Money, Banking and Financial Markets-Chapter 15

Where are federal funds rates determined?

Market for reserves

It's the interest rate at which commercial banks borrow from one another

Demand for reserves

Willingness of banks to buy reserves = demand curve

Reserves = required reserves + excess reserves

Opportunity cost of holding excess reserves

Interest rate on loans - interest rate on reserves

Interest rate on reserves (i_or) is usually set at a fixed amount below federal funds rate (i_ff)

What happens when i_ff decreases?

-cost of holding reserves decreases

-quantity demanded of reserves increases

demand curve is downward sloping and flat at i_or

Supply of reserves

Willingness of Fed and banks to sell reserves

Rs can be split into two parts: nonborrowed reserves NBR and borrowed reserves BR

Discount rate is i_d (cost of borrowing from Fed, which is set a fixed amount above the FFR target)

Borrowing from Fed is a substitute for borrowing from other banks

Shape of supply curve

If i_ff < i_d:

banks won't borrow from Fed

borrowed reserves are zero

supply curve will be vertical

as i_ff rises above i_d:

borrow more and more at i_d and relend the procees at i_ff

supply curve is horizontal at i_d

Conventional monetary policy tools

Used during normal (non-crisis?) times:

-open market operations

-discount lending

-reserve requirements

new since 2008: interest payments on reserves

Non-conventional monetary policy tools

Used during "desperate" times (e.g. 2008 crisis and COVID-19 crisis):

-liquidity provision

-asset purchase

-commitment to future monetary policy actions

Liquidity provision

Setting up Term Auction Facility (TAF)

-fed sets quantity of funds it's willing to lend to banks, then banks bid to borrow those funds

-interest rate is determined by amount of funds made available & competition among banks

-higher quantity of funds available increases Ms

Creating new lending programs

-many created 2008

-esp. for lending to investments banks to prevent their failure (bc they were decided to be too big to fail)

Asset purchase

Aka quantitative easing

OMO involves purchases of short-term govt. securities

(affects short-term interest rates, but these are at 0)

QE involved purchases of long-term govt. securities (to lower interest rates, to stimulate lending & economy)

Forward guidance

Aka management of expectations

-fed commits to maintaining short-term interest rates near zero for a long period of time (means future short-term interest rates are promised to be close to 0).

-creates downward pressure on long-term interest rates

-uses words to affect future expectations about short-term interest to lower current long-term interest rates

-fed's credibility problem (if economy recovers faster than expected, fed will need to increase interest rates sooner than promised)