Money and Banking: Chapter 15

Open market operations: Types

1) Dynamic 2) Defensive

Defensive

everyday operations to respond to the market and meet the federal funds rate target

Dynamic

used to implement monetary policy changes

How do changes in the reserve requirement affect the market for reserves?

• Changes the demand for reserves

How do changes in the interest paid on reserves affect the market for reserves?

• Changes the lower bound for the federal funds rate

What are the advantages and disadvantages of using the interest rate paid on reserves?

• Changes the lower bound for the federal funds rate • When banks have accumulated large amounts of excess reserves, the Fed can use the interest rate paid on reserves to raise the federal funds rate •Advantages: 1. When banks already have a lot of excess reserves, the open market operations needed to raise the federal funds rate would be very large

How do open market operations affect the market for reserves?

• Changes the supply of non-borrowed reserves

How do changes the discount rate affect the market for reserves?

• Changes the upper bound of the federal funds rate

What are the advantages and disadvantages of using the discount rate?

• Changes the upper bound of the federal funds rate • Discount lending: primary, secondary, seasonal •Advantages: 1. Fed can fulfill their role as lender of last resort 2. Discount rate acts as a ceiling on the federal funds rate (sends a signal of how high ff rate can go) •Disadvantages: 1. Moral hazard issues when banks take too much risk 2. Fed does not completely control the amount of discount loans (imprecise)

New Federal Reserve monetary policy tools a. How are they different from the original monetary policy tools? (Scope of lending, type of collateral, control of quantity)

• Includes: lending to investment banks as well as lending to promote purchases of commercial paper, mortgage-backed securities, and other asset-backed securities

New Federal Reserve monetary policy tools b. How does a special purpose vehicle work?

• The federal reserve gives a loan to the special purpose vehicle, who then gives money to banks and financial institutions in return for mortgage-backed securities, and hold them until they return and give the profit to the federal reserve

What are the advantages and disadvantages of using the reserve requirement?

•Advantages: 1. Can cause a really big change in the actions of banks if the reserve requirements are binding •Disadvantages: 1. Reserve requirements usually don't bind 2. This tool causes BIG changes

Open market operations: What are the advantages and disadvantages?

•Advantages: 1. Fed has complete control over the amount 2. Operations are flexible and precise 3. Operations can be large or small 4. Operations can be done quickly •Disadvantages: 1. Operations can have a large impact on the cost of financing government debt (Bad for the U.S. Treasury)