Tools of Monetary Policy Chapter 17 Tools of Monetary Policy

The Market for Reserves and the Federal Funds Rate Demand Curve for Reserves 1. R = RR + ER 2. i → opportunity cost of ER → ER 3. Demand curve slopes down Supply Curve for Reserves 1. If iFF is below iD, then no discount borrowing, RS = Rn 2. Supply curve flat (infinitely elastic) at iD because as iFF starts to go above iD, banks borrow more at iD Market Equilibrium where RD = RS at i*FF © 2006 Pearson Addison-Wesley. All rights reserved

Supply and Demand for Reserves © 2006 Pearson Addison-Wesley. All rights reserved

Response to Open Market Operations Open Market Purchase Non-borrowed reserves, Rn and shifts supply curve to right RS2: i to i2ff © 2006 Pearson Addison-Wesley. All rights reserved

Response to a Change in the Discount Rate (a) No discount lending Lower Discount Rate Horizontal section  and supply curve just shortens, iff stays same (b) Some discount lending Lower Discount Rate Horizontal section , iff  to i2ff = i2d

Response to Change in Required Reserves Demand for Reserves , RD shifts right and iff  to i2ff © 2006 Pearson Addison-Wesley. All rights reserved

Open Market Operations 2 Types 1. Dynamic to change MB 2. Defensive to offset other changes to MB using Repurchase Agreements (repos). Advantages of Open Market Operations 1. Completely controlled by Fed 2. Flexible and precise 3. Easily reversed 4. Implemented quickly © 2006 Pearson Addison-Wesley. All rights reserved

Discount Operations (Discount Loans) 3 Types 1. Primary Credit Backup source of liquidity for banks Puts a ceiling on iFF 2. Secondary Credit 3. Seasonal Credit © 2006 Pearson Addison-Wesley. All rights reserved

How the Primary Credit Facility Puts Ceiling on iff Rightward shift of RS to RS2 moves equilibrium to point 2 where i2ff = id and discount lending rises from zero to DL2

Discount Operations Advantages 1. Fed as Lender-of-Last Resort to Banks 1. To prevent bank panics Example: Continental Illinois 2. To prevent non-bank financial panics. Examples: 1987 stock market crash. Disadvantages 1. Not fully controlled by Fed © 2006 Pearson Addison-Wesley. All rights reserved

Reserve Requirements (Have been declining worldwide) Advantages 1. Powerful effect on the money supply Disadvantages 1. Tax on banks makes them less competitive and weak. 2. Small changes have very large effect on the money supply. 3. Expensive to administer. 4. Can cause liquidity problems for banks. 5. Frequent changes cause uncertainty for banks and make liquidity management more difficult. © 2006 Pearson Addison-Wesley. All rights reserved

Channel/Corridor System for Setting Interest Rates In the channel/corridor system standing facilities result in a step function supply curve, RS. If demand curve shifts between RD1 and RD2, iff always remains between ir and il © 2006 Pearson Addison-Wesley. All rights reserved