discount rate

Chapter 18
The Tools Of Federal
Reserve Policy
©Thomson/South-Western 2006
The Federal Reserve Goals and
 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)
The Reserve Requirement
 Can be considered a “tax” on banks because it
cause bank to hold a larger portion of their assets in
non-interest-earning form (reserves).
 Banks must maintain Reserve requirements or
required reserve ratios that the Fed set.
 Before 1980, reserve requirements only existed for
member banks and ratio for member banks were set
higher than non-members’. Now the ratio apply to all
Discount Window Policy
 A facility through which the Federal Reserve lend
reserves directly to depository institutions.
Funds borrowed are called discount loans
Funds are charged at a discount rate
Funds are short-term loan
Transaction is accomplished by a bookkeeping entry, bank
reserves increase with the amount of the loan.
Discount Window Policy
 Three classes of credit available:
 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
 Main function of the discount rate today is to set upper
limit on potential movement in the federal fund rate.
Open Market Operations:
Fundamental Considerations
 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
 Domain of 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.
 No matter what items it buys, Fed simply pays with a check written on itself.
 The Fed’s balance sheet impact will always be the same, regardless of the
type of asset the Fed purchases or sells.
Discovery Of Open Market Operations
And The Banking Act Of 1935
 Accidental Discovery
 Prior to 1920,the discount window was the only Fed policy
 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 bought U.S. government securities.
 When Fed purchased securities to compensate for
reducing interest income, interest rates in the market fell,
and credit conditions eased.
Impact of Open Market Ops
 The Fed conducts open market operation with
the desire to impact:
Short term interest rate
Bank reserves (R)
Monetary base (B)
Money aggregates (the M’s)
 The policy is conduct by selling and buy
Impact of Open Market Ops
 If the Fed sells $225 million in U.S. Treasury bills to
a government securities dealer
 reserves and the monetary base contract dollar-for-dollar,
 money supplies directly decrease by dollar-for-dollar
Impact of Open Market Ops
 When the Fed buys $400 million in Treasury bonds and bills
from banks,
 reserves and the monetary base expand dollar-for-dollar,
 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.
Impact of Open Market OpsSummary
 Sell and Buy to Banks
 reserves and the monetary
base contract/expand dollarfor-dollar,
 the money supply is not
directly or immediately
 This happens when banks
initiate the multiple deposit
 Sell and Buy to Dealers
 reserves and the monetary
base contract/expand dollarfor-dollar,
 the money supply is
immediately contract/expand
 The effect to money supply
will be even greater when
banks initiate the multiple
deposit contraction/expansion
Open Market Operations and the
Federal Funds Rate
 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. => lower
federal fund rate
 When the Fed sells securities, bank reserves
decline dollar-for-dollar. => higher federal fund
Figure 18-1
Purchase of Securities
Federal Funds Rate
The Effectiveness Of Open
Market Operations
 Impacts of Open Market Operations via two primary
 Impact on Bank Reserves, the Monetary Base, and the
Monetary Aggregates:
 The Fed can use 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 extends to yields on other assets.
Advantages of Open Market
 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.
Early Disadvantages of Open
Market Operations
 Signaling:
 Changes in the discount rate and reserve
requirements are superior to open market
operations in signaling policy changes to the
 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.
Technical Aspects Of Open
Market Operations
 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
 now, from protector to initiator
Outright Transactions versus
Repurchase Agreements
 Outright transactions
 The Fed uses outright purchases to bring about long-run
or permanent growth in reserves and the monetary
 Repurchase agreements (and reverse repurchase
 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.
Table 18-1
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