1. Chapter 18 Monetary Policy: Stabilizing the Domestic Economy
Chapter Eighteen
Chapter 18
Monetary Policy:
Stabilizing the Domestic Economy

2. Develop understanding of
Fed and ECB conventional policy tools.
How policy tools link to instruments link to goals.
Simple guides for policy setting.
Unconventional policy tools.

3. The Fed can control the MB but cannot precisely control the Money Supply
M1 = m x MB
1+(C/D)
M1 =  MB
rD + (ER/D) + (C/D)
Households can change C/D, causing the money multiplier (m) and M1 to change.
Banks can change ER/D, causing m and M1 to change.

5. The Fed’s “Traditional” Policy Tools
Open Market Operations - OMO.
Discount Rate - the interest rate the Fed charges on the loans it makes to banks
Reserve Requirement - the level of balances a bank is required to hold either as vault cash on deposit or at a Federal Reserve Bank
NOTE: The primary instrument of monetary policy is the Federal funds rate: the interest rate on overnight loans of reserves from one bank to another

6. A New (fourth) Tool Interest on Reserves - required and excess
Currently set at 1%
Often referred to as IOER – Interest on Excess Reserves.
Cecchetti refers to this as the Deposit Rate
The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to begin paying interest on reserve balances of depository institutions beginning October 1, 2011. 
The Emergency Economic Stabilization Act of 2008 accelerated date to October 1, 2008. 

7. More New Tools in the Works
Term Deposit Facility
ON RRP

8. Open Market Operations
The Fed buys and sells U.S. (Gov’t) securities in the secondary market in order to adjust the supply of reserves in the banking system.
Traditionally short-term T-bills.
This changed with “quantitative easing”.
Fed has purchased long-term T-bonds and MBS.
Most flexible means of carrying out monetary policy.
With OMO the Fed does not participate directly in the Federal Funds market.
The Fed does not want the credit risk associated with direct participation.

9. OMO and the Federal Funds Market
Federal funds are reserve balances that depository institutions lend to one another.
The most common federal funds transaction is an overnight, unsecured loan between two banks. (bilateral agreements)
Note that without the FF market, banks would need to hold a substantial amount of excess reserves.

10. Advantages of OMO Implemented quickly Fed has complete control
Flexible and precise
Easily reversed

11. Two Types of Open Market Operations
Permanent OMOs:
“involve the buying and selling of securities outright to permanently add or drain reserves available to the banking system.”
Temporary OMOs:
“involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system”

12. Open Market Operation - Repo
With a repurchase agreement ("repo"), the Fed buys securities from dealers who agree to buy them back, typically within one to fifteen days.
Repo adds reserves to the banking system and then withdraws them.
Can be viewed as the Fed temporarily lending reserves to dealers with the dealers posting securities as collateral.

13. Open Market Operation – Reverse Repo
The Fed sells securities to dealers and dealer agrees to sell them back to the Fed.
Reverse repo drains reserves and later adds them back.
Can be viewed as the Fed temporarily borrowing reserves from dealers with the Fed posting securities as collateral.
Also called a “matched-sale purchase transaction”.

14. Open Market Operation – Reverse Repo
Traditional use of REPO is to offer fixed quantity and let i adjust.
Fixed Rate Over Night Reverse Repurchase Agreement (“ON RRP”) is different. The Fed will state the interest rate (fix i) and let quantity adjust.

15. Monetary Policy There are three interest rates the Fed “controls”:
The federal funds rate,
The discount rate, and
The deposit rate (interest on reserves).
OMO, the discount rate, reserve requirement and the deposit rate are the primary tools of monetary policy during normal times.

16. Monetary Policy
The federal funds rate is the primary instrument of monetary policy. Referred to as the policy rate.
In the past monetary aggregates such as the monetary base or the money supply were use as the instruments on monetary policy.
Tools are used to affect instruments which in turn affect the goals of the central bank - maybe.

17. Monetary Policy
Between September 2007 and December 2008, the FOMC lowered its target for the federal funds rate 10 times from around 6% to zero.
This was the first time since the 1930s that the Fed hit the zero bound on the nominal federal funds rate.

18. The Target Federal Fund Rate

19. Monetary Policy
Federal fund rate at zero wasn’t enough to stabilize the economy.
The crisis had undermined the willingness and ability of major financial intermediaries to lend.
In this environment the Fed moved to substitute itself for dysfunctional intermediaries and markets.
This significantly altered the Fed’s balance sheet.

20. Monetary Policy
Policymakers then proceeded to develop and use a variety of unconventional policy tools including:
Massive purchases of risky assets in thin, fragile markets, and
Communicating its intent to keep interest rates low over an extended period- “forward guidance”
In a financial crisis, central banks may also adjust the size and composition of their balance sheet – “quantitative easing”

22. The Federal Funds Market
Instead of fixing the interest rate, the Fed controls the federal funds rate by manipulating the quantity of reserves.
The Fed does this by using open market operations.

23. The Federal Funds Market
We can use a standard supply-and-demand graph to analyze the market in which banks borrow and lend reserves.
The demand curve for reserves is downward sloping.
However, when the federal funds rate in the market drops to the deposit rate, banks are willing to hold any amount of reserves supplied beyond this level.
So the demand curve turns flat.

24. Banks can borrow all they want at the discount rate
Banks hold onto reserves at the deposit rate

25. The Target Federal Fund Rate and Open Market Operations
Within a day, the federal funds rate can fluctuate in a range from the deposit rate to the discount rate.
As the reserve demand shifts, the Fed staff will use open market operations to shift the daily reserve supply curve to accommodate the change.
This ensures that the market federal funds rate stays near the target.

26. An increase in reserve demand is met by an open market purchase.
The vertical portion of reserve supply shifts to the left to keep the federal funds rate at the target level.

27. The Target Federal Fund Rate and Open Market Operations

28. Why we Study the Term Structure of Interest Rates
The Federal Funds Rate is the overnight lending rate.
Long-term interest rates = average of expected short-term interest rates + the risk premium.
When the expected future path of the federal funds rate changes, long-term interest rates we all care about change.

29. Market for Reserves Response to an Open Market Purchase

30. Market for Reserves Response to an Open Market Operation
Federal
Funds Rate
Federal
Funds Rate
NBR1
NBR2
NBR1
NBR2 1 2 1 2
Quantity of
Reserves, R
Quantity of
Reserve, R
Step 1. An open market purchase shifts the
supply curve to the right …
Step 1. An open market purchase shifts the supply curve to the right …
Step 2. but the federal funds rate cannot fall below the interest rate paid on reserves.
Step 2. causing the federal funds rate to fall.
(a) Supply curve initially intersects demand
curve in its downward-sloping section
(b) Supply curve initially intersects
demand curve in its flat section

31. Market for Reserves Response to a Change in the Discount Rate
Federal Funds Rate
Federal Funds Rate 1 1 2
BR1
BR2
NBR
Quantity of Reserves, R
Quantity of Reserves, R
NBR
Step 1. Lowering the discount rate shifts the supply curve down…
Step 1. Lowering the discount rate shifts the supply curve down…
Step 2. but does not lower the federal funds rate.
Step 2. and lowers the federal funds rate.
(a) No discount lending (BR = 0)
(b) Some discount lending (BR > 0)

32. Market for Reserves Response to a Change in Required Reserves
Federal Funds Rate id
ior
Step 1. Increasing the reserve requirement causes the demand curve to shift to the right . . . 2 1
Step 2. and the federal funds rate rises.
NBR
Quantity of Reserves, R

33. Market for Reserves Response to a Change in the Deposit Rateid
Federal Funds Rate id
Federal Funds Rate 2 1 1
NBR
Quantity of Reserves, R
NBR
Quantity of Reserves, R
Step 1. A rise in the interest rate on reserves from to
Step 1. A rise in the interest rate on reserves from to
Step 2. leaves the federal funds rate unchanged.
Step 2. raises the federal funds rate to

34. Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate
Step 1. A rightward shift of the demand curve raises the federal funds rate to a maximum of the discount rate.
Step 2. A leftward shift of the demand curve lowers the Ederal funds rate to a minimum of the interest rate on reserves.
Quantity of Reserves, R
NBR*

35. Discount Lending, the Lender of Last Resort, and Crisis Management
Discount lending is the Fed’s primary tool for:
Ensuring short-term financial stability,
Eliminating bank panics, and
Preventing the sudden collapse of institutions that are experiencing financial difficulties.

36. Discount Lending, the Lender of Last Resort, and Crisis Management
But, a bank is supposed to show that it is sound to get a loan in a crisis.
This means having assets the central bank will take as collateral.
Bagehot
A bank that does not have assets it can use as collateral for a discount loan is a bank that should probably fail.

37. Discount Lending, the Lender of Last Resort, and Crisis Management
For most of its history, the Fed loaned reserves to banks at a rate below the target federal fund rate.
Borrowing from the Fed was cheaper than borrowing from another bank.
But no one borrowed.
The Fed required banks to exhaust all other sources of funding before they applied for a loan
Fear of increased oversight.

38. Discount Lending, the Lender of Last Resort, and Crisis Management
Because of this in 2002, officials instituted the discount lending procedures in place today.
The current discount lending procedures:
Provide a mechanism for stabilizing the financial system, and
Help the Fed meet its interest-rate stability objective by setting a ceiling on the federal funds rate.

39. Discount Lending, the Lender of Last Resort, and Crisis Management
The Fed makes three types of loans:
Primary credit,
Secondary credit, and
Seasonal credit.
The Fed controls the interest rate on these loans, not the quantity of credit extended.
The banks decide how much to borrow.
This is why changing the discount rate is a weak policy tool

40. Discount Lending - Primary Credit
Primary credit is extended on a very short-term basis, usually overnight, to institutions that the Fed’s bank supervisors deem to be sound.
Banks seeking to borrow much post acceptable collateral.
The interest rate on primary credit is set at a spread above the federal fund target rate called the primary discount rate.

41. Discount Lending - Primary Credit
The system is designed both:
To provide liquidity in times of crisis, ensuring financial stability, and
To keep reserve shortages from causing spikes in the market federal funds rate
Helps to maintain interest-rate stability.

42. Discount Lending – Secondary Credit
Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit.
The secondary discount rate is set about the primary discount rate.
There are two reason a bank might seek secondary credit:
A temporary shortfall of reserves, or
They cannot borrow from anyone else.

43. Seasonal Credit
Seasonal credit is used primarily by small agricultural banks in the Midwest to help in managing the cyclical nature of farmers’ loans and deposits.

44. Reserve Requirements
Since 1935, the Federal Reserve Board has had the authority to set the reserve requirements.
These are the minimum level of reserves banks must hold against transactions deposits either as vault cash or on deposit at the Fed.
Changes in the reserve requirement affect the money multiplier and the quantity of money and credit circulating in the economy.
Not used – too powerful. BUT,………

45. Reserve Requirements
Transactions Deposits = $1.9 trillion Required Reserves = 0.1 x $1.9 trillion = $190 billion Total Reserves = $2.6 trillion. Total saving and small denomination deposits = $8.5 trillion With $2.6 trillion in reserves, Fed can impose 100% RR on checkable deposits and still have $0.7 trillion in excess reserves.

46. Reserve Requirements
In 1980, the Monetary Control Act imposed the reserve requirement on all banks, not just member banks.
Fed can set the reserve requirement ratio between 8 and 14 percent of transactions deposits.
The RR on non-transactions deposits is zero.
Now that interest is paid on reserves, it is not so costly to the banks.

47. Operational Policy at the European Central Bank
Like the Fed, the ECB’s monetary policy toolbox contains:
An overnight interbank rate (federal funds rate),
A rate at which the central banks lends to commercial banks (discount rate),
A reserve deposit rate (deposit rate), and
A reserve requirement.

48. The ECB’s Target Interest Rate and Open Market Operations
The ECB provides reserves to the European banking system primarily through collateralized loans in what are called refinancing operations:
In normal times, a weekly auction of two-week repurchase agreements (repo) in which ECB, through the National Central Banks, provides reserves to banks in exchange for securities.
The transaction is reversed two weeks later.

49. The ECB’s Target Interest Rate and Open Market Operations
The policy instrument of the ECB’s Governing council is the minimum interest rate allowed at these refinancing auctions,
Which is called the main refinancing operations minimum bid rate.
We will refer to this minimum bid rate as the target refinancing rate (comparable to the target federal funds rate).

50. The ECB’s Target Interest Rate and Open Market Operations
In normal times, the main refinancing operations provide banks with virtually all their reserves.
Since 2007, the ECB has provided most reserves through longer term refinancing at maturities of three months or more.
To stabilize bank funding in late 2011 and early 2012, the ECB extended maturities to three years.

51. The ECB’s Target Interest Rate and Open Market Operations
The Eurosystem treats many different marketable assets as eligible collateral, including not only government-issued bonds but also privately issued bonds and bank loans.
When the rating on government bonds of one euro-area country fell below investment grade in 2010, the ECB continued to accept them as collateral.

52. The Marginal Lending Facility
The ECB’s Marginal Lending Facility is the analog to the Fed’s primary credit facility.
Rate set above the target-refinancing rate.
The spread between the marginal lending rate and the target refinancing rate is set by the Governing Council.

53. The Deposit Facility
Banks with excess reserves at the end of the day can deposit them overnight in the ECB’s Deposit Facility at a interest rate substantially below the target-refinancing rate.
Again, the spread is determined by the Governing Council.
The deposit facility places a floor on the interest rate that can be charged on reserves.
The ECB’s deposit facility was the model for the Fed’s deposit rate introduced in October 2008.

54. Reserve Requirements
Reserve requirement of 1% is applied to checking accounts and other deposits with maturities up to two years.
Initially reserve requirement was 2%. Changed to 1% in January 2012.

55. Overnight Cash Rate
The overnight cash rate is the European analog to the market/actual federal funds rate.