Monetary Policy Tools
Dynamic open market operations are
- intended to change the level of nonborrowed reserves and the monetary base -Conducted using Treasury bills
Corridor system:
-Discount rate is the upper bound of the fed funds rate -interest on reserves is the lower bound of the fed funds rate
Open market operations fall into one of two categories
-Dynamic Open Market Operations -Defensive Open Market Operations
The effect on the federal funds rate depends upon the initial position of i ∗ ff
-If i ∗ ff is on the downward sloping portion of R d i ∗ ff will not change -If i ∗ ff is on the elastic portion of R d iff will increase
The impact on the federal funds rate depends upon the initial position of i ∗ ff :
-If i ∗ ff is on the inelastic portion of R s iff will not change -If i ∗ ff is on the elastic portion of R s iff will change
Lender of Last Resort
-Important tool for preventing financial panics ~Emergency lending to depository institutions ~Emergency lending during financial crises -Creates an inevitable moral hazard problem
The supply of reserves (R s ) also falls into one of two categories
-Nonborrowed Reserves (NBR) -Borrowed Reserves(BR)
Three types of discount loans
-Primary Credit -secondary credit -seasonal credit
Large Scale Asset Purchases
-Purchased mortgage bonds in an attempt to ease credit conditions in mortgage markets. -Purchased long-term government bonds in an attempt to push down long-term rates ~The programs were referred to as quantitative easing (QE). -Following the financial crisis, there were three QE programs with the third being open-ended. -These programs were used again at the beginning of the Covid-19 pandemic -new lending programs and asset purchases- lending to investment banks and purchasing new types of debt instruments from corporations, municipalities, and commercial banks
Banks reserves can be split into two components
-Required reserves -Excess reserves
Some have argued that Quantitative Easing was ineffective because
-Short-term rates were uneffected -banks did not increase loans, only accumulated reserves
Zero Lower Bound
-Since 2008 the Fed has been constrained by the zero lower bound on its target interest rate. - The zero lower bound makes traditional monetary policy less effective -Policymakers have to figure out creative ways to achieve monetary policy objectives using non-conventional tools.
The Federal Reserve has four primary monetary policy tools
-The Federal Funds Rate (irr) (via Open Market Operations) -The Discount Rate (id ) -The Required Reserve Ratio (r) -Interest on Reserves (as of 2008) (ior)
Interest on Reserves
-The interest rate on reserves is set by the Board of Governors. -Lowering the rate encourages banks to lend and loosens monetary policy. -Raising the rate tightens monetary policy. -Paying interest on reserves is an imporant tool because: the Fed has more control over its balance sheet; the interest rate reduces the "tax" on reserves. -Keep in mind the criticisms.
During the 2007-2009 financial crisis and the Covid-19 pandemic, the Fed has expanded its lending facilities. These included:
-expanding the discount window - trying to encourage discount loans -term auction facilities - auctioning loans at competitive rates
The preceding illustrations reveal that federal funds rate will
-fluctuate between the discount rate and interest paid on reserves ~The narrower this range, the smaller the fluctuations in the federal funds rate ~The wider this range, the larger the fluctuations in the federal funds rate
Forward guidance
-is a commitment by policymakers to keep short-term rates at a specific level for the foreseeable future. -Forward guidance can be conditional on acheiving certain goals or unconditional. -The Fed used forward guidance from 2008-2014 and began using it again in 2020
seasonal credit
-lending to banks in areas with large seasonal swings in funding needs -The current seasonal credit rate is 2.45% -Seen as a relic from a period when credit markets were not as well developed
secondary credit
-lending to troubled banks -The current secondary credit rate is at 3.50%
The effect on the federal funds rate depends
-on the initial equilibrium federal funds rate: ~If i ∗ ff is on the downward sloping portion of R d iff will fall ~If i ∗ ff is on the elastic portion of R d iff will not change
Primary Credit
-overnight lending to healthy banks -The current primary credit rate is at 3% and the federal funds target range is 2.25% - 2.50% - Puts a ceiling on the federal funds rate
If iff ≤ ior
R d is perfectly elastic
The market for reserves is in equilibrium when
R^d = R^s
In late 2008 the Fed began using what is called
a floor system
Until 2008, the FOMC operated under a
corridor system with ior = 0.
Interactions between the demand and supply for reserves determines
federal funds rate
Interest on reserves serves as a floor
for the federal funds rate
In a floor system
i ∗ ff ≤ ior
Demand for reserves (R d ) is downward sloping as long as
iff > ior
An open market purchase
increases non-borrowed reserves and shifts the supply of reserves to the right
a decrease in the reserve requirement
increases the amount of deposits that the monetary base can support and increases the money supply
Monetary policy is now determined by
ior
The cost of borrowed reserves
is the discount rate
The opportunity cost of holding reserves
is the forgone rate at which they could be lent out, i.e., the federal funds rate
An increase (decrease) in the discount rate makes borrowing from the Fed
more (less) expensive
Defensive open market operations are
more day-to-day actions that are intended to offset temporary changes in the monetary base -repurchase agreements in the case of an open market purchase -"reverse repo" in the case of an open market sale
An increase (decrease) in ior
r raises (lowers) the elastic portion of R^d
An increase (decrease) in the discount rate
raises (lowers) the elastic portion of R s
an increase in the reserve requirement
reduces the amount of deposits that the monetary base can support and reduces the money supply
Ceteris paribus
the quantity of reserves demanded increases as the federal funds rate decreases
Required reserves are determined by
the required reserve ratio times deposits
The Fed can use open market operations to affect
the supply of reserves without affecting the monetary policy rate.
The Fed can change the supply of reserves without affecting
the target interest rate.
Quantitative Easing
when the Fed buys longer-term government bonds or other securities
primary dealers,
which are sanction trading counterparties of the New York Federal Reserve
Excess reserves are held to guard against
withdrawal risk
