Chapter 15: Tools of Monetary Policy

Reserve requirements

3% of the first $48.3 million of checkable deposits, 10% of checkable deposits above that Disadvantages -Can create liquidity problems -Increases uncertainty for banks

Shifts in Supply and Demand and the Limits of iff changes

Basically, iff has an upper bound (id) and a lower bound (ier)

Discount Policy and the Lender of Last resort

Discount rate isn't great for controlling money supply, but lender of last resort role is Primary credit: short term loans to healthy banks to meet reserve requirements Secondary credit: longer term loans to troubled banks with severe liquidity problems Seasonal credit: loans to small banks that have seasonal cash flow (agricultural and vacation areas) Fed charges slightly higher interest rate on second two Lender of last resort to prevent financial panics- creates moral hazard problems (safety net for banks, causes them to take risks) Advantages and Disadvantages of discount policy -It is used to perform the lender of last resort role (important during the subprime crisis of 2008-9) -But the amount of discount loans cannot be controlled by the fed; the decision maker is the individual bank (has to take the loan)

Conventional monetary policy tools

During normal times, three tools to control the money supply and interest rates: (1) OMO (2) Discount lending (3) reserve requirements

Open Market Operations (dominant tool)

Dynamic open market operations -Intended to change the monetary base, typically in conjunction with a change in the target (intended) federal funds rate -these are done after FOMC meetings and are meant to change the iff Defensive open market operations -Intended to offset changes in other factors that affect the monetary base, typically conducted to maintain the fed funds rate at its target level -these are the things that happen everyday to maintain iff at current level Advantages of OMO -Fed has complete control over the volume -Flexible and precise -Easily reverse -Quickly implemented

Increase in the Interest rate paid on loans at the fed (ier)

Increases the horizontal portion of demand curve

Unconventional tools during the global financial crisis

Liquidity provision: fed implemented unprecedented increases in its lending facilities to provide liquidity to financial markets

Increases in the discount rate

Shifts flat portion of supply curve up

Increase in reserve requirement

Shifts the diagonal portion of the demand curve to the right

Open Market Purchase of Securities

Shifts vertical portion of the supply curve to the right

Demand in the Market for Reserves

Since the fall of 2008, the Fed has paid interest on reserves at a level that is set at a fixed amount below the fed funds rate target When the fed funds rate is above the interest rate paid on excess reserves, ier, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls, and the quantity demanded of reserved increases Downward sloping demand curve becomes flat at ier (when fed funds rate lowers below ier, a bank has no reason to loan more to banks, instead puts all of reserves in fed)

Supply in the Market for Reserves

Two components: non-borrowed reserves (Open Market Operations) and borrowed reserves (discount loans) Cost of borrowing from the fed is the discount rate Borrowing from the fed is a substitute for borrowing from other banks If iff<id, then banks will not borrow from the fed and borrowed reserves are zero: The supply curve will be vertical As iff rises above id, banks will borrow more and more at id (banks can borrow cheaper from the fed so have no reason to borrow from other banks) The supply curve is horizontal (perfectly inelastic) at id (banks only borrow from the fed)