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 Reserves R2 R1

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.

Reserve Supply Federal Funds Rate 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 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 RS2 iff,1 RD NBR1 Reserves

Lowering the Discount Rate (Binding) Federal Funds Rate id,1 RS1 iff,2 = id,2 iff,1 id,2 RS2 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 Id,1 RS1 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