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TOOLS OF MONETARY POLICY

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TOOLS OF MONETARY POLICY Powered By Docstoc
					         BNFN 403
MONETARY THEORY AND POLICY


            WEEK 4
         MISHKIN (2004),
             CH.17

     Tools of Monetary Policy
     Tools of Monetary Policy
  Three policy tools that CB can use to manipulate
  the Money Supply and interest rates are:

• Open Market Operations

• Discount Rate

• Required Reserve ratio

                                                 2
      Tools of Monetary Policy
• Open market operations: CB affect the quantity
  of reserves and the monetary base by
  purchasing/selling securities.

• Discount rate: CB affect interest rates and the
  monetary base by influencing the quantity of
  discount loans.

• Required Reserve Ratio: CB affect money
  multiplier by setting the ratio

                                                    3
  The Market for Reserves and the
       Federal Funds Rate
• FED and other CB’s have increased their focus on the
  interest rate on overnight loans of reserves from one
  bank to another.(Federal Fund Rate for FED, Interbank
  interest rate for other CBs)
• FED announces a federal fund rate target at each FOMC
  meeting.
• A such announcement afects interest rates throughout
  the economy.
• In order to understand how the FED’s tools are used in
  the conduct of monetary policy, we must understand not
  only their effect on the money supply but their direct
  effects on the federal funds rate as well.

                                                       4
 The Market for Reserves and the
      Federal Funds Rate
  The market for reserves is where the
  federal funds rate is determined.
• Demand in the market for Reserves
  – The quantity of reserves demanded
    Reserves= RR + ER
  – i ↓ , opportunity cost of ER ↓, ER ↑
  – As federal funds rate decreases, opportunity
    cost of holding ER falls and , everything else
    constant the quantity of reserves demanded
    rises.
                                                     5
 The Market for Reserves and the
      Federal Funds Rate
• Supply in the market for Reserves
  – The components are
     • The amount of reserves that are supplied by the
       Fed’s open market operations (Non-borrowed
       reserves)
     • Discount Loans that are the amount of reserves
       borrowed from the Fed.
  – Borrowing federal funds is a substitute for
    taking out discount loans from the Fed.

                                                         6
Supply and Demand for Reserves




                                 7
     Response to Open Market Purchase or
          Lowering of Discount Rate



Open Market Purchase
 Reserves , Rs to
   right, i  from i1ff to
   i2ff

Discount Rate 
 Discount Borrowing 
   Reserves  , Rs to
   right, i  from i1ff to
   i2ff
                                       8
            Response to Rise in Reserve
                  Requirements




Rise in Required
Reserve Ratio
 RR  , Rd to right, i 
   from i1ff to i2ff




                                          9
The Market for Reserves and the
     Federal Funds Rate
– If iff < id , Banks will borrow from the federal
  funds market where the cost is cheaper
– As long as iff remains below id, the supply of
  reserves will just equal the amount of non-
  borrowed reserves supplied by the Fed, and
  so the supply curve will be vertical.
– As iff begins to rise above id,banks would want
  to keep borrowing at id and the supply curve
  becomes flat.

                                                     10
 The Market for Reserves and the
      Federal Funds Rate
• Market Equilibrium occurs where
  the quantity of reserves demanded equals
  the quantity supplied, Rs=Rd with an
  equilibrium federal funds rate of iff .

• at i¹ff , there are more reserves demanded than
  supplied (excess demand), iff ↑
• at i²ff , there are more reserves supplied than
  demanded (excess supplied), iff ↓
                                                    11
ANALYZING THE POLICY TOOLS
• Open Market Operations
  – Open market purchase leads to a greater
    quantity of reserve supplied, Rs shifts
    rightward, iff ↓ Rq ↑.
  – Open market sale decreases the quantity of
    reserve supplied, Rs shifts leftward, iff ↑,Rq ↓
  – An open market purchase causes the federal
    funds rate to fall,whereas an open market
    sale causes the federal funds rate to rise.

                                                       12
  ANALYZING THE POLICY TOOLS
• Discount Rate
  – The effect of a discount rate change depends on
    whether the demand curve intersects the supply
    curve in its vertical section vs itd flat section
     • If the intersection occurs at the vertical section ,
       no discount lending so that no effect of discount
       rate on federal funds rate.
     • If the intersection occurs at the flat section,
          – lowering the discount rate causes discount
            lending to rise , so federal funds rate to fall.
          – rising the discount rate causes discount lending
            to fall,so federal funds rate to rise.
                                                          13
  ANALYZING THE POLICY TOOLS
• Reserve Requirments
  – Rising required reserve ratios leads required
    reserves to increase and hence the quantity
    of reserves demanded to increase, a such
    increase shifts demand curve to the rightward,
    so that iff raises.
  – Lowering required reserve ratios leads
    required reserves to decrease and hence the
    quantity of reserves demanded to fall, a such
    fall shifts demand curve to the leftward, so
    that iff decreases.
                                                14
OPEN MARKET OPERATIONS
• The most important monetary policy tool is
  Open Market Operations (OMOs), it is

  – primary determinants of changes in interest
    rates and the monetary base

  – the main source of fluctuations in the money
    supply

                                                   15
OPEN MARKET OPERATIONS
• Open Market Purchases
  – expand reserves and the monetary base
  – raise the money supply
  – lower short term interest rates

• Open Market Sales
  – Shrink reserves and the monetary base
  – lower the money supply
  – raise short term interest rates
                                            16
  OPEN MARKET OPERATIONS
• How to conduct OMOs with the object of
  controlling short term interest rate and the
  money supply?
   Dynamic open market operations
   are intended to change the level of reserves
   and the monetary base
   Defensive open market operations
   are intended to offset movements in the other
   factors that affect reserves and the monetary
   base, such as treasury deposits or float
                                               17
OPEN MARKET OPERATIONS
• Fed (or other CBs) conducts most of its
  OMOs in treasury securities;
  – The market for treasury securities is the most
    liquid market
  – Securities has the largest trading volume
• Open Market Comitte is the decision
  making authority for OMOs
• The actual execution of these operations
  is conducted by the trading desk
                                                 18
OPEN MARKET OPERATIONS
• A day at the trading desk
  – Step 1. review of developments in the federal
    fund markets.Update the actual amount of
    reserves in the banking system
  – Step 2. detailed forecasts of what will be
    happening to some of short term factors
    affecting demand/supply of reserves
  – Step 3. Decision on defensive OMOs


                                                19
OPEN MARKET OPERATIONS
• To obtain desired level of the federal fund rate
  1.if reserves in banking system is too large
   – Rs > Rd iff ↓
   – Dynamic OMOs to sell securities to keep federal
     funds rate unchanged
  2.if reserves in banking system is too low
   – Rd > Rs iff ↑
   – Dynamic OMOs to purchase securities to keep
     federal funds rate unchanged


                                                       20
OPEN MARKET OPERATIONS
• Advantages of OMOs
  – OMOs occur at the initiative of the Fed which
    has complete control over their volume

  – OMOs are flexible and precise

  – OMOs are easily reversed

  – OMOs can be implemented quickly

                                                    21
              Discount Rate
• Fed’s discount policy involves changes in
  the discount rate
• The Federal Reserve facility at which
  discount loans are made to banks is called
  the discount window.
• Fed affect volume of discount loan by;
  – Affecting the price of loans (discount rate)
  – Affecting quantity of loans


                                                   22
             Discount Rate
• Affecting the price of loans (discount rate)
  – İrd ↓ DL ↑ Monetary Base ↑    M ↑ or
  – İrd ↑ DL ↓ Monetary Base ↓    M↓

• The Fed’s discount loans to banks are of
  three types
  – Primary (Adjustment) Credit
  – Secondary (Extended) Credit
  – Seasonal Credit
                                                 23
             Discount Rate
– Primary Credit is the discount lending that plays the
  most important role in monetary policy.
   • The interest rate on these loans is the discount
     rate.
   • Discount rate is higher than federal funds rate (
     abt.% 1),thus the amount of discount lending is
     very small.
   • The lending facility is intended to be back up
     source of liquidity for banks so that the federal
     funds rate never rises too far above the target
     rate.

                                                          24
             Discount Rate
• Secondary credit is given to banks that
  have severe liquidty problems.
• The interest rate is set at %0.5 above the
  discount rate.
• Seasonal Credit is given to meet the
  needs of a limited number of banks in
  vacation and agricultural areas.
• The interest rate is tied to the average of
  federal funds rate and deposit rates.
                                                25
                Discount Rate
• Banks that use discount loan face three costs
   – Discount rate that are paid on discount loan
   – More discount loan used rises the concern the health
     of the bank
   – Discount Loan in the future, because of two frequent
     trips to discount window
• Discount loans is also important in preventing
  financial panics as Fed’s the lender of last resort
  role.
• Discount policy can be used to signal the Fed’s
  intentsions about future monetary policy.
                                                        26
                   Discount Rate
• Advantages and disadvantages of Discount Policy
   – The most importan advantage is that the Fed can use it to
     perform the role of lender of last resort.
   – Signaling FED’s policy intentions
   – The first disadvantage is the confusion about the Fed’s
     intentions .
   – Large fluctuations will occur in the spread between maket
     interest rate and the discount rate where may cause unintended
     fluactuations in the volume of discount loand and hence in the
     money supply
   – Discount rate is the less effective tool.
      • Not completly discretion of Fed
      • Less easly reversed tool


                                                                  27
      Reserve Requirements
• RR was regarded by CBs as a prudential
  instrument.
• Then turned into the major tool in
  monetary policy.
• RR have two major role as;
  – Short run money managment
    if averaging is used, this can help to
 reduce volatility in market interest rates on
 a day to day basis
                                             28
    Reserve Requirements
– Monetary policy purposes
  • Change in reserve requirments affect money
    supply by casuing the money multiplier to change.
  • A rise in RR reduces the amount of deposits that
    can be supported by a given level of the monetary
    base and will lead decline in the money supply.
  • A rise in RR also increases the demand for
    reserves and raises ffr.
  • A decline in RR conversely leads to an expansion
    of the money supply and a fall in the ffr.

                                                    29
       Reserve Requirements
• Advantages of Reserve Requirment Changes
  – RR is very powerfull tool to affect money supply and
    interest rates, makes money multpilier more stable.
  – Causes to diminsh liquidity risk,creates liquidity pool
• Disadvantages of Reserve Requirment Changes
  – Small changes have very large effect on the money
    supply
  – may cause liquidity problem in banking system
  – Frequent changes cause uncertainty for banks
  – Tax on banks
                                                              30
      Reserve Requirements
• To avoid tax effect
  – be kept to the minimum necessary for
    monetary control
  – not to applied to interbank deposits
  – be applied equally to all banks and deposits
  – should not include goverment securities




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