Tools of Monetary Policy
The market for reserves and the federal funds rate
Banks hold excess reserves in order to meet deposit outflows and to ensure that
they are in compliance with reserve requirements. Many banks like to keep a
buffer of excess reserves to make sure these problems do not arise. But
because they do not make money on reserves the will lend the reserves out
overnight to banks that do not have sufficient excess reserves. This borrowing
and lending is called the federal funds market and the interest rate that prevails
in that market is called the federal funds rate. The Fed pays a good deal of
attention to the federal funds rate as an indicator of interest rates generally.
Further, the Fed believes that changes to the federal funds rate will be mirrored
in other interest rates.
Now banks have three possible avenues of earning revenues (1) by making
commercial and consumer loans, (2) by buying government securities, and (3) by
lending in the federal funds market. Usually banks won’t earn as much in the
federal funds market as the in the other two, but the existence of this market
makes holding excess reserves more attractive than would be the case where
they could earn no revenue on these reserves.
The supply of reserves
Reserves are comprised of required reserves and excess reserves. If required
reserves do not change and excess reserves increase then reserves will
increase. The same holds for a decrease. Consider a bank that is indifferent
between making a commercial loan, buying a security, or lending in the federal
funds market. If the federal funds rate increases, the bank most likely will opt for
the federal funds market. So we will say that banks will be willing to hold more
excess reserves (and hence reserves) if the federal funds rate increases.
The demand for reserves
Some banks will find themselves short of excess reserves. These banks can
borrow from the Fed (discount loans) or call in loans. They can also borrow in
the federal funds market. The lower the federal funds rate they more likely they
are to borrow there than obtain funds using the other two methods. The higher
the rate the less likely they will borrow.
Figure 17__1. The federal funds market
How monetary policy tools affect the federal funds rate
Open market operations
If the Fed buys securities it will increase reserves in the banking system. This
shifts the supply curve for federal funds to the right and lowers the federal funds
rate. An open market sale will reduce the level of reserves, shift the curve to the
left and raise the federal funds rate.
Discount loans
When the Fed makes discount loans, reserves in the banking system increase. If
the discount rate is lowered banks will tend to borrow more from the Fed and this
will increase the supply of reserves. In that case the supply curve shifts right and
the federal funds rate falls. If the Fed raises the discount rate banks will borrow
less and reserves will fall. In this case the federal funds rate rises.
Reserve requirements
If the Fed raises the reserve ratio banks will convert excess reserve into required
reserves. But now they will be holding less excess reserves than they would like.
If they don’t call in loans or sell securities, they must borrow in the federal funds
market. So an increase in the reserve atio will increase the demand for reserves
(shift demand curve right), raising the federal funds rate. A decrease in the
reserve ratio will shift the demand curve to the left lowering the federal funds
rate.
How the tools are used in practice
Open market operations.
There are two types of open market operations. Dynamic open market
operations are used to change the monetary base to increase or decrease the
money supply. Defensive open market operations are used to offset other things
that might change the monetary base against the desire of the Fed (say changes
in float).
The Fed continuously monitors such things a float and Treasury deposits with the
Fed that can change the monetary base. The Fed will then take action (usually
open market operations) to offset an increase or decrease in reserves caused by
the undesired changes in reserves.
The advantages of open market operations
1. The Fed controls open market operations. It only has partial control of
discount loans (the Fed can refuse to make loans but it can’t compel
banks to borrow).
2. Open market operations are flexible. They can be made larger or smaller
as needed.
3. Open market operations are easily reversed if a mistake has been made.
4. Open market operations can be implemented quickly.
Discount Loans
The Fed can affect the amount of discount borrowing in two ways
1. By changing the discount rate. It the Fed raises the discount rate banks
will borrow less from the Fed. The supply of reserves will decrease and
the federal funds rate will increase. If the Fed lowers the discount rate
banks will borrow more, the supply of reserves will increase and the
federal funds rate will decrease.
2. Administrative control of loans. The Fed makes three kinds of loans
a) Adjustment credit loans. These are loans used by banks with short
term liquidity problems caused by inadequate excess reserves.
These loans can be approved very quickly and are expected to be
paid back quickly.
b)
c)
Seasonal credit. These are loans made to banks which need to
make loans on a seasonal basis. Banks in agricultural areas and
banks that service tourism and vacation industries are typical.
Extended credit. These are loans make to banks with a severe
liquidity problem due to large deposit outflow. The loan is not
expected to be paid back quickly. The bank must justify the need
for the extended credit and present a plan for restoring liquidity.
While the Fed is willing to help banks out with occasional liquidity problems it
does not want banks to make a habit of borrowing. In particular it does not want
banks to view discount borrowing as a profit making activity. If the bank makes a
habit of visiting the discount window the Fed will deny it loans in the future.
Lender of last resort
One of the functions of the Fed is to act as the lender of last resort to prevent
bank panics. The very knowledge that the Fed is willing to act in such a fashion
is often all that is needed to prevent such a panic. The Fed can always pump
enough reserves into the economy by making discount loans as to meet deposit
outflow problems. These loans can be made very quickly.
The Fed did not act as the lender of last resort during the Great Depression. It
let banks fail making the panic worse. Because the Fed did not act as the lender
of last resort, banks had to protect themselves from deposit outflows by building
up excess reserves. So banks refused to lend just when the economy needed
lending the most.
Why should the Fed need to be the lender of last resort if the FDIC exist? The
FDIC is really rather small. It can be used to protect customers if a single bank
fails, but really would be inadequate for a large scale banking panic.
The Fed can also act as lender of last resort in financial crises that occur outside
the commercial banking industry. During the Black Monday stock market crash
of 1987, the Fed promised discount loans to banks that would, in turn, make
loans to financially strapped securities firms. This seemed to have stopped the
stock market panic and earned Greenspan much of his reputation.
The lender of last resort policy has its own drawbacks. If banks believe that the
Fed will always bail them out, they will be encouraged to engage in riskier
behavior. This may be particularly true of large banks feeling that they are “too
big to fail”.
Announcement effect
The Fed can use discount loan policy as a means of signaling to the financial
community its plans regarding interest rates. If the Fed wishes to halt an
inflationary expansion, it may decrease reserves thus raising the federal funds
rate and follow this with an increase in the discount rate. It may be able to stop
an expansion by raising the discount rate sending a signal that it will raise market
interest rates if financial institutions don’t. That may be sufficient to halt the
expansion.
The problem is that the announcement may be misinterpreted. The Fed may
raise the discount rate to discourage banks from applying for discount loans
rather than as a signal that the Fed wants market rates to increase.
Advantages and disadvantages of discount policy
1. When the Fed changes the discount rate this may be mistaken as a signal
of future Fed interest rate policy.
2. Suppose that the Fed fixes the discount rate and then market interest
rates rise. Banks will be encouraged to take out discount loans that will
increase reserves. This may not be what the Fed wants to have happen.
So this may make the Feds job more difficult.
3. Open market operations generally are more reliable and faster. Open
market operations are easier to reverse if necessary.
Changing reserve requirements
The final monetary policy tool the Fed can use to affect the federal funds rate is
by changing the reserve requirements. Increasing the reserve ratio will cause a
shift from excess reserves to required reserves. Some banks that used to have
excess reserves will now find that they do not have adequate reserves. They will
borrow in the federal funds market. This will raise the federal funds rate.
Lowering the reserve ratio will reduce the demand for excess reserves and will
cause a fall in the federal funds rate.
The Fed has had authority over the reserve requirement for commercial banks
since the 1930s. Now it controls the reserve requirement for all depository
institutions including commercial banks, S&Ls, mutual savings banks and credit
unions.
Advantages and disadvantages of reserve requirement changes
The chief advantage of changing reserve requirements is that it affects all banks
equally and is a very powerful tool.
The chief disadvantage of changing reserve requirements is that it affects all
banks equally and is a very powerful tool.
Banks can choose to apply for discount loans. Banks can choose to buy or sell
securities. Bank must comply with Fed decisions regarding reserve
requirements. So banks lose a good deal of freedom when the Fed changes the
reserve ratio. This will cause immediate liquidity problems for some banks due to
no fault of their own.
The tool is very powerful and hence should only be used with great care. Small
changes in the reserve ration can cause very large changes in the money supply
and the changes are not easy to predict.
Should reserve requirements be 100%
Milton Friedman has suggested that the reserve requirement be set at 100%. In
this case there would be no excess reserves and the money multiplier would be
m
and
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rD   ER D   C D 
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1  C D 
1   0 D   C D 
M  m  MB  MB
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so that the money supply would equal the monetary base. Friedman believes
that this would give the Fed better control of the money supply (assuming they
follow a constant growth rule for increasing the money supply).
Of course banks could no longer make loans. These would have to be made by
other financial institutions. Quite likely these institutions would develop
instruments that looked like checkable deposits.
Questions
1) In the market for reserves, an open market purchase shifts the supply curve
to the
A) left, lowering the federal funds interest rate.
B) right, lowering the federal funds interest rate.
C) right, raising the federal funds interest rate.
D) left, raising the federal funds interest rate.
2)
In the market for reserves, an open market _____ shifts the supply curve to
the _____, lowering the federal funds interest rate.
A) sale; left
B) sale; right
C) purchase; right
D) purchase; left
3
In the market for reserves, a lower discount rate shifts the supply curve to
the
A) left, lowering the federal funds interest rate.
B) right, lowering the federal funds interest rate.
C) right, raising the federal funds interest rate.
D) left, raising the federal funds interest rate.
4
In the market for reserves, a _____ discount rate shifts shifts the supply
curve to the _____, lowering the federal funds interest rate.
A) lower; left
B) lower; right
C) higher; right
D) higher; left
5
In the market for reserves, a _____ discount rate shifts the supply curve to
the _____, raising the federal funds interest rate.
A) lower; left
B) lower; right
C) higher; right
D) higher; left
6
In the market for reserves, an increase in the reserve requirement shifts the
demand curve to the
A) left, lowering the federal funds interest rate.
B) right, lowering the federal funds interest rate.
C) right, raising the federal funds interest rate.
D) left, raising the federal funds interest rate.
7)
the market for reserves, a _____ in the reserve requirement shifts the
demand curve to the left, _____ the federal funds interest rate.
A) rise; lowering
B) decline; raising
C) decline; lowering
D) rise; raising
8) Open market operations intended to offset movements in noncontrollable
factors (such as float) that affect reserves and the monetary base are called
A) defensive open market operations.
B) dynamic open market
operations.
C) offensive open market operations.
D) reactionary open market
operations.
9 The Fed's most commonly used means of changing the money supply is
A) changing reserve requirements.
B) changing the discount rate.
C) open market operations.
D) changes in the Regulation Q ceiling rate.
10) Fed's least commonly used means of changing the money supply is
A) changing reserve requirements.
B) changing the discount rate.
C) open market sales.
D) open market purchases.
11) The discount rate is
A) the interest rate the Fed charges on loans to banks.
B) the price the Fed pays for government securities.
C) the interest rate that banks charge their most preferred customers.
D) the price banks pay the Fed for government securities.
12)
A)
B)
C)
D)
The major loan extended to Continental Illinois in 1984 is an example of
which type of discount loan?
Seasonal credit
Extended credit
Adjustment credit
Installment credit
13) The most common type of discount loan, _____ credit loans, are intended to
help banks with short-term liquidity problems that often result from temporary
deposit outflows.
A) extended B) adjustment C) temporary D) seasonal
14) The most common type of discount loan, _____ credit loans, are intended to
help banks with _____-term liquidity problems that often result from _____
deposit outflows.
A) extended; short; temporary
B) adjustment; short; temporary
C) extended; long; permanent
D) seasonal; long; permanent
15) The Fed's ability to discourage banks from making too many trips to the
discount window is frequently referred to as
A) "arm twisting."
B) the "red dog" rule.
C) "discount blitzing!"
D) "moral suasion."
16) When the Federal Reserve was created, its most important role was intended
to be as
A) a storage facility for the nation's gold.
B) a lender-of-last-resort.
C) a regulator of bank holding companies.
D) none of the above.
17) Of the three policy tools that the Fed can use to change the money supply,
the one that does not affect the monetary base is
A) open market operations.
B) changes in the discount rate.
C) changes in the federal funds rate.
D) reserve requirements.
18) If the banking system has a large amount of reserves, many banks will have
excess reserves to lend and the federal funds rate will probably _____; if the
level of reserves is low, few banks will have excess reserves to lend and the
federal funds rate will probably _____.
A) fall; fall
B) fall; rise
C) rise; fall
D) rise; rise
19) Open market operations as a monetary policy tool have the advantages that
A) they occur at the initiative of the Fed.
B) they are flexible and precise.
C) they are easily reversed if mistakes are made.
D) all of the above.
20) Adjustment credit
A)
can be obtained with a telephone call.
B)
is expected to be repaid fairly quickly.
C) is the least common type of discount loan.
D) is all of the above.
E)
is only (a) and (b) of the above.
21) Adjustment credit
A) can be obtained with a telephone call.
B) is expected to be repaid fairly quickly.
C) is the least common type of discount loan.
D) is all of the above.
E) is only (a) and (b) of the above.
22) Discount policy
A) can be used to signal the Fed's intentions about future monetary policy.
B) can be important in preventing financial panics.
C) is the Fed's preferred method for changing the level of reserves in the
banking system.
D) all of the above.
E) only (a) and (b) of the above.
23) A financial panic was averted in October 1987 following "Black Monday" when
the Fed announced that
A) it was lowering the discount rate on extended credit.
B) it would provide discount loans to any bank that would make loans to the
security industry.
C) it stood ready to purchase common stocks to prevent a further slide in
stock prices.
D) all of the above.
24) The Fed is reluctant to use reserve requirements to control the money supply
and interest rates because
A) of their overly-powerful impact on the money supply.
B) they have the potential to create liquidity problems for banks with low
excess reserves.
C) frequent changes in reserve requirements complicate liquidity
management for banks.
D) of all of the above.
E) of only (a) and (b) of the above.
25) The most important advantage of discount policy is that the Fed can use it to
A) signal its intentions about future monetary policy.
B) perform its role as lender of last resort.
C) control the money supply.
D) punish banks that have deficient reserves.