Transcript Chapter 18 Monetary Policy: Using Interest Rates to

Chapter 18
Tools of Monetary Policy
Using Interest Rates to Stabilize the
Domestic Economy
Monetary Policy & Interest Rates:
The Big Questions
1. What are the tools used by central banks
to meet their stabilization objectives?
2. How are the tools linked to the central
bank’s balance sheet?
3. How is the interest rate target chosen?
From Chapter 17 : The Fed can control the MB but
cannot precisely control the Money Supply
M1 = m x MB
M1 =
1+(C/D)
rD + (ER/D) + (C/D)
 MB
Households can change C/D, causing the money
mutiplier (m) and M1 to change
Banks can change ER/D, causing m and M1 to
change
The Fed’s “Traditional” Policy Tools
• Open Market Operations - OMO.
• Discount Rate - the interest rate the Fed
charges on the loans it makes to banks
• Reserve Requirement - the level of balances a
bank is required to hold either as vault cash on
deposit or at a Federal Reserve Bank
• NOTE: The primary instrument of
monetary policy is the Federal funds rate:
the interest rate on overnight loans of
reserves from one bank to another
A New (fourth) Tool
• Interest on reserves - required and excess
• Currently set at 0.25%
• The Financial Services Regulatory Relief Act of
2006 authorized the Federal Reserve to begin
paying interest on reserve balances of depository
institutions beginning October 1, 2011.
• The Emergency Economic Stabilization Act of
2008 accelerated date to October 1, 2008.
Open Market Operations
• The Fed buys and sells U.S. Gov’t securities
in the secondary market in order to adjust the
supply of reserves in the banking system.
• Most flexible means of carrying out monetary
policy.
• The Fed does not participate directly in the
Federal Funds market. .
OMO and the Federal Funds Market
• Federal funds are reserve balances that
depository institutions lend to one another.
• The most common federal funds transaction
is an overnight, unsecured loan between two
banks. (bilateral agreements)
• Note that without the FF market, banks would
need to hold a substantial amount of excess
reserves.
Advantages of OMO
• Implemented quickly
• Fed has complete control
• Flexible and precise
• Easily reversed
Two Types of Open Market Operations
1. Permanent OMO:
“Permanent open market operations involve
the buying and selling of securities outright to
permanently add or drain reserves available to
the banking system.”
2. Temporary OMO:
“Temporary open market operations involve
repurchase and reverse repurchase agreements
that are designed to temporarily add or drain
reserves available to the banking system”
Open Market Operation - Repo
• With a repurchase agreement ("repo"),
the Fed buys securities from dealers
who agrees to buy them back, typically
within one to seven days.
• Repos add reserves to the banking
system and then withdraws them.
• Can be viewed as the Fed temporarily
lending reserves to dealers with the
dealers posting securities as collateral.
Open Market Operation – Reverse Repo
• With a reverse repo, the Fed sells
securities to dealers and agrees to buy
back in one to seven days.
• Reverse repo drain reserves and later
add them back.
• Can be viewed as the Fed temporarily
borrowing reserves from dealers with
the Fed posting securities as collateral.
http://www.newyorkfed.org/index.html
How is the Federal Funds Rate Determined?
Supply and Demand for Reserves
IOER
Demand for Reserves
• Why Do banks hold Reserves?
• Required
• Excess reserves are insurance against
deposit outflows
• The cost of holding this insurance is the
interest rate that could have been earned
minus the interest rate that is paid on
these reserves, ier , (IOER)
• For example, if T-bill rate = .5% and IOER =
.25%, opportunity cost = .25%
http://www.treasury.gov/resourcecenter/data-chart-center/interestrates/Pages/TextView.aspx?data=yield
Demand for Reserves
• As the federal funds rises above the rate paid
on excess reserves, ier, the opportunity cost of
holding excess reserves increases and the
quantity of reserves demanded decreases
• Downward sloping demand curve for reserves.
• The demand curve becomes flat (infinitely
elastic) at IOER
• IOER acts as a floor on the federal funds rate.
Supply of Reserves
• Two components to the supply of
reserves: non-borrowed and borrowed
reserves
• The discount rate (id) is the cost of
borrowing from the Fed. The interest
rate on loans from the Fed.
• Borrowing from the Fed is an
alternative to borrowing from other
banks in the Federal Funds market.
Supply for Reserves
• If the Federal Funds rate (iff )< Discount rate (id),
banks will not borrow from the Fed and borrowed
reserves are zero
• The supply curve will be vertical at the level of
non-borrowed reserves (NBR).
• As iff rises above id, banks will borrow more and
more at id, (NOTE: they can lend at iff )
• The supply curve is horizontal (perfectly elastic)
at id
How OMO Affects the Federal Funds Rate
• Open market operations shift the supply curve of
reserves.
• Effect of open an market operation on the federal
funds rate depends on whether the supply curve
initially intersects the demand curve on its
downward sloped section or 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.
Response to an Open Market Purchase
Open market operations have no effect on the
federal funds rate when intersection occurs at
the flat section of the demand curve.
Affecting the Federal Funds Rate: Discount 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, 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
Response to a Change in the Discount Rate
Affecting the Federal Funds Rate: Reserve
Requirement
• When the Fed raises reserve requirement,
the federal funds rate rises and when the
Fed decreases reserve requirement the
federal funds rate falls.
• Intuition -
Response to a Change in Required Reserves
Response to a Change in the Interest Rate on
Reserves
How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate
Discount Lending – Lender of Last Resort
• Lending to commercial banks has not
been an important part of the Fed’s dayto-day monetary policy.
• However, lending is the Fed’s primary
tool for ensuring short-term financial
stability, for eliminating bank panics, and
preventing the sudden collapse of
institutions that are experiencing financial
difficulties.
•
On Sept. 12, 2001, banks borrowed $45.5
billion from the Fed. (In addition, the Fed
purchased $80 billion in Gov’t securities).
Discount Lending
Types of Loans –
• Primary Credit (sound credit)
• Short-term, typically overnight
• Historically 100 basis points above target Fed Funds
Rate. Currently 50 bp
• Secondary Credit
• For banks that do not qualify for primary credit
• Hisorically 150 basis points above target Fed Funds
Rate.
• Seasonal Credit
• Small banks with cyclical farm loans
• http://www.frbdiscountwindow.org/index.cfm
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
• Does the “Lender of Last Resort” fucntion to
prevent financial panics create a moral hazard
problem?
Reserve Requirements
• Depository Institutions Deregulation and Monetary
Control Act of 1980 (MCA) subjected all banks to
the same reserve requirements as member banks
• Set reserve requirement within a range of 8 to 14
percent for transactions deposits and 0 to 9 percent
for non-transactions deposits.
• Fed now pays interest on reserves.
• To reduce burden on small banks, first few million $
in DD are exempt, then 3% up to about $71 mil.,
then 10%
• Note: Fed’s use of the reserve requirement in 1936.
Reserve Requirements
Advantages
1. Powerful effect
Disadvantages
1. Without excess reserves, small changes
have very large effect on Ms
2. Not binding with so many banks holding
excess reserves
3. Raising causes liquidity problems for banks
4. Frequent changes cause uncertainty for
banks
Operational Policy at the European Central
Bank http://www.ecb.int/home/html/index.en.html
• Main Refinancing Rate: Set via weekly auction of 2-week
repurchase agreements. Inject and withdraw reserves in the
banking system. Comparable to the Fed’s target FFR.
• Marginal Lending Facility
• 100 basis points above target refinancing rate
• Deposit Rate: Banks earn interest on excess reserves.
• Reserve Requirements
• 2% applied to checking accounts
• Overnight Cash rate.( Market FFR)
Operational Policy at
the European Central Bank