to the Discount Window

Feature Previous System Primary Credit

Rate Fed funds rate less Fed funds rate plus 25-50 basis points 100 basis points

Term Overnight Overnight

Eligibility Subjective Sound banks only

Administration Evaluated for Minimal, appropriateness Market based

Use of funds Can’t resell No restrictions

Discount Loans

• Advantages:– Lender of Last Resort function.

• Disadvantages:– Confusion interpreting discount rate changes.– Fluctuations in discount loans can cause

unintended fluctuations in the money supply.– Not fully controlled by the Fed.

Reserve Requirements

• Types:– Required reserves– Excess reserves

• Purpose:– Originally, reserve requirements were meant to

provide a cushion of reserves to meet unexpected depositor demands for funds.

Reserve Requirements

• Advantages:– Changes in reserve requirements can change the

rate of growth in the money supply rapidly.

• Disadvantages:– Increases can cause serious liquidity problems for

banks.– Continually fluctuating reserve requirements

create uncertainty for banks and make liquidity management more difficult.

Targets

Monetary Policy Goals

• The goals of monetary policy are:– High employment– Economic growth– Price stability– Interest rate stability– Financial markets stability– Exchange rate stability

Monetary Policy Targets

• The central bank wants to achieve its goals, but it does not directly influence the goals.

• It has a set of tools that affect the goals indirectly after a period of time.

• Therefore, the Fed must aim at targets that lie between its tools and its goals.

Targets

• Intermediate Targets:– Monetary aggregates such as M1and M2– Interest rates

• Operating Targets:– Reserve aggregates such as reserves, non-borrowed

reserves, monetary base, non-borrowed base.– Interest rates such as the federal funds rate or the

Treasury bill rate.

Choosing the Target

• There are two types of targets:– Aggregates (Monetary and Reserve)– Interest rates.

• When the Fed chooses one target, it loses control over the other.

i

0 Money

MoneyDemand

ih

il

MD low MDhigh

At high rates of interest, people holdinterest bearing assets so money demandis low.

At low rates of interest, people holdfewer interest bearing assets so moneydemand is higher.

Money Demand

i

0 Money

MoneySupply

MS

The money supply is determined by theFederal Reserve.

At every rate of interest, the money supplyis the same.

Money Supply

Targeting the Money Supply

i

0 Money

i3

i1

MoneySupply

MD1

MD2

MD3

i2

Let money demand fluctuate betweenMD1 and MD3, causing interest ratesto fluctuate between i1 and i3.

Targeting the money supply leads toloss of control over interest rates.

Targeting Interest Rates

i

0 Money

MS2

MD1

MD2

MD3

i*

Let money demand fluctuate betweenMD1 and MD3, causing interest ratesto fluctuate between i1 and i3.

To set interest at i*, money supply mustfluctuate between MS1 and MS3.

Targeting interest rates leads to lossof control over the money supply.

MS1 MSs3

Monetary Policy Targets

• It is not possible for the Federal Reserve to change economic conditions directly.

• Strategy:– Decide on goals for the overall economy.– Choose a set of variables called intermediate targets

that it believes will have an impact on the overall economy.

– Choose another set of variables called operating targets that impact the intermediate targets.

Target Criteria

• Measurability– Intermediate Targets

• Data on monetary aggregates are available after a two week delay.

• Data on interest rates are available daily.– But real interest rates (interest rates adjusted for expected

inflation) are hard to measure because there is no direct way to measure expected inflation.

– Operating Targets• Data on reserve aggregates and the federal funds rate are

available daily.

Target Criteria

• Controllability– Intermediate Targets

• The Fed’s control of the money supply is good but not perfect.

• The Fed can change interest rates through open market operations.

– Operating Targets• The Fed easily controls base and the federal funds

rate.

Target Criteria

• Predictable Effect on Goals– Intermediate Targets

• The ultimate economic goal is the target of the intermediate target.

– If the goal is price stability, a change in the money supply or interest rates should change the price level.

– If the goal is economic growth, a change in the money supply of interest rates should change the rate of growth in GDP.

Target Criteria

• Predictable Effect on Goals– Operating Targets

• The intermediate target is the goal of the operating target.

– If the intermediate target is interest rates, the operating target will also be an interest rate variable such as the federal funds rate.

– If the intermediate target is a monetary aggregate, the operating target will also be a reserve aggregate variable such as base.

Lags

• Data lag– Time to obtain information

• Recognition lag– Time to understand the information

• Legislative lag– Time to decide on policy

Lags

• Implementation lag– Time to implement the policy

• Effectiveness lag– Time for the policy to take effect.

• Monetary policy has a long and variable effectiveness lag.