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Tools of Monetary Policy. Chapter 15. Tools of Monetary Policy. Open market operations Affect the quantity of reserves and the monetary base Changes in borrowed reserves Affect the monetary base Changes in reserve requirements Affect the money multiplier. Tools of the Fed and Fed Funds. - PowerPoint PPT Presentation
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Tools of Monetary Policy
Chapter 15
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Tools of Monetary PolicyTools of Monetary Policy
Open market operationsOpen market operationsAffect the quantity of reserves and the Affect the quantity of reserves and the
monetary basemonetary base
Changes in borrowed reservesChanges in borrowed reservesAffect the monetary baseAffect the monetary base
Changes in reserve requirementsChanges in reserve requirementsAffect the money multiplierAffect the money multiplier
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Tools of the Fed and Fed FundsTools of the Fed and Fed FundsOpen market purchaseOpen market purchase
Increases reservesIncreases reservesSupply upSupply upFederal funds rate downFederal funds rate down
Discount rate increaseDiscount rate increaseReduces discount loansReduces discount loansReduces reservesReduces reservesSupply downSupply downFederal funds rate upFederal funds rate up
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Tools of the Fed and Fed FundsTools of the Fed and Fed Funds
Reserve requirement increaseReserve requirement increaseBanks scurry to find reservesBanks scurry to find reservesDemand for reserves risesDemand for reserves risesFederal funds rate upFederal funds rate up
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Federal Funds MarketFederal Funds Market
Federal funds rate—the interest rate on Federal funds rate—the interest rate on overnight loans of reserves from one bank overnight loans of reserves from one bank to anotherto anotherPrimary indicator of the stance of monetary Primary indicator of the stance of monetary
policypolicySince the beginning of February 1994, Since the beginning of February 1994,
after every FOMC meeting, the Fed after every FOMC meeting, the Fed announced the target federal funds rate as announced the target federal funds rate as monetary policy.monetary policy.
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Demand in the Market Demand in the Market for Reservesfor Reserves
What happens to the quantity of reserves What happens to the quantity of reserves (RR+ER) demanded by banks, holding (RR+ER) demanded by banks, holding everything else constant, as the federal everything else constant, as the federal funds rate, funds rate, iiffff, changes?, changes?
Excess reserves are insurance against Excess reserves are insurance against deposit outflowsdeposit outflowsThe cost of holding ER is the interest rate The cost of holding ER is the interest rate
that could have been earned minus the that could have been earned minus the interest rate that is paid on these reserves, interest rate that is paid on these reserves, iierer
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Banks’ Demand for ReservesBanks’ Demand for Reserves
1. 1. RR = = RRRR + + ERER
2. 2. iiffff opportunity cost of opportunity cost of ERER, , ERER
3. Demand curve slopes down3. Demand curve slopes down
4. Downward sloping demand curve becomes 4. Downward sloping demand curve becomes flat (infinitely elastic) at flat (infinitely elastic) at iierer
55..Since the fall of 2008 Fed has paid interest on Since the fall of 2008 Fed has paid interest on reserves at a level that is below the federal reserves at a level that is below the federal funds rate target. funds rate target.
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Banks’ Demand for ReservesBanks’ Demand for Reserves
ReservesReserves
FederalFederalFunds rateFunds rate
iiffff=i=ierer
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Fed’s Supply of ReservesFed’s Supply of Reserves Two components: non-borrowed and borrowed reservesTwo components: non-borrowed and borrowed reserves Cost of borrowing from the Fed is the discount rateCost of borrowing from the Fed is the discount rate Borrowing from the Fed is a substitute for borrowing Borrowing from the Fed is a substitute for borrowing
from other banksfrom other banks
If If iiffff < i < idd,, then banks will not borrow from the Fed and then banks will not borrow from the Fed and borrowed reserves are zeroborrowed reserves are zero
The supply curve will be verticalThe supply curve will be vertical
As As iiffff rises aboverises above i idd,, banks will borrow more and more at banks will borrow more and more at iidd, , and re-lend at and re-lend at iiffff
The supply curve is horizontal (perfectly elastic) at The supply curve is horizontal (perfectly elastic) at iidd
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Fed’s Supply of ReservesFed’s Supply of Reserves
iiffff=i=idd
NBRNBRReservesReserves
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Market for ReservesMarket for Reserves
Why does the Why does the federal federal funds rate funds rate converge converge to i*?to i*?
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Discount Loans and Discount RateDiscount Loans and Discount RateThe discount rate charged for primary credit (the primary credit rate) is set above the usual level of short-term market interest rates. (Because primary credit is the Federal Reserve's main discount window program, the Federal Reserve at times uses the term "discount rate" to mean the primary credit rate.) The discount rate on secondary credit is above the rate on primary credit. The discount rate for seasonal credit is an average of
selected market rates.
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Open Market OperationOpen Market Operation
Open market purchase => iOpen market purchase => iffff down unless it is already equal to i down unless it is already equal to ierer..
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Advantages of Open Market Advantages of Open Market OperationsOperations
1.1. The Fed is in complete control of the The Fed is in complete control of the tool. Discount rate tool needs tool. Discount rate tool needs cooperation of the banks.cooperation of the banks.
2.2. OMO is flexible and precise; it can be OMO is flexible and precise; it can be small or large.small or large.
3.3. OMO can be reversed easily.OMO can be reversed easily.
4.4. OMO is fast. There is no time lag OMO is fast. There is no time lag between the evaluation and the impact.between the evaluation and the impact.
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Open Market OperationsOpen Market Operations
Dynamic OMO: To change the level of Dynamic OMO: To change the level of reserves and the monetary base.reserves and the monetary base.
Defensive OMO: To offset the Defensive OMO: To offset the movements in other factors.movements in other factors.
Every day New York Fed evaluates the Every day New York Fed evaluates the federal funds market and buys or sells federal funds market and buys or sells securities to hit the desired federal securities to hit the desired federal funds rate.funds rate.
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Open Market OperationsOpen Market Operations
Temporary OMOTemporary OMORepo: Fed purchases securities with the Repo: Fed purchases securities with the
understanding that the seller will buy them understanding that the seller will buy them back within two weeks.back within two weeks.
Reverse repo (Matched sale-purchase): Reverse repo (Matched sale-purchase): Fed sells securities with the understanding Fed sells securities with the understanding that it will buy back them back.that it will buy back them back.
Permanent OMOPermanent OMOConducted after the temporary OMO.Conducted after the temporary OMO.
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Change in the Discount RateChange in the Discount Rate
Discount rate down => iDiscount rate down => iff ff maymay go down go down
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Discount PolicyDiscount PolicyPrimary credit allowed to healthy Primary credit allowed to healthy
banks without limit.banks without limit.Secondary credit extended to banks in Secondary credit extended to banks in
trouble at 50 basis points above the trouble at 50 basis points above the primary rate.primary rate.
Seasonal credit given to small banks Seasonal credit given to small banks in tourist and agricultural areas.in tourist and agricultural areas.
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Discount PolicyDiscount Policy
The Fed’s discount policy is designed to The Fed’s discount policy is designed to ward off financial crises.ward off financial crises.
The Fed is the The Fed is the lender of last resortlender of last resort.. Provides unlimited funds to banks in trouble.Provides unlimited funds to banks in trouble. It creates a buffer against bank panics and It creates a buffer against bank panics and
financial meltdown.financial meltdown. Franklin National received 5% of total reserves in 1974.Franklin National received 5% of total reserves in 1974. Continental Illinois in 1984 received three times the Continental Illinois in 1984 received three times the
amount FN got.amount FN got. The possible meltdown that could have occurred in The possible meltdown that could have occurred in
Black Monday (10/19/87) was avoided through Fed’s Black Monday (10/19/87) was avoided through Fed’s lender of last resort function.lender of last resort function.
During the financial meltdown of 2008, reserves During the financial meltdown of 2008, reserves increased from 100b to 1400b.increased from 100b to 1400b.
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Moral Hazard ofMoral Hazard of Discount PolicyDiscount Policy
If banks believe that the Fed will bail If banks believe that the Fed will bail them out in times of trouble, they them out in times of trouble, they will take unnecessary chances and will take unnecessary chances and will engage in risky behavior.will engage in risky behavior.
The Fed allowed many small banks The Fed allowed many small banks to fail.to fail.
Too-big-to-fail policy is seen to be Too-big-to-fail policy is seen to be unfair.unfair.
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Change in Required ReservesChange in Required Reserves
An increase in the An increase in the reserve ratio forces reserve ratio forces banks to hold more banks to hold more reserves at each reserves at each and every federal and every federal funds rate.funds rate.
Reserve ratio up => Reserve ratio up => iiffff up up
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Reserve RequirementsReserve Requirements Depository Institutions Deregulation and Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the Monetary Control Act of 1980 sets the reserve requirement the same for all reserve requirement the same for all depository institutionsdepository institutions
3% of the first $48.3 million of checkable 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over deposits; 10% of checkable deposits over $48.3 million$48.3 million
The Fed can vary the 10% requirement The Fed can vary the 10% requirement between 8% to 14%between 8% to 14%
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Reserve RequirementsReserve RequirementsThis is a very powerful tool.This is a very powerful tool. If deposits are around $800 billion, a 1% If deposits are around $800 billion, a 1%
change in the reserve requirement can change in the reserve requirement can have a $8 billion impact on the reserves have a $8 billion impact on the reserves of the banking system.of the banking system.
It is a blunt tool.It is a blunt tool. It can create severe liquidity problems It can create severe liquidity problems
for banks if the Fed raised the reserve for banks if the Fed raised the reserve requirement.requirement.
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Can Reserve Requirements Be Can Reserve Requirements Be Abolished?Abolished?
Each bank will have to keep reserves to Each bank will have to keep reserves to fulfill deposit outflows.fulfill deposit outflows.
The money supply process will work the The money supply process will work the same way except that ER/D and rd will be same way except that ER/D and rd will be combined.combined.
Many central banks have either reduced or Many central banks have either reduced or eliminated the reserve requirement.eliminated the reserve requirement.
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How the Fed Limits Fluctuations How the Fed Limits Fluctuations
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Monetary Policy Tools Monetary Policy Tools of the European Central Bankof the European Central Bank
Open market operationsOpen market operationsMain refinancing operationsMain refinancing operations
Weekly reverse transactionsWeekly reverse transactions
Longer-term refinancing operationsLonger-term refinancing operationsLending to banksLending to banks
Marginal lending facility/marginal Marginal lending facility/marginal lending rate (100 basis points above target)lending rate (100 basis points above target)
Deposit facility (100 basis points below target)Deposit facility (100 basis points below target)
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Monetary Policy Tools Monetary Policy Tools of the European Central Bankof the European Central Bank
Reserve RequirementsReserve Requirements 2% of the total amount of checking deposits and other 2% of the total amount of checking deposits and other
short-term depositsshort-term deposits
Pays interest on those deposits so cost of complying Pays interest on those deposits so cost of complying is lowis low
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Jiazuo Xie ApproachJiazuo Xie Approach
Federal Funds Rate is determined in the Federal Funds Rate is determined in the market where only banks appear as market where only banks appear as supplier and demander of Excess supplier and demander of Excess Reserves.Reserves.
Federal Reserve by increasing or Federal Reserve by increasing or decreasing reserves can forecast the decreasing reserves can forecast the change in ERchange in ERA constant ER/R ratio allows the Fed to A constant ER/R ratio allows the Fed to
predict the change.predict the change.
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Jiazuo Xie ApproachJiazuo Xie Approach Banks which are short of RR, demand Banks which are short of RR, demand
reserves from other banks.reserves from other banks. Their demand responds to the cost of Their demand responds to the cost of
reserves: ireserves: iffff..The higher the iThe higher the iffff, the lower the demand, the lower the demand
If iIf iffff exceeds i exceeds idd, they will borrow from the Fed , they will borrow from the Fed
instead of Federal Funds marketinstead of Federal Funds market Because the Fed pays iBecause the Fed pays ierer at i at iffff=i=ierer cost of cost of
borrowing is zero; infinite demand.borrowing is zero; infinite demand.
3333http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
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Demand for Federal FundsDemand for Federal Funds
id
ier
ER
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Jiazuo Xie ApproachJiazuo Xie ApproachThe The supplysupply of ER comes from banks that of ER comes from banks that
already have enough RR.already have enough RR. If iIf iffff=i=ierer, banks rather keep the ER, banks rather keep the ER
If iIf iffff>i>ierer, banks will supply the Federal , banks will supply the Federal
Funds market, the higher the difference, Funds market, the higher the difference, the higher the supplythe higher the supply
There is, however, a limited supply of ER There is, however, a limited supply of ER determined by the Feddetermined by the Fed
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Supply of Federal FundsSupply of Federal Funds
ER
ier
iiffff
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Fed Increases Nonborrowed Fed Increases Nonborrowed ReservesReserves
ER
iff
ier
NBR1 NBR2 NBR3 NBR4
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Fed Changes Reserve Fed Changes Reserve RequirementRequirement
idid
ier ier
ERER
Reserve Requirement Increased Reserve Requirement Decreased
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Discount Rate ChangedDiscount Rate Changed
Discount Rate Decreased Discount Rate Increased
iidd
iidd’’