Monetary Policy Tools
Instruments that initiate monetary
policy
Open Market Operations
The Discount Rate
Reserve Ratios
Open Market Operations
Defined as the buying or selling of
bonds by the Federal Reserve in the
open market.
Expansionary -- Fed buys bonds
(injects reserves)
Contractionary -- Fed sells bonds
(drains reserves)
Done at the Federal Reserve Bank of
New York
Open Market Operations:
How They’re Actually Done
Example -- Federal Reserve buys a
$1000 bond from Salomon
Brothers and pays with a check.
The check in turn is deposited in
checkable deposits at Chase,
which is Salomon Brothers bank.
Balance Sheet Portrayal
Salomon Brothers
Bonds -$1000
D
+$1000
R
Chase
+$1000
D +$1000
Federal Reserve Bank of NY
Bonds +$1000
R +$1000
Characteristics of
Open Market Operations
Sometimes done for temporary
periods
(Fed) Repurchase Agreement -- Fed
buys bond with agreement to sell it
back.
Matched-Sale Purchase -- Fed sells
bond with agreement to buy it back.
Open Market Operations -An Effective Policy Tool
Occurs at the initiative of the Fed.
Fed is in complete control.
They are flexible: Fed can do small
or large amounts.
They are reversible: Fed can undo
policy mistakes.
 Very low-key policy instrument:
difficult to tell what Fed has done.
The Discount Rate (iDISC)
Defined as the rate of interest
charged to banks that borrow from
the Federal Reserve.
Expansionary -- Fed lowers
discount rate.
Contractionary -- Fed raises
discount rate.
Effects of
Discount Rate Changes
Example -- Effect of Decrease in
the Discount Rate (iDISC).
iDISC  DL  M2
Increase in discount rate has the
reverse effect.
Types of Discount
Window Borrowing
Primary Credit -- borrowing for
short-term reserve adjustments.
Seasonal Credit -- borrowing for
seasonal needs.
Secondary Credit -- large, longerterm borrowing for banks facing
financial difficulties.
Discount Rate Policy -Characteristics
DL done at the discretion of
banks, not the Fed.
Discount Window can be abused
by banks, borrowing for profit
(actively or passively).
Sometimes is regarded as signal
of monetary policy, “the
announcement effect.”
Discount Rate Policy -Its Diminished Role
Larger volume of borrowing from other
sources -- Federal Funds, RPs,
Eurodollars  banks hardly use the
Federal Reserve for short-term reserve
adjustments.
Announcement effect now involves the
Federal Funds rate target.
Recent change in procedure
(generally): iDISC = Target iFF + 0.5%.
Reserve Ratios (rD, rT)
Designed to change the amount of
required reserves.
Expansionary Policy -- Fed lowers
reserve ratios.
Contractionary Policy -- Fed raises
reserve ratios.
Affects M2 by changing the
multiplier.
Characteristics of
Reserve Ratio Policy
rT = 0 for Savings and Time
Deposits (including MMDAs)
DIDMCA  Uniform Reserve
Requirements (based upon deposit
size)
Reserve Ratio Policy -Rarely Used
Too blunt -- needs tiny changes for
reasonable adjustments in money
growth.
Too Disruptive -- affects all banks
balance sheets.
The Market For
Bank Reserves
Demand for Reserves (RD) -- Banks
wishing to borrow reserves in the
Federal Funds market, generally in
response to loan demand.
Downward sloping curve when plotted
against iFF, (i.e. iFF  RD). It can shift
rightward (increase in demand) or
leftward (decrease in demand).
Supply of Reserves -- Banks offering
reserves to the Federal Funds market +
the Federal Reserve changing reserves
using open market operations.
Upward sloping curve when plotted
against iFF, (i.e. iFF  RS). It can shift
rightward (increase in supply) or
leftward (decrease in supply).
Determination of
the Federal Funds Rate
The Federal Funds Rate (iFF) is
determined by equilibrium in the
market for bank reserves (where
RD = RS).
The Federal Funds Rate changes
due to shifts in the Demand for
Bank Reserves or the Supply of
Bank Reserves.