slides14-19sp fed funds6econ.ucsb.edu/~bohn/135/slides14.pdfnbr = non-borrowed. 2. supply through...
TRANSCRIPT
[Notes on Mishkin Ch.15 - P.1]
Chapter 15: The Fed-Funds Market (“Tools of Monetary Policy” working in the Fed Funds market)
between banks = Buying and selling reserve balances held at the Fed. - Overnight loans, unsecured, OTC. Symbol:
i ff = Fed Funds rate.
- Key point: Trading does not change total reserves.
Supply of Reserves
1. Supply through open market operations:
NBR = Non-borrowed. 2. Supply through discount loans:
BR = borrowed at interest rate
id , provided to banks on demand, only for as long as discount loans are outstanding.
- Write as function
BR = BR(i ff − id ). Zero for
i ff < id . - Interest-elastic for
i ff ≥ id . Extreme case in Mishkin: horizonal at
i ff = id.
the Fed Funds rate
Rs(i ff ) = NBR+BR(i ff − id ) Shape: Corner at
i ff = id . Vertical for
i ff < id . Elastic for
i ff ≥ id .
[Notes on Mishkin Ch.15 - P.2]
Demand for Reserves
-
RR = rr ⋅D - Excess reserves:
ER = ERD +ERI => Total reserve demand:
Rd = RR+ER = rr ⋅D+ER
offer interest on reserves (ior).
2. Banks make decisions about excess reserves, multiple motives: - deposit taking – as discussed in the money multiplier model:
ERD = eD ⋅D. - interest on reserves – motivates banks to absorb excess:
ERI = ERI (ior − i ff ) - minimizing cost of reserves within a reserve maintenance period.
- Several arguments …
[Notes on Mishkin Ch.15 - P.3]
The Fed funds rate determines banks’ incentives to attract deposits and make loans => ff.
- cost (consumer interest rates) and transaction needs. Needs:
- Fed funds rate is the opportunity cost of funds for banks Changes in i ff triggers changes in retail interest rates (loans, deposits) =>
D = D(i ff ,Y ,P,...) downward sloping function of iff
- esired deposits depends on real output and prices (like money demand) - esired deposits
2: deposits - reserves are proportional to deposits (by definition) =>
RR = rr ⋅D(i ff ,Y ,P,...) downward sloping function of iff - Excess reserves are small and proportional to deposits, provided
i ff > ior : =>
R = (rr + e) ⋅D(i ff ,Y ,P,...) downward sloping function of iff
[Notes on Mishkin Ch.15 - P.4]
-run argument: - Banks are obliged to hold sufficient reserves over a reserve maintenance
period of 14 days => Incentives to hold more/less reserves on days when the -
elastic than deposits within each reserve maintenance period.
pecial argument : - If
i ff < ior , banks could earn arbitrage profits
ior − i ff by borrowing Fed funds
i ff < ior
i ff = ior (Textbook graph)
- Technical Caveat: Some institutions not eligible to receive interest on reserves => Find that
i ff ≥ ior −Δ with
Δ = small profit margin for intermediaries (Simplify theoretical exposition: assume
Δ ≈ 0 so
i ff ≥ ior.) - Main result: IOR provides a lower bound for the Fed Funds rate.
eserve demand function has two parts: - is decreasing function of the Fed funds rate for
i ff > ior - is horizontal at the lower bound
i ff = ior
[Notes on Mishkin Ch.15 - P.5]
Market Equilibrium :
Rs = NBR+BR(i ff − id ) = Rd (i ff ,ior ,Y ,P,.rr,...) i ff , i
d, and
ior
- iscount rate below the Fed funds target administrative restrictions on discount loans to discourage opportunistic borrowing by banks.
- – iscount rate set above the Fed funds target (penalty rate). No
ior = 0.25%. - Since
i ff ≈ ior.
iff
id
iff
id
iff
ior
[Notes on Mishkin Ch.15 - P.6]
Mishkin’s Diagrams
[Notes on Mishkin Ch.15 - P.7]
2. Impact of an Open Market Operations
Main tool for controlling the Fed Funds rate in normal times. Ineffective when with ample reserves and
i ff ≈ ior.
[Notes on Mishkin Ch.15 - P. ]
3. Impact of a reduced discount rate
[Notes on Mishkin Ch.15 - P.9]
Rd ≈ rr ⋅D => —similar answers)
[Notes on Mishkin Ch.15 - P. ]
5. Impact of a higher interest rate on reserve balances
Main tool for controlling the Fed Funds rate with ample reserves. Ineffective when
i ff > ior .
[Notes on Mishkin Ch.15 - P.11]
Fluctuations in the Demand for Reserves
, subject to shocks. - Macro disturbances: changes in Y, P => shifts in Md d - Financial disturbances: seasonal changes (holiday cash needs), banking
: iff
d. No Fed involvement => Loss of control over iff.
[Notes on Mishkin Ch.15 - P.12]
Coping with Fluctuating Reserve Demand
over the money supply. Monetary history = search for solutions. 1. Fed procedures before 2003: set the discount rate below the Fed funds rate
target, use administrative controls to restrict discount loans:
can take out discount loans.
rate effect of shifts in reserve demand.
s flat or more steep.
M1 = m * (MBn
- d: setup induces banks to claim emergencies to obtain “cheap” discount loans.
iff
id
[Notes on Mishkin Ch.15 - P.13]
2. Fed procedures 2003-2008: - Set the discount rate above the Fed funds rate target (penalty rate) -
Normal procedure:
stabilize iff between meetings. ff-the target as needed.
Open market operations that stabilize iff imply that money supply is perfectly elastic when demand shifts: Higher Md d => higher
ff constant => increase in M1 = m * MBn. - Procedures rely on FOMC to adjust the target to avoid excessive M1 growth. d are observed => gives FOMC information about Md
iff
id
[Notes on Mishkin Ch.15 - P.14]
3. Fed procedures since 2008 – -
reserves so that
i ff ≈ ior. Set the discount rate at penalty level.
stabilize iff between FOMC meetings
ff-target as needed.
What could possibly go wrong?
d are unobserved => No information about banks’ desired reserves
to support deposit taking vs. excess reserves held as investments 2. Question about how/if the Fed can control money supply
d includes excess reserves for deposit taking. Flat segment captures reserves held as investment.
-
i ff = ior and
R = ˆ R d = (rr + eD) ⋅D(ior )
iff
id
ior
[Notes on Mishkin Ch.15 - P.15]
Monetary Analysis with Ample Reserves
Rs > ˆ R d . Traditional case when
Rs ≤ ˆ R d.
Rs > ˆ R d :
-
ERI = Rs − ˆ R d > 0 and
e = ERDD + ERI
D > eD. - Open market purchases increase
ERI , increase
e, but have no impact on M1. Though MB increases, higher e reduces m enough to neutralize the effect. - Open market sales reduce
ERI , reduce
e, but have no impact on M1, unless they are large enough that reserve supply falls below
ˆ R d.
-elastic money supply
Term structure: money market rates (i) determined by current & expected iff
=> Fed can fix i=i* by setting ior => Then M = *
d curve shifts, M1 varies => Money supply curve is horizontal at i*
ior, the Fed must rely on term structure linkages and on the downward slope of Md(i)
i
M
i*
[Notes on Mishkin Ch.15 - P.16]
Final Comment: What else could the Fed do? -crisis) used both lower and
upper bounds to control money market interest rates
When reserve demand varies, Fed funds rate would bounce within the interval - Provides information about reserve demand related to deposit taking - Setting tight bounds would allow the Fed to reduce security holdings without
risk of triggering large interest rate changes. => Possible , return to pre-
operation of the Fed Funds market.
iff