The Economics of Money, Banking, and

Financial Markets
Twelfth Edition, Global Edition

Chapter 16
Tools of Monetary Policy

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Preview
• This chapter examines the tools used by the Federal
Reserve System to control the money supply and interest
rates

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Learning Objectives
• Illustrate the market for reserves and demonstrate how
changes in monetary policy can affect the federal funds
rate.
• Summarize how conventional monetary policy tools are
implemented and the advantages and limitations of each
tool.
• Explain the key monetary policy tools that are used when
conventional policy is no longer effective.
• Identify the distinctions and similarities between the
monetary policy tools of the Federal Reserve and those of
the European Central Bank.
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The Market for Reserves and the Federal
Funds Rate
• Demand and Supply in the Market for Reserves
• What happens to the quantity of reserves demanded by
banks, holding everything else constant, as the federal
funds rate changes?
• Since the fall of 2008, the Fed has paid interest on
reserves
– The level is set at a fixed amount below the federal
funds rate target (i.e., ior ≤ iff ).
• Excess reserves are insurance against deposit outflows
– The opportunity cost of holding these equals iff - ior

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Demand in the Market for Reserves
• The demand curve for reserves slopes downward when iff
is above ior and it becomes flat (infinitely elastic) at ior
– When the federal funds rate is above the rate paid on
excess reserves, ior, as the federal funds rate
decreases, the opportunity cost of holding excess
reserves falls, and the quantity of reserves demanded
increases.
– When iff falls below ior , banks keep on adding their
holdings of excess reserves indefinitely.

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Supply in the Market for Reserves
• Two components: nonborrowed 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 relend at iff
– The supply curve is horizontal (perfectly elastic) at id
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Figure 1 Equilibrium in the Market for
Reserves
Federal When iff < id , the quantity of reserves demanded
Funds Rate Equals the quantity of non-borrowed reserves.

id Rs

iff2 With excess supply of reserves, the

federal funds rate falls to iff* .
1
iff*

iff1 With excess demand for reserves, the

federal funds rate rises to iff* .
ior Rd

NBR Quantity of
Reserves, R

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How Conduct of Open Market Operations
Affect the Federal Funds Rate
• Open market purchases (sales) shift the supply curve to
the right (left).
• The effect 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).
• Open market operations have no effect on the federal
funds rate when intersection occurs at the flat section of
the demand curve.
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Figure 2 Response to an Open Market
Operation

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How Changes in the Discount Rate Affect
the Federal Funds Rate
• 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 where iff = id , a fall in
the discount rate shifts that portion of the supply curve
downward. Hence, the federal funds rate falls and
borrowed reserves increase.

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Figure 3 Response to a Change in the
Discount Rate

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How Changes in the Reserve Requirement
Affect the Federal Funds Rate
• When the Fed raises reserve requirement, the federal
funds rate rises and when the Fed decreases reserve
requirement, the federal funds rate falls.

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Figure 4 Response to a Change in Required
Reserves

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How Changes in Interest on Reserves Affect
the Federal Funds Rate
• If the intersection occurs on the demand curve’s
downward-sloping section, a rise in the interest rate on
reserves does not cause changes in the federal funds rate.
• If the supply curve intersects the demand curve on its flat
section, a rise in the interest rate on reserves raises the
federal funds rate.

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Figure 5 Response to a Change in the
Interest Rate on Reserves

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Application: How the Federal Reserve’s Operating
Procedures Limit 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.

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Figure 6 How the Federal Reserve’s Operating
Procedures Limit Fluctuations in the Federal Funds Rate

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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.

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Open Market Operations
• Dynamic open market operations
– intended to change reserves and monetary base
• Defensive open market operations
– Repurchase agreements (Repo)
– Matched sale-purchase agreements (Reverse Repo)
• Primary dealers
• TRAPS
– Open market operations are conducted electronically
with dealers in government securities, known as
primary dealers, by a computer system called TRAPS
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Discount Policy and the Lender of Last
Resort
• Discount window – there are three types of Fed discount
loans to banks
• Primary credit: standing lending facility
– Healthy banks are allowed to borrowed all they want at
very short maturities
– It is set usually 1 percentage point higher than the
federal funds rate target
• Secondary credit
• Seasonal credit
• Lender of last resort to prevent financial panics
– Creates moral hazard
Copyright problem
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Reserve Requirements
• Depository Institutions Deregulation and Monetary Control
Act of 1980 sets the reserve requirement the same for all
depository institutions.
• Reserve requirements are equal to zero for the first $15.5
million of a bank’s checkable deposits, 3% on checkable
deposits from $15.5 to $115.1 million, and 10% on
checkable deposits over $115.1 million.
• The Fed can vary the 10% requirement between 8% and
14%.

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Interest on Excess Reserves
• The Fed started paying interest on excess reserves only in
2008
• It is used to provide a floor under the federal funds rate
• The interest-on-excess-reserves tool came to the rescue
during the crash as banks were accumulating huge
quantities of excess reserves because it can be used to
raise the federal funds rate

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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 rate is less well used since it is no longer
binding for most banks, can cause liquidity problems, and
increases uncertainty for banks. The discount window
remains of tremendous value given its ability to allow the
Fed to act as a lender of last resort.

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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.

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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
• 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
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Figure 7 The Expansion of the Federal
Balance Sheet, 2007–2014

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Nonconventional Monetary Policy Tools
During the Global Financial Crisis (1 of 2)
• Quantitative Easing Versus Credit Easing
– Fed’s policies were directed not at expanding the Fed's
balance sheet but rather at credit easing—that is,
altering the composition of the Fed’s balance sheet in
order to improve the functioning of particular segments
of the credit markets.
• Forward Guidance
– By committing to the future policy action of keeping the
federal funds rate at zero for an extended period, the
Fed could lower the market’s expectations of future
short-term interest rates, thereby causing the long-term
interest rate to fall.
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Nonconventional Monetary Policy Tools
During the Global Financial Crisis (2 of 2)
• Negative Interest Rates on Banks’ Deposits
– Setting negative interest rates on banks’ deposits is
supposed to work to stimulate the economy by
encouraging banks to lend out the deposits they were
keeping at the central bank, thereby encouraging
households and businesses to spend more. However,
there are doubts that negative interest rates on
deposits will have the intended, expansionary effect.

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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
• 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
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