as shown in figure 1. The equilibrium moves from point 1 to point 2. lowering the federal funds rate 1 2 from i ff to i ff 1 . which affect the quantity of reserves and the monetary base. whereas an open market sale causes the federal funds rate to rise. Now. THE MARKET FOR RESERVES AND THE FEDERAL FUNDS RATE 1. R d . and changes in reserve requirements. R s = R d .TOOLS MONETARY POLICY There are three policy tools that the Fed can use to manipulate the money supply and interest rates as open market operations. which affect the money multiplier. the Federal Reserve has increasingly focused on the federal funds rate (the interest rate on overnight loans of reserves from one bank to another) as the primary indicator of the stance of monetary policy. FIGUR 2 Response to an Open Market Operation An open market pu8rchase increases and hence the reserves supplied and shifts the supply curve s from R1s to R2 . • How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate Open Market operations An open market purchase causes the federal funds rate to fall. which affect the monetary base. A. Supply and Demand in the Market for Reserves The demand curve for reserves. slopes downward and the supply curve becomes flat (infinitely elastic) at id . changes in borrowed reserves. FIGUR 1 Equilibrium in the Market for Reserves Equilibrium occurs at the intersection of the intersection of the supply curve R s and the demand curve R d at point 1 and an interest rate of i * ff 2. While market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied.

so that the equilibrium federal funds rate remains 1 1 2 unchanged at i ff . . Required reserve increase. In panel (b) when the discount rate is lowered by the Fed from id to id . • FIGUR 4 Reserve Requirements When the Fed raises reserve requirements. Response to a change in Required Reserves When the Fed raises reserve requirements. and the equilibrium federal funds rate 1 2 falls from i ff to i ff . The demand curve shifts d From R1d to R2 . the horizontal section of the supply curve R1s falls. the equilibrium moves from point 1 to point 2. which increase the Demand for reserves. Response to a Change in the Discount rate 1 2 In panel (a) when the discount rate is lowered by Fed from id to id the vertical section of s the supply curve just shortens.• FIGUR 3 Discount lending The most changes in the discount rate have no effect on the federal funds rate. as in R2 . the federal funds rate rises. and the federal fund rate 1 2 rises from i ff to i ff .

because they are the primary determinants of changes in interest rates and the monetary base.Open market operations are flexible and practice . Open market purchases expand reserves and the monetary base. DISCOUNT POLICY 1.2 B. the main source of fluctuations in the money supply. and thus in most circumstances the amount of discount lending under the primary credit facility is very small. .Open market operations occur at the initiative of the Fed. .Open market operations are easily reversed . Open market operations have several advantages over the other tools of monetary policy: . which has complete control over their volume. The interest rate on these loans is the discount rate. usually by 100 basis points (one percentage points). Open market sales shrink reserves and the monetary base. Operation of the Discount Window Discount window is the facility at which banks can borrow reserves from the Federal Reserve. it is set the higher than the federal funds rate target. OPEN MARKET OPERATIONS Open market operations are the most important monetary policy tool. thereby increasing the money supply and the lowering short term interest rates.Defensive Open Market Operation Defensive Open Market Operations are intended to offset movements in the factors that affect reserves and the monetary base.Open market operations can be implemented quickly C.Dynamic Open Market Operations Dynamic Open Market Operations are intended to change the level of reserves and the monetary base. The Fed’s discount loans to banks are of three types: Primary credit Primary credit is the discount lending that plays the most important role in monetary policy. There are two types of open market operations: . . decreasing the money supply and raising short term interest rates.

which in turn sets a target for the overnight cash rate. Seasonal credit Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. However. The interest rate on secondary credit is set at 50 basis points (0. . 1. In the past. A second category of open market operations is the longer term refinancing operations. with the discount rate changed to affect interest rates and the money supply. discount policy was use as a tool of monetary policy. to prevent bank failures from spinning out of control. Advantages and Disadvantages of Discount Policy The most important advantage of discount policy is that the Fed can use it to perform its role of lender of last resort. its most important role was intended to be as the lender of last resort. Lender of Last Resort The discount is important in preventing financial panics. 2. it was to provide reserves to bank when no one else would. that use of discount policy to conduct monetary policy has little to recommend it. E. MONETARY POLICY TOOLS OF THE EUROPEAN CENTRAL BANK The European System of Central Banks signal the stance of its monetary policy by setting a target financing rate. D. thereby preventing bank and financial panics.5 percentage points) above the discount rate. RESERVE REQUIREMENTS Changing reserve requirements is too blunt a tool to use for controlling the money supply and hence it is rarely used. 3. Open Market operations Main refinancing operations are the predominant from of open market operations and are similar to the Feds transactions. which are a much smaller source of liquidity for the euro area banking system and are similar to the Fed’s outright purchases or sales of securities. When the Federal Reserve System was created. because the decisions to take out discounts loans are made by banks and are therefore not completely controlled by the Fed.3 Secondary credit Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. Using the discount tool to avoid financial panics by performing the role of lender of last resort is an extremely important requirement of successful monetary policymaking.

Reserve Requirements All institutions are subject to minimum reserve requirements have access to the European Central Bank’s standing lending facilities and participate in open market operations.4 2. Lending to Banks The European Central Banks also operates standing lending facilities that operate like the corridor system and ensure that the overnight cash rate remains within 100 basis points of the target financing rate 3. .

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