Chapter 17 Tools of Monetary Policy

© 2004 Pearson Addison-Wesley. All rights reserved 17-2 The Market for Reserves and the Fed Funds Rate Demand Curve for Reserves 1. R = RR + ER 2. i  opportunity cost of ER , ER  3. Demand curve slopes down Supply Curve for Reserves (two parts) 1. If i ff is below i d, then discount borrowing, R s = R n 2. Supply curve flat (infinitely elastic) at i d because as i ff starts to go above i d, banks borrow more at i d Market Equilibrium R d = R s at i * ff

© 2004 Pearson Addison-Wesley. All rights reserved 17-3 Definitions Federal funds rate (or interbank rate): the interest rate on overnight loans to reserves from on bank to another, i ff. I d : discount rate R n : nonborrowed reserves

© 2004 Pearson Addison-Wesley. All rights reserved 17-4 Supply and Demand for Reserves

© 2004 Pearson Addison-Wesley. All rights reserved 17-5 Response to Open Market Operations Open Market Purchase Nonborrowed reserves, R n,  and shifts supply curve to right R s 2 : i  to i 2 ff

17-6 Response to a Change in the Discount Rate (a) No discount lending Lower Discount Rate Horizontal to section  and supply curve just shortens, i ff stays same (b) Some discount lending Lower Discount Rate Horizontal section , i ff  to i 2 ff = i 2 d

© 2004 Pearson Addison-Wesley. All rights reserved 17-7 Required reserve Requirement  Demand for reserves , R s shifts right and i ff  to i 2 ff Response to Change in Required Reserves

© 2004 Pearson Addison-Wesley. All rights reserved 17-8 Open Market Operations 2 Types 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB, typically uses repos (and reverse repo). Repurchase agreement: the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time (1 to 15 days). A temporary OMO.

© 2004 Pearson Addison-Wesley. All rights reserved 17-9 Open Market Operations Advantages of Open Market Operations 1.Fed has complete control 2.Flexible (to any extend) and precise 3.Easily reversed 4.Implemented quickly (involve no adminstrative delays)

© 2004 Pearson Addison-Wesley. All rights reserved Discount Loans 3 Types 1.Primary Credit : standing lending facility, for healthy banks; usually 100 basis points (one percentage point) higher than the federal funds rate target. (see graph) 2.Secondary Credit: for banks that are in financial trouble and experiencing sever liquidity problems; 50 basis points above the discount rate 3.Seasonal Credit: to meet the needs of a limited number of small banks in vacation and agricultural areas that have seasonal pattern of deposit.

17-11 How Primary Credit Facility Puts Ceiling on i ff Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2

© 2004 Pearson Addison-Wesley. All rights reserved Discount Loans Lender of Last Resort Function 1.To prevent banking panics FDIC (Federal Deposit Insurance Corporation) fund not big enough Example: Continental Illinois (1984) 2.To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident

© 2004 Pearson Addison-Wesley. All rights reserved Discount Policy Advantages 1.Lender of Last Resort Role cost: moral hazard problem; too big to fail Disadvantages 1.Fluctuations in discount loans cause unintended fluctuations in money supply 2.Not fully controlled by Fed

© 2004 Pearson Addison-Wesley. All rights reserved Reserve Requirements (rarely used) Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks