Chapter 18
Tools of Monetary Policy
Using Interest Rates to Stabilize the
Domestic Economy
Monetary Policy & Interest Rates:
The Big Questions
1. What are the tools used by central banks
to meet their stabilization objectives?
2. How are the tools linked to the central
bank’s balance sheet?
3. How is the interest rate target chosen?
From Chapter 17 : The Fed can control the MB but
cannot precisely control the Money Supply
M1 = m x MB
M1 =
1+(C/D)
rD + (ER/D) + (C/D)
 MB
Households can change C/D, causing the money
mutiplier (m) and M1 to change
Banks can change ER/D, causing m and M1 to
change
The Fed’s “Traditional” Policy Tools
• Open Market Operations - OMO.
• Discount Rate - the interest rate the Fed
charges on the loans it makes to banks
• Reserve Requirement - the level of balances a
bank is required to hold either as vault cash on
deposit or at a Federal Reserve Bank
• NOTE: The primary instrument of monetary
policy is the Federal funds rate: the interest rate
on overnight loans of reserves from one bank
to another
A New (fourth) Tool
• Interest on Reserves - required and excess
• Currently set at 0.25%
• Often referred to as IOER – Interest on Excess
Reserves.
• The Financial Services Regulatory Relief Act of
2006 authorized the Federal Reserve to begin
paying interest on reserve balances of depository
institutions beginning October 1, 2011.
• The Emergency Economic Stabilization Act of
2008 accelerated date to October 1, 2008.
More New Tools in the Works
• http://www.federalreserve.gov/monetarypo
licy/policytools.htm
18-7
Open Market Operations
• The Fed buys and sells U.S. (Gov’t) securities in the
secondary market in order to adjust the supply of
reserves in the banking system.
• Traditionally short-term T-bills.
• This changed with “quantitative easing”. Fed has
purchased long-term T-bonds and MBS
• Most flexible means of carrying out monetary policy.
• With OMO the Fed does not participate directly in the
Federal Funds market.
OMO and the Federal Funds Market
• Federal funds are reserve balances that
depository institutions lend to one another.
• The most common federal funds transaction
is an overnight, unsecured loan between two
banks. (bilateral agreements)
• Note that without the FF market, banks would
need to hold a substantial amount of excess
reserves.
Advantages of OMO
• Implemented quickly
• Fed has complete control
• Flexible and precise
• Easily reversed
Two Types of Open Market Operations
Permanent OMOs:
“involve the buying and selling of securities
outright to permanently add or drain
reserves available to the banking system.”
- Mishkin refers to as “dymanic”
Temporary OMOs:
“involve repurchase and reverse repurchase
agreements that are designed to temporarily
add or drain reserves available to the banking
system”
- Mishkin refers to as “defensive”
Open Market Operation - Repo
• With a repurchase agreement ("repo"), the
Fed buys securities from dealers who
agrees to buy them back, typically within
one to seven days.
• Repos add reserves to the banking system and
then withdraws them.
• Can be viewed as the Fed temporarily
lending reserves to dealers with the dealers
posting securities as collateral.
Open Market Operation – Reverse Repo
• With a reverse repo, the Fed sells securities
to dealers and agrees to buy back in one to
seven days.
• Reverse repo drain reserves and later add them
back.
• Can be viewed as the Fed temporarily borrowing
reserves from dealers with the Fed posting
securities as collateral.
• Traditional use of REPO is to offer fixed quantity
and let i adjust.
• Fixed Rate ON RRP – fixed rate overnight reverse
repo is different
http://www.newyorkfed.org/index.html
How is the Federal Funds Rate Determined?
Supply and Demand for Reserves
IOR
Demand for Reserves
• Why Do banks hold Reserves?
• Required
• Excess reserves are insurance against deposit
outflows
• The cost of holding this insurance is the
interest rate that could have been earned
minus the interest rate that is paid on these
reserves, ior , (IOER)
• For example, if T-bill rate = .5% and IOER =
.25%, opportunity cost = .25%
http://www.treasury.gov/resourcecenter/data-chart-center/interestrates/Pages/TextView.aspx?data=yield
Demand for Reserves
• As the federal funds rises above the rate paid
on excess reserves, the opportunity cost of
holding excess reserves increases and the
quantity of reserves demanded decreases
• Downward sloping demand curve for reserves.
• The demand curve becomes flat (infinitely
elastic) at IOR
• IOR acts as a floor on the federal funds rate.
Supply of Reserves
• Two components to the supply of
reserves: non-borrowed and borrowed
reserves
• The discount rate (id) is the cost of
borrowing from the Fed. The interest
rate on loans from the Fed.
• Borrowing from the Fed is an
alternative to borrowing from other
banks in the Federal Funds market.
Supply for Reserves
• If the Federal Funds rate (iff )< Discount rate (id),
banks will not borrow from the Fed and borrowed
reserves are zero
• The supply curve will be vertical at the level of
non-borrowed reserves (NBR).
• As iff rises above id, banks will borrow more and
more at id, (NOTE: they can lend at iff )
• The supply curve is horizontal (perfectly elastic)
at id
How OMO Affects the Federal Funds Rate
• Open market operations shift the supply curve of
reserves.
• An open market purchase causes the federal
funds rate to fall whereas an open market sale
causes the federal funds rate to rise when
intersection occurs at the downward sloped
section.
Response to an Open Market Purchase
Figure 2 Response to an Open Market Operation
Federal
Funds Rate
id
i ff1
i ff2
Federal
Funds Rate
R1s
id
R 2s
R1s
R 2s
1
2
1
2
R1d
ior
NBR1 NBR2
Quantity of
Reserves, R
Step 1. An open market purchase shifts the
supply curve to the right …
Step 2. causing the federal funds rate to fall.
(a) Supply curve initially intersects demand
curve in its downward-sloping section
iff1  iff2  ior
R1d
NBR1 NBR2
Quantity of
Reserve, R
Step 1. An open market purchase shifts the supply
curve to the right …
Step 2. but the federal funds rate cannot fall below
the interest rate paid on reserves.
(b) Supply curve initially intersects
demand curve in its flat section
Response to a Change in the Discount Rate
Federal
Funds Rate
Federal
Funds Rate
id1
R1s
id2
R2s
iff1
1
1
iff1

R s1
id1
2
iff2  id2
R d1
ior
ior
BR1
Rs2
R d1
BR2
NBR
Quantity of
Reserves, R
Step 1. Lowering the discount rate
shifts the supply curve down…
Step 2. but does not lower the
federal funds rate.
(a) No discount lending (BR = 0)
NBR
Quantity of
Reserves, R
Step 1. Lowering the discount rate
shifts the supply curve down…
Step 2. and lowers the federal
funds rate.
(b) Some discount lending (BR > 0)
Response to a Change in Required Reserves
Federal
Funds Rate
R1s
id
i ff2
i ff1
2
Step 1. Increasing the reserve requirement
causes the demand curve to shift to the right . . .
1
Step 2. and the federal funds rate rises.
R 2d
ior
R1d
NBR
Quantity of
Reserves, R
Response to a Change in the Interest Rate on Reserves
Federal
Funds Rate
Federal
Funds Rate
Rs
id
i
1
ff
i ff2  i or2
1
R 2d
i or2
i or1
R1d
NBR
Quantity of
Reserves, R
Step 1. A rise in the interest rate on reserves
1
from
to
i or
i or2 ...
Step 2. leaves the federal funds rate unchanged.
1
(a) initial i ff1 > ior
Rs
id
i ff1  i or1
2
R 2d
R1d
1
NBR
Quantity of
Reserves, R
Step 1. A rise in the interest rate on
reserves
to
i or1
i or2from
...
Step 2. raises the federal funds
i ff2 rate
 i or2 .to
1
(b) initial i ff1 = ior
Application: How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate
• Supply and demand analysis of the market
for reserves illustrates how an important
advantage of the Fed’s current
procedures for operating the discount
window and paying interest on reserves is
that they limit fluctuations in the federal
funds rate.
Figure 6 How the Federal Reserve’s Operating Procedures
Limit Fluctuations in the Federal Funds Rate
Federal
Funds Rate
Rd
R
d*
R d 
iff  id
Rs
Step 1. A rightward shift of the demand
curve raises the federal funds rate to a
maximum of the discount rate.
i ff*
Step 2. A leftward shift of the demand curve
lowers the Ederal funds rate to a minimum of
the interest rate on reserves.
iff  ior
NBR*
Quantity of
Reserves, R
Conventional Monetary Policy Tools
• During normal times, the Federal Reserve
uses the three Traditional tools of monetary
policy—open market operations, discount
lending, and reserve requirements—to
control the money supply and interest rates,
and these are referred to as conventional
monetary policy tools.
Discount Lending – Lender of Last Resort
• Lending to commercial banks has not
been an important part of the Fed’s dayto-day monetary policy.
• However, lending is the Fed’s primary
tool for ensuring short-term financial
stability, for eliminating bank panics, and
preventing the sudden collapse of
institutions that are experiencing financial
difficulties.
•
On Sept. 12, 2001, banks borrowed $45.5
billion from the Fed. (In addition, the Fed
purchased $80 billion in Gov’t securities).
Discount Lending
Types of Loans –
• Primary Credit (sound credit)
• Short-term, typically overnight
• Historically 100 basis points above target Fed Funds
Rate. Currently 50 bp
• Secondary Credit
• For banks that do not qualify for primary credit
• Hisorically 150 basis points above target Fed Funds
Rate.
• Seasonal Credit
• Small banks with cyclical farm loans
• http://www.frbdiscountwindow.org/index.cfm
Advantages and Disadvantages of Discount
Policy
• Used to perform role of lender of last resort
• Important during the subprime financial crisis
of 2007-2008.
• Cannot be controlled by the Fed; the decision
maker is the bank
• Discount facility is used as a backup facility to
prevent the federal funds rate from rising too far
above the target
• Does the “Lender of Last Resort” fucntion to
prevent financial panics create a moral hazard
problem?
Reserve Requirements
• Depository Institutions Deregulation and Monetary
Control Act of 1980 (MCA) subjected all banks to
the same reserve requirements as member banks
• Set reserve requirement within a range of 8 to 14
percent for transactions deposits and 0 to 9 percent
for non-transactions deposits.
• Fed now pays interest on reserves.
• To reduce burden on small banks, first few million $
in DD are exempt, then 3% up to about $71 mil.,
then 10%
• Note: Fed’s use of the reserve requirement in 1936.
Reserve Requirements
Advantages
1. Powerful effect
Disadvantages
1. Without excess reserves, small changes
have very large effect on Ms
2. Not binding with so many banks holding
excess reserves
3. Raising causes liquidity problems for banks
4. Frequent changes cause uncertainty for
banks
On the Failure of Conventional Monetary Policy
Tools in a Financial Panic
• When the economy experiences a full-scale
financial crisis, conventional monetary policy
tools cannot do the job, for two reasons.
• First, the financial system seizes up to such an
extent that it becomes unable to allocate capital
to productive uses, and so investment spending
and the economy collapse.
• Second, the negative shock to the economy can
lead to the zero-lower-bound problem.
Nonconventional Monetary Policy Tools
During the Global Financial Crisis
• Liquidity provision: The Federal Reserve
implemented unprecedented increases in
its lending facilities to provide liquidity to
the financial markets
• Discount Window Expansion
• Term Auction Facility
• New Lending Programs
Nonconventional Monetary Policy Tools
During the Global Financial Crisis
• Large-scale asset purchases: During the
crisis the Fed started three new asset
purchase programs to lower interest rates
for particular types of credit:
• Government Sponsored Entities Purchase
Program
• QE2
• QE3
The Expansion of the Federal Balance Sheet,
2007-2014
Operational Policy at the European Central
Bank http://www.ecb.int/home/html/index.en.html
• Main Refinancing Rate: Set via weekly auction of 2-week
repurchase agreements. Inject and withdraw reserves in the
banking system. Comparable to the Fed’s target FFR.
• Marginal Lending Facility
• 100 basis points above target refinancing rate
• Deposit Rate: Banks earn interest on excess reserves.
• Reserve Requirements
• 2% applied to checking accounts
• Overnight Cash rate.( Market FFR)
Operational Policy at
the European Central Bank
Full Allotment, Fixed Rate Over
Night Reverse Repo
New Policy Tool
Fed Reverse Repo
• Under a Reverse Repo with the Fed, bidders
“buy” securities from the Fed paying with
reserves
– they lend reserves to the Fed.
• Currently the Fed announces the quantity of
reserves it wants to borrow and buyers bid a
rate at which they will lend reserves to the
Fed.
– Q is fixed and interest rate varies
New Facility: The Interest Rate is Fixed
• Full Allotment, Fixed Rate Over Night Reverse Repo
• The Fed will announce a fixed-rate to be paid on
reverse repo loans.
– Interest rate is fixed and Q varies (up to a some max)
• This differs from the current process where the Fed
determines the amount of reserves it wants to
remove from the banking system and let’s the
interest rate vary in the Fed funds market
• The Fed is moving to a paradigm where short-term
interest rates are controlled directly.
Main Features
• Fed announces a fixed rate
• Fed will borrow as much as a counterparty wants to lend
up to a maximum.
• Broad list of counterparties including a large number of
banks, money market mutual funds and US Agencies
FNMA, FHLMC and FHLB.
– Not just Primary dealers
• The Fed will control short-term interest rates
IOER has not acted as a floor on the FFR
• Agencies can lend in the Fed funds market but they can not
deposit funds at the Fed and earn interest.
• MMMF lend to banks (repo or CP) and the banks deposit at
Fed and earn IOER.