16.3 Tools of Monetary Policy

Open Market Operations: Buying Securities

1. FROM COMMERCIAL BANKS When Federal Reserve Banks buy government bonds from commercial banks, (a) The commercial banks give up part of their holdings of securities (the government bonds) to the Federal Reserve Banks. (b) The Federal Reserve Banks, in paying for these securities, place newly created reserves in the commercial banks' accounts at the Fed. (These reserves are created "out of thin air," so to speak.) The commercial banks' reserves go up by the amount of the purchase of the securities. ** When Federal Reserve Banks purchase securities from commercial banks, they increase the reserves in the banking system, which then increases the lending ability of the commercial banks. 2. FROM THE PUBLIC The effect on commercial bank reserves is much the same when Federal Reserve Banks purchase securities from the general public through the primary dealers. (a) The seller gives up securities to the Federal Reserve Banks. It receives payment in the form of a check drawn by the Federal Reserve Banks on themselves. (b) The seller promptly deposits the check in its account with the X bank. (c) The X bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection. As a result, the X bank sees an increase in its reserves. ***whether the Fed buys bonds from the public or from commercial banks, the result is the same: When the Fed buys securities in the open market, commercial bank reserves are increased. ***the Federal Reserve Banks' purchase of government bonds directly increases the money supply. ****A modest change in reserves caused by Fed purchases or sales of government bonds can generate a much larger change in the overall money supply once the monetary multiplier kicks in.

Open Market Operations: Repos and Reverse Repos

REPOS When the Fed undertakes a repo transaction, it makes a loan of money in exchange for government bonds being posted as collateral. The Fed's repo loans are normally overnight loans but can last as long as 65 business days. The Fed holds the bonds posted as collateral until the loan is either repaid or goes into default. If the money is repaid on time, the Fed returns the bonds to the borrower. If the money is not repaid on time, the Fed keeps the bonds. REVERSE REPOS - transactions are repos in reverse. Instead of the Fed lending money against bond collateral, it is the Fed that posts government bonds as collateral when borrowing money from financial institutions. The key point is that repos involve the Fed lending money into the financial system whereas reverse repos involve the Fed borrowing money out of the financial system. That means that repos are like open-market purchases of bonds (because both increase the money supply) while reverse repos are like open-market sales of bonds (because both decrease the money supply).

The Reserve Ratio

The Fed can also manipulate the reserve ratio in order to influence the lending ability of commercial banks. RAISING THE RESERVE RATIO Raising the reserve ratio increases the amount of required reserves that banks are required to hold at the Fed. As a consequence, excess reserves will either shrink to a smaller positive amount, or shrink so far that banks will find themselves holding less reserves than are needed to meet the increased reserve requirement. - The first scenario diminishes banks' ability to create money by lending. - The second scenario will force banks to shrink checkable deposits and therefore the money supply. LOWERING THE RESERVE RATIO Lowering the reserve ratio transforms required reserves into excess reserves and enhances banks' ability to create new money by lending. - a change in the reserve ratio affects the money-creating ability of the banking system in two ways: 1. It changes the amount of excess reserves. 2. It changes the size of the monetary multiplier.

Interest on Reserves

The ability to pay interest on reserves gave the Fed a fourth policy tool by which it can implement monetary policy and either increase or decrease the amount of monetary stimulus in the economy. - if the Fed wishes to reduce the amount of bank lending and, consequently, the amount of money circulating in the economy. It can do so by increasing the IOER rate of interest that it pays on excess reserves held at the Fed. The higher the IOER rate, the more incentive banks will have to reduce their risky commercial lending for car, mortgage, and business loans in order to increase their excess reserves and thereby earn the risk-free IOER rate. - if the Fed wishes to increase the amount of money that banks lend into the economy, the Fed can lower the interest rate that it pays on excess reserves. The lower rate will make it less attractive for banks to keep reserves, and, consequently, banks will have a greater incentive to increase consumer and commercial lending and thereby stimulate the economy.

Open-market operations

The purchases and sales of U.S. government securities that the Federal Reserve System undertakes in order to influence interest rates and the money supply; one method by which the Federal Reserve implements monetary policy. the Fed either (1) buys or sells government bonds (U.S. securities) outright, or (2) utilizes government bonds as collateral on loans of money. - The conduit for the Fed's open-market operations is the trading desk of the New York Federal Reserve Bank.

collateral

- una garantia - The pledge of specific assets by a borrower to a lender with the understanding that the lender will get to keep the assets if the borrower fails to repay the loan with cash.

Fed's four main tools of monetary control that it can use to alter the reserves of commercial banks, and thus their ability to make new loans are

1. Open Market Operations 2. changing the required reserve ratio, 3. adjusting the discount rate 4. altering the interest rates on required and excess bank reserves.

repo

A repurchase agreement (or "repo") is a short-term money loan made by a lender to a borrower that is collateralized with bonds pledged by the borrower. The name repo refers to how the lender would view the transaction. The same transaction when viewed from the perspective of the borrower would be called a reverse repo.

Reverse Repo

A reverse repurchase agreement (or "reverse repo") is a short-term money loan that the borrower obtains by pledging bonds as collateral. The name reverse repo refers to how the borrower would view the transaction. The same transaction when viewed by the lender would be called a repo.

Fed

Federal Reserve Board

Interest on Excess Reserves (IOER)

Interest rate paid by the Federal Reserve on bank excess reserves

Relative Importance

Open-market operations are the most important of the four monetary policy tools because they give the Fed the ability to proactively alter the money supply in a way that will have immediate effects on the economy. The Fed can purchase, sell, borrow, or lend government securities in large or small amounts—and the impact on banks' reserves is immediate. - By contrast, if the Fed lowers the discount rate, banks may or may not come forward to take advantage of it; there may be be little to no change in bank reserves. - Changing the reserve ratio has similar problems. If there are plentiful excess reserves in the banking system, as there have been since the Great Recession, then changes in the required reserve ratio may have zero effect on lending because even a doubling of the reserve ratio (from the current level of 10 percent to 20 percent) would leave banks with excess reserves and, thus, no strong incentive to reduce lending.

Reserve Ratio

The fraction of checkable deposits that each commercial bank or thrift institution must hold as reserves at its local Federal Reserve Bank or in its own bank vault; also called the reserve requirement.

The Discount Rate

The interest rate that the Federal Reserve Banks charge on the loans they make to commercial banks and thrift institutions.

From the commercial banks' point of view, the discount rate is

a cost of acquiring reserves. This fact allows the Fed to alter the discount rate at its discretion in order to incentivize banks to increase or decrease their reserves and thereby increase or decrease the money supply. - A decrease of the discount rate encourages commercial banks to obtain additional reserves by borrowing from Federal Reserve Banks. When commercial banks lend any of these new reserves, the money supply will increase. - An increase of the discount rate discourages commercial banks from obtaining additional reserves by borrowing from the Federal Reserve Banks. Thus the Fed may raise the discount rate when it wants to restrict the money supply.

What makes commercial banks and the public willing to sell government securities to, or buy them from, Federal Reserve Banks?

the price of bonds and their interest yields. We know that bond prices and interest rates are inversely related. When the Fed buys government bonds, the demand for them increases. Government bond prices rise, and their interest yields decline. The higher bond prices and their lower interest yields prompt banks, securities firms, and individual holders of government bonds to sell them to the Federal Reserve Banks. When the Fed sells government bonds, the additional supply of bonds in the bond market lowers bond prices and raises their interest yields, making government bonds attractive purchases for banks and the public.

Open Market Operations: Selling Securities

When the Federal Reserve Banks sell government bonds, commercial banks' reserves are reduced. TO COMMERCIAL BANKS When the Federal Reserve Banks sell securities in the open market to commercial banks, (a) The Federal Reserve Banks give up securities that the commercial banks acquire. (b) The commercial banks pay for those securities by drawing checks against their deposits—that is, against their reserves—in Federal Reserve Banks. The Fed collects on those checks by reducing the commercial banks' reserves accordingly. TO THE PUBLIC When the Federal Reserve Banks sell securities to the public, the outcome is much the same. (a) The Federal Reserve Banks sell government bonds to Gristly, which pays with a check drawn on the Wahoo bank. (b) The Federal Reserve Banks clear this check against the Wahoo bank by reducing Wahoo's reserves. (c) The Wahoo bank returns the canceled check to Gristly, reducing Gristly's checkable deposit accordingly. ** Whether the Federal Reserve Banks sell bonds to the public or to commercial banks, the result is the same: When the Fed sells securities in the open market, commercial bank reserves are reduced. If all excess reserves have already been lent out, this decline in commercial bank reserves will decrease the nation's money supply by a multiple amount due to the monetary multiplier working in reverse.