Chapter 19
The
Instruments
of Central
Banking
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Learning Objectives
• Explain the level and determinants of reserve
requirements
• Understand the use of the discount window
• Realize the importance and use of open market
purchases and open market sales
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19-2
Introduction
• Bank lending and money supply are related by some
multiple to the level of bank reserves
• Federal Reserve exercises control over bank lending
and money supply by altering the level of reserves in
the system and influencing the deposit creation
multiplier
• Fed accomplishes these objectives by changing the
reserve requirements and by changing the actual
amount of reserves held
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19-3
Reserve Requirements
• Within limits established by Congress, Federal Reserve
can specify reserve requirements banks and deposittype institution must hold against deposits.
• This applies even if the institution is not a member of
the Federal Reserve
• Reserves can be in form of vault cash or deposits in
regional bank—do not earn interest
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19-4
Reserve Requirements (Cont.)
• Percentage of required reserves varies with
type of account
– Demand Deposits
• Can range between 8% to 14%
• 3% of the first $42.1 million of demand deposits
• Currently set at 10% on deposits above $42.1 million
– Business-owned time and savings deposits
• Can range between zero to 9%
• Currently set at 0%
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19-5
Reserve Requirements (Cont.)
• Effect of lowering the reserve requirement
– Automatically increases all banks’ excess reserves
– Increases demand deposit through multiple lending
– However, the ultimate impact depends on banks
desire to make loans— element of discretion
– Expands the money supply
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19-6
Reserve Requirements (Cont.)
• Effect of raising the reserve requirement
– Decrease banks’ excess reserves and may force them
to take steps to correct a deficit reserve position
– Restrains lending and deposit creation
– Contracts the money supply
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19-7
Reserve Requirements (Cont.)
• Even without legal reserve requirements,
banks would still need to hold cash reserves as
vault cash or on deposit with Federal Reserve
– Cash to meet customer withdrawals
– Balances at Fed to clear checks
– Without legal reserve requirements, it is likely the
multiplier relationship between reserves and money
supply may fluctuate considerably
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19-8
Discounting and the Discount Rate
• Discount rate—amount the Federal Reserve charges
banks for a temporary loan of reserves to cover a
deficiency
• Ability to borrow means that a bank does not need to
call in loans or sell securities (reduce money supply)
to deal with a deficit
• All depository institutions have access to borrowing at
the discount window, even if not a member of the Fed
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19-9
Discounting and the Discount Rate
(Cont.)
• Federal Reserve influences banks’ desire to borrow
reserves by changing discount rate
– Lower the rate—more borrowing, increase money supply
– Raising the rate—less borrowing, decrease money supply
• Actual borrowing (changes in money supply)
depends on banks’ willingness to use this facility of
the FED
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19-10
Discounting and the Discount Rate
(Cont.)
• Quantity of discount lending
– Central bank is the ultimate source of liquidity in the
economy
– Lender of last resort—Discount provision was
originally established to permit banks to borrow
from the Fed when threatened with cash drains
– Discount facility should not be used too often to get
banks out of reserve difficulties, primarily when a
bank is temporarily short of cash
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19-11
Discounting and the Discount Rate
(Cont.)
• Quantity of discount lending (Cont.)
– Banks should manage affairs so they do not need to
use discount facility very often
– Discounting is a privilege, not a right
– Banks are supposed to use discount facility because
of need, not to make profit
– Prior to 2003, the Fed used extensive administrative
and surveillance procedures to prevent “abuse”
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19-12
Discounting and the Discount Rate
(Cont.)
• Quantity of discount lending (Cont.)
– However, under the new discount lending procedure,
the Federal Reserve charges a penalty rate above
short-term market rates
– In return, the Fed removes conditions and
restrictions for banks that qualify for primary credit
– The intent of the new policy is to improve access to
discount window borrowing by removing the
negative connotation of borrowing from the Fed
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19-13
Discounting and the Discount Rate
(Cont.)
• Quantity of discount lending (Cont.)
– In March 2008, the Federal Reserve opened the
discount window to investment banks
– This expanded role of lender of last resort was aimed
at preventing the collapse of Bear Stearns which
would have lead to panic withdrawals from all
financial institutions
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19-14
Discounting and the Discount Rate
(Cont.)
• Discount Rate and Market Interest Rates
– Discounting is discouraged when the rate is above other
short-term rates, and encouraged when it is below
– In some countries, the discount rate is often kept above shortterm market rates—a penalty rate as a means of restraining
excessive borrowing
– In US, discount rate is usually below Treasury bill rate so Fed
relies on surveillance to prevent “abuse of the privilege”
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19-15
Discounting and the Discount Rate
(Cont.)
• Relationship between discount rate and other
market interest rates
– Discount rate is an “administered” rate, set by Fed
– Weak linkage between discount rate and reserves and money
supply
– Figure 19.1
• Change in the discount rate generally occurs after a change in the
Treasury bill rate or federal funds rate
• Also shows, after January 2003, the new primary credit rate is now
above the rate on three-month T-bill
– Reactive rather than proactive tool
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19-16
FIGURE 19.1 Movements in the discount
rate tend to come after Treasury bill rates.
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19-17
Discounting and the Discount Rate
(Cont.)
• Relationship between discount rate and other
market interest rates (Cont.)
– “Announcement” effect
• An unexpected change in discount rate will signal that the
Fed desires to change monetary policy
• The public, reacting to this expectation, takes action that
causes the Fed’s desire to occur
– Change in the discount rate usually confirms
what is happening, but does not initiate it
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19-18
Open Market Operations
• Fed’s most important tool to alter reserves
• About $3,200 billion worth of marketable government
securities outstanding
– Held by individuals, corporations, and financial institutions
– Used by the US Treasury to borrow to finance budget deficits
– The sale of government securities by the Treasury is
independent of the Fed and may work counter to the
Fed’s monetary policy
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19-19
Open Market Operations (Cont.)
• Open market operations—Buying and selling
government securities to influence bank reserves
– Purchase securities—expand reserves (money
supply)
– Sell securities—contract reserves (money supply)
– Does not matter whether Fed sells/purchases
government securities to/from a bank, other financial
institution, or individual—same result, assuming the
simple multiplier
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19-20
Open Market Operations (Cont.)
• Modifications to the simple multiplier discussed
in appendix to Chapter 19 will impact the
ultimate relationship between changes in
reserves and the money supply
• The Federal Reserve permits the market to set
the purchase/sales price of government
securities and, thereby, altering the rate of
interest on that class of securities
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19-21
Conducting Open Market
Operations
• The Federal Open Market Committee (FOMC) in
Washington decides on general aims and objectives of
monetary policy and sets monetary targets (bank
reserves, money supply, and interest rates)
• Buying/selling of government securities takes place at
Federal Reserve Bank of New York
• Located in the heart of the New York financial district
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19-22
Conducting Open Market
Operations (Cont.)
• A day at the trading desk
– Open Market Account manager keeps close contact with
securities dealers to get the “feel of the market” and what is
needed to meet targets
– Uses the federal funds rate as a barometer of reserve supply
relative to demand
– Tries to predict expected currency movements that can affect
reserve position of the banking system
– Contacts the US Treasury to determine what is happening to
Treasury balances in tax and loan accounts at commercial
banks
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19-23
Conducting Open Market
Operations (Cont.)
• A day at the trading desk (Cont.)
– Based on FOMC targets and projected changes in
reserve position of the banking system, decides on
appropriate sales/purchases of government securities
– If changes in bank reserves are considered to be
temporary, the open market account manager will
use repurchase agreement to offset these transitory
reserve movement
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19-24