Monetary Policy Notes

Monetary Policy

Monetary Policy Overview

• Monetary Policy: When the central bank changes the money supply to influence interest rates to achieve specific economic goals.

• The central bank can change the money supply by changing:

  1. The Reserve Requirements

  2. The Discount Rate

  3. Open Market Operations

Monetary Policy in Real Life

• In the US, the reserve requirement is effectively zero.

• Commercial banks deposit more reserves with the Fed because the Fed pays interest on reserves.

  • Less than $50$ billion historically.

  • Currently over $4$ Trillion.

Modern Changes to Banking

• Interest on Reserves (IOR): The interest rate that the Federal Reserve pays commercial banks to hold reserves.

• IOR and the discount rate are examples of administered rates.

• Administered rates: Interest rates set by the Fed rather than determined in a market.

• Reserves at the Fed have no risk.

• Therefore, banks have no incentive to lend money at an interest rate lower than what they can get from the Fed.

Limited Reserves vs Ample Reserves

• The tools used by central banks depend on whether the banking system has limited reserves or ample reserves.

Limited Reserves

• Banks deposit few reserves with the central bank.

• Small changes in the money supply can affect interest rates.

• The central bank conducts monetary policy by changing the reserve requirement, the discount rate, or using open market operations.

Ample Reserves

• Banks deposit a lot of reserves with the central bank.

• Changing the money supply has little or no effect on interest rates.

• The central bank conducts monetary policy by changing its administered rates (IOR or discount rate).

Reserve Market Model

• Federal Funds Rate (Policy Rate): The target rate that the Fed wants banks to use when loaning each other reserves overnight.

• There is an inverse relationship between the Federal Funds Rate (FFR) and the quantity of reserves demanded.

  • When the FFR is high, banks want to hold fewer reserves.

  • When the FFR is low, banks want to hold more reserves.

• Discount Rate:

  • The discount rate is usually the maximum rate that banks are willing to pay to borrow money.

  • If the FFR is higher than the discount rate, then banks will just borrow from the Fed.

  • The discount rate acts as a cap on the Federal Funds Rate.

  • At a super low Federal Funds Rate, banks have an incentive to just deposit their extra funds at the Fed and earn IOR.

  • Banks have extra reserves, plenty of money to cover their obligations, and can earn IOR.

  • This is a banking system that has ample reserves.

Reserve Market Model - Limited Reserves

• When there are limited reserves, if the central bank buys bonds from banks:

  • Banks will have more reserves.

  • The supply of reserves will shift to the right.

  • The interest rate will decrease.

Reserve Market Model - Ample Reserves

• When there are ample reserves, if the central bank buys bonds:

  • The interest rate doesn’t change.

  • Open market operations (OMO) don’t work.

Decreasing Rates - Ample Reserves

• When there are ample reserves, what can the central bank do to decrease rates?

  • Decrease interest on reserves and the discount rate.

Increasing Rates - Ample Reserves

• When there are ample reserves, what can the central bank do to increase rates?

  • Increase interest on reserves and the discount rate.

The Point

• The traditional three tools of monetary policy (reserve requirement, discount rate, OMO) are primarily used when there are limited reserves.

• When there are ample reserves, the primary tool is interest on reserves (IOR).

Monetary Policy in Real Life

• The United States has ample reserves, so monetary policy is primarily done by changing IOR rather than OMO. (Copyright ACDC Leadership 2022)