Chapter 15: Tools of Monetary Policy

The market for resesrves and the federal funds rate

Supply and Demand in the market for reserves
1. Demand curve: quantity of excess reserves demanded = required reserves + quantity of excess reserves demanded
-excess reserves are insurance against deposit outflow and the cost of holding er is the interest rate that could have been earned on lending it out which is the federal funds rate.
-fund funds rate decreases --> cost of holding er falls --> quan of reserves rises

2. Supply curve:
-two components: amount of reserves supplied by fed's open market operations called nonborrowed reserves; and the amount of reserves borrowed from the fed, the borrowed reserves
-cost of borrowing from fed is the interest rate fed charges on these loans, the discount rate (id)
-bowworing from other banks at the fed funds rate; as long as iff is less than id, banks will not borrow from fed; vertical line until id

How changes in the tools of monetary policy affect the federal funds rate
1. open market operations: an open market purchase causes the fed funds rate to fall, whereas an open market sale causes the fed funds rate to rise
-open market purchase leads to greater quan of reservess supplied; shirts the sc to the right

2. discount lending: effect depends on whether dc intersects the supply curve in its vertical section or flat section
-when intersect at vertical section - most changes int eh discount rate have no effect on the fed runds rate
-intersect at flat section; some discount lending; iff moves with id

3. reserve requirements: when required reserve ratio increases, quan of resreves demanded increases for any given interest rate --> shift demand curve to the right --> raises the fed funds rate
-when the fed raises reserve requirements, the fed funds rate rises

Open market operations (t-bills)
-most useful monetary policy tool; primary determinants of changes in interest rates and monetary base --> change in money supply
-open market purchases expand reserves and monetary base and money supply lowering short-term interest rates
-open market sales shrink reserves and monetary base decreasing money supply and increasing short-term interest rates.
-two types of open market operations: dynamic open market operations: change the level of reserves and monetary base
-defensive omo: offset movements in other factors that affect reserves and the monetary base
-repurchase agreement: fed purchases securities with an agreement that the seller will repurchase them; temp open market purchase
-matched sale-purchase transaction (reverse repo): temp open market sale; fed sells securities and buyer agrees to sell them back to fed

Advantages of open market operations
1. fed has complete control over it
2. flexible, precise and used to any extent
3. easily reversed
4. implemented quickly; no administrative delays

Operation of the discount window
1. three types of discount loans:
a. primary credit: most important; healthy banks allowed to borrow all they want for short maturities --> standing lending facility
-lent at discountr ate which is 100 basis points (1%) higher than fed funds rate
b. secondary credit: banks taht are in financial trouble and experiencing severe liquidity problems
-interest set at 50 basis points above the discount rate
c. seasonal credit: small banks in vacation and agricultural areas that ahve seasonal pattern of deposits
-interest rate is average of fed funds rate and certificate of deposit rates

Lender of last resort
1. fed as lender of last resort to prevent bank panics
2. moral hazard problems

Advantages and disadvantages of discount policy
1. ad: lender of last resort
2. dis: decisions to take out discount loans are made by banks and are not controlled by the fed

Reserve requirements
-affect money supply by changing money supply multiplier
-rise in reserve requirements reduces the amount of deposits that can be supported by level of monetary base and lead to contraction of ms.
-rise in rr also increases the demand for reserves and raises the fed funds rate
1. disadvantages of reserve requirements
-no longer binding for most banks
-raising requirements can cause immediate liquidity problems for banks where reserve requirements are binding; create more uncertainty for banks

Application: Why have reserve requirements been declining worldwide?
-makes banks less competitive

ApplicationThe channel/corridor system for setting interest rates used in other countries
-central banks ets up a standing lending facility; commonly called a lombard facility; interest rate charged is called lombard rate
-overnight interest rate is always between ir and il

Monetary policy tools of the european central bank
1. set target financing rate which sets target for overnight cash rate
2. Open market operations: main refinancing operations are predominant form of open market operations and are similar to the fed's repo; they involve weekly reverse transactions
-longer-term refnancing operations: similar to fed's outright purchases or sales

3. lending to banks: marginal lending facility; borrow overnight loans from national central banks at the marginal lending rate which is 100 basis points above target financing rate; similar to discount rate; ceiling
-deposit facility: banks are paid fixed interest rate that is 100 basis points below target financing rate; floor for overnight market interest rate

4. Reserve requirements: pays interest on required reserves