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					CHAPTER 27
Policy Implementation

Learning Objectives

   What the contents and format of the policy directive are
   How open market operations affect the fed funds rate
   How the Trading Desk reacts to new information
   How required reserves are calculated
   The difference between temporary and outright open market transactions

Chapter Outline

I.      A Morning at the New York Fed
II.     The FOMC Policy Directive
III.    The Reserves Market and Open Market Operations
IV.     How the Demand and Supply of Reserves Are Calculated
V.      Trading Desk Market Techniques
        A.     Outright Transactions in the Market
        B.     Temporary Transactions

Answers to Review Questions

What should the Trading Desk do in the fed funds rate falls below the targeted rate?

If the fed funds rate falls below the target rate, the Trading Desk red uces the amount of
reserves available to depository institutions in order to drive the fed funds rate back to the
target level. In this case, the Trading Desk should sell government securities (open market
sales).

Explain what is meant by the reserve need.

The reserve need is the projected amount of reserves to be supplied or withdrawn by open
market operations to maintain or reach the existing levels of the Fed funds rate prescribed by
the policy directive. The reserve need is estimated by the staff of t he Fed.

For what purposes are repurchase agreements and matched sale -purchase transactions
    likely to be used?

Repurchase agreements refer to the temporary purchase of securities by the Fed. The seller is a
securities dealer who agrees to buy back the secu rities from the Trading Desk of the Fed by a
specified date. Such transactions occur overnight or over a relatively short period of two to
seven days. As such these transactions are used to offset a temporary drain on reserves.




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Policy Implementation                                                                           157


Matched sale-purchase transactions or reverse repurchase agreements are temporary
transactions conducted by the Fed in order to withdraw reserves from the system. The trading
desk of the Fed sells securities and buys back the same in a relatively short period of time.

For what purposes are outright purchases and sales likely to be used?

The Trading Desk of the Fed conducts outright transactions when the Fed wants to absorb or
inject reserves on a more permanent basis. Such transactions offset permanent reserve needs
and are utilized when projections indicate that a reserve shortfall or reserve excess is likely to
persist

What is the computation period? What is the maintenance period?

The maintenance period is the period in which banks are required to hold reserve assets. The
computation period is the period during which the determination is made of the actual amount
of required reserve assets that must be held during the maintenance period.

When and why would the Fed “accommodate” a rise in reserve demand by supplying
   more reserves?

The Fed will "accommodate" a rise in reserve demand by supplying more reserves if it
determines there is a reserve need. The Fed will supply more reserves to achieve a particular
level of Fed funds rate.

What characteristics of Treasury bills make the m desirable for use in outright
   transactions by the Trading Desk?

The huge size of the secondary T -bills market and its considerable depth, breadth, and liquidity
enable it to absorb large transactions smoothly. Thus , Treasury bills are ideal for use in
outright transactions by the Trading Desk.

The float increases unexpectedly. Will the Fed typically respond with outright purchases
    or temporary purchases?

The Fed will most typically respond with temporary purchase to the unexpected increase in
float. The reserve need generated by the unexpected increase would be temporary and self -
reversing.

Why have required reserves fallen in recent years? Will the trend continue?

In recent years required reserves have declined substantially due to the emergence of retail
sweep accounts in 1994. These accounts, “sweep” out balances from deposit accounts (subject
to reserve requirements) and into other highly liquid accounts (not subject to reserve
requirements). Current data suggests that this trend is likely to continue even though some are
concerned that this may lead to volatility in the fed funds rate.
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Explain how the bank reserve equation is derived from the Fed’s balance sheet. Which
   items raise bank reserves? Which items lower bank reserves?

The Fed’s balance sheet consists of the following:
Assets
Government securities held (GS)
Gold and special drawing rights (SDRs) accounts, which reflect international reserve holdings
(IR)
Discount loans (L)
Float (F )
Other assets (OA)

Liabilities
Reserve balances of depository institutions with the Fed (DF )
Currency outside the Fed (C*)
Treasury deposits (TD)
Other liabilities (OL)

The bank reserve equation is derived from the Fed's balance sheet by rearranging the balance
sheet, equating assets to liabilities, and combining items . As in equation (27-3),

(DF+VC) = R = GS+IR+L+F+OACTDOL = bank reserves equation

Any of the items preceded by a plus sign will raise bank reserves while increases in any of the
items preceded by a minus sign will lower bank reserves.

Under lagged reserve accounting, how does the computation period correspond with the
   maintenance period? Under contemporaneous reserve accounting, how does the
   computation period correspond with the maintenance period? What are the
   advantages of a lagged reserve accounting period?

Banks hold reserve assets during a maintenance period that correspond to the amount of
required reserves based on the amount of checkable deposits in a computation period. Since
July 1998, the reserve maintenance period begins 30 days after the beginning of the two-week
reserve computation period (lagged reserve accounting). In the maintenance period, the
average daily amount of reserves must equal the average daily amount of deposits times the
required reserve ratio in the computation period.

Prior to 1998, the maintenance period more or less corresponded to the computation period
(contemporaneous reserve accounting).

One of the advantages of a lagged reserve accounting period is that depository institutions
know the exact amount of required reserves that will be needed in the maintenance period
before the maintenance period begins because the required reserves in any maintenance period
are based on a two-week computation period that started 30 days earlier. A lagged reserve
accounting system makes it easier for depository institutions to calculate their required reserve
balances for the current maintenance period. In addition, with this system the Trading Desk at
the New York Fed can obtain more accurate information about required reserves, w hich is
helpful in carrying out open market operations.
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Why has the Fed become more open about monetary policy decisions in recent years?

The Fed has become more open in recent years because it believes that if it better
communicates current and future policy moves then there will be less uncertainty. The less
uncertainty means more control over future expectations and through this, more control over
long term interest rates. Changes in long term interest rates have the greatest impact on
economic activity and it is long term rates that the Fed is aiming to affect through changes in
short term rates.

A side effect of the new openness is that there is a smaller volume of open market operations
needed to hit a given targeted fed funds rate. The smaller vol ume results from the Fed’s
announcement of the new target directly and its effect on expectations of the short -term rate.

A second side effect of the new openness seems to be a reduction in the long and variable lag
for monetary policy to take effect in the economy. The conventional wisdom was that it took
at least six months or more for an interest rate reduction to stimulate the economy. With the
new openness of the Fed and the greater transparency, financial markets can more easily
anticipate what the Fed will do and act accordingly and preemptively, thus reducing the lag.




Answers to Analytical Questions


Assume checkable deposits are $500 billion, desired excess reserves are 1 percent of
    deposits, the required reserve ratio is 10 percent, and the amount of reserves is $50
    billion. What is the reserve need to maintain the existing reserve conditions?

The reserve need is $5 billion. With $500 billion in checkable deposits and a required reserve
ration of 10 percent, required reserves are $50 bi llion. Likewise, desired excess reserves are
$5 billion ($5 billion = $500 billion x .1 percent). Thus, the total demand for reserves is $55
billion. With a supply of reserves equal to $50 billion, the reserve need is $5 billion.

Describe what the Fed should do to meet the reserve need in question 13.

To meet the reserve need in Problem 13, the Fed can engage in a system repurchase agreement
or in outright purchases of securities, depending on whether the reserve need is thought to be
temporary, seasonal, or permanent.

The Fed anticipates a seasonal reserve need of $10 billion over the next month. Is it more
    likely to use outright purchases or temporary transactions to meet this need? If the
    Fed supplies $20 billion in reserves, what will happen t o the fed funds rate?

If the reserve need is temporary, the Fed will most likely engage in a system repurchase
agreement. If the reserve need is more permanent or seasonal, the Fed will most likely engage
in outright transactions. Thus, if the Fed anticipates a seasonal reserve need of $10 billion, it
will most likely use outright purchases. If the Fed supplies $20 billion in reserves, the fed
funds rate will fall since $20 billion is greater than the reserve need.
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Explain the following statement: Even though outright purchases account for less than 10
   percent of Fed transactions, the Fed’s portfolio of securities consists mainly of
   securities bought outright.

The Fed's portfolio of securities consists mainly of securities bought outright because
temporary purchases are self-reversing and hence wash out over time.

Assume that the demand for required plus excess reserves is $50 billion, the level of
    discount borrowing is $100 million, and the actual level of nonborrowed reserves is
    $49 billion. What is the reserve need if the existing degree of pressure on reserve
    positions is to be maintained? What will happen if the Fed supplies less reserves than
    the reserve need?

In this case, the reserve need is $900 million ($50 billion - $49 billion - $100 million = $900
million). If the Fed supplies less than the reserve need, interest rates will rise.

What are the implications of the following Fed activities?
      a.   The Fed sells securities using matched sales.
      b.   The Fed buys securities using system repurchase agreements.
      c.   The Fed makes outright purchases for the system account.

a. The Fed is temporarily draining reserves from the banking system.
b. The Fed is supplying reserves on a temporary basis.
c. The Fed is supplying reserves on a more permanent or seaso nal basis.

				
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