Chapter 30.3a: Interest Rates and Monetary Policy 

Tools of Monetary Policy

• The Fed has four main tools of monetary policy it can use to alter the reserves of commercial banks:
  • open market operations
  • reserve ratio
  • discount rate
  • interest on reserves

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1. Open-Market Operations

• Bond markets are “open” to all buyers and sellers of corporate and government bonds (securities)
• The Federal Reserve is the largest single holder of U.S. government securities
• open-market operations::
  • The purchases and sales of U.S. government securities that the Federal Reserve System undertakes in order to influence interest rates and the money supply
  • consist of bond market transactions in which the Fed either buys or sells government bonds (U.S. securities) outright or uses them as collateral on loans of money
• collateral::
  • The pledge of specific assets by a borrower to a lender with the understanding that the lender will get to keep the assets if the borrower fails to repay the loan with cash.
• Fed’s open-market operations occur at the trading desk of the New York Federal Reserve bank.
  • When the Fed buys or sells government bonds
  • the New York Fed interacts exclusively with a group of about 23 large financial firms called “primary dealers.”
  • When the Fed borrows or lends money via collateralized transactions called repos and reverse repos, the New York Fed interacts with a larger group:
  • 20 commercial banks (ex. Bank of America and Goldman Sachs)
  • 41 nonbank financial institutions
  • 28 investment management companies (ex. Fidelity and Vanguard)
  • 13 government-sponsored financial entities (ex. Federal Home Loan Bank of Boston, Federal National Mortgage Association, Fannie Mae)

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Open Market Operations: Buying Securities

• suppose the Fed decides to have the Federal Reserve Banks buy government bonds from commercial banks or from the public

• When Federal Reserve Banks buy securities from ==commercial banks==

  • a) commercial banks give up part of their holdings of securities (the government bonds) to the Federal Reserve Banks.

  • b) The Federal Reserve Banks place new reserves in the accounts of the commercial banks at the Fed when paying for these securities.

  • The reserves of the commercial banks go up by the amount of the purchase of the securities.

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  • the 3 labels marked (a) show that securities have moved from the commercial banks to the Federal Reserve Banks

  • the 3 labels marked (b) show that the Federal Reserve Banks have provided reserves to the commercial banks

  • although commercial bank reserves have increased, they are a liability to the Federal Reserve Banks because the reserves are owned by the commercial banks.

  • when Federal Reserve Banks purchase securities from commercial banks, they increase the reserves in the banking system, ^^which increases the lending ability of the commercial banks.^^

• When Federal Reserve Banks buy securities from @@the public@@

  • Suppose the “Gristly” company sells government bonds in the open market to the Federal Reserve Banks.
  • Gristly gives securities to the Federal Reserve Banks and gets paid a check drawn by the Federal Reserve Banks on themselves.
  • Gristly deposits the check in its account at the Wahoo bank.
  • The Wahoo bank sends this check against the Federal Reserve Banks to a Federal Reserve Bank for collection.
    • the Wahoo bank enjoys an increase in its reserves.

• similarities between the Fed purchasing securities from commercial banks vs the public

  • ^^the purchases of securities from either increase the reserves and lending ability of the commercial banking system.^^

• differences between the Fed purchasing securities from commercial banks vs the public

  • bond purchases from commercial banks increase the actual reserves and excess reserves of commercial banks ^^by the entire amount of the bond purchases.^^
  • bond purchases from the public increase actual reserves but also increase checkable deposits when the sellers place the Fed’s check into their checking accounts
  • in the right figure, a $1,000 bond purchase from the public would increase checkable deposits and actual reserves of the banking system by $1,000
    • with a 20% reserve ratio applied to the $1,000 checkable deposit, the excess reserves of the would be only $800 since $200 would be held as required reserves.

  

• in both cases, ^^the potential increase in money supply is the same^^

  • in the figure, a $1,000 purchase of bonds by the Federal Reserve results in a potential $5,000 increase regardless of who the purchase was made from
  • on the left, this $5000 is from:
    • $1000 excess reserves* (1/20% reserve ratio) = $5000
  • on the right, this $5000 is from:
    • $800 excess reserves * (1/20% reserve ratio) = $4000
    • the $1000 checkable deposit paid from the Fed to the Gristly company
  • when securities are purchased from the public, part of the increase in money supply is due to the increase in checkable deposits

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Open Market Operations: Selling Securities

• The opposite from buying securities happens

• When Federal Reserve Banks sell securities to ==commercial banks==

  • a) The Federal Reserve Banks give up securities to commercial banks
  • b) The commercial banks pay for those securities by drawing checks against their deposits (against their reserves in Federal Reserve Banks)
  • The Fed collects on those checks by reducing the commercial banks’ reserves accordingly

  

• When Federal Reserve Banks sell securities to @@the public@@

  • a) The Federal Reserve Banks sell government bonds to the Gristly company
  • Gristly pays with a check drawn on the Wahoo bank.
  • b) The Federal Reserve Banks clear this check by reducing Wahoo bank’s reserves.
  • c) The Wahoo bank reduces Gristly’s checkable deposit accordingly

• Differences

  • a $1,000 bond sale to the commercial banking system
  • reduces the system’s actual and excess reserves by $1,000 ^^(the exact amount of the sale)^^
  • a $1,000 bond sale to the public
  • the public’s checkable-deposit money is reduced by $1,000 (the amount of the sale)
    • required reserves are reduced by $200 ^^(the amount of the sale * reserve ratio)^^
    • excess reserves are reduced by $800 (the amount of the sale - change in required reserves)

• Similarities

  • When Federal Reserve Banks sell securities in the open market, commercial bank reserves are reduced and the money supply declines
  • in the example, a $1,000 sale of government securities results in a $5,000 decline in the money supply whether the sale is made to commercial banks or to the general public

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Why commercial banks and the public sell government securities to or buy them from Federal Reserve Banks

• When the Fed buys government bonds
  • the demand for them increases.
  • Government bond prices rise and their interest yields decline.
  • banks, securities firms, and individual holders of government bonds sell them to the Federal Reserve Banks
• When the Fed sells government bonds
  • the supply for them increases
  • bond prices decrease and their interest yields increase
  • government bonds become attractive purchases for banks and the public

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