1 Lecture 29: Monetary policy – part one Mishkin Ch15 – part A page

2 Tools of monetary policy 1. Open market operations  Affect the quantity of reserves and the monetary base 2. Changes in borrowed reserves (discount loans)  Affect the monetary base 3. Changes in reserve requirements (required reserves ratio)  Affect the money multiplier Federal funds rate: the interest rate on overnight loans of reserves from one bank to another  Primary indicator of the stance of monetary policy

3 Demand in the market for reserves Quantity of demand: reserves Price: federal funds rate – interest rate in the federal funds market. Reserves = required reserves + excess reserves  Excess reserves are insurance against deposit outflows  The cost of holding these is the interest rate that could have been earned If federal funds rate decreases  the opportunity cost of holding excess reserves falls  quantity of reserves demanded rises Downward sloping demand curve

4 Supply in the market for reserves Quantity of supply = non-borrowed + borrowed reserves Price: federal funds rate Cost of borrowing from the Fed is the discount rate, and borrowing from the Fed is a substitute for borrowing from other banks (in federal funds market) 1. If i ff < i d, then banks will not borrow from the Fed and borrowed reserves are zero The supply curve will be vertical 2. As i ff rises above i d, banks will borrow more and more at i d, and re-lend at i ff The supply curve is horizontal (perfectly elastic) at i d

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6 Equilibrium The equilibrium quantity of reserves and federal funds rate occurs at the intersection of the demand curve and supply curve. Next question: how would changes in using the three monetary policy tools cause changes in the equilibrium federal funds rate?

7 Open market operations affect federal funds rate Open market purchase  Nonborrowed part increase  supply curve shifts to the right  the federal funds rate to fall An open market purchase causes the federal funds rate to fall; an open market sale causes the federal funds rate to rise.

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9 Change in discount rate might affect federal funds 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 decrease in discount rate results in a fall in federal funds rate, an increase in discount rate leads to a rise in federal funds rate.

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11 Change in reserve requirement affect federal funds rate If required reserves ratio increases  banks need more reserves  demand curve shifts to the right  federal funds rate increase When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.

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