monetary policy tools

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monetary policy tools

  1. 1. Monetary Policy Tools <ul><li>Instruments that initiate monetary policy </li></ul><ul><li>Open Market Operations </li></ul><ul><li>The Discount Rate </li></ul><ul><li>Reserve Ratios </li></ul>
  2. 2. Open Market Operations <ul><li>Defined as the buying or selling of bonds by the Federal Reserve in the open market. </li></ul><ul><li>Expansionary -- Fed buys bonds (injects reserves) </li></ul><ul><li>Contractionary -- Fed sells bonds (drains reserves) </li></ul><ul><li>Done at the Federal Reserve Bank of New York </li></ul>
  3. 3. Open Market Operations: How They’re Actually Done <ul><li>Example -- Federal Reserve buys a $1000 bond from Salomon Brothers and pays with a check. The check in turn is deposited in checkable deposits at Chase, which is Salomon Brothers bank. </li></ul>
  4. 4. Balance Sheet Portrayal <ul><li>Salomon Brothers </li></ul><ul><li> Bonds -$1000 </li></ul><ul><li> D +$1000 </li></ul><ul><li>Chase </li></ul><ul><li> R +$1000  D +$1000 </li></ul><ul><li>Federal Reserve Bank of NY </li></ul><ul><li> Bonds +$1000  R +$1000 </li></ul>
  5. 5. Characteristics of Open Market Operations <ul><li>Sometimes done for temporary periods </li></ul><ul><ul><li>(Fed) Repurchase Agreement -- Fed buys bond with agreement to sell it back. </li></ul></ul><ul><ul><li>Matched-Sale Purchase -- Fed sells bond with agreement to buy it back. </li></ul></ul>
  6. 6. Open Market Operations -- An Effective Policy Tool <ul><li>Occurs at the initiative of the Fed. </li></ul><ul><li>Fed is in complete control. </li></ul><ul><li>They are flexible : Fed can do small or large amounts. </li></ul><ul><li>They are reversible : Fed can undo policy mistakes. </li></ul><ul><li>Very low-key policy instrument: difficult to tell what Fed has done. </li></ul>
  7. 7. The Discount Rate (i DISC ) <ul><li>Defined as the rate of interest charged to banks that borrow from the Federal Reserve. </li></ul><ul><li>Expansionary -- Fed lowers discount rate. </li></ul><ul><li>Contractionary -- Fed raises discount rate. </li></ul>
  8. 8. Effects of Discount Rate Changes <ul><li>Example -- Effect of Decrease in the Discount Rate (i DISC  ). </li></ul><ul><li>i DISC   DL   M2  </li></ul><ul><li>Increase in discount rate has the reverse effect. </li></ul>
  9. 9. Types of Discount Window Borrowing <ul><li>Primary Credit -- borrowing for short-term reserve adjustments. </li></ul><ul><li>Seasonal Credit -- borrowing for seasonal needs. </li></ul><ul><li>Secondary Credit -- large, longer-term borrowing for banks facing financial difficulties. </li></ul>
  10. 10. Discount Rate Policy -- Characteristics <ul><li>DL done at the discretion of banks, not the Fed. </li></ul><ul><li>Discount Window can be abused by banks, borrowing for profit (actively or passively). </li></ul><ul><li>Sometimes is regarded as signal of monetary policy, “the announcement effect.” </li></ul>
  11. 11. Discount Rate Policy -- Its Diminished Role <ul><li>Larger volume of borrowing from other sources -- Federal Funds, RPs, Eurodollars  banks hardly use the Federal Reserve for short-term reserve adjustments. </li></ul><ul><li>Announcement effect now involves the Federal Funds rate target. </li></ul><ul><li>Recent change in procedure (generally): i DISC = Target i FF + 0.5% . </li></ul>
  12. 12. Reserve Ratios (r D , r T ) <ul><li>Designed to change the amount of required reserves. </li></ul><ul><li>Expansionary Policy -- Fed lowers reserve ratios. </li></ul><ul><li>Contractionary Policy -- Fed raises reserve ratios. </li></ul><ul><li>Affects M2 by changing the multiplier. </li></ul>
  13. 13. Characteristics of Reserve Ratio Policy <ul><li>r T = 0 for Savings and Time Deposits (including MMDAs) </li></ul><ul><li>DIDMCA  Uniform Reserve Requirements (based upon deposit size) </li></ul>
  14. 14. Reserve Ratio Policy -- Rarely Used <ul><li>Too blunt -- needs tiny changes for reasonable adjustments in money growth. </li></ul><ul><li>Too Disruptive -- affects all banks balance sheets. </li></ul>
  15. 15. The Market For Bank Reserves <ul><li>Demand for Reserves (R D ) -- Banks wishing to borrow reserves in the Federal Funds market, generally in response to loan demand. </li></ul><ul><li>Downward sloping curve when plotted against i FF , ( i.e. i FF   R D  ). It can shift rightward ( increase in demand ) or leftward ( decrease in demand ). </li></ul>
  16. 16. <ul><li>Supply of Reserves -- Banks offering reserves to the Federal Funds market + the Federal Reserve changing reserves using open market operations. </li></ul><ul><li>Upward sloping curve when plotted against i FF , (i.e. i FF   R S  ). It can shift rightward ( increase in supply ) or leftward ( decrease in supply ). </li></ul>
  17. 17. Determination of the Federal Funds Rate <ul><li>The Federal Funds Rate (i FF ) is determined by equilibrium in the market for bank reserves (where R D = R S ). </li></ul><ul><li>The Federal Funds Rate changes due to shifts in the Demand for Bank Reserves or the Supply of Bank Reserves. </li></ul>

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