Money and Banking Chapter 16 Monetary Policy Tools

Chapter 16 Monetary Policy Tools CHAPTER OBJECTIVES By the end of this chapter , students should be able to . List and assess the strengths and weaknesses of the three primary monetary policy tools that central banks have at their disposal . Describe the federal funds market and explain its importance . Explain how the Fed influences the equilibrium fed funds rate to move toward its target rate . Explain the purpose of the Fed discount window and other lending facilities . Compare and contrast the monetary policy tools of central banks worldwide to those of the Fed . URL books 337

The Federal Funds Market and Reserves LEARNING OBJECTIVES . What three monetary policy tools do central banks have at their disposal ?

What are the strengths and weaknesses of each ?

What is the federal funds market and why is it important ?

Central banks have three primary tools for the money supply the reserve requirement , discount loans , and open market operations . The first , as we saw in Chapter 14 The Money Supply Process and Chapter 15 The Money Supply and the Money Multiplier , works through the money multiplier , constraining multiple deposit expansion the larger it becomes . Central banks today rarely use it because most banks work around reserve requirements . The second and third tools the monetary base ( Discount loans depend on banks ( or borrowers , where applicable ) first borrowing from , then repaying loans to , the central bank , which therefore does not have precise control over . Open market operations ( are generally preferred as a policy tool because the central bank can easily expand or contract to a precise level . Using , central banks can also reverse mistakes quickly . In the United States , under typical conditions , the Fed conducts monetary policy primarily through the federal funds ( fed funds ) market , an overnight market where banks that need reserves can borrow them from banks that hold reserves they don need . Banks can also borrow their reserves directly from the Fed , but , except during crises , most prefer not to because the Feds discount rate is generally higher than the federal funds rate . Also , borrowing too much , too often from the Fed can induce increased regulatory scrutiny . So usually banks get their overnight funds from the fed funds market , which , as Figure Equilibrium in the fed funds market shows , pretty much works like any other market . Figure ( URL books 338

Federal Funds Rate Quantity of Reserves , The downward slope of the demand curve for reserves is easily explained . Like anything else , as the price of reserves ( in this case , the interest rate paid for them ) increases , the quantity demanded decreases . As reserves get cheaper , banks will want more of them because the opportunity cost of that added protection , of that added liquidity , is lower . But what is the deal with that upside down looking reserve supply curve ?

Note that the curve takes a hard right ( becomes elastic ) at the discount rate . That because , if the federal funds rate ever exceeded the discount rate , banks thirst for Fed discount loans would be unquenchable because a clear arbitrage opportunity would exist borrow at the discount rate and relend at the higher market rate . Below that point , the reserve supply curve is vertical ( perfectly inelastic ) at whatever quantity the Fed wants to supply via open market operations . The intersection of the supply and demand curves is the equilibrium or market rate , the actual federal funds rate , When the Fed makes open market purchases , the supply of reserves shifts right , URL books 339

lowering ( When it sells , it moves the reserve supply curve left , increasing ) all else constant . The discount rate sets an upper limit to because no bank would borrow reserves at a higher rate in the federal funds market than it could borrow directly from the Fed . Figure Fed targeting , fed ( Fed Funds Mule ! fo ' Duh Figure targeting , 2008 URL books 340

05 Fed funds Fed funds Martel 15 . ad , 53 , 93 , if , Dam Theoretically , the Fed could also directly affect the demand for reserves by changing the reserve requirement . If it increased ( decreased ) demand for reserves would shift up ( down ) increasing ( decreasing ) As noted above , however , banks these days can so easily sidestep required reserves that the Feds ability to the demand for reserves is extremely limited . Demand for reserves can also shift right or left due to bank liquidity management activities , increasing ( decreasing ) as expectations of net deposit increase ( decrease ) The Fed tries to anticipate such shifts and generally has done a good job of it . Although there have been days when differed from the target by several percentage points ( several hundred basis points ) between 1982 and 2007 , the fed funds target was , on average , only of a percent lower than . Between 2000 and the subprime mortgage uproar in the summer of 2007 , the Fed did an even better job of moving to its target , as Figure Fed funds targeting , shows . During the crises of 2007 and 2008 , however , the Fed often missed its target by a long way , as shown in Figure Fed funds targeting , 2008 . Stop and Think Box URL books 341

In Chapter 13 Central Bank Form and Function , you learned that America central banks , the BUS and , controlled commercial bank reserve levels by varying the speed and intensity by which it redeemed convertible bank liabilities ( notes and deposits ) for reserves ( gold and silver ) Can you model that system ?

Kudos if you can ! plot quantity of reserves along the horizontal axis and interest rate along the vertical axis . The reserve supply curve was probably highly but not perfectly inelastic and the reserve demand curve sloped downward , of course . When the BUS or wanted to tighten monetary policy , it would return commercial bank monetary liabilities in a great rush , pushing the reserve demand curve to the right , thereby raising the interest rate . When it wanted to soften , it would dawdle before redeeming notes for gold and so forth , allowing the demand for reserves to move left , thereby decreasing the interest rate . KEY TAKEAWAYS Central banks can influence the money multiplier ( simple , etc . via reserve requirements . That tool is somewhat limited these days given the introduction of sweep accounts and other reserve requirement loopholes . Central banks can also influence via loans to banks and open market operations . For policy implementation , open market operations are preferable because they are more precise and immediate and almost completely under the control of the central bank , which means it can reverse mistakes quickly . Discount loans depend on banks borrowing and repaying loans , so the central bank has less control over if it relies on loans alone . Discount loans are therefore used now primarily to set a ceiling on the overnight interbank rate and to provide liquidity during crises . The federal funds market is the name of the overnight interbank lending market , basically the market where banks borrow and lend bank reserves , in the United States . It is important because the Fed uses open market operations ( to move the equilibrium rate toward the target established by the Federal Open Market Committee ( URL books 342

Open Market Operations and the Discount Window LEARNING OBJECTIVES . How does the Fed influence the equilibrium fed funds rate to move toward its target rate ?

What purpose does the Fed discount window now serve ?

In practical terms , the Fed engages in two types , dynamic and defensive . As those names imply , it uses dynamic to change the level of the , and defensive to offset movements in other factors affecting , with an eye toward maintaining the federal funds target rate determined by the Federal Open Market Committee ( at its most recent meeting . As noted in Chapter 13 Central Bank Form and Function , the responsibility for actual buying and selling government bonds devolves upon the Federal Reserve Bank of New York ( Each trading day , staff members look at the level of reserves , the fed funds target , the actual market fed funds rate , expectations regarding , and Treasury activities . They also garner information about Treasury market conditions through conversations with primary dealers , specialized and banks that make a market in Treasuries . With the input and consent of the Monetary Affairs Division of the Board of Governors , the determines how much to buy or sell and places the appropriate order on the Trading Room Automated Processing System ( TRAPS ) computer system that links all the primary dealers . The then selects the best offers up to the amount it wants to buy or sell . It enters into two types of trades , outright ones , where the bonds permanently join or leave the Fed balance sheet , and temporary ones , called and reverse . In a repo ( aka a repurchase agreement ) the Fed purchases government bonds with the guarantee that the sellers will repurchase them from the Fed , generally one to days hence . In a reverse repo ( aka a matched transaction ) the Fed sells securities and the buyer agrees to sell them to the Fed again in the near future . The availability of such contracts and the liquidity of the government bond market render open market operations a precise tool for implementing the Fed monetary policy . The discount window , where banks come to borrow reserves from the Federal district banks , is today primarily a used during crises , when market might URL books 343

. As noted above , the discount rate puts an effective cap on by providing banks with an alternative source of reserves ( see Figure The discount window sets an upper bound on overnight interest rates ) Note that no matter how far the reserve demand curve shifts to the right , once it reaches the discount rate , it merely slides along it . Figure The ( an ) 11 rates Federal Funds Rate I I I I I I I I I I I I I Quantity of Reserves , As lender of last resort , the Fed has a responsibility to ensure that borrowers can obtain as much as they want to borrow provided they can post what in normal times would be considered good collateral security . To ensure that banks do not rely too heavily on the discount window , the discount rate is usually set a full percentage point above , a penalty of 100 basis points . This policy is usually known as Law , but the insight actually originated with Alexander Hamilton , America first Treasury secretary , so we call it Hamilton Law . On several occasions ( including the 1984 failure of URL books 344

Continental Illinois , a large commercial bank the stock market crash of 1987 and the subprime mortgage debacle of 2007 ) the discount window added the liquidity ( reserves ) and confidence necessary to stave off more serious disruptions to the economy , like those described in Chapter 12 The Financial Crisis of and Chapter 23 Aggregate Supply and Demand , the Growth Diamond , and Financial Shocks . During crisis , during which many credit markets properly , the Federal Reserve invoked its emergency powers to create additional lending powers and programs , including the following . Term Auction Facility ( a credit facility that allows depository institutions to bid for short term funds at a rate established by auction . Primary Dealer Credit Facility ( which provides overnight loans to primary dealers at the discount rate . Term Securities Lending Facility ( which also helps primary dealers by exchanging Treasuries for riskier collateral for periods . Commercial Paper Money Market Mutual Liquidity Facility , which helps money market mutual funds to meet without having to sell their assets into distressed markets . Commercial Paper Funding Facility ( which allows the , through a purpose vehicle ( to purchase commercial paper ( bonds ) issued by corporations . Money Market Investor Funding Facility ( which is another lending program designed to help the money markets ( markets for bonds ) return to normal . Presumably , most or all of these programs will phase out as credit conditions return to normal . The Bank of England and other central banks have implemented similar programs . Stop and Think Box What in Sam Hill happened in Figure Total bank from the Federal Reserve System , 2001 ?

Hint The dates are important . URL books 345 Figure hank om the Federal Reserve , 2001 ( lugs ) 10 ) a ' A av xi Terrorists attacked New York City and Washington , with hijacked airplanes , shutting down the nation and parts of the system for the better part of a week . Some primary dealers were destroyed in the attacks , which also brought on widespread fears of bankruptcies and bank runs . Banks beefed up reserves by selling bonds to the Fed and by borrowing from its discount window . Excess reserves jumped from a average of around billion to 19 billion . This is an excellent example of the discount window providing services to the economy . The discount window is also used to provide moderately shaky banks a source of credit at an even higher penalty rate percentage ( 50 basis ) points above the regular discount rate . Finally , the Fed will also lend to a small number of banks in vacation and agricultural areas that experience large deposit over the course of a year . Increasingly , however , such banks are becoming part of larger banks with more stable deposit , or they handle their liquidity management using the market for negotiable certificates of deposit or other market . KEY TAKEAWAYS URL books 346

The Fed can move the equilibrium fed funds rate toward its target by changing the demand for reserves by changing the required reserve ratio . However , it rarely does so anymore . It can also shift the supply curve to the right ( add reserves to the system ) by buying assets ( almost always Treasury bonds ) or shift it to the left ( remove reserves from the system ) by selling assets . The discount window caps because if were to rise above the Fed discount rate , banks would borrow reserves from the Fed ( technically its district banks ) instead of borrowing them from other banks in the fed funds market . Because the Fed typically sets the discount rate a full percentage point ( 100 basis ) points above its feds fund target , rises above the discount rate only in a crisis , as in the aftermath of the 1987 stock market crash and the 2007 subprime mortgage debacle . Credit Markets A Lifeline for Banks . The Bank of England Bold Initiative Should Calm Frayed Financial Nerves , The Economist , April 26 , 2008 , URL books 347

The Monetary Policy Tools of Other Central Banks LEARNING OBJECTIVE . In what ways are the monetary policy tools of central banks worldwide similar to those of the Fed ?

In what ways do they differ ?

The European Central Bank ( also uses open market operations to move the overnight interbank lending toward its target . It too uses and reverse for reversible , defensive and outright purchases for permanent additions to . Unlike the Fed , however , the spreads the love around , conducting in multiple cities throughout the European Union . The national central banks ( like the Fed district banks , also lend to banks at a marginal lending rate , which is generally set 100 basis points above the overnight cash rate . The pays interest on reserves , a practice the Fed took up only recently . Canada , New Zealand , and Australia do likewise and have eliminated reserve requirements , relying instead on what is called the channel , or corridor , system . As Figure Paying interest on reserves puts a under the overnight interest rate depicts , the supply curve in the corridor system looks like a backward . The vertical part of the supply curve represents the area in which the central bank engages in to the market rate , i , to meet its target rate , in The top horizontal part of the supply curve , ii for the Lombard rate , is the functional equivalent of the discount rate in the American system . The and other central banks using this system , like the ed , will lend at this rate whatever amount banks with good collateral desire to borrow . Under normal circumstances , that quantity is nil because it ( and i ) will be 25 , 50 , or more basis points lower , depending on the country . The innovation is the lower ofthe supply curve , ir , or the rate at which the central bank pays banks to hold reserves . That sets a on i because no bank would lend in the overnight market if it could earn a higher return by depositing its excess funds with the central bank . Using the corridor system , a central bank can keep the overnight rate within the bands set by and ir and use to keep i near it . Figure a , on reserves puts under the interest rate URL books 348

Overnight Interest Rate , i , if i ?

Quantity of Reserves , In response to the financial crisis of 2008 , the Fed began to pay interest rates on reserves and will likely continue to do so because it appears to have become central bank best practice . KEY TAKEAWAYS Most central banks now use instead of discount loans or reserve requirement adjustments for conducting monetary policy . Some central banks , including those of the euro zone and the British Commonwealth ( Canada , Australia , and New Zealand ) have developed an ingenious new method called the channel or corridor system . Under that system , the central bank conducts to get the overnight interbank lending rate near the central bank target , as the Fed does in the United States . That market rate is capped at both ends , however on the upper end by the discount ( aka Lombard ) rate , and at the lower end by the reserve rate , the interest rate the central bank pays to banks for holding . URL books 349

The market overnight rate can never dip below that rate because banks would simply invest their extra funds in the central bank rather than lend them to other banks at a lower rate During the financial crisis of 2008 , the Fed adopted the corridor system by paying interest on reserves . URL books 350

Suggested Reading , Robert The Monetary Policy of the Federal Reserve A History . New York Cambridge University Press , 2008 . Frederic Monetary Policy Strategy . Cambridge , MA MIT Press , 2007 . URL , or books 351