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Lecture 30: Monetary policy – part two

Mishkin Ch15 – part B

page 378-391

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Review

Open market operationsNBR supply curve shift interest rate

Discount policyDiscount rate its impact depends on what

section of the supply curve contains the intersection of D&S curves.

Reserve requirementsDemand curve shift interest rate

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Outline

Details about the three policy toolsOpen market operationsDiscount policyReserve requirements

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Importance of open market operations

The most important monetary policy tool The primary determinants of changes in

interest rates and the monetary base The main source of fluctuations (especially

in the long-term) in the money supply

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Two types of open market operations Dynamic open market operations

Intended to change the level of reserves and the monetary base

Defensive open market operations Intended to offset movements in other factors

that affect reserves such as float and Treasury deposits

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Open market operations

Trading mainly in U.S Treasury bills Market for T-bills is

Most liquid Of largest trading volume can absorb a large

trading amount without experiencing excessive price fluctuations that would disrupt the market

Decision-making authority is FOMC Actual execution is by the trading desk at the

Federal Reserve Bank of New York.

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A trading day

Manager of domestic open market operations

Primary dealers Reserve management strategy TRAPS (Trading Room Automated

Processing System) Repurchase agreements (repo)

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Advantages of open market operations The Fed has complete control over

the volume (compare with discount loans) Flexible and precise, used to any extent Easily reversed Quickly implemented, no administrative

delays

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Discount policy Discount window: the facility at which banks

can borrow reserves form the Fed. Three types1. Primary credit (standing lending facility): healthy

banks are allowed to borrow all they want (usually overnight). A backup source of liquidity. Upper limit of federal funds rate.

2. Secondary credit: to help troubled banks

3. Seasonal credit

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Lender of last resort

In additional to its use as a tool to influence reserves and money supply, discount window is also used to prevent financial panic

bank panic collapse of banking system scares credit and low money supply recession

creates moral hazard problem Should the Fed extend discount window to

investment banks?

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Comments on discount policy

Used primary to perform role of lender of last resort

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

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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

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%

Reserve requirement tool is of less importance now

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Effects of reserve requirements

If required reserve ratio increase 1. the amount of deposits that can be

supported by a given level of the monetary base decreases money multiplier decrease money supply decrease

22 increase demand of reserves rise federal funds rate

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Comments on reserve requirements

No longer binding for most banks, which hold excess reserves.

Can cause liquidity problems for banks. Fluctuating reserve requirements increase

uncertainty for banks. Recommendations to eliminate this

requirement.

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New problem

If reserve requirement is eliminated, demand for reserves may fall to zero, then a central bank may not be able to exercise control over interest rate.

Solution: the channel or corridor system

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The channel/corridor system

Sets up a standing lending facility (lombard facility) and stands ready to loan overnight any amount banks ask for at a fixed interest rate (lombard rate) interest rate upper bound

Another standing facility is set up that pays banks a fixed interest rate on any deposits they would like to keep at the central bank interest rate lower bound

In between, the quantity supplied equals non-borrowed reserves

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