1 CH 17: Tools of Monetary policy

2 Three policy tools the Fed use to control money supply and the interest rate: 1. OMOs 2. Discount rate 3. Reserve requirements

3 The market for reserves and the Federal Funds Rate (iff): OMOs and Discount lending affect the Fed's balance sheet and the amount of reserves (R). The market for reserves is where the (iff) is determined.

4 Supply and Demand in the market for reserves: Demand Curve for Reserves: What happens to the quantity of reserves demanded as (iff) changes? R= RR + ER Recall that ER are insurance against deposit outflow, and the cost of holding ER is their opportunity cost: the interest rate that could have been earned on lending these ER, which is iff. Result: As iff decreases, the OC of holding ER falls and the quantity of R demanded (Rd) increases. (Negative slope)

5 Supply Curve: As discount lending increases, the quantity of reserves supplied (Rs) to the banking system also increases. When the bank borrows from the Fed, the bank is not having to borrow from the FED market. Thus: Discount lending is a substitute for borrowing Federal Funds. Result: when (iff) increases, banks will borrow more from the Federal Reserve, and the resulting increase in discount lending means that the quantity of reserves supplied rises. (Positive slope)

6 FFR (i ff ) R S i* ff 1 R D Quantity of Reserves (R)

7 Equilibrium in the Market for Reserves How Changes in tools of monetary policy affect the (iff)? OMOs: OM purchase leads to a higher level of Rs, this will shift the supply curve to the right lowering the (iff) OM sale leads to a lower level of Rs, this will shift the supply curve to the left rising the (iff). Result: An open market purchase causes iff to fall while an open market sale causes iff to rise.

8 FFR (i ff ) R S i* ff R D Quantity of Reserves (R)

9 Discount Lending: An increase in discount lending rises quantity of reserves supplied (cost = discount rate). Banks borrow more from the Fed as the discount rate falls. Thus, a lower discount rate leads to a greater quantity of reserves supplied and shifts the supply curve to the right, and the iff falls. Result: When the Fed lowers the discount rate, iff falls and when the Fed raises the discount rate, the iff rises.

10 Reserve Requirements: When the required reserve ratio (r) increases, required reserves increase and thus, the quantity of reserves demanded increases, and the demand curve shifts to the right, increasing the iff. Result: When the Fed rises the (r), iff rises, and when (r) decreases, the iff falls.

11 FFR (i ff ) R S i* ff R D Quantity of Reserves (R)

12 1- Open market Operations: The most important monetary policy tool. The primary determinants of changes in interest rate and the MB. OMO expand reserves and the MB, thus raising MS and lowering short-term interest rate. Open market sale lower reserves and MB, lowering MS and raising interest rate.

13 Types of OMOs: Dynamic OMO: intended to change the level of reserves and the MB. Defensive OMO: intended to offset movements in other factors that affect reserves and the MB (i.e. changes in treasury deposits).

14 Advantages of OMOs: The Fed has complete control over the size of the operations. OMOs are flexible and exact, and can be used to any extent (small or large). OMOs are easily reversed when a mistake is made. Quick effect.

15 2. Discount Policy: Made at the discount window, and used to influence reserves, MB, and MS: Primary credit: is the discount lending that plays the most important role in monetary policy (good credit banks are allowed to borrow all they want from the primary credit). Interest rate charged is the discount rate.

16 Secondary credit: is given to banks that are in a financial trouble and with sever liquidity problems(0.5% above discount rate) Seasonal credit: is given to meet the needs of a limited number of small banks that have s seasonal patterns of deposits. The interest rate charged is linked to federal funds rate. Discount loans are also important in preventing financial panics. The Fed is the “Lender of Last Resort”;

17 To prevent bank failures from spinning out of control. The Fed provide reserves to banks where no others would do. Announcement Effect: Discount policy can be used to signal the Fed’s intentions about future monetary policy.

18 If the Fed decided to slow the expansion of the economy, can “announce” that the discount rate will increase = the public will expect the monetary policy to be less expansionary in the future. Advantages and disadvantages of discount policy: Lender of last resort, but even if discount rate is changed, no guarantee that banks will follow.

19 3- Reserve Requirements: Changes in (r) affect MS through (m). A rise in (r) reduces the amount of deposits that can be supported by a given level of the MB, leading MS to fall.

20 A rise in (r) will also increase the demand for reserves and raises the federal funds rate. Advantages and disadvantages: Equal affect of all banks, but can cause immediate liquidity problems for banks with low (ER). However, this tool is infrequently used.