Tools of Monetary
Policy
Chapter 15
1
2
Tools of Monetary Policy

Open market operations


Changes in borrowed reserves


Affect the quantity of reserves and the
monetary base
Affect the monetary base
Changes in reserve requirements

Affect the money multiplier
3
Tools of the Fed and Fed Funds

Open market purchase
Increases reserves
 Supply up
 Federal funds rate down


Discount rate increase
Reduces discount loans
 Reduces reserves
 Supply down
 Federal funds rate up

4
Tools of the Fed and Fed Funds

Reserve requirement increase
Banks scurry to find reserves
 Demand for reserves rises
 Federal funds rate up

5
Federal Funds Market

Federal funds rate—the interest rate on
overnight loans of reserves from one bank
to another


Primary indicator of the stance of monetary
policy
Since the beginning of February 1994,
after every FOMC meeting, the Fed
announced the target federal funds rate as
monetary policy.
6
Demand in the Market
for Reserves
What happens to the quantity of reserves
(RR+ER) demanded by banks, holding
everything else constant, as the federal
funds rate, iff, changes?
 Excess reserves are insurance against
deposit outflows


The cost of holding ER is the interest rate
that could have been earned minus the
interest rate that is paid on these reserves, ier
7
Banks’ Demand for Reserves
1. R = RR + ER
2. iff opportunity cost of ER, ER 
3. Demand curve slopes down
4. Downward sloping demand curve becomes
flat (infinitely elastic) at ier
5.Since the fall of 2008 Fed has paid interest on
reserves at a level that is below the federal
funds rate target.
8
Banks’ Demand for Reserves
Federal
Funds rate
iff=ier
Reserves
9
Fed’s Supply of Reserves

Two components: non-borrowed and borrowed reserves

Cost of borrowing from the Fed is the discount rate

Borrowing from the Fed is a substitute for borrowing
from other banks

If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero

The supply curve will be vertical

As iff rises above id, banks will borrow more and more
at id, and re-lend at iff

The supply curve is horizontal (perfectly elastic) at id
10
Fed’s Supply of Reserves
iff=id
NBR
Reserves
11
Market for Reserves
Why does the
federal
funds rate
converge
to i*?
12
13
Discount Loans and Discount Rate
The discount rate charged for
primary credit (the primary credit
rate) is set above the usual level of
short-term market interest rates.
(Because primary credit is the
Federal Reserve's main discount
window program, the Federal
Reserve at times uses the term
"discount rate" to mean the primary
credit rate.) The discount rate on
secondary credit is above the rate on
primary credit. The discount rate for
seasonal credit is an average of
selected market rates.
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15
Open Market Operation
Open market purchase => iff down unless it is already equal to ier.
16
Advantages of Open Market
Operations
1.
2.
3.
4.
The Fed is in complete control of the
tool. Discount rate tool needs
cooperation of the banks.
OMO is flexible and precise; it can be
small or large.
OMO can be reversed easily.
OMO is fast. There is no time lag
between the evaluation and the
impact.
17
Open Market Operations
Dynamic OMO: To change the level of
reserves and the monetary base.
 Defensive OMO: To offset the
movements in other factors.
 Every day New York Fed evaluates the
federal funds market and buys or sells
securities to hit the desired federal
funds rate.

18
Open Market Operations

Temporary OMO
Repo: Fed purchases securities with the
understanding that the seller will buy them
back within two weeks.
 Reverse repo (Matched sale-purchase):
Fed sells securities with the understanding
that it will buy back them back.


Permanent OMO

Conducted after the temporary OMO.
19
Change in the Discount Rate
Discount rate down => iff may go down
20
Discount Policy
Primary credit allowed to healthy
banks without limit.
 Secondary credit extended to banks in
trouble at 50 basis points above the
primary rate.
 Seasonal credit given to small banks in
tourist and agricultural areas.

21
Discount Policy


The Fed’s discount policy is designed to
ward off financial crises.
The Fed is the lender of last resort.


Provides unlimited funds to banks in trouble.
It creates a buffer against bank panics and
financial meltdown.




Franklin National received 5% of total reserves in 1974.
Continental Illinois in 1984 received three times the
amount FN got.
The possible meltdown that could have occurred in
Black Monday (10/19/87) was avoided through Fed’s
lender of last resort function.
During the financial meltdown of 2008, reserves
increased from 100b to 1400b.
22
Moral Hazard of
Discount Policy
If banks believe that the Fed will bail
them out in times of trouble, they
will take unnecessary chances and
will engage in risky behavior.
 The Fed allowed many small banks
to fail.
 Too-big-to-fail policy is seen to be
unfair.

23
Change in Required Reserves
An increase in the
reserve ratio forces
banks to hold more
reserves at each
and every federal
funds rate.
Reserve ratio up =>
iff up
24
Reserve Requirements

Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the
reserve requirement the same for all
depository institutions

3% of the first $48.3 million of checkable
deposits; 10% of checkable deposits over
$48.3 million

The Fed can vary the 10% requirement
between 8% to 14%
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Reserve Requirements
This is a very powerful tool.
 If deposits are around $800 billion, a 1%
change in the reserve requirement can
have a $8 billion impact on the reserves
of the banking system.
 It is a blunt tool.
 It can create severe liquidity problems
for banks if the Fed raised the reserve
requirement.

26
Can Reserve Requirements Be
Abolished?
Each bank will have to keep reserves to
fulfill deposit outflows.
 The money supply process will work the
same way except that ER/D and rd will be
combined.
 Many central banks have either reduced or
eliminated the reserve requirement.

27
How the Fed Limits Fluctuations
28
Monetary Policy Tools
of the European Central Bank

Open market operations

Main refinancing operations
 Weekly


reverse transactions
Longer-term refinancing operations
Lending to banks
Marginal lending facility/marginal
lending rate (100 basis points above target)
 Deposit facility (100 basis points below target)

29
Monetary Policy Tools
of the European Central Bank

Reserve Requirements

2% of the total amount of checking deposits and other
short-term deposits

Pays interest on those deposits so cost of complying
is low
30
Jiazuo Xie Approach
Federal Funds Rate is determined in the
market where only banks appear as
supplier and demander of Excess
Reserves.
 Federal Reserve by increasing or
decreasing reserves can forecast the
change in ER


A constant ER/R ratio allows the Fed to
predict the change.
31
Jiazuo Xie Approach
Banks which are short of RR, demand
reserves from other banks.
 Their demand responds to the cost of
reserves: iff.


The higher the iff, the lower the demand
If iff exceeds id, they will borrow from the
Fed instead of Federal Funds market
 Because the Fed pays ier at iff=ier cost of
borrowing is zero; infinite demand.

32
http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
33
Demand for Federal Funds
id
ier
ER
34
Jiazuo Xie Approach
The supply of ER comes from banks that
already have enough RR.
 If iff=ier, banks rather keep the ER
 If iff>ier, banks will supply the Federal
Funds market, the higher the difference,
the higher the supply
 There is, however, a limited supply of ER
determined by the Fed

35
Supply of Federal Funds
iff
ier
ER
36
Fed Increases Nonborrowed
Reserves
iff
ier
ER
NBR1
NBR2
NBR3 NBR4
37
Fed Changes Reserve
Requirement
id
id
ier
ier
ER
ER
Reserve Requirement Increased
Reserve Requirement Decreased
38
Discount Rate Changed
id
id’
Discount Rate Decreased
Discount Rate Increased
39