Open Market Operations The Tools of Monetary

Document Sample
Open Market Operations The Tools of Monetary Powered By Docstoc
					The Tools of Monetary Policy

  Reserve Requirements, Discount
     Rates, and Open Market
       Operations…oh my!
    Tools of Monetary Policy
• Open market operations
  – Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves
  – Affect the monetary base
• Changes in reserve requirements
  – Affect the money multiplier

Target of Monetary Policy: Federal Funds Rate
  - The interest rate on overnight loans of reserves from
    one bank to another.
    The Demand for Bank Reserves
• Why do banks demand reserves?
  – The Fed requires banks to hold a certain percentage
    of reserves as deposits
  – Banks may choose to hold excess reserves to ensure
    against increased deposit outflows.

• Every dollar held in reserve is not earning
  interest as a loan
  – The federal funds rate represents the interest that
    could have been earned.
  – As the federal funds rate falls, the opportunity cost of
    holding reserves falls.
            Reserve Demand




               R2   R1            Reserves
       The Supply of Bank Reserves
• Bank Reserve Supply consists of two components:
   – Non-Borrowed Reserves (NBR)
       • Supplied to the banking system through the Fed’s open market
         operations (i.e. the reserves banks earn by selling bonds to the
   – Borrowed Reserves (BR)
       • Reserves borrowed from the Fed by banks.

• The cost of borrowing from the Fed is the discount rate
• As long as the federal funds rate (iff) is less than the
  discount rate, BR = 0
   – It’s cheaper to borrow reserves from other banks than from the
• When iff > id, it is cheaper to borrow from the Fed
   – We assume that the Fed is willing to lend as much as banks are
     willing to borrow at the discount window.
            Reserve Supply




                 NBR              Reserves
Equilibrium in the Market for Reserves
               Open Market Operations
• Suppose the Fed decided to purchase bonds on the
  open market
   – This would lead to an increase in NBR since the Fed is paying
     for bonds with money (that then gets classified as “non-borrowed
     bank reserves)
   – The increase in NBR causes the supply of reserves held by
     banks to shift right
   – There will be a decrease in the federal funds rate since banks
     will be more willing to lend to one another at lower rates.

• Now suppose the Fed sold bonds on the open market
   – There would be a decrease in NBR since the Fed is replacing
     vault cash with bonds (not classified as reserves)
   – The supply of reserves will shift left as bank reserves fall
   – This forces the federal funds rate up
   – If the cut in NBR is large enough then the federal funds rate may
     go as high as the disocunt rate
   – It will not exceed the discount rate, since any ff rate above i d will
     no longer be binding (banks will just borrow directly from the Fed
     at iff>id)
            An Open Market Purchase

    iff,1                     RS2



                    NBR1   NBR2        Reserves
            An Open Market Sale


                 RS2   RS1


               NBR2 NBR1           Reserves
       Advantages of Open Market Operations
• The Fed has complete control over
  the volume
   – Compare this to discount lending, in which the Fed sets the price of
     borrowing, but does not directly control how much banks actually

• Flexible and precise
   – Can be used to enact both small and large changes in the monetary

• Easily reversed
   – Mistakes can be quickly corrected in a way that would not have been
     possible with reserve requirements or discount lending.

• Quickly implemented
   – There is no administrative delay to conducting open market operations.
     Orders go to the trading desk in New York and they are executed
          Changing the Discount Rate
• Changing the discount rate will only affect
  reserves (and thus the money supply) and the
  federal funds rate if…
  – It is lowered below the federal funds rate
  – It was previously below iff, but is raised above iff.

• The Fed purposefully keeps the discount rate
  above iff
  – As a result, changes in the discount rate rarely have
    an effect on the money supply.
  – Rather, the discount rate has been used at times to
    inject liquidity into the financial system (Stock Market
    Crash in 10/87, directly after 9/11)
Lowering the Discount Rate (Non-Binding)

    Id,1                         RS1

    Id,2                         RS2


                 NBR1             Reserves
  Lowering the Discount Rate (Binding)

    id,1                                   RS1

                            iff,2 = id,2

   id,2                                    RS2


                NBR1   R2                   Reserves
            The Fed as a Lender of Last Resort
• One of the most important functions of the Fed is its role as a lender
  of last resort to the banking system.

• Banks in need of liquidity may borrow from the Fed at the discount

• A large increase in the demand for reserves (demand for liquidity) by
  banks is tempered by the Fed’s ability to step in and lend at the
  discount rate.
    – The federal funds rate is actually capped by the discount rate.

• While this role has helped avert some bank panics (since FDIC
  could not by itself cover all losses from a bank panic), it may have
  created moral hazard costs
    –   Banks know they will be bailed out by the Fed if they fail
    –   Encourages them to take on high-return/high-risk loans
    –   If the loan comes in, they keep all the profits
    –   If the loan fails, the Fed subsidizes the losses.
       Changing the Reserve Requirement
• When the Fed requires a larger percentage of deposits to be held in
  reserve, bank’s demand a larger quantity of reserves
    – Increasing the reserve ratio shifts the demand for reserves to the right
    – Decreasing the reserve ratio shifts the demand for reserves left.

• An increase in reserve demand pushes up the federal funds rate
  and lowers the money supply (lower multiplier)

• In practice, the reserve requirement is not the most effective policy
    – Many banks hold excess reserves due to classification rules
    – An increase or decrease in the reserve requirement may not alter their
    – Changing the reserve requirement will only affect the federal funds rate
      and money supply if the requirement is binding.
    – For banks in which the requirement is binding, raising it can cause
      severe liquidity problems.
    – In fact, many countries have abandoned reserve requirements as a
      policy tool (Australia, Canada, New Zealand)
Raising the Reserve Requirement (Binding)

     Id,1                          RS1




                 NBR1               Reserves
           The Channel/Corridor System
• Without reserve requirements, can a central bank still
  control interest rates?
• If banks don’t hold reserves, then how can the Fed
  induce changes in interest rates through changes in

• One solution is the channel/corridor system
   – Banks set up one facility that stands ready to lend to banks at a
     guaranteed lending rate (il)
   – This facility will supply as many reserves to banks as they desire
     at this rate

   – Another facility is set up that accepts deposits from banks and
     pays them a guaranteed interest rate on these deposits (i r)
   – This facility will accept an unlimited amount of deposits.

   – These two interest rates present the lower and upper bound for
     the federal funds rate negotiated between banks.
The Channel System

Description: Open Market Operations document sample