1. Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 2
Chapter Eighteen
Chapter 18
Monetary Policy:
Stabilizing the Domestic Economy
Part 2

2. 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 drops to the deposit rate, banks will hold any amount of reserves supplied beyond this level.
So the demand curve turns flat.

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

4. The Market for Reserves
The federal funds rate can fluctuate in a range between 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.

5. 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.

6. Why we Studied 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.

7. Market for Reserves Response to an Open Market Purchase

8. 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

9. 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)

10. 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

11. 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

12. 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 federal funds rate to a minimum of the interest rate on reserves.
Quantity of Reserves, R
NBR*

13. 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.
Banks must show that they are sound to get a loan in a crisis.
assets the central bank will take as collateral.
A bank that does not have assets it can use as collateral for a discount loan should probably fail.

14. 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 at the low rate...
Fed required banks to exhaust all other sources of funding before applying for a loan
Banks feared of increased oversight.

15. 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

16. 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.

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

18. 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.

19. 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.

20. Reserve Requirements
Since 1935, the Federal Reserve Board has had the authority to set the reserve requirements.
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,………

21. Reserve Requirements Transactions Deposits = $2.0 trillion
Required Reserves = 0.1 x $2 trillion
= $200 billion
Total Reserves = $2.4 trillion.
With $2.4 trillion in reserves, Fed can impose 100% RR on checkable deposits and still have $0.4 trillion in excess reserves.

22. 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 currently zero.
No longer costly to hold reserves.

23. Operational Policy at the European Central Bank
Like the Fed, the ECB’s monetary policy toolbox contains:
An overnight interbank cash 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.

24. 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.
The policy instrument of the Governing Council is the target refinancing rate (comparable to the target federal funds rate).

25. 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.

26. 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.

27. 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.

28. 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.
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.

29. 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.

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