Money and Banking Lecture 36

Review of the Previous Lecture Deposit Multiplier and Money Multiplier Central Bank’s Monetary Policy Toolbox Target Federal Funds Rate and Open Market Operation

The central bank chooses to control the federal funds rate by manipulating the quantity of reserves through open market operations: the central bank buys or sells securities to add or drain reserves as required.

Discount Lending, the Lender of Last Resort and Crisis Management Lending to commercial banks is not an important part of the central bank’s day- to-day monetary policy. However, such lending is the central bank’s primary tool for ensuring short- term financial stability, for eliminating bank panics, and preventing the sudden collapse of institutions that are experiencing financial difficulties.

The central bank is the lender of last resort, making loans to banks when no one else can or will, but a bank must show that it is sound to get a loan in a crisis. The current discount lending procedures also help the central bank meet its interest-rate stability objective. The central bank makes three types of loans: primary credit, secondary credit, seasonal credit.

Primary credit is extended on a very short- term basis, usually overnight, to sound institutions. It is designed to provide additional reserves at times when the day’s reserve supply falls short of the banking system’s demand. The system provides liquidity in times of crisis, ensures financial stability, and restricts the range over which the market federal funds rate can move (helping to maintain interest-rate stability).

Secondary credit is available to institutions that are not sufficiently sound to qualify for primary credit. Banks may seek secondary credit due to a temporary shortfall in reserves or because they have longer-term problems that they need to work out. Seasonal credit is used primarily by small agricultural banks to help in managing the cyclical nature of farmers’ loans and deposits

Reserve Requirements By adjusting the reserve requirement, the central bank can influence economic activity because changes in the requirement affect deposit expansion. Unfortunately, the reserve requirement turns out not to be very useful because small changes in the reserve requirement have large (really too large) impacts on the level of deposits.

Today, the reserve requirement exists primarily to stabilize the demand for reserves and help the central bank to maintain the market federal funds rate close to target; it is not used as a direct tool of monetary policy

The central bank’s Monetary Policy Toolbox Central bank

Linking Tools to Objectives Desirable Features of a Policy Instrument Easily observable by everyone Controllable and quickly changed Tightly linked to the policymakers’ objectives These requirements leave policymakers with few choices, and over the years central banks have switched between controlling the quantity and controlling the prices.

Reserve targets make interest rates volatile. Central bank

Targets and Instruments Operating instruments refer to actual tools of policy, instruments that the central bank controls directly. Intermediate target refers to instruments that are not directly under the control of the central bank but that lie between their policymaking tools and their objectives.

Targets and Instruments Over the last two centuries, central bankers largely abandoned intermediate targets, having realized that they didn’t make much sense. Instead, policymakers focus on how their actions directly affect their target objectives