The document discusses several monetary policy tools used by the Federal Reserve: 1) Open market operations, where the Fed buys or sells bonds to influence the money supply and interest rates. This is the most flexible and reversible tool. 2) The discount rate, which is the interest rate banks pay to borrow from the Fed. Lowering this rate makes borrowing cheaper and expands the money supply. 3) Reserve requirements, which set the minimum reserves banks must hold. Lowering these ratios expands the money supply by increasing bank lending capacity.

1. Monetary Policy Tools Instruments that initiate monetary policy Open Market Operations The Discount Rate Reserve Ratios

2. Open Market Operations Defined as the buying or selling of bonds by the Federal Reserve in the open market. Expansionary -- Fed buys bonds (injects reserves) Contractionary -- Fed sells bonds (drains reserves) Done at the Federal Reserve Bank of New York

3. Open Market Operations: How They’re Actually Done 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.

4. Balance Sheet Portrayal Salomon Brothers  Bonds -$1000  D +$1000 Chase  R +$1000  D +$1000 Federal Reserve Bank of NY  Bonds +$1000  R +$1000

5. Characteristics of Open Market Operations Sometimes done for temporary periods (Fed) Repurchase Agreement -- Fed buys bond with agreement to sell it back. Matched-Sale Purchase -- Fed sells bond with agreement to buy it back.

6. Open Market Operations -- An Effective Policy Tool Occurs at the initiative of the Fed. Fed is in complete control. They are flexible : Fed can do small or large amounts. They are reversible : Fed can undo policy mistakes. Very low-key policy instrument: difficult to tell what Fed has done.

7. The Discount Rate (i DISC ) Defined as the rate of interest charged to banks that borrow from the Federal Reserve. Expansionary -- Fed lowers discount rate. Contractionary -- Fed raises discount rate.

8. Effects of Discount Rate Changes Example -- Effect of Decrease in the Discount Rate (i DISC  ). i DISC   DL   M2  Increase in discount rate has the reverse effect.

9. Types of Discount Window Borrowing Primary Credit -- borrowing for short-term reserve adjustments. Seasonal Credit -- borrowing for seasonal needs. Secondary Credit -- large, longer-term borrowing for banks facing financial difficulties.

10. Discount Rate Policy -- Characteristics DL done at the discretion of banks, not the Fed. Discount Window can be abused by banks, borrowing for profit (actively or passively). Sometimes is regarded as signal of monetary policy, “the announcement effect.”

11. Discount Rate Policy -- Its Diminished Role Larger volume of borrowing from other sources -- Federal Funds, RPs, Eurodollars  banks hardly use the Federal Reserve for short-term reserve adjustments. Announcement effect now involves the Federal Funds rate target. Recent change in procedure (generally): i DISC = Target i FF + 0.5% .

12. Reserve Ratios (r D , r T ) Designed to change the amount of required reserves. Expansionary Policy -- Fed lowers reserve ratios. Contractionary Policy -- Fed raises reserve ratios. Affects M2 by changing the multiplier.

13. Characteristics of Reserve Ratio Policy r T = 0 for Savings and Time Deposits (including MMDAs) DIDMCA  Uniform Reserve Requirements (based upon deposit size)

14. Reserve Ratio Policy -- Rarely Used Too blunt -- needs tiny changes for reasonable adjustments in money growth. Too Disruptive -- affects all banks balance sheets.

15. The Market For Bank Reserves Demand for Reserves (R D ) -- Banks wishing to borrow reserves in the Federal Funds market, generally in response to loan demand. 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 ).

16. Supply of Reserves -- Banks offering reserves to the Federal Funds market + the Federal Reserve changing reserves using open market operations. 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 ).

17. Determination of the Federal Funds Rate The Federal Funds Rate (i FF ) is determined by equilibrium in the market for bank reserves (where R D = R S ). The Federal Funds Rate changes due to shifts in the Demand for Bank Reserves or the Supply of Bank Reserves.