Chapter 18 Using Interest Rates to Stabilize the Domestic Economy Tools of Monetary Policy Using Interest Rates to Stabilize the Domestic Economy

Monetary Policy & Interest Rates: The Big Questions What are the tools used by central banks to meet their stabilization objectives? How are the tools linked to the central bank’s balance sheet? How is the interest rate target chosen?

From Chapter 17 : The Fed can control the MB but cannot precisely control the Money Supply M1 = m x MB 1+(C/D) M1 =  MB rD + (ER/D) + (C/D) Households can change C/D, causing the money mutiplier (m) and M1 to change Banks can change ER/D, causing m and M1 to change

The Fed’s “Traditional” Policy Tools Open Market Operations - OMO. Discount Rate - the interest rate the Fed charges on the loans it makes to banks Reserve Requirement - the level of balances a bank is required to hold either as vault cash on deposit or at a Federal Reserve Bank NOTE: The primary instrument of monetary policy is the Federal funds rate: the interest rate on overnight loans of reserves from one bank to another

A New (fourth) Tool Interest on reserves - required and excess Currently set at 0.25% The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve to begin paying interest on reserve balances of depository institutions beginning October 1, 2011.  The Emergency Economic Stabilization Act of 2008 accelerated date to October 1, 2008. 

Open Market Operations The Fed buys and sells U.S. Gov’t securities in the secondary market in order to adjust the supply of reserves in the banking system. Most flexible means of carrying out monetary policy. The Fed does not participate directly in the Federal Funds market. . The Fed does not want the credit risk associated with direct participation.

OMO and the Federal Funds Market Federal funds are reserve balances that depository institutions lend to one another. The most common federal funds transaction is an overnight, unsecured loan between two banks. (bilateral agreements) Note that without the FF market, banks would need to hold a substantial amount of excess reserves.

Advantages of OMO Implemented quickly Fed has complete control Flexible and precise Easily reversed

Two Types of Open Market Operations 1. Permanent OMO: “Permanent open market operations involve the buying and selling of securities outright to permanently add or drain reserves available to the banking system.” Temporary OMO: “Temporary open market operations involve repurchase and reverse repurchase agreements that are designed to temporarily add or drain reserves available to the banking system”

Open Market Operation - Repo With a repurchase agreement ("repo"), the Fed buys securities from dealers who agrees to buy them back, typically within one to seven days. Repos add reserves to the banking system and then withdraws them. Can be viewed as the Fed temporarily lending reserves to dealers with the dealers posting securities as collateral.

Open Market Operation – Reverse Repo With a reverse repo, the Fed sells securities to dealers and agrees to buy back in one to seven days. Reverse repo drain reserves and later add them back. Can be viewed as the Fed temporarily borrowing reserves from dealers with the Fed posting securities as collateral.

http://www.newyorkfed.org/index.html

How is the Federal Funds Rate Determined How is the Federal Funds Rate Determined? Supply and Demand for Reserves IOER

Why Do banks hold Reserves? Demand for Reserves Why Do banks hold Reserves? Required Excess reserves are insurance against deposit outflows The cost of holding this insurance is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ier , (IOER) For example, if T-bill rate = .5% and IOER = .25%, opportunity cost = .25% http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Demand for Reserves As the federal funds rises above the rate paid on excess reserves, ier, the opportunity cost of holding excess reserves increases and the quantity of reserves demanded decreases Downward sloping demand curve for reserves. The demand curve becomes flat (infinitely elastic) at IOER IOER acts as a floor on the federal funds rate.

Supply of Reserves Two components to the supply of reserves: non-borrowed and borrowed reserves The discount rate (id) is the cost of borrowing from the Fed. The interest rate on loans from the Fed. Borrowing from the Fed is an alternative to borrowing from other banks in the Federal Funds market.

Supply for Reserves If the Federal Funds rate (iff )< Discount rate (id), banks will not borrow from the Fed and borrowed reserves are zero The supply curve will be vertical at the level of non-borrowed reserves (NBR). As iff rises above id, banks will borrow more and more at id, (NOTE: they can lend at iff ) The supply curve is horizontal (perfectly elastic) at id

How OMO Affects the Federal Funds Rate Open market operations shift the supply curve of reserves. Effect of open an market operation on the federal funds rate depends on whether the supply curve initially intersects the demand curve on its downward sloped section or 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.

Response to an Open Market Purchase

Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve.

Affecting the Federal Funds Rate: Discount Rate 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. 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 and 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

Affecting the Federal Funds Rate: Reserve Requirement When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement the federal funds rate falls. Intuition -

Response to a Change in Required Reserves

Response to a Change in the Interest Rate on Reserves

How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate

Discount Lending – Lender of Last Resort Lending to commercial banks has not been an important part of the Fed’s day-to-day monetary policy. However, lending is the Fed’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. On Sept. 12, 2001, banks borrowed $45.5 billion from the Fed. (In addition, the Fed purchased $80 billion in Gov’t securities).

Primary Credit (sound credit) Discount Lending Types of Loans – Primary Credit (sound credit) Short-term, typically overnight Historically 100 basis points above target Fed Funds Rate. Currently 50 bp Secondary Credit For banks that do not qualify for primary credit Hisorically 150 basis points above target Fed Funds Rate. Seasonal Credit Small banks with cyclical farm loans http://www.frbdiscountwindow.org/index.cfm

Advantages and Disadvantages of Discount Policy Used to perform role of lender of last resort Important during the subprime financial crisis of 2007-2008. Cannot be controlled by the Fed; the decision maker is the bank Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target Does the “Lender of Last Resort” fucntion to prevent financial panics create a moral hazard problem?

Reserve Requirements Depository Institutions Deregulation and Monetary Control Act of 1980 (MCA) subjected all banks to the same reserve requirements as member banks Set reserve requirement within a range of 8 to 14 percent for transactions deposits and 0 to 9 percent for non-transactions deposits. Fed now pays interest on reserves. To reduce burden on small banks, first few million $ in DD are exempt, then 3% up to about $71 mil., then 10% Note: Fed’s use of the reserve requirement in 1936.

Reserve Requirements Advantages 1. Powerful effect Disadvantages Without excess reserves, small changes have very large effect on Ms Not binding with so many banks holding excess reserves Raising causes liquidity problems for banks Frequent changes cause uncertainty for banks

Operational Policy at the European Central Bank http://www. ecb Main Refinancing Rate: Set via weekly auction of 2-week repurchase agreements. Inject and withdraw reserves in the banking system. Comparable to the Fed’s target FFR. Marginal Lending Facility 100 basis points above target refinancing rate Deposit Rate: Banks earn interest on excess reserves. Reserve Requirements 2% applied to checking accounts Overnight Cash rate.( Market FFR)

Operational Policy at the European Central Bank