Week 15 Pt 2 Study Notes on Open Market Operations, Required Reserve Ratio, and Monetary Policy Tools
Open Market Operations
Types of Open Market Operations
Open Market Purchase
Definition: The Federal Reserve (the Fed) buys government securities (such as U.S. Treasury bonds) from commercial banks, which injects newly created money into the banking system by increasing the bank's reserves held at the Fed.
Example Scenario:
Bank A sells 1,000,000 worth of government securities to the Fed.
The Fed credits Bank A's reserve account with 1,000,000, effectively increasing its deposit balance at the Fed. If the account balance was initially 10,000,000, it changes to 11,000,000.
Money Creation: This process creates money essentially "out of thin air." The Fed, as the central bank, has the unique ability to create reserves by merely adjusting bank's deposit balances on its ledger. This is a balance sheet operation where the Fed's assets (securities) increase, and its liabilities (bank reserves) also increase.
Effect on Reserves:
Total reserves in the banking system instantly increase. In the example, reserves increase to 11,000,000.
As total reserves increase, the amount of excess reserves (reserves held by banks beyond what is legally required) also increases. Banks are incentivized to lend out these excess reserves to earn interest.
This leads to banks creating more loans, which are deposited into borrowers' accounts. These newly created checkable deposits represent new money in the economy, thus increasing the money supply.
Current Money Supply (M1):
Defined as: The most liquid components of the money supply, including currency held outside of banks, plus checkable deposits (demand deposits, NOW accounts, etc.), plus travelers' checks. Increasing checkable deposits through increased loan activity directly expands the M1 money supply.
Open Market Sale
Definition: The Federal Reserve sells government securities to commercial banks, which removes money from the banking system by decreasing the banks' reserves held at the Fed.
Example Scenario:
The Fed sells 1,000,000 worth of government securities to Bank A.
Bank A pays for these securities by using funds from its reserve account at the Fed. If Bank A's reserve account was initially 10,000,000, after the transaction, it's adjusted down to 9,000,000.
Money Disappearance: Similar to money creation, the 1,000,000 essentially disappears from the banking system as a mere accounting adjustment on the Fed's books. The Fed's liabilities (bank reserves) decrease, and its assets (securities) also decrease.
Effect on Reserves:
Reserves in the banking system decrease. This causes banks to become reserve deficient relative to their required reserve ratio if they were previously holding only the minimum required.
Example of Required Reserve Ratio:
If the required reserve ratio (r) is 10\%, a bank must hold 10 cents in reserves for every 1 dollar in checkable deposits. If a bank has 100 in checkable deposits, it must hold 10 in reserves.
If an open market sale reduces a bank's reserves to 9 when it has 100 in deposits and a 10\% reserve ratio, the bank is deficient by 1 in reserves (10 required vs. 9 held).
Resolution:
To cover the deficiency, banks must take action: they can borrow funds from other banks in the federal funds market, borrow from the Fed at the discount window, or, more significantly, reduce their lending by calling in loans or selling assets. The most common and impactful response is to reduce lending or allow existing loans to mature without issuing new ones, which results in a decrease in checkable deposits.
Overall Effect: An open market sale leads to a contraction of bank lending, a decrease in checkable deposits, and consequently, a decrease in the overall money supply.
Required Reserve Ratio
Concept of Required Reserve Ratio
Definition: The percentage of total checkable deposits that commercial banks are legally required to hold as reserves, either as vault cash or as deposits with the Federal Reserve. This requirement ensures a level of liquidity and provides the Fed with a tool to influence the money supply.
Equation: The potential change in checkable deposits (the maximum amount the money supply can expand or contract) due to a change in reserves is given by: Change in Checkable Deposits = \frac{1}{r} * Change in Reserves, where r is the required reserve ratio.
Simple Deposit Multiplier
The formula (\frac{1}{r}) that calculates the maximum potential by which the total money supply (specifically checkable deposits) will change with respect to an initial change in reserves. This multiplier assumes that banks lend out all of their excess reserves and that all loaned funds are redeposited into the banking system.
Example Calculations:
Assuming an initial change in reserves of 100 and a required reserve ratio of 0.1 (10\%$), the simple deposit multiplier is 1/0.1 = 10.
The maximum potential change in checkable deposits would therefore be 10 * 100 = 1,000.
If the required reserve ratio decreases to 0.05 (5\%$), the multiplier increases to 1/0.05 = 20, leading to a larger potential change in checkable deposits: 20 * 100 = 2,000.
Conclusion: Lowering the reserve ratio increases the simple deposit multiplier, thus increasing the potential money supply and encouraging banks to lend more. Conversely, raising the reserve ratio decreases the multiplier, reducing the potential money supply and curbing lending.
Discount Rate and Federal Funds Rate
Discount Rate
Definition: The interest rate charged by the Federal Reserve for short-term loans made to commercial banks and other depository institutions through its "discount window." This rate serves as a backstop liquidity facility for banks.
Example: If the discount rate is set at 4\%, banks seeking temporary loans directly from the Fed must pay this interest rate on the borrowed funds.
Setting Mechanism: The Fed sets the discount rate unilaterally as part of its monetary policy, rather than letting it be determined by market forces.
Federal Funds Rate
Definition: The interest rate that one commercial bank charges another commercial bank for overnight loans of excess reserves. Banks lend to each other in the federal funds market to meet their reserve requirements or to temporarily deploy excess reserves.
Market Setting: Unlike the discount rate, the federal funds rate is determined by the supply and demand for reserves in the marketplace for interbank reserves. However, the Fed heavily influences this rate through its open market operations.
Signaling:
If the Fed sets the discount rate lower than the prevailing federal funds rate (e.g., discount rate at 4\%, federal funds rate at 6\%$), it encourages banks to borrow from the Fed rather than other banks, potentially increasing reserves in the system and easing liquidity.
Conversely, setting the discount rate higher than the federal funds rate signals to banks that borrowing from the Fed is a last resort, thereby maintaining stability in reserves and encouraging interbank lending.
Impacts on Money Supply
A lower discount rate makes it cheaper for banks to borrow reserves from the Fed. This can lead to an influx of reserves into the banking system, encouraging increased lending and the creation of more checkable deposits, ultimately increasing the money supply.
A higher discount rate makes borrowing from the Fed more expensive, deterring banks from seeking such loans. This can lead to a decrease in overall reserves, lower lending activity, and consequently, a decrease in the money supply.
Federal Funds Rate Target
Current vs. Target Rate
Current Federal Funds Rate: Represents the prevailing market-determined equilibrium rate for overnight interbank lending of reserves.
Target Rate: The desired level for the federal funds rate set by the Federal Open Market Committee (FOMC) as a key indicator of its monetary policy stance. This is a primary tool for guiding the overall level of interest rates in the economy.
Example Scenario: If the current federal funds rate is 5.5\% and the FOMC sets a target of 4\%$$, it signals that the Fed desires a lower cost of borrowing and a more accommodative monetary policy for the economy.
Method of Adjustment:
The Fed primarily achieves its federal funds rate target through open market operations. To lower the federal funds rate towards its target, the Fed conducts open market purchases, buying government securities from banks.
This action directly increases the supply of reserves in the banking system. An increase in the supply of reserves, with unchanged demand, pushes down the equilibrium federal funds rate.
The increased reserves and lower federal funds rate lead to higher liquidity throughout the banking system. This greater liquidity impacts banks' willingness to lend and the cost of borrowing for businesses and consumers, thereby influencing investment and consumption and ultimately raising the money supply.