Money and Banking Chapter 15: Tools of Monetary Policy
Two types of open market operations
1. Dynamic open market operations (intended to change the level of reserves and the monetary base) 2. Defensive open market operations (intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury deposits with the Fed or changes in float)
Two situations in which other market tools have advantages over open market operations
1. Fed wants to raise interest rates after banks have accumulated large amounts of excess reserves - The funds rate can be raised by increasing the interest on reserves Eliminates the need to conduct massive open market operations 2. When the discount policy can be used by the Fed to perform its role as lender of last resort
2 things the Fed controls in the economy.
1. Money Supply 2. Interest Rates
Open Market Operations
1. Most important conventional monetary policy tool = primary determinants of changes in interest rates and the monetary base The main source of fluctuations in the money supply
Four tools of monetary policy
1. Open Market Operations 2. Discount Lending 3. Reserve requirements 4. Interest rate paid on reserves These four tools affect the market for reserves and the equilibrium federal funds rate
1. Open Market Operations (and it's effect on the Federal Funds Rate) Open market purchase vs open market sale
An open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise
Why does the supply curve (market for reserves) flatten out and becomes horizontal?
As the federal funds rate begins to rise above the discount rate, banks will want to keep borrowing more and more at the discount rate and then lending out proceeds in the federal funds market at the higher federal funds rate. The supply curve becomes flat (infinitely elastic)
Why does an open market purchase cause the federal funds rate to fall?
Because it lies on the downward portion of the demand curve. An open market purchase leads to a greater quantity of reserves supplied; this is true at any given federal funds rate because of the higher amount of non-borrowed reserves between the shifting points.
Why does the Fed conduct so much of its open market operations in Treasury securities
Because the market for these securities is the most liquid and has the largest trading volume. Has the ability to absorb the Fed's substantial volume of transactions without experiencing excessive price fluctuations that would disrupt the market.
Review Who sets the Federal Funds Rate
FOMC (Federal Open Market Committee)
True or False? Excess reserves are insurance against deposit inflows.
False Excess reserves are insurance against deposit outflows
True or False? Secondary credit is given to banks that are financially viable
False Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems The interest rate on secondary credit is set at 50 basis points above the discount rate. Interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers
What the equilibrium signify (market for reserves)
Federal Funds Rate = Targeted Federal Funds Rate
What if the intersection happens on the flat section. Would a rightward shift do anything to the federal funds rate?
No The interest rate paid on reserves sets a floor for the federal funds rate
Because of both of these problems, the central banks need non-interest-rate tools, known as _____________________
Non-conventional monetary policy tools
Discount lending rules
The effect of a discount rate change depends on whether the demand curve intersects the supply curve in its vertical section or its flat section. If the demand curve intersects the supply curve on its flat section, so that there is some discount lending changes in the discount rate do affect the federal funds rate. (graph b)
Quantitative Easing
The expansion of the balance sheet (that leads to a huge increase in the monetary base. Before the financial crisis began in 2007, the amount of Federal Reserve assets rose from about $800 billion to over $4 trillion. Huge increase in monetary base would usually result in an expansion of the money supply
Discount lending (finally) What's a discount window?
The facility at which banks can borrow reserves from the Federal Reserve
Federal Funds Rate
The interest rate on overnight loans of reserves from one bank to another Primary instrument of monetary policy for the Federal Reserve
Reserve Requirements (rules for supply and demand) When the reserve requirement ratio increases, required reserves ________
increase = hence the quantity of reserves demanded increases for any given interest rate. Rise in the required reserve ratio shifts the demand curve to the right, moves the equilibrium and raises the federal funds rate. When the Fed raises revenue requirements, the federal funds rate rises When the Fed decreases reserve requirements, the federal funds rate falls
The primary cost of borrowing from the Fed is the ___________
interest rate charged by the Fed on these loans = the discount rate = which is set at a fixed amount above the federal funds target rate.
Discount Window Expansion
the Fed lowered the discount rate (interest rate on loans it makes to banks) above the federal funds rate target from 50 to 100 points. Borrowing from the discount window has a "stigma" attached to it (borrowing suggests that the borrowing bank is in trouble), thus it wasn't used that much.
When the Federal Reserve System was created, its most important role was intended to be as the ___________
lender of last resort
When the federal funds rate is below the equilibrium rate, what happens?
More reserves are demanded than are supplied (excess demand) and so the federal funds rate rises, as shown by the upward arrow
3 ways the Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets
1. Discount Window Expansion 2. Team Auction Facility 3. New Lending Programs
4 advantages open market operations have over other tools
1. Open market operations occur at the initiative of the Fed, which has complete control over their volume. 2. Open market operations are flexible and precise; they can be used to the exact extent desired - No matter how small a change in reserves or the monetary base is required, open market operations can achieve it with a small purchase or sale of securities 3. Open market operations are easily reversed - the Fed can reverse any mistake immediately 4. Open market operations can be implemented quickly - no administrative delays
What causes a rightward shift in open market operations? What causes a leftward shift?
1. Open market purchase = right 2. Open market sale (decreases the quantity of nonborrowed reserves supplied) = left
Two types of defensive open market operations
1. REPO (repurchase agreements - the fed purchases securities with an agreement that the seller will repurchase them in a short period of time) anywhere from one to fifteen days from the original date of purchase especially desirable way of conducting a defensive open market purchase that will be reversed shortly 2. matched sale-purchase transaction (sometimes called a repo) in which the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future.
Reserves can be split up into two components. What are they?
1. Required reserves (equal to the required reserve ratio times the amount of deposits on which reserves are required) The amount of funds a bank is required to hold 2. Excess Reserves = The additional reserves banks choose to hold
New lending programs
1. Te Fed broadened its provision of liquidity to the financial system well beyond its traditional lending to banking institutions. - Auctions included (lending to investment banks, lending to promote purchases of commercial paper, mortgage-backed securities 2. The Fed engaged in lending to J.P. Morgan to assist in its purchase of Bear Stearns and to AIG to prevent its failure. 3. Whole new set of abbreviations (TAF, TSLF, PDCF, AMLF, MMIFF, CPFF, and TALF
At first glance, having the FDIC and lender-of-last-resort might seem redundant. How isn't it redundant?
1. The FDIC's insurance funds amounts to about 1% of the total amount of deposits held by banks. If a large number of bank failures occurred simultaneously, the FDIC wouldn't be able to cover all the depositors' losses. 2. The $1.7 trillion of large-denomination deposits in the banking system are not guaranteed by the FDIC because they exceed the $250,000 limit. (cause of this, bank panics may still occur)
Why can't the conventional monetary tools cover everything in a financial crisis?
1. The financial system seizes up to such a extent that it becomes unable to allocate capital to productive uses (investments spending and the economy collapses) 2. The negative shock to the economy can lead to the zero-lower-bound problem
Skeptic's argument for quantitative easing
1. The huge expansion in the Fed's balance sheet and the monetary base din't result in a large increase in the money supply - Because most of the increase in the monetary base just flowed into holdings of excess reserves 2. Because the federal funds rate had already fallen to the zero lower bound, the expansion of the balance sheet and the monetary base couldn't lower short-term interest rates any further (couldn't stimulate the economy 3. An increase in monetary base doesn't mean that banks will increase lending, because they can just add to their holdings of excess reserves instead of making loans.
3 forms of non-conventional monetary policy tools
1. liquidity provision 2. asset purchases 3. commitment to future monetary policy actions
Two components that the supply of reserves can be broken up to.
1. non-borrowed reserves (NBR) 2. borrowed reserves (BR)
Operation of the discount window What are the Fed's three types of discount loans to banks
1. primary credit - discount lending that plays the most important role 2. secondary credit 3. seasonal credit
Reserve Requirements A rise in reserve requirements _______ the amount of deposits that can be supported by a given level of monetary base and leads to a ______ in money supply
1. reduces 2. contraction
Review When did the Fed start paying interest on reserves
2008
When did the federal reserve paid interest on reserves?
2008
3 types of LSAP programs that were implemented (2008, 2010, and 2012)
2008 = the Fed set up a Government Sponsored Entities Purchase Program in which the Fed eventually purchased $1.25 trillion of mortgage-backed securities (MBS) guaranteed by Fannie Mae and Freddie Mac 2010 = Fed purchased $600 billion of long-term Treasury securities at a rate of about $75 billion per month. - Intended to lower long-term interest rates. 2012 = The Federal Reserve announced a third large-scale asset-purchase-program (QE3). Fed conducted $40 billion of mortgage backed securities and $45 billion of long-term Treasuries.
Why is the supply curve in the Market for Reserves straight?
Borrowing federal funds from other banks is a substitute for borrowing (taking out discount loans) from the Fed If the federal funds rate is below the discount rate, then banks will not borrow from the Fed. Borrowed reserves will be zero because borrowing in the federal funds market is cheaper. Federal funds rate remains below the discount rate = the supply of reserves will equal the amount of non-borrowed reserves supplied by the Fed. ^ Supply curve will be vertical
When the federal funds rate is above the equilibrium rate, what happens?
More reserves are supplied than are demanded (excess supply) So the federal funds rate falls to iff, as shown by the downward arrow
Standing lending facility
Healthy banks (they are allowed to borrow all they want at very short maturities [overnight] from the primary credit facility)
Supply and Demand curves - Market for Reserves (graph)
Ignore the shifting supply curve
Seasonal credit
Is given to meet the needs of a limited number of small banks in vacation and agriculture areas that have a seasonal pattern of deposits.
Benefits of the discount window
It can prevent and address financial panics that aren't triggered by bank failures Back Monday Trade Center 2001
LSAP
Large-Scale Asset Purchases The Fed's open market operations normally involve only the purchase of government securities (short-term). However, during the crisis, the Fed started two new, large-scale asset purchase programs to lower interest rates for particular types of credit
How does the Fed conduct open market operations in the U.S.
Mainly through treasury deposits with the Fed and Treasury/government agency securities (T-bills)
How does open market purchases affect reserves and supply (in general)
Open market purchases expand reserves and the monetary base, thereby increasing the money supply and lowering short-term interest rates. Open market sales = shrink reserves and the monetary base, decreasing the money supply and raising short-term interest rates
Because excess reserves are insurance against deposit outflows, the cost of holding excess reserves is their _________
Opportunity cost The interest rate that could have been earned on lending these reserves our (minus the interest rate that is earned on these reserves)
Team Auction Facility
TAF Set up by the Fed Made loans at a rate determined through competitive auctions Used more than the discount window because it allowed banks to borrow at a rate lower than the discount rate
What has the Fed learned in WW2
The Fed has used its discount lending weapon (lender of last resort) several times to avoid bank panics
Conventional Monetary Policy Tools
The Federal Reserve uses three tools of monetary policy (open market operations, discount lending, and reserve requirements) to control the money supply and interest rates. These 3 tools = conventional monetary policy tools
Zero-lower-bound problem
The central bank is unable to lower short-term interest rates further because they have hit a floor of zero
Drawbacks with the lender of last resort
The discount tool has not always been used by the Fed to prevent financial panics (massive bank failures during the Great Depression)
Where is the federal funds rate determined?
The market for reserves We turn to a supply and demand analysis of this market to analyze how the tools of monetary policy affect the federal funds rate.
How are open market operations conducted?
They're conducted electronically through a specific set of dealers in government securities Primary Dealers by a computer system called TRAPS
TRAPS
Trading Room Automated Processing System A message is electronically transmitted to all the primary dealers simultaneously over TRAPS, indicating the type and maturity of the operation being arranged Dealers are given several minutes to respond via TRAPS with their propositions to buy or sell government securities at various prices. Propositions are then assembled and displayed on a computer screen for evaluation. TRAPS will notify which propositions have been chosen.
True or False All depository institutions (commercial banks, savings and loan associations, etc.) are subject to the same rate.
True Required reserves on all checkable deposits 0 = first $13.3 million 3% = $13.3 - 80 mill 10% = 89+
True or False? The interest rate on these loans (from standing lending facilities) are set higher than the federal funds rate target because the Fed prefers that banks borrow each other in the federal funds market so that they continually monitor each other for credit risk.
True Therefore, discount lending under the primary credit facility is very small.
True or False? The quantity of reserves demanded by banks equals requires reserves plus the quantity of excess reserves demanded
True reserve quantity (demanded by banks) = (required reserves + excess reserves) Since two components of reserves are required and excess reserves
When did non-conventional monetary policy tools take effect?
When the economy experiences a full-scale financial crisis (2008)
Why does the demand curve become straight at the end?
When the federal funds rate begins to fall below the interest rate paid on excess reserves, banks don't lend in the overnight market at a lower interest rate. Instead, they just keep on adding to their holdings of excess reserves indefinitely (infinitely elastic demand curve)
Why does the demand curve for the Market for Reserves slope down?
When the federal funds rate is above the rate paid on reserves, then as the federal funds rate decreases, the opportunity cost of holding excess reserves falls. This causes the quantity of reserves demanded to rise
Interest Rate on Reserves
When the federal funds rate is at the interest rate paid on reserves, a rise in the interest rate on reserves raises the federal funds rate.
The Fed sets the discount rate ___ the federal funds target -- to encourage borrowing and lending in the federal funds market
above
Credit easing
altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets
The Fed, to date, generally has set the interest rates on reserves _____ the federal funds target
below
Discounting is not only a useful tool to influence reserves, but it's also important in preventing ______
financial panics
Changes in reserve requirements affect the money supply by causing the ________ to change
money supply multiplier
If the amount of discount lending under the standing lending facility is so small, why does the Fed have it?
the facility is intended to be a backup source of liquidity for sound banks so that the federal funds rate never rises too far above the federal funds target set by the FOMC.
Lender of last resort
to prevent bank failures from spinning out of control The Fed was to provide reserves to banks when no one else would, thereby preventing bank and financial panics.