Chapter 15
Tools of Monetary Policy
1
Introduction


Who controls the Monetary Policy?
What is the main goal for the Central Bank?
Stabilizing the economy through controlling…………using…………….

What are the tools of the Monetary Policy?
A.
B.
C.

What is the expansionary Monetary Policy vs. the
contractionary Monetary Policy?
2
Demand and Supply in The Market for Reserves
and the Interbank Rate


The reserves market is where the interbank rate is determined.
The market explains the relationship between the interbank rate
(Federal Fund Rate) and Reserves.
1) Demand Curve for Reserves

ER is an insurance against deposits outflow,& the cost of holding
ER is their opportunity cost (the interest rate that could have been
earned on lending these ER( iff ))

The higher iff the higher the opportunity cost of holding reserves
(ER), and the lower the quantity of R demanded.
(graph)
3
Demand and Supply in The Market for Reserves
and the Interbank Rate
2) Supply Curve for Reserves


As discount lending increases, the quantity of reserves supplied
(Rs) to the banking system also increases.
Discount lending is a substitute for borrowing from commercial
banks at the rate of iff .
(graph)
3) Equilibrium at the Reserves Market
The equilibrium interbank rate is determined at the point of
intersection between the reserves supply and demand curves.
(graph)
4
How Changes in the Tools Affect the Interbank Rate
1. OMOs:
A purchase of bonds by the central bank increases the
quantity supplied of reserves in the reserves market, which
shifts the reserves supply curve to the right.
(graph)
Result:
An open market purchase lowers the interbank rate, while an
open market sale causes the interbank rate to rise.
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2. Discount Lending
An increase in discount lending leads to an increase in the quantity supplied of
reserves, which shifts the reserves supply curve to the right.
Case One
(graph)
Case two
(graph)
Result:
An increase in discount lending causes the interbank rate to fall (when Demand and
Supply curves intersect on the flat section), while a decline in discount lending
causes the interbank rate to rise.
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3. Reserve Requirements
A rise in the required reserve ratio increases the quantity
demanded of reserves, which shifts the reserves demand
curve to the right.
(graph)
Result:
A decline in the required reserve ratio causes the interbank
rate to fall, while an increase in the required reserve ratio
causes the interbank rate to rise.
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First: Open Market Operations
They are the most important monetary policy tool because
they are the primary determinants of changes in interest
rates and the monetary base, which is the main source of
fluctuations in the money supply.
Types of Open Market Operations
Dynamic OMOs: intended to change the level of reserves
and the MB.
Defensive OMOs: intended to offset movements in other
factors that affect reserves and the MB.
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Advantages of OMOs
1. The central bank can start them and has complete
control over the size of operations and securities traded.
2. They are flexible and precise.
The central bank can change the level of reserves and
MB by any desired amount.
3. They are easily reversed.
If a mistake is made, it can be immediately reversed.
4. They can be implemented quickly because they
involve no administrative delays.
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Second: Discount Policy

Primarily involves changes in the discount rate.
 It affects the money supply by affecting the volume of discount loans,
where a rise in discount loans increases reserves, MB, and money supply.
 The discount loans lent to banks are three types or windows :
Primary Credit:
This type of discount lending plays an important role in monetary
policy. It involves good credit banks that can borrow all they need
from this widow. Interest rate charged is the discount rate.
Secondary Credit:
Given to banks with financial trouble and sever liquidity problems.
Interest rate charged is 0.5% above the discount rate.
Seasonal Credit:
Given to banks with seasonal patterns of deposits. Interest rate charged
is linked to the average federal fund rate.
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Second: Discount Policy
Lender
of last Resort:
Discount lending prevents financial panics by providing
banks with reserves when no one else would do so.
Announcement Effect:
Discount lending can be used to signal the central bank’s
intentions about future monetary policy.

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Advantage of Discount Lending
Performing the role of lender of last resort, therefore
strengthening financial institutions.
Disadvantages of Discount Lending
No guarantee that banks will follow the announcement of
the discount policy because the decision of borrowing is
for commercial bank. Thus, this tool is not completely
controlled by the fed compared to OMOs.
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Third: Reserve Requirements
They affect money supply by affecting reserves and the
money multiplier.
A rise in reserve requirements:
1) reduces excess reserves and banks’ ability to lend,
2) increases the demand for reserves,
3) increases the interbank rate, and
4) reduces the money supply.
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Advantage of Reserve Requirements
It affects all banks equally and has a powerful effect on
money supply.
Disadvantages of Reserve Requirements
1. Not practical because small changes in required reserve
ratio leads to large changes in money supply, making
mistakes too costly.
2. Raising reserve requirements may cause liquidity
problems for banks with low excess reserves.
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