Monetary Theory and Policy
Chapter 15：Tools of Monetary Policy
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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 instrument of monetary policy
Chapter 15 2 / 32
The Market For Reserves and the Federal
Funds Rate
What happens to the quantity of reserves demanded by
banks, holding everything else constant, as the federal
funds rate changes?
Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could have
been earned minus the interest rate that is paid on these
reserves, ier
Chapter 15 3 / 32
Demand in the Market for Reserves
Since the fall of 2008 the Fed has paid interest on
reserves at a level that is set at a fixed amount
below the federal funds rate target.
When the federal funds rate is above the rate paid
on excess reserves, ier, 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 that becomes
flat (infinitely elastic) at ier
Chapter 15 4 / 32
Figure 1 Equilibrium in the Market for Reserves
Federal
Funds Rate
With excess supply of reserves, the
federal funds rate falls to iff* .
id
Rs
With excess demand for reserves, the
iff2 federal funds rate rises to iff* .
1
iff*
iff1
ior Rd
NBR Quantity of
Reserves, R
Chapter 15 5 / 32
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
Chapter 15 6 / 32
Figure 1 Equilibrium in the Market for Reserves
Federal
Funds Rate
With excess supply of reserves, the
federal funds rate falls to iff* .
id
Rs
With excess demand for reserves, the
iff2 federal funds rate rises to iff* .
1
iff*
iff1
ior Rd
NBR Quantity of
Reserves, R
Chapter 15 7 / 32
Affecting the Federal Funds Rate
Effects of an open market operation depends on
whether the supply curve initially intersects the
demand curve in its downward sloped section versus its
flat section.
An open market purchase causes the federal funds rate
to fall whereas an open market sale causes the federal
funds rate to rise (when intersection occurs at the
downward sloped section).
Chapter 15 8 / 32
Affecting the Federal Funds Rate (cont’d)
Open market operations have no effect on the
federal funds rate when intersection occurs at the
flat section of the demand curve.
Chapter 15 9 / 32
Figure 2 Response to an Open Market Operation
Federal Federal
Funds Rate Funds Rate
id id
R1s R2s R1s R2s
iff1 1
iff2 2
1 2
1 2
ior R1d i=
ff i=
ff ior R1d
NBR1 NBR2 Quantity of NBR1 NBR2 Quantity of
Reserves, R Reserve, R
Step 1. An open market purchase shifts the Step 1. An open market purchase shifts the supply
supply curve to the right … curve to the right …
Step 2. causing the federal funds rate to fall. Step 2. but the federal funds rate cannot fall below
the interest rate paid on reserves.
(a) Supply curve initially intersects demand (b) Supply curve initially intersects
curve in its downward-sloping section demand curve in its flat section
Chapter 15 10 / 32
Affecting the Federal Funds Rate (cont’d)
If the intersection of supply and demand occurs on
the vertical section of the supply curve, a change in
the discount rate will have no effect on the federal
funds rate.
If the intersection of supply and demand occurs on
the horizontal section of the supply curve, a change in
the discount rate shifts that portion of the supply
curve and the federal funds rate may either rise or fall
depending on the change in the discount rate.
Chapter 15 11 / 32
Figure 3 Response to a Change in the Discount
Rate
Federal Federal
Funds Rate Funds Rate
id1 R1s
id2 R2s 1
1 iff1 = id1 R s1
iff1
2
iff2 = id2 R s2
ior R d1 BR1 R d1
ior
BR2
NBR Quantity of NBR Quantity of
Reserves, R Reserves, R
Step 1. Lowering the discount rate Step 1. Lowering the discount rate
shifts the supply curve down… shifts the supply curve down…
Step 2. but does not lower the Step 2. and lowers the federal
federal funds rate. funds rate.
(a) No discount lending (BR = 0) (b) Some discount lending (BR > 0)
Chapter 15 12 / 32
Affecting the Federal Funds Rate (cont’d)
When the Fed raises reserve requirement, the
federal funds rate rises and when the Fed
decreases reserve requirement, the federal funds
rate falls.
Chapter 15 13 / 32
Figure 4 Response to a Change in Required
Reserves
Federal
Funds Rate
id R1s
2 Step 1. Increasing the reserve requirement
i ff2
causes the demand curve to shift to the right . . .
1
i ff1 Step 2. and the federal funds rate rises.
R2d
ior
R1d
NBR Quantity of
Reserves, R
Chapter 15 14 / 32
Figure 5 Response to a Change in the Interest
Rate on Reserves
Federal Federal
Funds Rate Funds Rate
id Rs id Rs
2
i 1
1 i ff2 = i or2 R2d
ff
i or2 R2d
i ff1 = i or1 R1d
i or1 R1d 1
NBR Quantity of NBR Quantity of
Reserves, R Reserves, R
Step 1. A rise in the interest rate on reserves Step 1. A rise in the interest rate on
1
from i or to i or2 ...
1
reserves from i or to i or2 ...
Step 2. leaves the federal funds rate unchanged. Step 2. raises the federal funds
rate to i ff2 = i or2 .
(a) initial i ff1 > i or
1
(b) initial i ff1 = i or
1
Chapter 15 15 / 32
Application: How the Federal Reserve Limits
Fluctuations in the Federal Funds Rate
Supply and demand analysis of the market for reserves
illustrates how an important advantage of the Fed’s
current procedures for operating the discount window
and paying interest on reserves is that they limit
fluctuations in the federal funds rate.
Chapter 15 16 / 32
Application: How the Federal Reserve Limits
Fluctuations in the Federal Funds Rate
Federal
Funds Rate
Rd′ d* R d ′′
R
iff′′ = id Rs
Step 1. A rightward shift of the demand
curve raises the federal funds rate to a
maximum of the discount rate.
iff* Step 2. A leftward shift of the demand curve
lowers the Ederal funds rate to a minimum of
the interest rate on reserves.
iff′ = ior
NBR* Quantity of
Reserves, R
Chapter 15 17 / 32
Conventional Monetary Policy Tools
During normal times, the Federal Reserve uses three
tools of monetary policy—open market operations,
discount lending, and reserve requirements—to control
the money supply and interest rates, and these are
referred to as conventional monetary policy tools.
Chapter 15 18 / 32
Open Market Operations
Dynamic open market operations
Defensive open market operations
Primary dealers
TRAPS (Trading Room Automated Processing System)
Repurchase agreements
Matched sale-purchase agreements
Chapter 15 19 / 32
Advantages of Open Market Operations
The Fed has complete control over the volume
Flexible and precise
Easily reversed
Quickly implemented
Chapter 15 20 / 32
Discount Policy
Discount window
Primary credit: standing lending facility
Secondary credit
Seasonal credit
Lender of last resort to prevent financial panics (FDIC)
Creates moral hazard problem
Chapter 15 21 / 32
Advantages and Disadvantages of Discount Policy
Used to perform role of lender of last resort
Important during the subprime financial crisis of 2007-2008.
Cannot be controlled by the Fed; the decision maker is
the bank
Discount facility is used as a backup facility to prevent
the federal funds rate from rising too far above the
target
Chapter 15 22 / 32
Figure 6 How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate
Federal
Funds Rate
Rd′ d* R d ′′
R
iff′′ = id Rs
Step 1. A rightward shift of the demand
curve raises the federal funds rate to a
maximum of the discount rate.
iff* Step 2. A leftward shift of the demand curve
lowers the Ederal funds rate to a minimum of
the interest rate on reserves.
iff′ = ior
NBR* Quantity of
Reserves, R
Chapter 15 23 / 32
Reserve Requirements
Depository Institutions Deregulation and
Monetary Control Act of 1980 sets the
reserve requirement the same for all depository
institutions
3% of the first $48.3 million of checkable deposits;
10% of checkable deposits over $48.3 million
The Fed can vary the 10% requirement between
8% to 14%
Chapter 15 24 / 32
Relative Advantages of the Different Monetary
Policy Tools
• Open market operations are the dominant policy
tool of the Fed since it has complete control
over the volume of transactions, these
operations are flexible and precise, easily
reversed and can be quickly implemented.
• The discount window remains of tremendous
value given its ability to allow the Fed to act as
a lender of last resort.
Chapter 15 25 / 32
Disadvantages of Reserve Requirements
No longer binding for most banks
Can cause liquidity problems
Increases uncertainty for banks
Chapter 15 26 / 32
On the Failure of Conventional Monetary Policy Tools
in a Financial Panic
When the economy experiences a full-scale financial
crisis, 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.
Chapter 15 27 / 32
Nonconventional Monetary Policy Tools During the
Global Financial Crisis
Liquidity provision: The Federal Reserve implemented
unprecedented increases in its lending facilities to
provide liquidity to the financial markets
Discount Window Expansion
Term Auction Facility
New Lending Programs
Chapter 15 28 / 32
Nonconventional Monetary Policy Tools During the
Global Financial Crisis
Large-scale asset purchases: During the crisis the Fed
started three new asset purchase programs to lower
interest rates for particular types of credit:
Government Sponsored Entities Purchase Program
QE2
QE3
Chapter 15 29 / 32
Figure 7 The Expansion of the Federal Balance
Sheet, 2007-2014
Chapter 15 30 / 32
Monetary Policy Tools of the European Central Bank
Open market operations
Main refinancing operations
Weekly reverse transactions
Longer-term refinancing operations
Lending to banks
Marginal lending facility/marginal lending rate
Deposit facility
Chapter 15 31 / 32
Monetary Policy Tools of the European Central Bank (cont’d)
Reserve Requirements
2% of the total amount of checking deposits and other
short-term deposits
Pays interest on those deposits so cost of complying is low
Chapter 15 32 / 32
