©Thomson/South-Western 2006 1

 Goals
 influence greater output
 lower the unemployment rate
 prices level stability
 tools of monetary policy or instruments of monetary policy
 open market operations
 discount window policy
 reserve requirement policy
 intermediate target variables
 short-term interest rates
 monetary aggregates (M1, M2, M3)
2

 Open market operations
 Buying and selling of securities in the open market
 The Fed is empowered to buy or sell
 U.S. Treasury securities
 federal agency securities
 banker's acceptances
 other securities
 If the Fed sells $225 million in U.S. Treasury bills to a government securities dealer
3

Discovery Of Open Market Operations
And The Banking Act Of 1935
 Discovery
 Prior to 1920,the discount window was the only Fed policy tool,
 The Fed's revenues were only the interest received on the
Fed's discounts loans.
 An early 1920s recession led to a drop in revenue, so individual Fed banks bought U.S. government securities.
 When banks purchased securities, interest rates fell, and credit conditions eased.
 The Banking Act of 1935:
 eliminated individual Fed banks’ power to conduct separate policies, and
 shifted a significant amount of power to the Board of
Governors in Washington, D.C.
4

 Federal Reserve's open market operations could be carried out in any asset.
 To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances.
 When the Fed buys $400 million in Treasury bonds and bills from banks,
 reserves and the monetary base expand dollar-for-dollar, but
 the money supply is not directly or immediately affected.
 This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.
5

 Impacts of Open Market Operations
 Impact on Bank Reserves, the Monetary Base, and the
Monetary Aggregates:
 The Fed can exert relatively accurate control over bank reserves and the monetary base by manipulating its security portfolio.
 Impact on Security Prices and Interest Rates (Yields):
 When the Fed buys government securities in the open market, it bids up security prices and therefore reduces their yields.
 Marketable securities are substitutable, so a decline in government security yields spills over to yields on other assets.
6

 Precision:
 firm and accurate control over aggregate bank reserves and the monetary base, while
 a high degree of accuracy cannot be achieved through changes in the discount rate or reserve requirements.
 Flexibility:
 in the market each day, buying and selling large quantities of securities
 very easy for the Fed to alter course
 Source of Initiative:
 The Fed is able to dominate aggregate bank reserves and the monetary base.
7

 Signaling:
 Changes in the discount rate and reserve requirements are superior to open market operations in signaling policy changes to the public.
 Regional Bias:
 Prior to well-developed financial markets, a regional bias operated in open market operations, because the effects were concentrated in select urban areas where security dealers were located; open market operations did not disperse across the nation.
8

 The effects of the Fed's open market operations transmit very quickly throughout the nation through the federal funds market.
 The supply of reserves is determined by
Federal Reserve policy.
 When the Fed purchases securities, bank reserves are boosted dollar-for-dollar.
 When the Fed sells securities, bank reserves decline dollar-for-dollar.
9

Purchase of Securities
S
1
S
2
4.0
3.5
Reserves
Demand
10

 Defensive Operations versus Dynamic
Operations
 Defensive open market operations
 open market operations made for the purpose of
"defending" bank reserves and the monetary base against the influence of outside forces
 Dynamic open market operations
 open market operations made to deliberately change the course of economic activity
11

 Outright transactions
 The Fed uses outright purchases to bring about long-run or permanent growth in reserves and the monetary aggregates.
 Repurchase agreements (and reverse repurchase agreements )
 The Fed uses repurchase agreements (repos) and reverse repurchase agreements to neutralize the impact on reserves and the monetary base of transitory changes.
 Recall a repurchase agreement is a money market instrument wherein one party sells securities with an explicit agreement to buy them back at a specified future date and price.
12

13

 Arriving at the Policy Directive
 Eight times annually, FOMC meets in Washington to formulate monetary policy.
 It issues a policy directive to the manager of the System Open
Market Account.
 Implementation of the Policy Directive
 The manager of the System Open Market Account will:
 9:00 a.m.: contact dealers in government securities to get expectations of conditions during the day
 10:00 a.m.: receive a report from the Fed staff on the expected movement of several important factors that influence bank reserves
 10:30 a.m.: phone the U.S. Treasury for forecast on deposits
 mid-morning: get approval from reps from the Board of Governors and the FOMC
 Implement purchases or sales through TRAPS (Trading Room Automated
Trading System)
14

 The discount window is a facility through which the Federal
Reserve district banks lend reserves directly to depository institutions.
 Discount policy is the set of conditions under which banks are permitted to borrow reserves and the interest rate charged
( discount rate ).
 Categories of Conditions:
 Primary credit--
 granted to banks in good condition who are permitted to borrow as much as they want
 discount rate > fed funds rate
 Secondary credit
 provided to troubled banks that are experiencing liquidity problems
 ½ percentage point higher rate
 Seasonal credit
 provided to banks subject to seasonal fluctuations in loan demand —like agricultural activity
15

 Prior to 2003,
 discount rate < fed funds;
 the Fed had to create policies to discourage overuse of the discount window, and
 Use was a “privilege” not a “right.”
 After 2003,
 Lombard system
 discount rate > fed funds rate;
 use became a right rather than a privilege, so
 So relatively high discount rate naturally discouraged overuse of the discount window.
16

17

 Since 1935, the Fed has had the authority to set and change reserve requirements or required reserve ratios that banks must maintain.
 Before 1980, reserve requirements only existed for member banks, now enforced for all banks.
18

 The Monetary Control Act of 1980 established a new structure of reserve requirements for all banks and thrift institutions.
19

20

 Reserve Averaging
 Banks must meet the required reserve ratio (on a daily average) over the settlement period.
 Carryover Allowance
 2% leeway may be carried over one settlement period.
21

The Economic Effects Of Changes In
The Reserve Requirement
 Influence on the Money Supply and Interest Rates m
1
 r r
1
 k
 r e
 k
 A change in r
 Let r r
 Let r r r has an impact on m
1:
=.1, k=.9, r
=.09, k=.9, r
 Change in m
1 e
=.005, then m
1 e
=.005, then m
=1.891
1
=1.910
is not as large as it was when we used naïve multiplier in chapter 14.
22

 Speed of Impact:
 When the Fed changes reserve requirements, all institutions experience an immediate change in their excess-reserve position.
 Neutrality:
 Unlike open market operations and discount rate changes, the impact of reserve requirement changes is spread across all banks and thrift institutions uniformly.
 Potential Use in an Emergency:
 At rare times when other tools cannot do the job, changes in reserve requirements may be needed to neutralize major changes in the monetary base.
23

 Bluntness:
 A one percentage point reduction (increase) in the reserve requirement would release (absorb) $7 billion of excess reserves.
 Such large changes make this tool too clumsy to be used regularly.
 Lack of Flexibility:
 Unlike other tools, an early reversal of a previous position would constitute the Fed making a significant and obvious admission of error.
 Frequent changes in reserve requirements create uncertainty for banks.
 Raising the reserve requirement level can trigger liquidity problems for many banks.
24