Tools of Monetary Policy

Chapter 18: Tools of Monetary Policy

Learning Objectives

• Market for Reserves

  • Illustrate how changes in monetary policy affect the federal funds rate.

• Conventional Monetary Policy Tools

  • Summarize implementation, advantages, and limitations.

• Key Monetary Policy Tools

  • Explain tools used when conventional policy is ineffective.

• Monetary Policy Distinctions

  • Identify distinctions and similarities between Federal Reserve and European Central Bank tools.

The Reserves Market and the Federal Funds Rate

• Demand and Supply

  • Examines how the quantity of reserves demanded by banks changes as the federal funds rate changes, holding all else constant.

  • Excess Reserves:

  • Defined as reserves held by banks that exceed the required minimum.

  • Function as insurance against unexpected deposit outflows.

  • Opportunity Cost:

  • Opportunity Cost of holding reserves can be measured against the interest rates available on assets.

  • Represents the cost of not placing those reserves into higher-yielding investments.

  • Interest on Reserves (IOR):

  • Interest paid to banks by the Federal Reserve on their reserve balances.

Equilibrium in the Market for Reserves (Figure 1)

• Federal Funds Rate:

  • The equilibrium rate where demand and supply for reserves intersect.

  • Scenario of Excess Supply:

  • Occurs when the federal funds rate falls below a certain threshold ($i^*$).

  • Scenario of Excess Demand:

  • Occurs when the federal funds rate rises above a specific point ($i$).

  • Visual representation shows how shifts in supply and demand affect the equilibrium rate.

Response to an Open Market Operation (Figure 2)

• Open Market Purchases:

  • Step 1: An increase in reserves causes the supply curve to shift to the right.

  • Step 2: This action results in a reduction of the federal funds rate.

  • The federal funds rate cannot fall below the interest rate paid on reserves (IOR).

  • Two scenarios are presented:

  • (a) Initial supply curve intersects the demand curve in its downward-sloping section.

  • (b) Initial supply curve intersects the demand curve in its flat section.

Response to Changes in Discount Rate (Figure 3)

• Explanation of the impacts of changing the discount rate on the reserves market, illustrating shifts in equilibrium and available reserves for banks.

Response to Changes in Required Reserves (Figure 4)

• Analysis of how changes in required reserve ratios impact banks' reserve holdings and federal funds rate.

Response to Changes in Interest Rate on Reserves (Figure 5)

• Investigation into the effects of altering the interest rate on reserves and its impact on bank behavior and the broader economy.

Federal Reserve's Operating Procedures (Figure 6)

• Overview of how the operational procedures of the Federal Reserve limit fluctuations in the federal funds rate, including mechanisms that stabilize rates during market disruptions.

Conventional Monetary Policy Tools

• Three Main Tools:

  • Open Market Operations

  • Discount Lending

  • Reserve Requirements

  • These tools are pivotal for controlling the money supply and interest rates under normal economic conditions.

Open Market Operations

• Dynamic Operations:

  • Involve buying and selling securities to affect money supply and federal funds rate.

• Defensive Operations:

  • Aim to maintain existing monetary policy stance rather than to change it.

• Primary Dealers:

  • Selected banks or financial institutions that the Fed conducts transactions with.

• TRAPS (Trading Room Automated Processing System):

  • A system that facilitates the execution and analysis of open market operations.

• Repurchase Agreements:

  • Short-term lending agreements to manage liquidity in the economy.

• Matched Sale–Purchase Agreements:

  • A sale of securities with an agreement to repurchase them later.

Inside the Fed: Day at the Trading Desk

• The manager oversees analysts and traders executing transactions to meet the federal funds rate targets.

Discount Policy and Lender of Last Resort

• Discount Window:

  • A facility through which banks can borrow funds in emergency situations.

• Types of Credit:

  • Primary Credit: Standard lending facility available to healthy banks.

  • Secondary Credit: Available to banks in trouble facing higher interest rates.

  • Seasonal Credit: Available for institutions with seasonal fluctuations in funding needs.

• Lender of Last Resort:

  • Role of the central bank in preventing financial panics, with potential ethical implications relating to moral hazard.

Reserve Requirements

• Depository Institutions Deregulation and Monetary Control Act of 1980:

  • Established uniform reserve requirements across all depository institutions, affecting savings and lending processes across various types of banks.

• Institution Types:

  • Commercial Banks

  • Savings & Loan Associations

  • Mutual Savings Banks

  • Credit Unions

Interest on Excess Reserves

• Initiated in 2008, this tool allowed the Fed to manage reserve levels effectively, helping to stabilize the federal funds rate after the financial crisis by serving as a means for banks to manage large excess reserves.

Inside the Fed: Using Discount Policy to Prevent Financial Panics

• Discussion of strategies employed to prevent sudden, widespread economic collapses during crises by providing liquidity and support to the banking system.

Relative Advantages of Different Monetary Policy Tools

Open Market Operations

• Advantages:

  • High volume of transactions, flexible, precise, easily reversible, and quick implementation.

Discount Rate

• Limitations:

  • Rarely used, can create liquidity issues, causes uncertainty among banks, serves primarily as a lender of last resort.

On the Failure of Conventional Monetary Policy Tools in a Financial Panic

• Conventional monetary policy tools fail during full-scale financial crises due to:

  • Seizure of financial systems preventing effective capital allocation to productive uses, leading to collapsed investment and economy.

  • The emergence of the zero-lower-bound problem, where interest rates cannot be lowered further to stimulate the economy.

Nonconventional Monetary Policy Tools During the Global Financial Crisis

• Liquidity Provision:

  • Involves mechanisms like:

  • Discount Window Expansion

  • Term Auction Facility

  • New Lending Programs

• Large-scale Asset Purchases:

  • Government Sponsored Entities Purchase Program

  • Quantitative Easing (QE2, QE3)

  • Credit Targeting

Quantitative Easing Versus Credit Easing

• Quantitative Easing:

  • Involves expansion of the Fed's balance sheet, increasing both monetary base and money supply, creating inflationary pressures.

• Credit Easing:

  • Focuses on making credit more available during financial stress through unconventional policy tools.

• Forward Guidance:

  • Communicating future monetary policy directions to influence economic expectations and behavior.

Negative Interest Rates on Banks’ Deposits

• A policy leading to interest being paid to borrowers instead of lenders, incentivizing borrowing over saving.

Inside the Fed: Fed Lending Facilities During the Global Financial Crisis

• Overview of new lending facilities established to restore liquidity including significant loans to key financial institutions (e.g., AIG, JP Morgan).

Monetary Policy Tools of the European Central Bank

• Main Refinancing Operations:

  • Weekly reverse transactions and longer-term refinancing.

• Lending to Banks:

  • Marginal Lending Facility and Deposit Facility:

  • Set reserve requirements at 2% of total checking and short-term deposits, providing low cost of compliance through interest payments.

Conclusion

• Summary of the various tools and strategies employed by central banks, illustrating the complexities and variations in approaches taken by different institutions (Federal Reserve vs. European Central Bank).

• Emphasis on adherence to effective monetary policy as vital for economic stability and growth.