Lecture 10 and 11 Money and Banking

Tools of monetary policy

Outline:

1)The market for reserves and the federal funds rate.

2)Effects of changes of MP tools on the federal funds
rate.
3)Conventional monetary policy tools.
4)Nonconventional monetary policy tools.
5)Summary.

We seek to:

 Illustrate the market for reserves and demonstrate

how changes in monetary policy can affect the
federal funds rate.
 Summarize how conventional monetary policy tools
are implemented and the advantages and limitations
of each tool.
 Explain the key monetary policy tools that are used
when conventional policy is no longer effective.
 Identify the distinctions and similarities between the
monetary policy tools of the Federal Reserve and
those of the European Central Bank.

Reading: Chapter 16 and lecture slides.

Why should we be studying the tools that monetary
policy use?

 In order to understand how central banks use

monetary policy (MP) tools, need to understand not
only effect on money supply but also effect on
relevant interest rate.
 Objective is to achieve an interest rate that is close
to the target.
 Start with simple demand and supply analysis of
market of reserves.
 How the following monetary policy tools determine
the federal funds rate (Fed rate).
1)Open market operations (OMOs).
2)Discount policy.
3)Reserve requirements.
4)Interest paid on reserves.

Demand in the market for reserves

What happens to the quantity of reserves demanded by

banks, holding everything else constant, as the federal
funds rate changes?

Quantity of reserves demanded = required reserves +

excess reserves

 Excess reserves are insurance against deposits

outflows. The cost of holding these is the interest
 rate that could have been earned minus the interest
rate that is paid on these reserves, ior – their
opportunity cost.
 Since 2009, the Fed has paid interest on reserves at
a level that is set at a fixed amount below the
federal funds rate target.
 When the federal funds rate is above the rate paid
on excess reserves, ior, as the federal funds
rate decreases, the opportunity cost of
holding excess reserves falls, and the
quantity of reserves demanded rises.
 Downward sloping demand curve that
becomes flat (infinitely elastic) at ior

Supply in the market for reserves

 Two components:
1)Nonborrowed reserves.
2)Borrowed reserves.

 Cost of borrowing from the Fed is the discount

rate.
 Borrowing from the Fed is a substitute for
borrowing from other banks.
 If iff < id, then banks will not borrow
from the Fed and borrowed reserves
are zero. Supply curve will be vertical.
  As iff rises above id, banks will borrow
more and more at id, and relend at iff.
The supply curve is horizontal
(perfectly elastic) at id.

Equilibrium in the market for reserve

Does a change in MP tools affect the

federal funds rate?
 We consider how changes in four main MP tools
affect market for reserves.
 Any changes in reserve market will change the
federal funds rate.
 Four possible MP changes:
1)An open market operation (purchases or sale).
 2)Change in discount rate.
3)Change in reserve requirements.
4)Change in interest on reserves.

An open market operation

 Effects of an open market operation depends on

whether the supply curve initially intersects the
Demand curve in its downward sloped section versus
its flat section.
 An open market purchase causes the federal funds
rate to fall whereas an open market sale causes the
federal funds rate to rise (when intersection occurs at
the downward sloped section).
 Open market operations have no effect on the federal
funds rate when intersection occurs at the flat section
of the demand curve.

Response to an open market operation

Change in discount rate
1)If the intersection of supply and demand occurs on
the vertical section of the supply curve:
- A change in the discount rate will have no effect on
the federal funds rate.
2) If the intersection of supply and demand occurs on
the horizontal section of the supply curve:
- A change in the discount rate shifts that portion of
the supply curve.
- The federal funds rate may either rise or fall
depending on the change in the discount rate.
 Response to a change in the discount rate.

Change in reserve requirements

Response to a change in required reserves

Change in reserve requirements

 1)When the Fed raises reserve requirements, the
federal funds rate rises.
2)When the Fed decreases reserve requirements, the
federal funds rate falls.

Change in interest on reserves

1)If supply and demand intersect in the downward-

sloping section:
- If initially iff > ior, an increase in ior1 to ior2 causes
horizontal part of the demand curve to rise R2d.

- Intersection remains at point 1.

- Funds rate remains unchanged.
2)If supply and demand intersect in the flat section:
- If initially iff = ior, an increase in ior1 to ior2
increases funds rate.
Change in interest on reserves
How the Federal Reserve’s operating procedures limit
fluctuations in the federal funds rate.

Supply and demand analysis of the market for reserves:

1)Illustrates how an important advantage of the Fed’s

current procedures for operating the discount
window and paying interest on reserves is that they
limit fluctuations in the federal funds rate.

Consider Figure 6:

1)Initially equilibrium level funds rate = iTff

2) If large unexpected increase in demand, demand

curve shifts to the right to Rd.
3) Intersects supply curve on the flat portion –
equilibrium funds rate equals the discount rate id.
 4) If large unexpected decrease in demand, demand
curve shifts to the left to Rd – funds rate equals the
reserves rate ior.

How the Federal Reserve’s operating procedures limit

fluctuations in the federal funds rate

Federal Reserve’s operating procedures limiting

fluctuations in the federal.

Conventional monetary policy tools

To control the money supply and interest rates during
normal times, the Federal Reserve uses tools of
monetary policy:
1)Open market operations.
2)Discount lending.
3)Reserve requirements.
The above three are referred to as conventional
monetary policy tools.

Open market operations

Fed
- Dynamic open market operations.
- Defensive open market operations.
- Primary dealers.
- TRAPS (Trading Room Automated Processing
System).
- Repurchase agreements.
- Matched sale purchase agreements.
BoE
- Not used in this case.
 Discount policy and the lender of last resort
1)Discount window
-Primary credit: standing lending facility (interest
rate is discount rate). Lombard facility.
- Secondary credit: banks in financial trouble.
- Seasonal credit: given to banks with seasonal
patterns of deposits.
2) Lenders of last resort to prevent financial
trouble
- Discounting used in preventing financial panics.
- Creates moral hazard problem.
Reserve requirements
Fed
- Depositary Institutions Deregulation and
Monetary Control Act of 1980 sets the reserve
requirement the same for all depositary
institutions.
- Reserve requirements are equal to zero for the
first 15.5$. million of a bank’s checkable deposits,
3 % on checkable deposits from 15.5$ to 115.1$,
 and 10% on checkable deposits over 115.1
million$.
- The Fed can vary the 10% requirement between
8% and 14%.
BoE
- BoE follows Prudential Regulation Committee
(PRC) and Sterling Monetary Framework (SMF) in
setting reserve requirements.
Generally
- Requirements at central banks differ depending on
terms and liquidity of deposits.

Interest on excess reserves

Fed
- The Fed started paying interest on excess reserves
only in 2008.
- The interest-on-excess-reserves tool came to the
rescue during the crash as banks were
accumulating huge quantities of excess because it
can be used to raise the federal funds rate.
- Fed sets discount rate above funds rate target to
encourage borrowing and lending in federal funds
market.
BoE
- BoE pays interest on reserves equal to the bank
rate.
- This implies that overnight cash rates stay close to
bank rate as there is no incentive for banks to
borrow or lend to each other at rates different to
bank rate.
Monetary policy tools of the ECB
1)Open market operations:
- Main refinancing operations.
- Weekly reverse transactions.
- Longer-term refinancing operations.
2)Lending to banks:
- Marginal lending facility or marginal lending rate.
3)Interest rate on reserves:
- Deposit facility – ECB set the interest rate on
reserves to negative values starting in June 2014.
4)Reserve requirements:
- 2% of the total amount of checking deposits and
other short-term deposits.
- Pays interest on those deposits.
Relative advantages of the different monetary policy
tools
1)Open market operations are the dominant policy
tools of the Fed since it has complete control over
the volume of transactions:
- These operations are flexible and precise.
- Easily reversed.
- Can be quickly implemented.
2)The discount rate is less well used since it is no
longer binding for most banks:
- Can cause liquidity problems.
- Increases uncertainty for banks.
3)However, the discount window remains of
tremendous value given its ability to allow the Fed to
act as a lender of last resort.
Problem with conventional monetary policy tools
- When the economy experiences a full-scale
financial crisis, conventional monetary policy tools
cannot do the job, for two reasons.
1)The financial system seizes up to such an extent
that. It becomes unable to allocate capital to
productive uses, and so investment spending and
the economy collapse.
 2)The negative shock to the economy can lead to
the zero lower bound problem.
Liquidity provision
Fed
1)The Fed implemented unprecedented increase in its
lending facilities to provide liquidity to the financial
markets:
- Discount window expansion.
Fed lowered discount rate to 50 basis points above
funds rate.
- Term auction facility
Loans made at a rate determined through
competitive auctions.
- New lending programs.

BoE
The BoE provides liquidity insurance but only lends to
banks that are solvent and viable. Why?
1)Discount window facility.
- Banks can borrow up to 30 days – i.e. short-term
liquidity support.
 2)Asset purchase facilities.
- Gilt purchases, corp bond purchases, Term
Funding Scheme (TFS).
Large-scale asset purchases
Fed
During the crisis the Fed started three new asset
purchase programs to lower interest rates for particular
types of credit: Government Sponsored Entities Purchase
Program.
1)Purchased $1.2 trillion mortgage-backed securities
(2008)
2)Quantitative easing (QE) 2 – purchased $600 billion
long term treasury securities (75$ billion per month)
aimed at lowering long term interest rates (2010).
3)QE 3 – 40$ billion mortgage-backed plus 45$ billion
long term Treasuries (2012).

BoE
1)During the crisis the BoE had a “bank rescue
package” that totaled 500 billion pounds for entire
banking system.
2)Of that, 200 billion pounds was made available by
banks through special liquidity scheme.
 3)As of February 2017:
- Gilt purchases amounted to 435 billion pounds.
- Corporate bond purchases = 7.7 billion pounds.
42.9 billion pounds has been drawn in the TFS.
Quantitative easing verses credit easing
- During the global financial crisis, the Federal
Reserve became very creative in assembling a host
of new lending facilities to help restore liquidity to
different parts of the financial system.
- Expansion of the Fed balance sheet referred to as
quantitative easing.
It led to huge increase in monetary base.
What was effect of quantitative easing in the case of US
and UK?
- Could make potential argument for credit easing.
It is Altering the composition of CB balance sheet
in order to improve functioning of segments of
credit market.

Forward guidance
Fed
 - By committing to the future policy action of
keeping the federal funds rate at zero for an
extended period, the Fed could lower the market’s
expectations of future short-term interest rates.
- Thereby causing the long-term interest rate to fall.
BoE
- BoE launched forward guidance in 2013.
Negative interest rates on bank’s deposits
- Setting negative interest rates on banks’ deposits
is supposed to work to stimulate the economy by
encouraging banks to lend out the deposits they
were keeping at the Central bank, thereby
encouraging households and businesses to spend
more.
- However, there are doubts that negative interest
rates on deposits will have the intended,
expansionary effects.
Summary
- A supply and demand analysis of the market for
reserve to determine the federal fund rate.
- A conventional monetary policy tools include:
1)Open market operations.
2)Discount policy.
 3)Reserve requirements.
4)Interest on reserves.
- At the zero-lower bound conventional monetary
policy tools are no long effective.
- Unconventional monetary policy tools include:
1)Liquidity provision.
2)Asset purchases.
3)Forward guidance.
4)Negative interest rates on banks’ deposit.
Next lecture: The conduct of Monetary Policy: Strategy
and Tactics.