chapter 17 tools of monetary policy. © 2006 pearson addison-wesley. all rights reserved 17-2 the...
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Chapter 17
Tools of Monetary Policy
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The Market for Reserves and the Federal Funds RateDemand Curve for Reserves
1. R = RR + ER2. i→ opportunity cost of ER→ ER3. Demand curve slopes down
Supply Curve for Reserves1. If iFF is below iD, then no discount borrowing, RS =
Rn
2. Supply curve flat (infinitely elastic) at iD because as iFF starts to go above iD, banks borrow more at iD
Market Equilibrium where RD = RS at i*FF
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© 2006 Pearson Addison-Wesley. All rights reserved 17-3
Supply and Demand for Reserves
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Response to Open Market Operations
Open Market Purchase
Non-borrowed reserves, Rn and shifts supply curve to right RS
2: i to i2ff
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17-5
Response to a Change in the Discount Rate
(a) No discount lending Lower Discount RateHorizontal section and supply curve just shortens, iff stays same
(b) Some discount lendingLower Discount RateHorizontal section , iff to i2
ff = i2d
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Required Reserves Demand for Reserves , RD shifts right and iff to i2
ff
Response to Change in Required Reserves
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Open Market Operations
2 Types1. Dynamic to change MB
2. Defensive to offset other changes to MB using Repurchase Agreements (repos).
Advantages of Open Market Operations1.Completely controlled by Fed
2.Flexible and precise
3.Easily reversed
4. Implemented quickly
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Discount Operations (Discount Loans)
3 Types1. Primary Credit
Backup source of liquidity for banks
Puts a ceiling on iFF
2. Secondary Credit
3. Seasonal Credit
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17-9
Rightward shift of RS to RS
2 moves equilibrium to point 2 where i2
ff = id and discount lending rises from zero to DL2
How the Primary Credit Facility Puts Ceiling on iff
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Discount Operations
Advantages1. Fed as Lender-of-Last Resort to Banks 1. To prevent bank panics
Example: Continental Illinois
2. To prevent non-bank financial panics.
Examples: 1987 stock market crash.
Disadvantages1. Not fully controlled by Fed
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Reserve Requirements (Have been declining worldwide)
Advantages1. Powerful effect on the money supply
Disadvantages1. Tax on banks makes them less competitive and
weak.
2. Small changes have very large effect on the money supply.
3. Expensive to administer.
4. Can cause liquidity problems for banks.
5. Frequent changes cause uncertainty for banks and make liquidity management more difficult.
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Channel/Corridor System for Setting Interest Rates
In the channel/corridor system standing facilities result in a step function supply curve, RS. If demand curve shifts between RD
1 and RD
2, iff always remains between ir and il