Tools of Monetary Policy

• Open market operations– Affect the quantity of reserves and the monetary base

• Changes in borrowed reserves– Affect the monetary base

• Changes in reserve requirements– Affect the money multiplier

• Federal funds rate—the interest rate on overnight loans of reserves from one bank to another– Primary indicator of the stance of monetary policy

Chapter 15: The Market for Reserves and the Fed Funds Rate, iff

Demand in the Market for Reserves• What happens to the quantity of reserves demanded, holding everything else

constant, as the federal funds rate changes?• Two components: required reserves and

excess reserves– Excess reserves are insurance against deposit outflows– The cost of holding these is the interest rate that could have been earned

• As the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises

• Downward sloping demand curve

Supply in the Market for Reserves• Two components: non-borrowed and

borrowed reserves

• 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, and re-lend at iff

• The supply curve is horizontal (perfectly elastic) at id

Reserves

iFF

D1R

SR

DR = f {iFF; RR + ER} (-) (rxD) , DFE

SR = Rn + DL

Rn

iD

i*FF

Reserves Market

iER

Fed Funds Interest Rate

0

1

2

3

4

5

6

7

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Percen

t

FED RES

ConservativeBank

D = 250

DL = 0

DL = 0

C = 125

RR = 50ER = 50

R = 125

GS = 250

AggressiveBank

RR = 25ER = 0 D = 250

DL = 0

Assume:r = 20%c = 25%iD = 10%

iFF SR RRD ERD SFF

10% 100 50 0 50

6% 100 50 10 40

4% 100 50 15 35

2% 100 50 50 0

Conservative Bank

iFF SR RRD ERD DFF

10% 25 50 0 -25

6% 25 50 5 -30

4% 25 50 10 -35

2% 25 50 15 -40

Aggressive Bank

10

8

6

4

2

10

8

6

4

2

100 115 125 135 145 155 165 10 20 30 40 50

Reserves Market Fed Funds Market

100

115

125

165

25

30

35

40

50

40

35

0

iFF

iFF

Reserve Requirements

Advantages

1.Powerful effect

Disadvantages

1.Small changes have very large effect on Ms

2.Raising causes liquidity problems for banks

3.Frequent changes cause uncertainty for banks

4.Tax on banks

Reserves

iFF

D1R

SR

Rn

iD

i1FF

Policy : r => RRD => DR shifts right => iFF

D2R

i2FF

iER

Open Market Operations

2 Types1. Dynamic:

Meant to change MB

2. Defensive:

Meant to offset other factors affecting MB,

typically uses repos

Advantages of Open Market Operations1. Fed has complete control

2. Flexible and precise

3. Easily reversed

4. Implemented quickly

Fed

Currency

Reserves Gov. Sec.s

Reserves, R

iFF

DR

S1R OMP:

Rn => shift SR right => iFF

Policy : Open Market Operation

R1n

iD

i1FF

i2FF

R2n

S2R

OMS: Rn => shift SR left => iFF

Discount Loans

3 Types1. Primary Credit

2. Secondary Credit

3. Seasonal Credit

Lender of Last Resort Function1. To prevent banking panics

FDIC fund not big enough

Example: Continental Illinois

2. To prevent nonbank financial panics

Examples: 1987 stock market crash and 9/11 terrorist incident

Reserves, R

iFF

D1R

S1R

Rn

iD = 6.25%

i*FF = 5.25%

1% Spread iD to 5.25%

D2R

iD is safety valve to relieve market pressure

S2R

9/11 => DR => iFF => DL => Policy : iD => iFF => DL

Econ 330 Chapter 15 Homework

Due Friday, March 28

Chapter 15Questions & Applied Problems 9, 11, 20, 23, 25