© 2004 Pearson Addison-Wesley. All rights reserved 17-1 The Market for Reserves and the Fed Funds Rate Demand Curve for Reserves 1. R = RR + ER 2. i  opportunity cost of ER , ER  3. Demand curve for reserves slopes down Supply Curve for Reserves 1. If i ff is below i d, then discount borrowing, R s = R n i d = primary credit rate (aka “discount rate”) 2. Supply curve flat (infinitely elastic) at i d because as i ff starts to go above i d, banks borrow more at i d Market Equilibrium R d = R s at i * ff

© 2004 Pearson Addison-Wesley. All rights reserved 17-2 Supply and Demand for Reserves

© 2004 Pearson Addison-Wesley. All rights reserved 17-3 Response to Open Market Operations Open Market Purchase Nonborrowed reserves, R n,  and shifts supply curve to right R s 2 : i  to i 2 ff

17-4 Response to a Change in the Primary Credit Rate (a)No discount lending Lower Primary Credit Rate Horizontal to section  and supply curve just shortens, i ff stays same (b) Some discount lending Lower Primary Credit Rate Horizontal section , i ff  to i 2 ff = i 2 d

© 2004 Pearson Addison-Wesley. All rights reserved 17-5 Required reserve Ratio  Demand for reserves , R s shifts right and i ff  to i 2 ff Response to Change in Required Reserves

© 2004 Pearson Addison-Wesley. All rights reserved 17-6 Open Market Operations Flavors 1.Dynamic: Meant to change MB 2.Defensive: Meant to offset other factors affecting MB Repurchase agreements to temporarily increase MB Matched sales-purchase to temporarily decrease MB Advantages 1.Fed has complete control 2.Flexible and precise 3.Easily reversed 4.Implemented quickly

© 2004 Pearson Addison-Wesley. All rights reserved 17-7 Discount Loans Flavors 1.Primary Credit (i d = Target i ff basis points) 2.Secondary Credit (Rate = i d + 50 basis points) 3.Seasonal Credit Lender of Last Resort Function : Too Big to Fail 1.To prevent banking panics (FDIC fund not big enough) Example: Continental Illinois 2.To prevent nonbank financial panics Examples: 1987 stock market crash and September 11 terrorist incident

17-8 How Primary Credit Facility Puts Ceiling on i ff Rightward shift of R s to R s 2 moves equilibrium to point 2 where i 2 ff = i d and discount lending rises from zero to DL 2

© 2004 Pearson Addison-Wesley. All rights reserved 17-9 Discount Policy Advantages 1.Lender of Last Resort Role Disadvantages 1.Confusion interpreting discount rate changes 2.Fluctuations in discount loans cause unintended fluctuations in money supply 3.Not fully controlled by Fed

© 2004 Pearson Addison-Wesley. All rights reserved Reserve Requirements Advantages 1.Powerful effect Disadvantages 1.Small changes have very large effect on M s 2.Raising causes liquidity problems for banks 3.Frequent changes cause uncertainty for banks 4.Tax on banks

© 2004 Pearson Addison-Wesley. All rights reserved Channel/Corridor System in Other Countries: Interest on Excess Reserves In the channel/corridor system standing facilities result in a step function supply curve, R s. If demand curve shifts between R d 1 and R d 2, i ff always remains between i r and i l