Domestic and Intl. Banking Chp 15

a. The Fed reduces reserve requirements.

A decrease in required reserves shifts the demand for reserves line to the left, at any given interest rate. The result is that the fed funds rate decreases, and NBR and BR remain unchanged.

20. Using the supply and demand analysis of the market for reserves, indicate what happens to the federal funds rate, borrowed reserves, and nonborrowed reserves, holding everything else constant, under the following situations. a. The economy is surprisingly strong, leading to an increase in the amount of checkable deposits.

A rise in checkable deposits leads to a rise in required reserves at any given interest rate, and thus shifts the demand curve to the right. If the federal funds rate is initially below the discount rate, this then leads to a rise in the federal funds rate. As shown below, borrowed reserves and nonborrowed reserves do not change. If the federal funds rate is initially at the discount rate, then the federal funds rate will just remain at the discount rate, but borrowed reserves will increase.

1. Following the global financial crisis in 2008, assets on the Federal Reserve's balance sheet increased dramatically, from approximately $800 billion at the end of 2007 to $3 trillion by 2011. Many of the assets held are longer-term securities acquired through various loan programs instituted as a result of the crisis. In this situation, how could reverse repos (matched sale-purchase transactions) help the Fed reduce its assets held in an orderly fashion, while reducing potential inflationary problems in the future?

Because of the large amount of liquidity in banks and the financial system, this could eventually lead to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system through bank lending and ends up as deposits or currency in the hands of the public. But because of the longer maturities of some of the assets held by the Fed, these assets may not be easily drawn off the balance sheet in order to remove liquidity from banks and financial markets. As a result, reverse repos could be used to temporarily but continually remove reserves from the banking system until the longer maturity securities can be drawn off the balance sheet of the Fed.

1. If float decreases to below its normal level, why might the manager of domestic operations consider it more desirable to use repurchase agreements to affect the monetary base, rather than an outright purchase of bonds?

Because the decrease in float is only temporary, the monetary base is expected to decline only temporarily. A repurchase agreement only temporarily injects reserves into the banking system, so it is a sensible way of counteracting the temporary decline in the monetary base due to the decline in float.

1. Why is the composition of the Fed's balance sheet a potentially important aspect of monetary policy during an economic crisis?

By purchasing particular types of securities, the Fed can impact interest rates and liquidity in particular sectors of credit and financial markets, thereby providing a more surgical provision of liquidity where it may be needed the most (as opposed to typical open market purchases, which add reserves to the general banking system). For example, as a result of the global financial crisis the Fed purchased a significant amount of mortgage-backed securities from government sponsored enterprises, which helped to lower mortgage rates and support the housing market.

1. Why is paying interest on reserves an important tool for the Federal Reserve in managing crises?

During crises, the Fed may need to provide a large amount of liquidity to the banking and financial system, which would reduce the fed funds rate. If the Fed needs to sterilize these effects, it would need to conduct open market sales of securities to maintain a given fed funds rate target. If the liquidity provision is large, then offsetting the liquidity could eventually result in the Fed running out of securities to sell. In this case, the interest rate on excess reserves can be raised to push the fed funds rate up, without having to conduct offsetting open market sales that decrease the holdings of government securities by the Fed.

1. "The only way that the Fed can affect the level of borrowed reserves is by adjusting the discount rate." Is this statement true, false, or uncertain? Explain your answer.

False. The Fed also can affect the level of borrowed reserves by directly limiting the amount of loans to an individual bank or the broader financial system.

a. Banks expect an unusually large increase in withdrawals from checking deposit accounts in the future.

If banks expect that an unusually large increase in withdrawals will occur in the future, they will want to hold more excess reserves today, meaning the demand for reserves will increase at any given interest rate. This will have the same effect on the fed funds rate, NBR, and BR as in part (a) above.

1. In which economic conditions would a central bank want to use a "forward-guidance" strategy? Based on your previous answer, can we easily measure the effects of such a strategy?

In general, a central bank would use a strategy of "forward guidance" when other types of conventional tools of monetary policy cannot affect the economy in the desired way. In practice, this strategy was followed by the Fed during the aftermath of the Great Recession to try to lower long-term interest rates (since the federal funds rate had hit the zero bound). As economic conditions are usually quite abnormal during the implementation of these strategies, it is in general difficult to ascertain their effects: during abnormal economic conditions standard models of agent's behavior are not good representations of their decision making process and economists cannot therefore identify the reasons as to why one variable has changed.

20. How do the monetary policy tools of the European System of Central Banks compare to the monetary policy tools of the Fed? Does the ECB have a discount lending facility? Does the ECB pay banks an interest rate on their deposits?

In general, the set of monetary policy tools available to the ECB is quite similar to the one at the Fed's disposal. The ECB has a discount lending facility, called the marginal lending facility that is ready to supply funds to member banks at the marginal lending rate. This rate also acts as a ceiling for the overnight market rate, as in the U.S. does the discount rate. The ECB pays bank members an interest rate for their deposits at the ECB, thereby creating a floor for the overnight rate, as the Fed does in the United States.

If a switch occurs from deposits into currency, what happens to the federal funds rate? Use the supply and demand analysis of the market for reserves to explain your answer.

In most cases, the discount rate is set far enough above the fed funds target rate such that, even if there was a reduction in the discount rate with no change in the target fed funds rate, the equilibrium rate would still be below the discount rate, thus banks would still be better off borrowing at the market rate rather than the discount rate. In other words, even if the discount rate decreases, the amount of borrowed reserves may not change since the equilibrium will still fall below the discount rate, as shown in the graph below.

Why is it that a decrease in the discount rate does not normally lead to an increase in borrowed reserves? Use the supply and demand analysis of the market for reserves to explain.

In most cases, the discount rate is set far enough above the fed funds target rate such that, even if there was a reduction in the discount rate with no change in the target fed funds rate, the equilibrium rate would still be below the discount rate, thus banks would still be better off borrowing at the market rate rather than the discount rate. In other words, even if the discount rate decreases, the amount of borrowed reserves may not change since the equilibrium will still fall below the discount rate, as shown in the graph below.

In early 2016 as the Bank of Japan began to push policy interest rates negative, there was a sharp increase in sales for home safes in Japan. Why might this be, and what does it mean for the effectiveness of negative interest rate policy?

Negative policy interest rates have the effect of making deposit rates at banks negative. Thus, people can avoid negative returns on holding cash by simply pulling their money out of deposit accounts and keeping the cash in safes (with a zero return). This has two main implications for the effectiveness of negative interest rate policy. First, it has the potential side effect of decreasing liquidity in the banking sector as depositors pull their money from banks. This can destabilize the banking system and reduce the amount of money in the banking system available for lending. Second, the intended effect of negative interest rates is to penalize saving in the form of deposits, and thereby encourage consumption and borrowing, which can help stimulate the economy. However, if depositors are simply pulling their deposits and instead holding them as cash in safes, it does not increase spending and create the intended stimulus.

1. "Considering that raising reserve requirements to 100% makes complete control of the money supply possible, Congress should authorize the Fed to raise reserve requirements to this level." Discuss.

One problem with this proposal is that it provides perfect control over the official measure of the money supply, but it may weaken control over the measure of the money supply that is economically relevant. An additional problem is that it will result in a costly restructuring of the financial system, as banks are forced to get out of the loan business.

1. Compare the methods of controlling the money supply—open market operations, loans to financial institutions, and changes in reserve requirements—on the basis of the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Open market operations are more flexible, reversible, and faster to implement than the other two tools. Discount policy is more flexible, reversible, and faster to implement than changing reserve requirements, but it is less effective than either of the other two tools.

1. What are the disadvantages of using loans to financial institutions to prevent bank panics?

Providing loans to financial institutions creates a moral hazard problem. If firms know that they will have access to Fed loans, they are more likely to take on risk, knowing that the Fed will bail them out if a panic should occur. As a result, banks that deserve to go out of business because of poor management may survive because of Fed liquidity provision to prevent panics. This might lead to an inefficient banking system with many poorly run banks.

1. What are the advantages and disadvantages of quantitative easing as an alternative to conventional monetary policy when short-term interest rates are at the zero lower bound?

Since short-term interest rates cannot be lowered below the zero bound in this environment, conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing is that purchases of intermediate and longer term securities could reduce longer-term interest rates, increase the money supply further, and lead to expansion. One disadvantage of quantitative easing is that it may not actually have the effect of increasing economic activity through greater loans and monetary expansion: If credit and financial markets are significantly damaged, banks may simply hold the extra liquidity as excess reserves, which would not lead to greater loans and monetary expansion.

What is the main advantage and the main disadvantage of an unconditional policy commitment?

The main advantage to an unconditional policy commitment is that it provides a significant amount of transparency and certainty, which makes it easier for markets and households to make decisions about the future. The main disadvantage is that it represents a tacit commitment by the central bank; if conditions suddenly change where a change in the policy stance may be warranted, then holding to the commitment could be destabilizing. On the other hand, not strictly maintaining the commitment could then be viewed as reneging on a promise, and the central bank could lose significant credibility.

20. If a switch occurs from deposits into currency, what happens to the federal funds rate? Use the supply and demand analysis of the market for reserves to explain your answer.

The switch from deposits into currency lowers the amount of reserves as was shown in the T-accounts of Chapter 14, and this lowers the supply of reserves at any given interest rate, thus shifting the supply curve to the left. The fall in deposits also leads to lower required reserves, and hence a shift in the demand curve to the left. However, because the fall in required reserves is only a fraction of the fall in the supply of reserves (because the required reserve ratio is much less than one), the supply curve shifts left by more than the demand curve. Thus, if the discount rate is initially above the fed funds target, the fed funds rate will rise (as shown in the graph below). However, if the fed funds rate is at the discount rate, then the fed funds rate will remain at the discount rate.

1. "Discount loans are no longer needed because the presence of the FDIC eliminates the possibility of bank panics." Is this statement true, false, or uncertain?

This statement is false. The FDIC alone would likely be ineffective in eliminating bank panics without the Fed's ability to provide discount loans to troubled banks to keep bank failures from spreading. In particular, the FDIC's insurance only covers about 1% of total bank deposits. Since the Fed has unlimited ability to provide loans to the banking system, it can be much more effective in stabilizing the banking system in a panic.

a. The Fed raises the target federal funds rate.

To raise the target fed funds rate, the Fed will have to conduct an open market sale of securities, which will shift the supply of nonborrowed reserves to the left. The fed funds rate will increase, and as long as the equilibrium fed funds rate remains below the discount rate, borrowed reserves will remain the same.

"The federal funds rate can never be above the discount rate." Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the discount rate, it would never surpass the discount rate since banks would then borrow directly from the Fed, and not in the fed funds market, which would prevent the fed funds rate from ever rising above the discount rate. However, in practice, the fed funds rate can (and has) been above the discount rate. This may occur due to the stigma associated with banks borrowing directly from the Fed; i.e., banks may prefer to pay a higher market rate than to borrow directly from the Fed and incur the perceived stigma. In addition, nonbank financial institutions, which do not have access to the discount window, can and do participate in the federal funds market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is above the discount rate may not be arbitraged away.

1. "The federal funds rate can never be below the interest rate paid on reserves." Is this statement true, false, or uncertain? Explain your answer.

Uncertain. In theory, the market for reserves model indicates that once the fed funds rate reaches the interest rate on excess reserves, it would never go below this rate since banks could then earn a risk-free interest rate paid directly from the Fed, rather than loaning excess reserves in the more risky fed funds market at an equivalent or lower rate; this should prevent the fed funds rate from ever falling below the interest rate paid on excess reserves. However, in practice, the fed funds rate can (and has) been below the interest rate paid on excess reserves. This is because nonbank financial institutions, which cannot earn interest on reserves, participate in the federal funds market and provide a significant amount of funding to the market. The extent to which nonbank financial companies participate in the fed funds market may mean that the gap when the fed funds rate is below the interest rate on excess reserves may not be arbitraged away.

1. During the holiday season, when the public's holdings of currency increase, what defensive open market operations typically occur? Why?

When the public's holding of currency increases during holiday periods, the currency-checkable deposits ratio increases and the money supply falls. To counteract this decline in the money supply, the Fed will conduct a defensive open market purchase of securities.

1. If the Treasury pays a large bill to defense contractors and as a result its deposits with the Fed fall, what defensive open market operations will the manager of the open market desk undertake?

As we saw in Chapter 14, when the Treasury's deposits at the Fed fall, the monetary base increases. To counteract this increase, the manager would undertake an open market sale of securities.

1. Open market operations are typically repurchase agreements. What does this tell you about the likely volume of defensive open market operations relative to the volume of dynamic open market operations?

It suggests that defensive open market operations are far more common than dynamic operations because repurchase agreements are used primarily to conduct defensive operations to counteract temporary changes in the monetary base.

a. The Fed raises the interest rate on reserves above the current equilibrium federal funds rate.

Raising the interest rate on reserves above the current fed funds rate means that the floor of reserve demand will push the equilibrium fed funds rate up along with the interest rate on reserves. Both borrowed reserves and nonborrowed reserves will remain the same.

Why are repurchase agreements used to conduct most short-term monetary policy operations, rather than the simple, outright purchase and sale of securities?

Repurchase agreements are used because they are temporary and allow the Fed to adjust open market operations relatively easy in response to day-to-day changes in conditions in the market for reserves.

1. If the manager of the open market desk hears that a snowstorm is about to strike New York City, making it difficult to present checks for payment there and so raising the float, what defensive open market operations will the manager undertake?

The snowstorm would cause float to increase, which would increase the monetary base. To counteract this effect, the manager will undertake a defensive open market sale of securities using a reverse repo transaction.

a. The Fed reduces reserve requirements and then offsets this action by conducting an open market sale of securities.

With the decrease in required reserves, this reduces reserve demand as shown in part (e) above. This will decrease the equilibrium fed funds rate. In order to sterilize the effects and keep the fed funds rate unchanged, the Fed will conduct an open market sale of securities, shifting the reserve supply line to the left. The end result is that the fed funds rate and borrowed reserves will be unchanged, and nonborrowed reserves will decrease.