Tools of Monetary Policy. Tools of Monetary Policy. The Market for Reserves and the Federal Funds Rate

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1 Tools of Monetary Policy BNFN 403 MONETARY THEORY AND POLICY WEEK 4 MISHKIN (2004), CH.17 Tools of Monetary Policy Open Market Operations Required Reserve ratio Three policy tools are the policy tools that CB can use to manipulate the Money Supply and interest rates 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 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 contact 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. 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. 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. 1

2 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 nonborrowed 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. 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? 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. 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. 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. 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 2

3 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 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 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 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 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 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 3

4 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 Affecting the price of loans (discount rate) Ird? DL? Monetary Base? M? or Ird? DL? Monetary Base? M? The Fed s discount loans to banks are of three types Primary (Adjustment) Credit Secondary (Extended) Credit Seasonal Credit 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. 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. 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. 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 4

5 STANDING FACILITIES Other Central Banks than FED have standing facilities instead of discount window Standing facilities regarded as a safety valve mechanism, to provide and absorb liquidity when other techniques have not been fully exploited. Some CBs as Canada,New Zealand adopted The Channel/Coridor System for setting overnight interest rates 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 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. 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 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 5