The Tools of Monetary Policy
Reserve Requirements, Discount
Rates, and Open Market
Operations…oh my!
Tools of Monetary Policy
• Open market operations
– Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves
– Affect the monetary base
• Changes in reserve requirements
– Affect the money multiplier
Target of Monetary Policy: Federal Funds Rate
- The interest rate on overnight loans of reserves from
one bank to another.
The Demand for Bank Reserves
• Why do banks demand reserves?
– The Fed requires banks to hold a certain percentage
of reserves as deposits
– Banks may choose to hold excess reserves to ensure
against increased deposit outflows.
• Every dollar held in reserve is not earning
interest as a loan
– The federal funds rate represents the interest that
could have been earned.
– As the federal funds rate falls, the opportunity cost of
holding reserves falls.
Reserve Demand
Federal
Funds
Rate
iff,2
iff,1
RD
R2
R1
Reserves
The Supply of Bank Reserves
• Bank Reserve Supply consists of two components:
– Non-Borrowed Reserves (NBR)
• Supplied to the banking system through the Fed’s open market
operations (i.e. the reserves banks earn by selling bonds to the
Fed.)
– Borrowed Reserves (BR)
• Reserves borrowed from the Fed by banks.
• The cost of borrowing from the Fed is the discount rate
(id).
• As long as the federal funds rate (iff) is less than the
discount rate, BR = 0
– It’s cheaper to borrow reserves from other banks than from the
Fed.
• When iff > id, it is cheaper to borrow from the Fed
– We assume that the Fed is willing to lend as much as banks are
willing to borrow at the discount window.
Federal
Funds
Rate
Reserve Supply
iff,3
RS
id
iff,2
iff,1
NBR
Reserves
Equilibrium in the Market for Reserves
Open Market Operations
• Suppose the Fed decided to purchase bonds on the
open market
– This would lead to an increase in NBR since the Fed is paying
for bonds with money (that then gets classified as “non-borrowed
bank reserves)
– The increase in NBR causes the supply of reserves held by
banks to shift right
– There will be a decrease in the federal funds rate since banks
will be more willing to lend to one another at lower rates.
• Now suppose the Fed sold bonds on the open market
– There would be a decrease in NBR since the Fed is replacing
vault cash with bonds (not classified as reserves)
– The supply of reserves will shift left as bank reserves fall
– This forces the federal funds rate up
– If the cut in NBR is large enough then the federal funds rate may
go as high as the disocunt rate
– It will not exceed the discount rate, since any ff rate above id will
no longer be binding (banks will just borrow directly from the Fed
at iff>id)
An Open Market Purchase
Federal
Funds
Rate
id
RS1
RS2
iff,1
iff,2
RD
NBR1
NBR2
Reserves
An Open Market Sale
Federal
Funds
Rate
id
iff,2
iff,1
RS2
RS1
RD
NBR2 NBR1
Reserves
Advantages of Open Market Operations
• The Fed has complete control over
the volume
– Compare this to discount lending, in which the Fed sets the price of
borrowing, but does not directly control how much banks actually
borrow.
• Flexible and precise
– Can be used to enact both small and large changes in the monetary
base.
• Easily reversed
– Mistakes can be quickly corrected in a way that would not have been
possible with reserve requirements or discount lending.
• Quickly implemented
– There is no administrative delay to conducting open market operations.
Orders go to the trading desk in New York and they are executed
immediately.
Changing the Discount Rate
• Changing the discount rate will only affect
reserves (and thus the money supply) and the
federal funds rate if…
– It is lowered below the federal funds rate
– It was previously below iff, but is raised above iff.
• The Fed purposefully keeps the discount rate
above iff
– As a result, changes in the discount rate rarely have
an effect on the money supply.
– Rather, the discount rate has been used at times to
inject liquidity into the financial system (Stock Market
Crash in 10/87, directly after 9/11)
Lowering the Discount Rate (Non-Binding)
Federal
Funds
Rate
Id,1
RS1
Id,2
iff,1
RS2
RD
NBR1
Reserves
Lowering the Discount Rate (Binding)
Federal
Funds
Rate
RS1
id,1
iff,2 = id,2
iff,1
RS2
id,2
RD
NBR1
R2
Reserves
The Fed as a Lender of Last Resort
• One of the most important functions of the Fed is its role as a lender
of last resort to the banking system.
• Banks in need of liquidity may borrow from the Fed at the discount
rate.
• A large increase in the demand for reserves (demand for liquidity) by
banks is tempered by the Fed’s ability to step in and lend at the
discount rate.
– The federal funds rate is actually capped by the discount rate.
• While this role has helped avert some bank panics (since FDIC
could not by itself cover all losses from a bank panic), it may have
created moral hazard costs
–
–
–
–
Banks know they will be bailed out by the Fed if they fail
Encourages them to take on high-return/high-risk loans
If the loan comes in, they keep all the profits
If the loan fails, the Fed subsidizes the losses.
Changing the Reserve Requirement
• When the Fed requires a larger percentage of deposits to be held in
reserve, bank’s demand a larger quantity of reserves
– Increasing the reserve ratio shifts the demand for reserves to the right
– Decreasing the reserve ratio shifts the demand for reserves left.
• An increase in reserve demand pushes up the federal funds rate
and lowers the money supply (lower multiplier)
• In practice, the reserve requirement is not the most effective policy
tool
– Many banks hold excess reserves due to classification rules
– An increase or decrease in the reserve requirement may not alter their
behavior.
– Changing the reserve requirement will only affect the federal funds rate
and money supply if the requirement is binding.
– For banks in which the requirement is binding, raising it can cause
severe liquidity problems.
– In fact, many countries have abandoned reserve requirements as a
policy tool (Australia, Canada, New Zealand)
Raising the Reserve Requirement (Binding)
Federal
Funds
Rate
RS1
Id,1
iff,2
iff,1
RD2
RD1
NBR1
Reserves
The Channel/Corridor System
• Without reserve requirements, can a central bank still
control interest rates?
• If banks don’t hold reserves, then how can the Fed
induce changes in interest rates through changes in
reserves?
• One solution is the channel/corridor system
– Banks set up one facility that stands ready to lend to banks at a
guaranteed lending rate (il)
– This facility will supply as many reserves to banks as they desire
at this rate
– Another facility is set up that accepts deposits from banks and
pays them a guaranteed interest rate on these deposits (ir)
– This facility will accept an unlimited amount of deposits.
– These two interest rates present the lower and upper bound for
the federal funds rate negotiated between banks.
The Channel System