1 Chapter 18 The Tools Of Federal Reserve Policy © Thomson/South-Western 2006

2 The Federal Reserve Goals and Tools  Goals  influence greater output  lower the unemployment rate  prices level stability  tools of monetary policy or instruments of monetary policy  open market operations  discount window policy  reserve requirement policy  intermediate target variables  short-term interest rates  monetary aggregates (M1, M2, M3)

3 The Reserve Requirement Instrument  Can be considered a “tax” on banks because it cause bank to hold a larger portion of their assets in non-interest-earning form (reserves).  Banks must maintain Reserve requirements or required reserve ratios that the Fed set.  Before 1980, reserve requirements only existed for member banks and ratio for member banks were set higher than non-members’. Now the ratio apply to all banks.

4 Discount Window Policy  A facility through which the Federal Reserve lend reserves directly to depository institutions.  Funds borrowed are called discount loans  Funds are charged at a discount rate  Funds are short-term loan  Transaction is accomplished by a bookkeeping entry, bank reserves increase with the amount of the loan.

5 Discount Window Policy  Three classes of credit available:  Primary credit--  granted to banks in good condition who are permitted to borrow as much as they want  discount rate > fed funds rate  Secondary credit  provided to troubled banks that are experiencing liquidity problems  ½ percentage point higher rate  Seasonal credit  provided to banks subject to seasonal fluctuations in loan demand—like agricultural activity  Main function of the discount rate today is to set upper limit on potential movement in the federal fund rate.

6 Open Market Operations: Fundamental Considerations  Open market operations  Buying and selling of securities in the open market  The Fed is empowered to buy or sell  U.S. Treasury securities  federal agency securities  banker's acceptances  other securities  Domain of Federal Reserve's open market operations could be carried out in any asset.  To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances.  No matter what items it buys, Fed simply pays with a check written on itself.  The Fed’s balance sheet impact will always be the same, regardless of the type of asset the Fed purchases or sells.

7 Discovery Of Open Market Operations And The Banking Act Of 1935  Accidental Discovery  Prior to 1920,the discount window was the only Fed policy tool,  The Fed's revenues were only the interest received on the Fed's discounts loans.  An early 1920s recession led to a drop in revenue, so individual Fed bought U.S. government securities.  When Fed purchased securities to compensate for reducing interest income, interest rates in the market fell, and credit conditions eased.

8 Impact of Open Market Ops  The Fed conducts open market operation with the desire to impact:  Short term interest rate  Bank reserves (R)  Monetary base (B)  Money aggregates (the M’s)  The policy is conduct by selling and buy securities sssss

9 Impact of Open Market Ops (Selling)  If the Fed sells $225 million in U.S. Treasury bills to a government securities dealer  reserves and the monetary base contract dollar-for-dollar,  money supplies directly decrease by dollar-for-dollar

10 Impact of Open Market Ops (Buying)  When the Fed buys $400 million in Treasury bonds and bills from banks,  reserves and the monetary base expand dollar-for-dollar, But  the money supply is not directly or immediately affected.  This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.

11 Impact of Open Market Ops- Summary  Sell and Buy to Banks  reserves and the monetary base contract/expand dollar- for-dollar, BUT  the money supply is not directly or immediately affected.  This happens when banks initiate the multiple deposit contraction/expansion process.  Sell and Buy to Dealers  reserves and the monetary base contract/expand dollar- for-dollar, AND  the money supply is immediately contract/expand dollar-for-dollar.  The effect to money supply will be even greater when banks initiate the multiple deposit contraction/expansion process.

12 Open Market Operations and the Federal Funds Rate  The effects of the Fed's open market operations transmit very quickly throughout the nation through the federal funds market.  The supply of reserves is determined by Federal Reserve policy.  When the Fed purchases securities, bank reserves are boosted dollar-for-dollar. => lower federal fund rate  When the Fed sells securities, bank reserves decline dollar-for-dollar. => higher federal fund rate

13 Figure 18-1 Demand S1S1 Reserves Federal Funds Rate 4.0 Purchase of Securities S2S2 3.5

14 The Effectiveness Of Open Market Operations  Impacts of Open Market Operations via two primary channels:  Impact on Bank Reserves, the Monetary Base, and the Monetary Aggregates:  The Fed can use relatively accurate control over bank reserves and the monetary base by manipulating its security portfolio.  Impact on Security Prices and Interest Rates (Yields):  When the Fed buys government securities in the open market, it bids up security prices and therefore reduces their yields.  Marketable securities are substitutable, so a decline in government security yields extends to yields on other assets.

15 Advantages of Open Market Operations  Precision:  firm and accurate control over aggregate bank reserves and the monetary base, while  a high degree of accuracy cannot be achieved through changes in the discount rate or reserve requirements.  Flexibility:  in the market each day, buying and selling large quantities of securities  very easy for the Fed to alter course  Source of Initiative:  The Fed is able to dominate aggregate bank reserves and the monetary base.

16 Early Disadvantages of Open Market Operations  Signaling:  Changes in the discount rate and reserve requirements are superior to open market operations in signaling policy changes to the public.  Regional Bias:  Prior to well-developed financial markets, a regional bias operated in open market operations, because the effects were concentrated in select urban areas where security dealers were located; open market operations did not disperse across the nation.

17 Technical Aspects Of Open Market Operations  Defensive Operations versus Dynamic Operations  Defensive open market operations  open market operations made for the purpose of "defending" bank reserves and the monetary base against the influence of outside forces  Dynamic open market operations  open market operations made to deliberately change the course of economic activity  now, from protector to initiator

18 Outright Transactions versus Repurchase Agreements  Outright transactions  The Fed uses outright purchases to bring about long-run or permanent growth in reserves and the monetary aggregates.  Repurchase agreements (and reverse repurchase agreements)  The Fed uses repurchase agreements (repos) and reverse repurchase agreements to neutralize the impact on reserves and the monetary base of transitory changes.  Recall a repurchase agreement is a money market instrument wherein one party sells securities with an explicit agreement to buy them back at a specified future date and price.

19 Table 18-1