Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 19 The Instruments of Central Banking

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved Reserve Requirements Within limits established by Congress, Federal Reserve can specify reserve requirements banks and deposit- type 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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%

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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”

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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 short- term 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”

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved FIGURE 19.1 Movements in the discount rate tend to come after Treasury bill rates.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved 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