Chapter 16

non-interest-rate tools, known as nonconventional monetary policy tools, are (4 forms)

(1) liquidity provision, (2) asset purchases, (3) forward guidance, and (4) negative interest rates on bank deposits at a central bank.

Liquidity Provision in three ways:

Discount Window Expansion: lowered the discount rate Term Auction Facility: To encourage additional borrowing, in December 2007 the Fed set up a temporary Term Auction Facility (TAF), in which it made loans at a rate determined through competitive auctions. The TAF was more widely used than the discount window facility because it enabled banks to borrow at a rate lower than the discount rate, and the rate was determined competitively rather than being set at a penalty rate. New Lending Programs: The Fed broadened its provision of liquidity to the financial system well beyond its traditional lending to banking institutions. These actions included lending to investment banks as well as lending to promote purchases of commercial paper, mortgage-backed securities, and other asset-backed securities.

_________________ is a particularly effective way to provide reserves to the banking system during a banking crisis because reserves are immediately channeled to the banks that need them most.

Discounting

Because such an increase in the monetary base would usually result in an expansion of the money supply, it seems as though such an expansion could be a powerful force in stimulating the economy in the near term and possibly producing inflation down the road. There are reasons to be very skeptical of this hypothesis:

First, as we saw in the final application in Chapter 15, the huge expansion in the Fed's balance sheet and the monetary base did not 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. Second, because the federal funds rate had already fallen to the zero lower bound, the expansion of the balance sheet and the monetary base could not lower short-term interest rates any further and thereby stimulate the economy. Third, an increase in the monetary base does not mean that banks will increase lending, because they can just add to their holdings of excess reserves instead of making loans

However, there are doubts that negative interest rates on deposits will have the intended, expansionary effect. Why?

First, banks might not lend out their deposits at the central bank, but instead move them into cash. Second, charging banks interest on their deposits might be very costly to banks if they still have to pay positive interest rates to their depositors

At first glance, it might seem that the presence of the FDIC, which insures depositors up to a limit of $250,000 per account from losses due to a bank's failure, would make the lender-of-last-resort function of the Fed superfluous. There are two reasons why this is not the case:

First, it is important to recognize that the FDIC's insurance fund amounts to about 1% of the total amount of deposits held by banks. If a large number of bank failures occurred simultaneously, the FDIC would not be able to cover all the depositors' losses. Second, the $1.6 trillion of large-denomination deposits in the banking system are not guaranteed by the FDIC because they exceed the $250,000 limit. A loss of confidence in the banking system could still lead to runs on banks from the large-denomination depositors, and bank panics could still occur despite the existence of the FDIC.

However, when the economy experiences a full-scale financial crisis like the one we recently experienced, conventional monetary policy tools cannot do the job, for two reasons:

First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse. Second, the negative shock to the economy can lead to the zero-lower-bound problem, in which 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, as occurred at the end of 2008

the discount window

The facility at which banks can borrow reserves from the Federal Reserve

What happens the discount lending is lowered and the demand curve cross the horizontal/flat part of the supply curve? What if it is raised?

The federal funds rate falls The federal funds rate rises

What happens when the intersection is on the demand's flat sloping part and the interest rate on reserves rises?

The federal funds rate rises because the flat part of demand rises. IMPORTANT: When the federal funds rate is at the interest rate paid on reserves (intersection at flat part of demand curve), a rise in the interest rate on reserves raises the federal funds rate.

However, if the supply curve initially intersects the demand curve on its flat section, as in panel (b) of Figure 2, open market operations ____________________. Why?

have no effect on the federal funds rate. because the interest rate paid on reserves, ior, sets a floor for the federal funds rate.2

Indeed, this tool of monetary policy ( ____________) was used extensively when the Fed wanted to ___________ the federal funds rate and exit from the policy of maintaining it at zero in December 2015.

interest on reserves raise

the Fed to date generally has __________________ below the federal funds target

set the interest rate on reserves

Setting negative interest rates on banks' deposits is supposed to work to ______________

stimulate the economy by encouraging banks to lend out the deposits they were keeping at the central bank, thereby encouraging households and businesses to spend more.

Like the Federal Reserve, the European System of Central Banks (usually referred to as the European Central Bank) signals the stance of its monetary policy by setting a ______________, which in turn sets a target for the __________________.

target financing rate, overnight cash rate

credit easing:

that is, altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets.

What does an open market purchase do for equilibrium (on the downward sloping part of the demand curve)?

leads to a greater quantity of reserves supplied, this shifts the supply curve to the right, and lowers the federal funds rate

Federal Reserve's operating procedures limit the fluctuations of the federal funds rate so that it ________________

remains between ior and id.

Defensive open market operations are of two basic types:

repurchase agreement (often called a repo) and matched sale-purchase transaction (sometimes called a reverse repo)

Therefore, the quantity of reserves demanded by banks equals

required reserves plus the quantity of excess reserves demanded.

Required reserve requirements shifts what curve?

reserves demand curve

Open market operations constitute the most important conventional monetary policy tool because they have four basic advantages over the 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. 3. Open market operations are easily reversed. 4. Open market operations can be implemented quickly; they involve no administrative delays

Altering the composition of the Fed's balance sheet can stimulate the economy in several ways:

First, when the Fed provides liquidity to a particular segment of the credit markets that has seized up, such liquidity can help unfreeze the market and thereby enable it to allocate capital to productive uses, consequently stimulating the economy. Second, when the Fed purchases particular securities, it increases the demand for those securities and, as we saw in Chapter 6, such an action can lower the interest rates on those securities relative to rates on other securities. Thus, even if short-term interest rates have hit a floor of zero, asset purchases can lower interest rates for borrowers in particular credit markets and thereby stimulate spending.

Why does the supply curve turn flat at a certain point?

However, as the federal funds rate begins to rise above the discount rate, banks will want to keep borrowing more and more at id and then lending out the proceeds in the federal funds market at the higher rate, iff. The result is that the supply curve becomes flat (infinitely elastic) at id,

Although the Fed's role as the lender of last resort provides the benefit of preventing bank and financial panics, it does come with a cost, which is?

If a bank expects that the Fed will provide it with discount loans if it gets into trouble, then it will be willing to take on more risk, knowing that the Fed will come to the rescue if necessary. The Fed's lender-of-last-resort role has thus created a moral hazard problem similar to the one created by deposit insurance (discussed in Chapter 10): Banks take on more risk, thus exposing the deposit insurance agency, and hence taxpayers, to greater losses. The moral hazard problem is most severe for large banks, which may believe that the Fed and the FDIC view them as "too big to fail"; that is, they believe they will always receive Fed loans when they are in trouble because their failure would be likely to precipitate a bank panic.

____________________ are the predominant form of open market operations and are similar to the Fed's repo transactions

Main refinancing operations

There are two situations in which the other tools have advantages over open market operations:

One is when the Fed wants to raise interest rates after banks have accumulated large amounts of excess reserves. In this case, the federal funds rate can be raised by increasing the interest on reserves, which eliminates the need to conduct massive open market operations to raise the federal funds rate by reducing reserves. The second situation is when discount policy can be used by the Fed to perform its role as lender of last resort.

MONETARY POLICY TOOLS OF THE EUROPEAN CENTRAL BANK:

Open Market Operations, Lending to Banks, Interest on Reserves, Reserve Requirements

Interest rate on reserves effects what curve?

Reserve demand curve

Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the primary credit facility, and it is therefore referred to as a standing lending facility. Why is the amount of discount lending small here?

The interest rate on these loans is the discount rate, and as we mentioned before, it is set higher than the federal funds rate target, usually by 100 basis points (one percentage point) because the Fed prefers that banks borrow from each other in the federal funds market so that they continually monitor each other for credit risk. 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. **********The primary credit facility has thus put a ceiling on the federal funds rate at id.*********

What is the cost of holding onto excess reserves?

The oppurtunity cost, they could have loaned them out and earned interest or bought other assets

What does discount lending effect?

The supply curve

the Federal Reserve had the option of taking a different route in its efforts to achieve lower long-term interest rates, how? (called forward guidance)

To see how this would work, recall our discussion of the expectations theory of the term structure of interest rates in Chapter 6. There we saw that long-term interest rates will equal an average of the shortterm interest rates that markets expect to occur over the life of the long-term bond. By 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. Michael Woodford of Columbia University has referred to such a strategy as management of expectations, but it is more commonly referred to as forward guidance.

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 (0.5 percentage point) above the discount rate. The interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers.

When does discount lending actually cause a change?

When the demand curve interests the supply curve on its flat section

What are negative interest rates?

With inflation very low and their economies weak after the global financial crisis, central banks in Europe and Japan recently began experimenting with a new nonconventional monetary policy tool, setting interest rates on deposits held by banks at their central banks to be negative. In other words, banks now had to pay their central bank to keep deposits in the central bank.

Conversely, a decline in reserve requirements leads to an expansion of the money supply and does what to the federal funds rate?

a fall in the federal funds rate

A second category of open market operations (European) is longer-term refinancing operations, which are

a much smaller source of liquidity for the euro-area banking system and are similar to the Fed's outright purchases or sales of securities.

Seasonal credit is _____________________

given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates.

since the Fed usually keeps the federal funds rate target ______________

above the interest rate paid on reserves

Dynamic open market operations _________

are intended to change the level of reserves and the monetary base

Defensive open market operations __________________

are 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.

Because borrowing federal funds from other banks is a substitute for borrowing (taking out discount loans) from the Fed, if the federal funds rate, iff, is below the discount rate, id, then banks will not borrow from the Fed. Borrowed reserves will be zero because borrowing in the federal funds market is cheaper. Thus, ____

as long as, iff, remains below, id, the supply of reserves will just equal the amount of nonborrowed reserves supplied by the Fed, NBR, and so the supply curve will be vertical

The policy rate, such as the federal funds rate, is unlikely to fall below zero because ______________________

financial institutions are unwilling to earn a lower return by lending in the federal funds market than they could earn by holding cash, with its zero rate of return.

If, however, the federal funds rate begins to fall below the interest rate paid on reserves, ior, banks do not lend in the overnight market at a lower interest rate. Instead, they just keep on adding to their holdings of excess reserves indefinitely. The result is that the demand curve for reserves, Rd, becomes

flat (infinitely elastic)

As is the case for the Fed, the next most important tool of monetary policy for the European Central Bank involves lending to banking institutions which is carried out by national central banks, just as discount lending is performed by the individual Federal Reserve Banks. This lending takes place through a standing lending facility called the __________________. Through these facilities, banks can borrow (against eligible collateral) overnight loans from the national central banks at the ____________________, which is set at 100 basis points above the target financing rate.

marginal lending facility , marginal lending rate

When the federal funds rate is below the equilibrium rate at i1f f,

more reserves are demanded than are supplied (excess demand), and so the federal funds rate rises, as shown by the upward arrow.

When the federal funds rate is above the equilibrium rate at i2ff, _______

more reserves are supplied than are demanded (excess supply), and so the federal funds rate falls to i*ff, as shown by the downward arrow.

What happens the discount lending is lowered and the demand curve cross the vertical part of the supply curve?

most changes in the discount rate have no effect on the federal funds rate.

conventional monetary policy tools

open market operations, discount lending, and reserve requirements

When the Fed wants to conduct a temporary ________________, it engages in a matched sale-purchase transaction in which _____________

open market sale in which the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future.

What does an open market sale do for equilibrium (on the downward sloping part of demand curve)?

open market sale decreases the quantity of nonborrowed reserves supplied, shifts the supply curve to the left, and causes the federal funds rate to rise.

When the federal funds rate is above the rate paid on reserves, i (subscript)or, then as the federal funds rate decreases, the _______________

opportunity cost of holding reserves falls. Holding everything else constant, including the quantity of required reserves, the quantity of reserves demanded rises

The Fed's discount loans to banks are of three types:

primary credit, secondary credit, and seasonal credit.

Main refinancing operations involve weekly reverse transactions (____________________________) that are reversed within two weeks

purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral

This expansion of the balance sheet is referred to as _________________ because, it leads to a huge increase in the monetary base.

quantitative easing

A rise in reserve requirements reduces the amount of deposits that can be supported by a given level of the monetary base and leads to a contraction of the money supply. A rise in reserve requirements also increases the demand for reserves and does what to federal funds rate?

raises the federal funds rate

In a repurchase agreement (often called a repo), ______________. Why is this a desirable way of conducting defensive open market operations?

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. Because the effects on reserves of a repo are reversed on the day the agreement matures, a repo is actually a temporary open market purchase and is an especially desirable way of conducting a defensive open market purchase that will be reversed shortly.

Primary credit is ___________________

the discount lending that plays the most important role in monetary policy.

When the Fed decreases reserve requirements,

the federal funds rate falls.

when the Fed raises reserve requirements, ___________

the federal funds rate rises

What happens when the intersection is on the demand's downward sloping part and the interest rate on reserves rises?

the flat part of the demand curve would go up, but the equilibrium point wouldn't change

The effect of an open market operation depends on whether __________

the supply curve initially intersects the demand curve in its downward-sloped section or in its flat section.

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.