Monetary Theory and Policy
Chapter 15：Tools of Monetary Policy
1 / 31 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 Federal funds rate: the interest rate on overnight loans of reserves from one bank to another Primary instrument of monetary policy
Chapter 15 2/ 32 The Market For Reserves and the Federal Funds Rate
What happens to the quantity of reserves demanded by banks, holding everything else constant, as the federal funds rate changes? Excess reserves are insurance against deposit outflows The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ier
Chapter 15 3/ 32 Demand in the Market for Reserves
Since 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. When 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 falls and the quantity of reserves demanded rises Downward sloping demand curve that becomes flat (infinitely elastic) at ier
Chapter 15 4/ 32 Figure 1 Equilibrium in the Market for Reserves
Federal Funds Rate With excess supply of reserves, the * federal funds rate falls to iff . i d Rs
With excess demand for reserves, the 2 * iff federal funds rate rises to iff .
* 1 iff
1 iff
d ior R
NBR Quantity of Reserves, R
Chapter 15 5/ 32 Supply in the Market for Reserves
Two components: non-borrowed and borrowed reserves Cost of borrowing from the Fed is the discount rate Borrowing from the Fed is a substitute for borrowing from other banks
If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero The supply curve will be vertical
As iff rises above id, banks will borrow more and more at id, and re-lend at iff
The supply curve is horizontal (perfectly elastic) at id
Chapter 15 6/ 32 Figure 1 Equilibrium in the Market for Reserves
Federal Funds Rate With excess supply of reserves, the * federal funds rate falls to iff . i d Rs
With excess demand for reserves, the 2 * iff federal funds rate rises to iff .
* 1 iff
1 iff
d ior R
NBR Quantity of Reserves, R
Chapter 15 7/ 32 Affecting the Federal Funds Rate
Effects of an open 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).
Chapter 15 8/ 32 Affecting the Federal Funds Rate (cont’d)
Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve.
Chapter 15 9/ 32 Figure 2 Response to an Open Market Operation Federal Federal Funds Rate Funds Rate
id id s s s s R1 R2 R1 R2 1 1 iff
2 iff 2 1 2 d 12= = d ior R1 iiiff ff or R1
NBR1 NBR2 Quantity of NBR1 NBR2 Quantity of Reserves, R Reserve, R
Step 1. An open market purchase shifts the Step 1. An open market purchase shifts the supply supply curve to the right … curve to the right …
Step 2. causing the federal funds rate to fall. Step 2. but the federal funds rate cannot fall below the interest rate paid on reserves.
(a) Supply curve initially intersects demand (b) Supply curve initially intersects curve in its downward-sloping section demand curve in its flat section
Chapter 15 10 / 32 Affecting the Federal Funds Rate (cont’d)
If 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.
Chapter 15 11/ 32 Figure 3 Response to a Change in the Discount Rate
Federal Federal Funds Rate Funds Rate
s 1 R1 id s 2 R2 id 1 11 s 1 1 ii= R i ff d 1 ff 2 222 s iiff = id R 2
d d BR1 R ior R1 1 ior
BR2
NBR Quantity of NBR Quantity of Reserves, R Reserves, R
Step 1. Lowering the discount rate Step 1. Lowering the discount rate shifts the supply curve down… shifts the supply curve down…
Step 2. but does not lower the Step 2. and lowers the federal federal funds rate. funds rate.
(a) No discount lending (BR = 0) (b) Some discount lending (BR > 0)
Chapter 15 12/ 32 Affecting the Federal Funds Rate (cont’d)
When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.
Chapter 15 13/ 32 Figure 4 Response to a Change in Required Reserves
Federal Funds Rate
i s d R1
2 i 2 Step 1. Increasing the reserve requirement ff causes the demand curve to shift to the right . . .
1 1 iff Step 2. and the federal funds rate rises.
d R2 i or d R1
NBR Quantity of Reserves, R
Chapter 15 14 / 32 Figure 5 Response to a Change in the Interest Rate on Reserves
Federal Federal Funds Rate Funds Rate
s s id R id R
222 2 1 d iiff= i or iff 1 R2 d 2 R2 ior 11 d d ii= 1 R ff or R1 ior 1 1
NBR Quantity of NBR Quantity of Reserves, R Reserves, R
Step 1. A rise in the interest rate on reserves Step 1. A rise in the interest rate on 1 1 2 2 reserves from i or to i ... from i or to ior ... or Step 2. raises the federal funds Step 2. leaves the federal funds rate unchanged. 22 rate to ii ff = or .
11 11 (a) initial iiff > or (b) initial iiff = or
Chapter 15 15/ 32 Application: How the Federal Reserve Limits Fluctuations in the Federal Funds Rate
Supply and demand analysis of the market for reserves illustrates how an important advantage of the Fed’s current procedures for operating the discount window and paying interest on reserves is that they limit fluctuations in the federal funds rate.
Chapter 15 16/ 32 Application: How the Federal Reserve Limits Fluctuations in the Federal Funds Rate
Federal ′′ ′ d Funds Rate d d * R R R
′′ = s iiff d R
Step 1. A rightward shift of the demand curve raises the federal funds rate to a maximum of the discount rate.
* iff Step 2. A leftward shift of the demand curve lowers the Ederal funds rate to a minimum of the interest rate on reserves.
iiff′ = or
NBR* Quantity of Reserves, R
Chapter 15 17 / 32 Conventional Monetary Policy Tools
During normal times, the Federal Reserve uses three tools of monetary policy—open market operations, discount lending, and reserve requirements—to control the money supply and interest rates, and these are referred to as conventional monetary policy tools.
Chapter 15 18/ 32 Open Market Operations
Dynamic open market operations Defensive open market operations Primary dealers TRAPS (Trading Room Automated Processing System) Repurchase agreements Matched sale-purchase agreements
Chapter 15 19/ 32 Advantages of Open Market Operations
The Fed has complete control over the volume Flexible and precise Easily reversed Quickly implemented
Chapter 15 20/ 32 Discount Policy
Discount window Primary credit: standing lending facility Secondary credit Seasonal credit Lender of last resort to prevent financial panics (FDIC) Creates moral hazard problem
Chapter 15 21/ 32 Advantages and Disadvantages of Discount Policy
Used to perform role of lender of last resort Important during the subprime financial crisis of 2007-2008. Cannot be controlled by the Fed; the decision maker is the bank Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target
Chapter 15 22/ 32 Figure 6 How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate
Federal ′′ ′ d Funds Rate d d * R R R
′′ = s iiff d R
Step 1. A rightward shift of the demand curve raises the federal funds rate to a maximum of the discount rate.
* iff Step 2. A leftward shift of the demand curve lowers the Ederal funds rate to a minimum of the interest rate on reserves.
iiff′ = or
NBR* Quantity of Reserves, R
Chapter 15 23/ 32 Reserve Requirements
Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million The Fed can vary the 10% requirement between 8% to 14%
Chapter 15 24/ 32 Relative Advantages of the Different Monetary Policy Tools
• Open market operations are the dominant policy tool of the Fed since it has complete control over the volume of transactions, these operations are flexible and precise, easily reversed and can be quickly implemented. • The discount rate is less well used since it is no longer binding for most banks, can cause liquidity problems, and increases uncertainty for banks. The discount window remains of tremendous value given its ability to allow the Fed to act as a lender of last resort.
Chapter 15 25/ 32 On the Failure of Conventional Monetary Policy Tools in a Financial Panic
When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job, for two reasons. First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse. Second, the negative shock to the economy can lead to the zero-lower-bound problem.
Chapter 15 26/ 32 Nonconventional Monetary Policy Tools During the Global Financial Crisis
Liquidity provision: The Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets Discount Window Expansion Term Auction Facility New Lending Programs
Chapter 15 27/ 32 Nonconventional Monetary Policy Tools During the Global Financial Crisis
Large-scale asset purchases: During the crisis the Fed started three new asset purchase programs to lower interest rates for particular types of credit: Government Sponsored Entities Purchase Program QE2 QE3
Chapter 15 28/ 32 Figure 7 The Expansion of the Federal Balance Sheet, 2007-2014
Chapter 15 29/ 32 Disadvantages of Reserve Requirements
No longer binding for most banks Can cause liquidity problems Increases uncertainty for banks
Chapter 15 30/ 32 Monetary Policy Tools of the European Central Bank
Open market operations Main refinancing operations Weekly reverse transactions Longer-term refinancing operations
Lending to banks Marginal lending facility/marginal lending rate Deposit facility
Chapter 15 31/ 32 Monetary Policy Tools of the European Central Bank (cont’d)
Reserve Requirements 2% of the total amount of checking deposits and other short-term deposits Pays interest on those deposits so cost of complying is low
Chapter 15 32/ 32