ECON 310 Chapter 15: Chapter 15 Notes

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ECON 310
Chad Hogan

Chapter 15 Notes: Tools of Monetary Policy PREVIEW • Federal funds rate - the interest rate on overnight loans of reserves from one bank to another • Four tools of monetary policy - open market operations, discount policy, reserve requirements and the interest paid on reserves THE MARKET FOR RESERVES AND THE FEDERAL FUNDS RATE • Open Market Operations - changes in nonborrowed reserves • Federal lending - changes in borrowed reserves • The market for reserves is where the federal funds rate is determined THE DEMAND AND SUPPLY IN THE MARKET FOR RESERVES • Find demand and supply curves, the equilibrium is the level of the federal funds rate, the interest rate charged on the loans of these reserves Demand 1. Required reserves 2. Excess reserves • Quantity demanded = required reserves plus the quantity of excess reserves demanded • Opportunity cost - the cost of holding excess reserves or the interest rate potentially earned on lending these reserves out minus the interest rate that is earned on the reserves • Demand curve - downward sloping and the flat when the federal funds rate is below the interest rate because the banks will choose to keep their excess reserves to themselves and earn the interest Supply 1. Nonborrowed reserves (NR) - the amount of reserves that are supplied by the Fed’s open market operations 2. Borrowed reserves (BR) - the amount of reserves borrowed from the Fed • Discount rate - the interest rate charged by the Fed (fixed above the federal funds rate) • Based on the federal funds rate target • Supply of reserves - the amount of nonborrowed reserves supplied by the Fed • Vertical curve and then indefinitely to the right because the banks will want to borrow reserves from the discount rate when it is cheaper than the federal funds rate Market Equilibrium • R^s=R^d • FFR > DR - excess supply of reserves, so the i falls to the equilibrium rate HOW CHANGES IN THE TOOLS OF MONETARY POLICY AFFECT THE FEDERAL FUNDS RATE • Open Market Operations - purchase leads to a greater quantity of reserves supplied • Shifts the supply curve to the right - lowers FFR • Depends on if the supply curve intersects the demand curve while it is downward sloping or flat • An open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise • Flat - the interest rate paid on reserves i_or (flat portion) sets a floor for the federal funds rate - no change in the interest rate from the OMO • Discount Lending • Depends on intersecting the flat or vertical portion of the supply curve • Most changes in the discount rate have no effect on the FFR • Intersection is in the vertical portion - lowering the DR shifts the flat part of the supply curve down, but does not lower the FFR (the inelastic portion remains the same) • BR = 0 (No discount lending) • There is discount lending BR > 0 • The DR is lowered, the supply curve shifts down, and the FFR falls as well • Reserve Requirements • When the Fed raises reserve requirements, the FFR rises • Shift the demand curve to the right and the FFR rises • When the Fed decreases reserve requirements, the FFR falls • Interest on Reserves • Interest rate paid by the Fed on reserves • Vertical intersection - shifts the flat part of the demand curve up, which has no effect on the FFR • Horizontal intersection - shifts the flat part up, which increases the FFR • When the federal funds rate is at the interest paid on reserves, a rise in the interest rate on reserves raises the federal funds rate (flat) THE FED CONTROLLING THE FFR • Discount loans and paying interest for reserves limits fluctuations for reserves • The Federal Reserve’s operating procedures limit the fluctuations of the federal funds rate so that it remains between i_er and i_d • Shift left - borrow at i_d • Shift right - borrow at i_er CONVENTIONAL MONETARY POLICY • Conventional monetary policy tools - open market operations, discount lending, and reserve requirements • Tools to control the money supply and interest rates OPEN MARKET OPERATIONS • Most important - primary determinant of changes in interest rates and the monetary base - main source of fluctuations in the money supply through Treasury bills • Objectives - controlling short-term interest rates and the money supply 1. Dynamic OMOs - intended to change the level of reserves and the monetary base 2. Defensive OMOs - intended to offset movements in other factors that affect reserves and the monetary base (changes in the Treasury deposits with the Fed or the float) • FOMC sets a FFR target - executed by the Federal Reserve Bank of New York • Primary dealers - OMOs are conducted by dealers in government securities through TRAPS (trading room automated processing system) • Prepositions to buy or sell at what prices and the transactions continue until all of the securities have been sold • Defensive OMOs - 1. Repurchase agreement (Repo) - the Fed purchases securities with an agreement that the seller will repurchase them in a short period of time (1-15 days) 2. Matched sale-purchase transaction (reverse repo) - temporary open market sale where the Fed sells securities and the buyer agrees to sell them back to the Fed in the near future DISCOUNT POLICY AND THE LENDER OF LAST RESORT • Discount window - the facility at which the banks can borrow reserves from the Federal Reserve • Helps prevent and address financial panics that are not triggered by bank failures Operation of the Discount Window • Fed’s discount loans: primary credit, secondary credit, and season credit • Primary credit - most important • Standing lending facility - healthy banks borrowing reserves with very short maturities (usually overnight) from the primary credit facility • Interest is the DR • DR is usually 100 basis points (one percentage point) above the FFR target • Created to limit the FFR from becoming too high due to lack of reserve supply • Secondary credit - banks in financial trouble and experiencing severe liquidity problems • 50 bps above the discount rate (0.5%) - penalty • Season credit - given to meet the needs of small banks in vacations and agricultural areas that have a seasonal pattern of deposits • Interest rate is tied to the average FFR and certificate of deposit rates Lender of Last Resort • Lender of last resort - the Fed was to provide reserves to banks when no one else would, thereby preventing bank and financial panics • Reasons why t
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