Econ Chapter 15 Monetary Policy and Bank Regulation

Discount loans

 The loans the Fed makes to banks are called discount loans

Discount rate

and the interest rate the Fed charges on the loans is called a discount rate. 

Federal funds rate

 is the interest rate at which banks lend to one another on an overnight basis to meet reserve requirements. Shifts the money supply curve to the left or right.

Open market operations

Not a primary tool of the Fed but used to maintain ample reserves.

Expansionary open market operation.

• The Fed buys bonds from banks or the public.

• It pays for these bonds by adding money to the banking system (increasing bank reserves).

This is called a contractionary open market operation.

• Banks or investors buy the bonds from the Fed.

• The money they pay goes out of the banking system.

Reserve requirements

 percentage of deposits that banks must hold

• They limit how much banks can lend out.
  This directly affects how much money the banking system can create.

• They influence the money multiplier.
  A higher reserve requirement → banks lend less → smaller money supply.
  A lower reserve requirement → banks lend more → larger money supply.

• They help maintain stability.
  Banks need enough reserves to meet withdrawal demand, reducing the risk of bank runs.

Required reserves

are funds that a depository institution must hold in reserves.

Excess reserves

are funds that a depository institution holds in excess of its required reserve balances.  

Quantitative easing

Quantitative easing is when the Federal Reserve buys large amounts of financial assets—usually long-term government bonds and mortgage-backed securities—to increase the money supply and lower interest rates.

Quantitative tightening

Quantitative tightening is the opposite of QE. The Federal Reserve reduces the size of its balance sheet by selling bonds or letting them mature without replacing them.

What is the difference between OMO and Quantitative Easing/tightening?

Open Market Operations (OMO)

• Routine, everyday tool of the Federal Reserve.

• Involves small-scale buying or selling of short-term government bonds.

• Used to adjust the federal funds rate (short-term interest rate).

• Happens daily or weekly to fine-tune monetary conditions

Quantitative Easing (QE) / Quantitative Tightening (QT)

• Large-scale, extraordinary policies used during major economic crises or high inflation periods.

• QE involves massive purchases of long-term assets (Treasury bonds, mortgage-backed securities).

• QT involves reducing the Fed’s balance sheet (selling assets or letting them mature).

• Used when normal tools (like changing interest rates) are no longer enough

IORB rate

interest rate that banks earn from the Fed on the funds they deposit into their reserve balance accounts.  

• The interest on reserve balances rate steers the federal funds rate into the FOMC’s target range.  

Reservation rate

the lowest interest rate the banks are likely willing to accept for ledning out their funds

Arbitrage

the simultaneous purchase and sale of in order to profit from a difference in interest rates

ON RRP rate

administered rate that acts like a reservation rate for a large number of financial institutions. The overnight reverse repurchase agreement offering rate helps to set a floor on the federal funds rate.

• ON RRP works by the Fed selling securities to banks and agreeing to buy them back the next day at a slightly higher price.

• For banks, this is a way to earn a safe overnight return on their excess cash by essentially lending it to the Fed.

 Forward guidance

is a communication from the central bank about its future monetary policy intentions including its likely path for interest rates

What is the structure of the Fed?

• Congress divided the country into 12 Federal Reserve Districts.  

• Each district has its own Federal Reserve Bank, which provides services to banks in that district.  

• The real power of the Fed, however, lies in Washington, DC, with the Board of Governors.

What is the structure of the Board of Governors?

•  The seven members of the Board of Governors are appointed by the President of the United States and confirmed by the Senate to 14-year, nonrenewable terms.  

• One member of the Board of Governors is appointed chair and serves a 4-year, renewable term.  

What is the structure of the Federal Open Market Committee?

• Most key decisions about monetary policy are made by the Federal Open Market Committee (FOMC).  

• They meet eight times a year in Washington, D.C.  

• Monetary policy refers to the actions the Fed takes to manage interest rates to attain macroeconomic policy objectives.  

• The FOMC has 12 voting members:  

• The 7 members of the Federal Reserve’s Board of Governors- What tools to use 

• The president of the Federal Reserve Bank of New York  

• The presidents of 4 of the other 11 Federal Reserve Banks (who serve one-year rotating terms as voting members of the FOMC- Picks FFR Range) 

What decisions do the Board of Governors make, and what decisions does the Federal Open Market Committee make?

• FOMC picks the FFR target range

• Board of Governors is responsible for setting rates to keep the FFR within the target range and it supervises the Federal Reserve Banks.

What is the role of the central bank? 

Conducts monetary policy

Regulates banks

Acts as lender of last resort

Maintains financial stability

Oversees the payment system

Issues currency
Supports government debt management

What tools did the Federal Reserve use under a limited reserve regime versus an ample reserve regime?

limited reserves regime:  

• Open market operations  

• Discount window  

• Reserve requirements

Ample reserve regime: 

• Primary Tool: Interest on Reserve Balances

• Overnight Reverse Repurchase Agreement Facility

• Discount Rate

• Open market operations

When were we operating under a limited reserve regime, and what changed?

We operated under a limited reserve regime until 2008, but the financial crisis, QE, and the introduction of interest on reserves forced the Fed to adopt an ample reserve regime, which became permanent by 2019.

 How does the reserve market change when the Fed makes policy changes?

Expansionary policy: reserve supply curve shifts right, lowering the federal funds rate.

Contractionary policy: reserve supply curve shifts left, raising the federal funds rate.

What are the two concepts that IROB relies on, and how do they influence the federal funds rate?

• Arbitrage and reservation rate

IORB sets the reservation rate → minimum a bank will accept to lend reserves.

Arbitrage ensures that if market rates drop below IORB, banks deposit funds at the Fed instead.
Result: The federal funds rate stays at or slightly above IORB, keeping short-term rates stable.

What is the ON RRP rate, and how does it differ from the IORB rate?

The Overnight Reverse Repurchase Agreement (ON RRP) rate is offered to non-bank financial institutions as a lower interest rate option for overnight lending, while the Interest on Reserve Balances (IORB) rate is paid to banks for reserves they hold at the Federal Reserve, setting a floor for overnight lending rates. Essentially, IORB applies to banks, and ON RRP applies to other financial entities, helping the Federal Reserve manage short-term interest rates.

What is the role of forward guidance, and how does it influence expectations regarding Inflation?

Forward guidance is the Fed’s use of public statements to influence expectations about future interest rates, which in turn affects spending, investment, and expectations about inflation, helping to guide actual inflation toward its target.

• These expectations influence current spending, saving, and investment decisions.

How do expectations regarding inflation impact the Phillips curve, wages, and the aggregate market?

• If inflation is expected to rise, workers demand higher wages to maintain their real purchasing power.

• Firms raise prices to cover higher wage costs.

• This shifts the short-run Phillips curve upward, meaning higher inflation for the same level of unemployment.

Aggregate Demand (AD):

• Not directly affected by inflation expectations in the short run, but consumer and business spending can change if they expect higher inflation.

Short-Run Aggregate Supply (SRAS):

• Firms set prices based on expected costs, including expected wages and input prices.

• Higher expected inflation → SRAS shifts upward/left (higher prices at each output level).

Long-Run Effects:

• If inflation expectations are anchored, the long-run Phillips curve is vertical at the natural rate of unemployment.

• If expectations are unanchored, persistent high inflation can occur even if unemployment is normal.