Chapter 15: Tools of Monetary Policy

Longer-Term Refinancing Operations (QE?)

A category of open market operations by the European Central Bank that are similar to the Fed's outright purchases or sales of securities

Whats the FED's most important role?

Being a lender of last resort

What's the most effective way to *provide reserves to the banking system during a banking crisis*?

Discounting, because reserves are immediately channeled to the banks that need them most.

What does a change in Reserve Requirement do?

Shift the sloping part of R(d) in/out

Primary Dealers

government securities dealers, operating out of private firms or commercial banks, with whom the Fed's open market desk trades

How does the Interest Rates on Reserve work?

in the aftermath of the global financial crisis, banks have accumulated huge quantities of reserves and, in this situation, increasing the federal funds rate would require massive amounts of open market operations to remove these reserves from the banking system. The interest-on-reserves tool can come to the rescue because it can be used to raise the federal funds rate

Dynamic Open Market Operations

intended to change the level of reserves and the monetary base

Repurchase Agreements

is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period

Reverse Repo (Matched Sale)

is an act of buying securities with the intention of returning—reselling—those same assets back in the future at a profit.

Non-conventional Monetary Policy

non-interest-rate tools used by the central bank to stimulate the economy

Lender of Last Resort

provides funds to troubled banks that cannot find any other sources of funds to prevent bank failures from spinning out of control

Unconditional Commitment

stated that the decision to change is independent from the state of the economy

Conditional Commitment

stated that the decision was predicated on something else occurring or not-occuring in the market

Target Financing Rate (EU's IR?)

the European Central Bank's target for the overnight cash rate

Standing Lending Facility

Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the primary credit facility

Quantitative Easing (QE)

an expansion of the Federal Reserves balance sheet because these programs lead to a huge increase in the monetary base (focuses on asset side of balance sheet)

What does a central bank charging a negative interest rate mean?

banks now had to pay their central bank to keep deposits in the central bank

Forward Guidance

commitment of a future path of policy interest rates

Management of Expectations

committing to the future policy action of keeping the federal funds rate at zero for an extended period, the Fed could lower the market's expectations of future short-term interest rates, thereby causing the long-term interest rate to fall

Secondary Credit

discount loans available to banks that are in financial trouble and are experiencing severe liquidity problems (interest rate on these loans is .5% above the discount rate)

Primary Credit

discount loans available to healthy banks experiencing temporary liquidity problems (interest rate on these loans is the discount rate)

Seasonal Credit

discount loans given to meet the needs of a limited number of small banks in vacation and agricultural/tourist areas that have a seasonal pattern of deposits (interest rate is tied to the FFR)

Defensive Open Market Operations

intended to offset movements in other factors that affect the monetary base (such as changes in Treasury deposits with the Fed or changes in float)

How is the Interest Rates on Reserve different then the other monetary poilicies?

the Fed has not yet used interest on reserves as a tool of monetary policy, but instead has just used it to help provide a floor under the federal funds rate.

Overnight Cash Rate (EU's FFR)

the interest rate for very-short-term interbank loans in the euro area

(2) Types of defensive open market operations

Repo agreement Matched-sales price transaction

Main Refinancing Operations

Weekly reverse transactions (purchase or sale of eligible assets under repurchase agreements or credit operations against eligible assets as collateral) that are reversed within two weeks and are the primary monetary policy tool of the European Central Bank

What is the basic advantage of IOR?

When banks have and excess of reserves the interest rate (federal funds rate) can be raised by increasing the interest on reserves.

Credit Easing

altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets (focuses on liabilities side of balance sheet)

Conventional Monetary Policy

Fed policies designed to increase or decrease the federal funds rate using open market operations.

(4) Types of Non-conventional Monetary Policy

(1) Liquidity Provision (2) Asset Purchases (3) Forward Guidance (4) Negative Interest Rates on deposits at the FED

(4) Types of Conventional Monetary Policy

(1) OMO (2) Discount Rate (3) Reserve Requirement (4) Interest paid on reserves

Reserve Requirement

0% for the first $15.5 million 3% from $15.5 to $115.1 million and between 8-18% (usually 10%) over $115.1 million

What are the (4) basic advantages of OMO?

1. Occur at the initiative of the Fed 2. Flexible and precise 3. Easily reversed 4. Implementation is quick

Take Away #1

A supply and demand analysis of the market for reserves yields the following results: When the Fed makes an open market purchase or lowers reserve requirements, the federal funds rate drops. When the Fed makes an open market sale or raises reserve requirements, the federal funds rate rises. Changes in the discount rate and the interest rate paid on reserves may also affect the federal funds rate.

What is the basic advantage of Discount Rate?

Allows FED to play lender of last resort.

Take Away #3

Conventional monetary policy tools are no longer effective when the zero-lower-bound problem occurs, in which the central bank is unable to lower short-term interest rates because they have hit a floor of zero. In this situation, central banks use nonconventional monetary policy tools, which involve liquidity provision, asset purchases, and commitment to future policy actions. Liquidity provision and asset purchases lead to an expansion of the central bank balance sheet, which is referred to as quantitative easing. Expansion of the central bank balance sheet by itself is unlikely to have a large impact on the economy, but changing the composition of the balance sheet, which is accomplished by liquidity provisions and asset purchases and is referred to as credit easing, can have a large impact by improving the functioning of particular credit markets.

Take Away #2

Conventional monetary policy tools include open market operations, discount policy, reserve requirements, and interest on reserves. Open market operations are the primary tool used by the Fed to implement monetary policy in normal times because they occur at the initiative of the Fed, are flexible, are easily reversed, and can be implemented quickly. Discount policy has the advantage of enabling the Fed to perform its role of lender of last resort, while raising interest rates on reserves to increase the federal funds rate eliminates the need to conduct massive open market operations to reduce reserves when banks have accumulated large amounts of excess reserves.

What is the shape of the demand curve for reserves when the Federal Funds Rate > Interest on Reserves?

Downward sloping until IOR

Asset Purchases

During the crisis the Fed started new asset purchase programs to lower interest rates for particular types of credit -Government Sponsored Entities Purchase Program (Fannie Mae & Freddie Mac buy MBS's to lower interest rates and prop up market) -QE2 (FED purchasing of long-term Treasury securities to lower long term interest rates and increase investment spending) -QE3 (FED purchasing of MBS's & Treasury securities to lower interest rates and increase investment spending, *however; QE3's goal was not to increase assets by a fixed dollar amount but instead was open-ended, with the purchase plan set to continue contingent on labor market*)

Dynamic vs. Defensive OMO

Dynamic (Long Term) Defensive (Short Term)

What is the shape of the supply curve for reserves when the Federal Funds Rate > Interest on Reserves?

Elastic until ID then flat

Discount Window

FED facility at which banks can borrow reserves from the Federal Reserve (Discount Loan)

Reverse Transactions

Purchase or sale of eligible assets by the European Central Bank under repurchase agreements or credit operations against eligible assets as collateral that are reversed within two weeks.

What does a change in the Interest Rate on reserves do?

Shift the flat part of R(d) up/down; overall effect depends on where iff is in relation to id (*iff>ior* = *nothing* *iff=ior* = *decrease or increase in iff&ior*)

What does a change in OMO do?

Shifts R(s) in/out; overall effect depends on where R(d) intersects R(s) (downward or elastic part)

What does a change in Discount Rate do?

Shifts R(s) up/down; overall effect depends on where iff is in relation to id (*id>iff* = *nothing* *id=iff* = *decrease or increase in iff&id*)

Reserve Requirement

The European Central Bank's also have a reserve requirement to set a

Deposit Facility

The European Central Bank's standing facility in which banks are paid to deposit excess reserves

Marginal Lending Facility

The European Central Bank's standing lending facility in which banks can borrow (against eligible collateral) overnight loans from the national central bank

What has the Fed been focusing on lately as their primary instrument of monetary policy?

The Federal Funds Rate because it affects interest rates (since February 1994 the Fed has announced a federal funds rate target at each FOMC meeting)

Liquidity Provision

The Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets -Discount Window Expansion - Term Auction Facility - New Lending Programs

The Fed prefers that banks borrow from each other in the federal funds market so in most circumstances the amount of discount lending under the primary credit facility is very small. If this is true what is the purpose of the Primary Credit Facility?

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

Federal Funds Rate

The interest rate on overnight loans of deposits at the Federal Reserve

Take Away #4

The monetary policy tools used by the European Central Bank are similar to those used by the Federal Reserve System and involve open market operations, lending to banks, and reserve requirements. Main financing operations—open market operations in repos that are typically reversed within two weeks—are the primary tool used to set the overnight cash rate at the target financing rate. The European Central Bank also operates standing lending facilities, which ensure that the overnight cash rate remains within 100 basis points of the target financing rate.

Opportunity cost of holding excess reserves

the interest rate that could have been earned on lending these reserves out minus the interest rate that is earned on these reserves (Before the fall of 2008, the Federal Reserve did not pay interest on reserves, but since then it has paid interest on reserves at a level that is typically set at a fixed amount below the federal funds rate target and therefore changes when the target changes)

Zero-Lower-Bound Problem

when the central bank is unable to lower its policy interest rate (the federal funds rate for the Fed) further because it has hit a floor of zero