Chapter 9 - Monetary Policy Tools Money and Banking – Michael Brandl ©2017 Cengage Learning

9-1a Open Market Operations as a Monetary Tool Most Flexible and most often used of the FED’s tools in the conduct of monetary policy Buying and selling of government securities to influence the level of bank reserves Contractionary OMO Expansionary OMO FED is not buying government securities directly from the Government but to and from a private entity Money and Banking – Michael Brandl ©2017 Cengage Learning

9-2 Monetary Policy Tools: Discount Window and Term Auction Facility Primary Credit Secondary Credit Seasonal Credit Stigma Effect

9-2a When Traditional Policies Fail Stigma effect during the summer of 2007 Banks must decide whether to lend the increases in reserves to customers Firms and households would not be able to borrow funds needed for desired level spending Term Auction Facility: a combination of OMOs and discount window lending Money and Banking – Michael Brandl ©2017 Cengage Learning

9-3a Emergency Lending Problems arise in Financial Markets well beyond just depository institutions. Investment banks, insurance companies did not have a lender of last resort Fed created a collection of short-term lending facilities Term Securities lending Facility Primary Dealer Credit Facility Asset-Backed Commercial Paper Money market Liquidity Facility Money Market Investor Funding Facility Commercial Paper Funding Facility Term Asset-Backed Securities Loan Facility Money and Banking – Michael Brandl ©2017 Cengage Learning

9-3b Quantitative Easing QE 1 (11/2008 -3/2010) – Fed announces the purchase of $100B direct debt from Fannie Mae, Freddie Mac and The Federal Home Loan Banks 500B of mortgage backed securities Goal is NOT to reduce interest rates but to inject liquidity into the markets The interest rate on a 30 year fixed rate drops by a whole 1 point Money and Banking – Michael Brandl ©2017 Cengage Learning

9-3b Quantitative Easing (cont’d) QE2 (11/2010 – 6/2011) FED buys 900B of Treasury Securities in a range of 6-30 year maturities QE3: June 2013 – Bernanke announces a tapering of Quantitative easing contingent on continued and improved economic conditions Money and Banking – Michael Brandl ©2017 Cengage Learning

9-3c Required Reserve Ratio Could be a useful monetary policy tool; In reality it is seldom used. Customer balances above a certain amount are swept out of a checking account and put into overnight accounts paying interest. The rise of ATM’s: 70% of banks voluntarily have reserves that exceed the level of Required Reserves Money and Banking – Michael Brandl ©2017 Cengage Learning

9-4a Irving Fisher on Money Demand 1911 American Economist: Irving Fisher hypothesized 2 ways Money used in transactions, how often each unit of money is used in a year The total amount of transactions as the amount of goods & services bought within a year and the price level Price Level x Transactions = GDP Money and Banking – Michael Brandl ©2017 Cengage Learning

9-4b John Maynard Keynes on Money Demand 3 motives for people to hold or demand money all of which revolve around interest rates Liquidity preference theory Transactional demand for money Precautionary demand for money Speculative demand for money Money and Banking – Michael Brandl ©2017 Cengage Learning

9-5a Liquidity Traps As an economy shows signs of weakness: Businesses hold cash Banks fear borrowers won’t repay loans The economy slows not because of lack of liquidity or lack of cash but due to lack of Spending Self-fulfilling prophecy Money and Banking – Michael Brandl ©2017 Cengage Learning

9-5a Liquidity Traps (continued) Keynes famously argues that contractionary monetary policy works to slow the economy Expansionary monetary policies are not effective in getting an economy out of a slow down Money and Banking – Michael Brandl ©2017 Cengage Learning

9-5b Government Budget Deficits and Monetary Policy Monetization of public debt: Government either cannot or does not want to sell its bonds in the open market. Due to high level of default risk Government may not want the outside world to know how much it needs to borrow When a government monetizes public debt, it is essentially forcing the banking system to create money for the government to spend. Money and Banking – Michael Brandl ©2017 Cengage Learning

9-6a ECB’s OMO: Tenders and Reserve Transactions European Central Bank (ECB) – has four different tools Main refinancing operations Long term refinancing Fine Tuning operations Operations that provide structural liquidity Money and Banking – Michael Brandl ©2017 Cengage Learning

9-6a ECB’s OMO: Tenders and Reserve Transactions (continued) Standard Tenders are settled in 24 hours Quick tenders are normally executed within 90 minutes of the announcement of tender, and the funding takes place immediately after the announcement of who has won the auction. Money and Banking – Michael Brandl ©2017 Cengage Learning

9-6b ECB’s Deposit Facility This facility is available for institutions with excess funds; it allows them to put the funds on deposit with the ECB and earn interest. The interest rate on the deposit facility is normally 100 basis points below the ECB’s required minimum bid in open market or refinancing operations. There is a two percentage point “corridor” between the interest rate floor provided by the deposit facility and the marginal lending rate ceiling Money and Banking – Michael Brandl ©2017 Cengage Learning

9-6c ECB’s Minimum Reserve Balances The amount of reserves each institution must hold is determined by that institution’s reserve base. Institutions must hold 2% reserves against short-term deposits (those that are eligible for withdrawal in two years or less) and short-term debt securities (those with maturities up to two years) that the institution has issued. Institutions have zero reserve requirements on deposit and debt securities with maturities of more than two years and all repurchase agreements. Money and Banking – Michael Brandl ©2017 Cengage Learning

Summary Traditional tools of monetary policy OMOS Discount window Required reserves Non-traditional monetary policy QE Other means Review of Money Demand theories Liquidity trap Debt monetization ECB monetary policy