Lecture 30:
Monetary policy – part
two
Mishkin Ch15 – part B
page 378-391
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2
Review

Open market operations
 NBR

 supply curve shift  interest rate
Discount policy
rate its impact depends on what
section of the supply curve contains the
intersection of D&S curves.
 Discount

Reserve requirements
 Demand
curve shift  interest rate
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Outline

Details about the three policy tools
 Open
market operations
 Discount
policy
 Reserve
requirements
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Importance of open market
operations
The most important monetary policy tool
 The primary determinants of changes in
interest rates and the monetary base
 The main source of fluctuations (especially
in the long-term) in the money supply

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Two types of open market
operations

Dynamic open market operations
 Intended
to change the level of reserves and
the monetary base

Defensive open market operations
 Intended
to offset movements in other factors
that affect reserves such as float and Treasury
deposits
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Open market operations


Trading mainly in U.S Treasury bills
Market for T-bills is
 Most
liquid
 Of largest trading volume  can absorb a large
trading amount without experiencing excessive price
fluctuations that would disrupt the market


Decision-making authority is FOMC
Actual execution is by the trading desk at the
Federal Reserve Bank of New York.
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A trading day
Manager of domestic open market
operations
 Primary dealers
 Reserve management strategy
 TRAPS (Trading Room Automated
Processing System)
 Repurchase agreements (repo)

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Advantages of
open market operations
The Fed has complete control over
the volume (compare with discount loans)
 Flexible and precise, used to any extent
 Easily reversed
 Quickly implemented, no administrative
delays

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Discount policy


1.
2.
3.
Discount window: the facility at which
banks can borrow reserves form the Fed.
Three types
Primary credit (standing lending facility):
healthy banks are allowed to borrow all they
want (usually overnight). A backup source of
liquidity. Upper limit of federal funds rate.
Secondary credit: to help troubled banks
Seasonal credit
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Lender of last resort




In additional to its use as a tool to influence
reserves and money supply, discount window is
also used to prevent financial panic
bank panic  collapse of banking system 
scares credit and low money supply  recession
creates moral hazard problem
Should the Fed extend discount window to
investment banks?
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Comments on discount policy
Used primary to perform role of lender of
last resort
 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

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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%

Reserve requirement tool is of less importance
now
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Effects of reserve requirements

1.
2.
If required reserve ratio increase
the amount of deposits that can be
supported by a given level of the
monetary base decreases  money
multiplier decrease  money supply
decrease
 increase demand of reserves  rise
federal funds rate
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Comments on reserve
requirements
No longer binding for most banks, which
hold excess reserves.
 Can cause liquidity problems for banks.
 Fluctuating reserve requirements increase
uncertainty for banks.
 Recommendations to eliminate this
requirement.

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New problem
If reserve requirement is eliminated,
demand for reserves may fall to zero, then
a central bank may not be able to exercise
control over interest rate.
 Solution: the channel or corridor system

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The channel/corridor system



Sets up a standing lending facility (lombard
facility) and stands ready to loan overnight any
amount banks ask for at a fixed interest rate
(lombard rate)  interest rate upper bound
Another standing facility is set up that pays
banks a fixed interest rate on any deposits they
would like to keep at the central bank  interest
rate lower bound
In between, the quantity supplied equals nonborrowed reserves
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