1. Monetary Policy Tools zInstruments that initiate monetary policy zOpen Market Operations zThe Discount Rate zReserve Ratios

2. Open Market Operations zDefined as the buying or selling of bonds by the Federal Reserve in the open market. zExpansionary -- Fed buys bonds (injects reserves) zContractionary -- Fed sells bonds (drains reserves) zDone at the Federal Reserve Bank of New York

3. Open Market Operations: How They’re Actually Done zExample -- Federal Reserve buys a $1000 bond from Salomon Brothers and pays with a check. The check in turn is deposited in checkable deposits at Chase, which is Salomon Brothers bank.

4. Balance Sheet Portrayal Salomon Brothers  Bonds -$1000  D +$1000 Chase  R +$1000  D +$1000 Federal Reserve Bank of NY  Bonds +$1000  R +$1000

5. Characteristics of Open Market Operations zSometimes done for temporary periods y(Fed) Repurchase Agreement -- Fed buys bond with agreement to sell it back. yMatched-Sale Purchase -- Fed sells bond with agreement to buy it back.

6. Open Market Operations -- An Effective Policy Tool zOccurs at the initiative of the Fed. zFed is in complete control. zThey are flexible: Fed can do small or large amounts. zThey are reversible: Fed can undo policy mistakes. z Very low-key policy instrument: difficult to tell what Fed has done.

7. The Discount Rate (i DISC ) zDefined as the rate of interest charged to banks that borrow from the Federal Reserve. zExpansionary -- Fed lowers discount rate. zContractionary -- Fed raises discount rate.

8. Effects of Discount Rate Changes zExample -- Effect of Decrease in the Discount Rate (i DISC  ). i DISC   DL   M2  zIncrease in discount rate has the reverse effect.

9. Types of Discount Window Borrowing zPrimary Credit -- borrowing for short-term reserve adjustments. zSeasonal Credit -- borrowing for seasonal needs. zSecondary Credit -- large, longer- term borrowing for banks facing financial difficulties.

10. Discount Rate Policy -- Characteristics zDL done at the discretion of banks, not the Fed. zDiscount Window can be abused by banks, borrowing for profit (actively or passively). zSometimes is regarded as signal of monetary policy, “the announcement effect.”

11. Discount Rate Policy -- Its Diminished Role zLarger volume of borrowing from other sources -- Federal Funds, RPs, Eurodollars  banks hardly use the Federal Reserve for short-term reserve adjustments. zAnnouncement effect now involves the Federal Funds rate target. zRecent change in procedure (generally): i DISC = Target i FF + 0.5%.

12. Reserve Ratios (r D, r T ) zDesigned to change the amount of required reserves. zExpansionary Policy -- Fed lowers reserve ratios. zContractionary Policy -- Fed raises reserve ratios. zAffects M2 by changing the multiplier.

13. Characteristics of Reserve Ratio Policy zr T = 0 for Savings and Time Deposits (including MMDAs) zDIDMCA  Uniform Reserve Requirements (based upon deposit size)

14. Reserve Ratio Policy -- Rarely Used zToo blunt -- needs tiny changes for reasonable adjustments in money growth. zToo Disruptive -- affects all banks balance sheets.

15. The Market For Bank Reserves zDemand for Reserves (R D ) -- Banks wishing to borrow reserves in the Federal Funds market, generally in response to loan demand. Downward sloping curve when plotted against i FF, (i.e. i FF   R D  ). It can shift rightward (increase in demand) or leftward (decrease in demand).

16. zSupply of Reserves -- Banks offering reserves to the Federal Funds market + the Federal Reserve changing reserves using open market operations. Upward sloping curve when plotted against i FF, (i.e. i FF   R S  ). It can shift rightward (increase in supply) or leftward (decrease in supply).

17. Determination of the Federal Funds Rate zThe Federal Funds Rate (i FF ) is determined by equilibrium in the market for bank reserves (where R D = R S ). zThe Federal Funds Rate changes due to shifts in the Demand for Bank Reserves or the Supply of Bank Reserves.