Tools of Monetary Policy
• Open market operations
• Discount rate borrowed reserves
– LENDER OF LAST RESORT
• Reserve requirements
– Affect the money multiplier…don’t touch/don’t matter
• Federal funds rate—the interest rate on overnight
loans of reserves from one bank to another
– Primary indicator of the stance of monetary policy
Determined by Supply and Demand reserves
• As federal funds rate decreases,
…the opportunity cost of holding excess reserves falls
… the quantity of reserves demanded rises
 Downward sloping demand curve
Supply of reserves by Fed: Nonborrowed + borrowed reserves
Cost of borrowing from the Fed is the discount rate
•If iff < id, banks won’t borrow from the Fed;
• Borrowed reserves are zero  Supply curve is vertical
•As iff rises above id, banks will borrow more and more at id
• The supply curve is horizontal (perfectly elastic) at id
Demand for reserves by banks:
•Banks will hold any amount of excess reserves at ier
BuyEaseSellTighten
• Open market purchase federal funds rate
falls
• Open market sale  federal funds rate rises
• Impact of discount rate on federal funds rate
• Impact of reserve requirement on federal funds
rate
Response to an Open Market Purchase
Response to a Reduction in the Discount Rate
Response to a Change in Required Reserves
Open Market Operations
• Dynamic open market operations
• Defensive open market operations
– Repurchase agreements
– Matched sale-purchase agreements
• TRAPS (Trading Room Automated Processing System)
• Primary dealers
Advantages of Open Market Operations
•The Fed has complete control
•Flexible and precise
•Easily reversed
•Quickly implemented
Discount Policy
Primary credit—standing lending facility
• Secondary credit
• Seasonal credit
• Lender of last resort to prevent financial panics …
moral hazard problem
Cannot be controlled by the Fed;
the decision maker is the bank
Discount facility keeps the federal funds rate
from rising too far above the target
Reserve Requirements
• No longer binding for most banks
• Can cause liquidity problems
• Increases uncertainty
• Recommendations to eliminate
How the Federal Reserve’s Operating Procedures
Limit Fluctuations in the Federal Funds Rate