1. How to Analyze an Open Market Operation
The most frequently used action by the Federal Reserve

2. If the Fed wishes to dampen down inflation, what actions can it take?

3. If the Fed wishes to dampen down inflation, what actions can it take?
Raise Reserve Requirements (almost never done)

4. If the Fed wishes to dampen down inflation, what actions can it take?
Raise Reserve Requirements (almost never done)
Raise the Discount Rate (often done, but mostly symbolic because borrowed reserves from the Fed are small)

5. If the Fed wishes to dampen down inflation, what actions can it take?
Raise Reserve Requirements (almost never done)
Raise the Discount Rate (often done, but mostly symbolic because borrowed reserves from the Fed are small)
Open Market Sales of Bonds (most frequently used operation) They’ll say, “We’re raising the target rate for Federal Funds.”

6. If the Fed is scared of recession and wishes to speed up the economy, what actions can it take?

7. If the Fed is scared of recession and wishes to speed up the economy, what actions can it take?
Lower Reserve Requirements (almost never done)

8. If the Fed is scared of recession and wishes to speed up the economy, what actions can it take?
Lower Reserve Requirements (almost never done)
Lower the Discount Rate (often done, but mostly symbolic because borrowed reserves from the Fed are small)

9. If the Fed is scared of recession and wishes to speed up the economy, what actions can it take?
Lower Reserve Requirements (almost never done)
Lower the Discount Rate (often done, but mostly symbolic because borrowed reserves from the Fed are small)
Open Market Purchases of Bonds (most frequently used operation) They’ll say, “We’re lowering the target rate for Federal Funds.”

10. Policy Action How it works
Lower Reserve Requirements

11. Policy Action How it works
Lower Reserve Requirements
Banks now have excess reserves.

12. To Speed up the Economy: Policy Action How it works
Lower Reserve Requirements
Banks now have excess reserves. They are in a position to lend more.

13. To Speed up the Economy: Policy Action How it works
Lower Reserve Requirements
Banks now have excess reserves. They are in a position to lend more. When they make more loans, the supply of loanable funds rises, and interest rates fall.

14. Policy Action How it works
Lower Reserve Requirements
Banks now have excess reserves. They are in a position to lend more. When they make more loans, the supply of loanable funds rises, and interest rates fall. The increase in lending places more account money in the hands of the public. Aggregate demand rises.

15. To Speed up the Economy: Policy Action 2 How it works
Lower Discount Rate

16. Policy Action How it works
Lower Discount Rate
Lowers bankers’ costs of borrowing reserves from the Fed.

17. Policy Action How it works
Lower Discount Rate
Lowers the cost of borrowing reserves from the Fed. Banks pass on lower interest rates to customers, who borrow more.

18. Policy Action How it works
Lower Discount Rate
Lowers the cost of borrowing reserves from the Fed. Banks pass on lower interest rates to customers, who borrow more. This speeds up aggregate demand and the amount of checkable deposits rises with the increased loans.

19. To Speed up the Economy:
What should the Fed do to the amount of reserves in the system?

20. To Speed up the Economy:
What should the Fed do to the amount of reserves in the system?
Increase the amount of reserves in the system. This will allow banks to lend more, interest rates will fall, and aggregate demand will rise. (a Keynesian View)

21. To Speed up the Economy:
What should the Fed do on the bond market to increase reserves in the system?

22. Policy Action How it works
What should the Fed do on the bond market to increase reserves in the system?
The Fed should buy bonds off the used bond market.

23. Policy Action How it works
What should the Fed do on the bond market to increase reserves in the system?
The Fed should buy bonds off the used bond market. The Fed pays for the bonds with a check on itself.

24. Policy Action How it works
What should the Fed do on the bond market to increase reserves in the system?
The Fed should buy bonds off the used bond market. The Fed pays for the bonds with a check on itself. When the bond dealer deposits the check in its bank, the bank deposits it at the fed, and presto, reserves have risen by the same amount.

25. Assume Salomon Brothers deposits the check at Citibank
Show the effects of an open market purchase of $5 billion in Treasury Bonds by the New York Fed on the balance sheets of the NYFed and Citibank
Assume the New York Fed buys $5 billion from one bond dealer (Salomon Brothers)
Assume Salomon Brothers deposits the check at Citibank

26. NY Fed buys $5billion in T-bonds from Salomon Bros
NY Fed buys $5billion in T-bonds from Salomon Bros. And pays for the bonds with a check on itself
Where do the bonds end up?

27. NY Fed buys $5billion in T-bonds from Salomon Bros
NY Fed buys $5billion in T-bonds from Salomon Bros. And pays for the bonds with a check on itself
Where do the bonds end up?
What happens to Salomon’s account at Citibank?

28. NY Fed buys $5billion in T-bonds from Salomon Bros
NY Fed buys $5billion in T-bonds from Salomon Bros. And pays for the bonds with a check on itself
Where do the bonds end up?
What happens to Salomon’s account at Citibank?
Citibank’s account at the Fed?

29. NY Fed buys $5billion in T-bonds from Salomon Bros
NY Fed buys $5billion in T-bonds from Salomon Bros. And pays for the bonds with a check on itself
Where do the bonds end up?
What happens to Salomon’s account at Citibank?
Citibank’s account at the Fed?
Show the first round effect on T-accounts of the NYFed and
Citibank.

30. NY Fed buys $5billion in T-bonds from Salomon Bros
NY Fed buys $5billion in T-bonds from Salomon Bros. With a check on itself.
Citibank
N Y Fed A L
Assets
Liabilities
$5 billion
T-bonds
$5 billion
Citibank’s
Reserves at
Fed
$5 billion
Reserve
Deposit
at NYFed
$5 billion
checking acct
of Salomon
Steps: 1. Fed buys $5 b. T bonds from Salomon Bros., who deposits
the check in its account at Citibank.
2. Citibank deposits in its account at the Fed, which increases
Citibank’s reserves by $5 billion.

31. Will the process stop here?
Calculate how much reserves Citibank has to hold to cover the increase in its liabilities of $5 billion if there is a 1/10 Reserve Requirement.

32. Will the process stop here?
Calculate how much reserves Citibank has to hold to cover the increase in its liabilities of $5 billion if there is a 1/10 Reserve Requirement. (1/10* $5b= $.5 billion required reserves to back up $5 billion deposits)

33. Will the process stop here?
Calculate how much reserves Citibank has to hold to cover the increase in its liabilities of $5 billion if there is a 1/10 Reserve Requirement. ($.5 billion required reserves)
Does Citibank get paid anything by the Fed for reserve holdings?

34. Will the process stop here?
Calculate how much reserves Citibank has to hold to cover the increase in its liabilities of $5 billion if there is a 1/10 Reserve Requirement. ($.5 billion required reserves)
Does Citibank get paid anything by the Fed for reserve holdings?
What will Citibank do with the $4.5 billion in excess reserves?

35. Show what happens if Citibank lends $4.5 billion to IBM

36. Show what happens if Citibank lends $4.5 billion to IBM
Reserves
$5 billion
Salomon Acct
$4.5 billion
9.5%
$4.5 b IBM’s
account
credited

37. IBM spends the money on computer chips
IBM writes a check out to Intel for $4.5 billion
Intel deposits the $4.5 billion in its account at Bank of America
Bank of America deposits the endorsed check at the Fed
Show the balance sheets at the Fed, Citibank, and B of A as the check clears

38. NY Fed Citibank Bank of America A L A L A L $5 b T bonds $5 b Citibank
-4.5
$.5 b Citibank
$4.5b
Intel’s
account
4.5 b
Reserves
$5 b
-4.5
$.5 b
Reserves
$4.5 b
loan to
9.5%
$5 b
Salomon 2. 3.
$4.5 IBM
-4.5 IBM
$0 left in
IBM’s acct. 1. 1.
$4.5 b
Bof A’s
account 4. 2.
1. Intel deposits check in Bof A, which deposits the endorsed check at the Fed.
2. The Fed debits Citibank’s account and credits Bof A’s account for $4.5b.
3. Citibank is left with only $1/2 a billion in Reserves
4. IBM’s account is debited as the check clears
Final Position: Citibank has $.5 b reserve backing for the $5b account of Salomon, and a nice loan to IBM that earns 9.5 % interest per annum.

39. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit

40. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit (1/10*$4.5billion= $.45 billion)

41. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit ($.45 billion)
Calculate excess reserves ($ =$4.05b)
B of A lends $4.05 b to 9.5%
Show the balance sheet of Bof A

42. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit ($.45 billion)
Calculate excess reserves

43. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit ($.45 billion)
Calculate excess reserves ($ =$4.05b)
B of A lends $4.05 b to 9.5%
Show the balance sheet of Bof A

44. Will the lending stop here?
Calculate the required reserves B of A needs to back up the $4.5 billion Intel Deposit ($.45 billion)
Calculate excess reserves ($ =$4.05b)
B of A lends $4.05 b to 9.5%
Show the balance sheet of B of A

45. Show what happens if B of A lends $4.05 billion to Xerox
Reserves
$4.5 b Intel
$4.05 b
9.5%
owed by
Xerox
$4.05 b Xerox
account
Note: When xerox spends down the account, the recipients will deposit in their
banks, and the reserves of B of A depleted. Each successive bank has fewer excess
reserves to lend. The process will go on and on until all excess reserves
have been lent out.

46. What will happen after the $5 billion injection of Reserves has spread through the entire banking system?

47. What will happen after the $5 billion injection of Reserves has spread through the entire banking system?
There will be a total creation of 10 times the original injection of reserves if:
1) no excess reserves (banks lend to the max)
2) all money is re-deposited in commercial banks (none is hoarded as cash or placed in other financial intermediaries)

48. Effect of a $5 billion purchase of bonds by the Fed on the banking system (Step 1.)
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
Step 1. Fed buys bonds from New York dealers, who deposit proceeds in their
accounts at big New York Banks

49. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities

50. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
How much money did the Fed directly create?

51. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
How much money did the Fed directly create? $ 5 billion in the bank deposits of
the bond dealers

52. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
How much money did the banking system create? $45 billion in the bank deposits
when loans were made. The act of lending creates money.

53. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
How much money does the total money supply rise by?

54. Effect of a $5 billion purchase of bonds by the Fed on the banking system. Banks lend to max, public redeposits in banks, reserves spread through whole system.
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
How much money does the total money supply rise by?
+$50 billion on the liability side of the Banking System’s balance sheet

55. How will this affect the economy from a Keynesian point of view?
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities

56. How will this affect the economy from a Keynesian point of view?
Fed
Banking System as a Whole A L A L
+ $5 billion
T- bonds
+ $5 billion
Reserves
+ 5 billion deposits
of bond dealers
+ $5 billion
Reserves
+ $45 billion
loans
+ $45 billion in checkable
deposits
+ 50 billion in
bank system
assets
+ $50 billion in bank
system checkable deposit
liabilities
Loanable funds supply
has increased by $45 billion. This will lower interest rates for corporations
and other borrowers, which will increase aggregate demand and the
economy will speed up.

57. The impact of a $45 billion increase in loanable funds on the loanable funds market.
Prime rate r
Suppliers of loanable funds (savers and
banks)- as r rises, what happens
to their willingness to save or
lend?
Demanders of loanable funds (as
r declines what happens to their will-
ingness to borrow?)
Q of loanable funds supplied and demanded

58. The impact of a $45 billion increase in loanable funds on the loanable funds market.
Prime rate r
Suppliers of loanable funds (savers and
banks)- as r rises, what happens
to their willingness to save or
lend?
r before
Demanders of loanable funds (as
r declines what happens to their will-
ingness to borrow?)
Q of loanable funds supplied and demanded

59. The impact of a $45 billion increase in loanable funds on the loanable funds market.
Prime rate r
S before
S after increase in
loanable funds by
banks
r before
r after
D before
Q of loanable funds supplied and demanded
The Fed’s injection has lowered the prime rate.

60. Show how the lower prime rate will affect the macroeconomy from a Keynesian perspective.
How do you draw a Keynesian aggregate supply curve?
How will lower interest rates feed through the economy?

61. Effect of a decline in interest rates on the macroeconomy
Effect of a decline in interest rates on the macroeconomy. Keynesian View
Agg. Supply
Price Level
P1=P2
D before
D after y1 y2

62. How open market operations work through micro financial markets
Which financial market is hit first by a purchase of T-bonds by the NYFed?

63. How open market operations work through micro financial markets
Which financial market is hit first by a purchase of T-bonds by the NYFed?
The New York bond market

64. How open market operations work through micro financial markets
Which financial market is hit first by a purchase of T-bonds by the NYFed?
The New York bond market
Which side of the bond market will move as a result of the purchase of bonds by the Fed?

65. How open market operations work through micro financial markets
Which financial market is hit first by a purchase of T-bonds by the NYFed?
The New York bond market
Which side of the bond market will move as a result of the purchase of bonds by the Fed?
A purchase is a demand. Demand for bonds shifts to the right. Price of bonds rises, what happens to yields?

66. How open market operations work through micro financial markets
A purchase is a demand. Demand for bonds shifts to the right. Price of bonds rises, what happens to yields?
When bond prices rise yields fall. These are long-term interest rates, but is a purchase of $5 billion going to impact a market that has daily turnover many times that amount?

67. How open market operations work through micro financial markets
When bond prices rise yields fall. These are long-term interest rates, but is a purchase of $5 billion going to impact a market that has daily turnover many times that amount?
The impact on long-term yields of a purchase of $5 billion will be small and short-lived.

68. Open market purchase of $5 billion- effect on bond market
S of bonds
P 2
P 1
$5b.
D’ for bonds when Fed
buys $5 billion
D for bonds before
Quantity of bonds
Note: When the NYFed buys $5 billion in bonds, there is temporarily an excess
demand for bonds, creating a seller’s market, and bond prices will rise. When
bond prices rise, effective yields decline, putting a small downward pressure on
long-term interest rates, but this is a small influence and will be short-lived.

69. Which side of the federal funds market moves?
What happens to the Federal Funds market when the bond dealer’s bank deposits check at the Fed?
At the end of the day, the bond-dealers’ banks will have excess reserves, which they will lend overnight to other banks who have too few reserves
Which side of the federal funds market moves?

70. Which side of the federal funds market moves?
What happens to the Federal Funds market when the bond dealer’s bank deposits check at the Fed?
At the end of the day, the bond-dealers’ banks will have excess reserves, which they will lend overnight to other banks who have too few reserves
Which side of the federal funds market moves?
The supply of federal funds will shift to the right.

71. The supply of federal funds will shift to the right.
What happens to the Federal Funds market when the bond dealer’s bank deposits check at the Fed?
The supply of federal funds will shift to the right.
What will happen to the federal funds interest rate?

72. The supply of federal funds will shift to the right.
What happens to the Federal Funds market when the bond dealer’s bank deposits check at the Fed?
The supply of federal funds will shift to the right.
What will happen to the federal funds interest rate?
The federal funds rate will decline.
This is what the Fed does when it lowers the target rate for federal funds. It will engage in open market purchases of bonds to pull the actual federal funds rate into the lower target range.

73. Impact of a $5 billion purchase of bonds on the Federal Funds Market
rate
S1- banks with excess reserves
S2- bond dealers’ banks have more
excess reserves after Fed injects
$5 billion more into the system
$5 bill r1 r2
D- banks with too few reserves
Q of federal funds
Note: When the fed injects $5 billion more in reserves by buying bonds, the bond
dealers’ banks will end up with excess reserves and they will lend them out for over-
night use to other banks with too few reserves. This creates a buyer’s market for
federal funds and lowers the actual federal funds rate.

74. When banks lend excess reserves to the max, ($45 billion):
Which side of the loanable funds market is affected?

75. When banks lend excess reserves to the max, ($45 billion):
Which side of the loanable funds market is affected?
The supply of loanable funds will shift to the right.
What will happen to the prime rate?

76. When banks lend excess reserves to the max, ($45 billion):
Which side of the loanable funds market is affected?
The supply of loanable funds will shift to the right.
What will happen to the prime rate?
The prime rate will fall.

77. Impact of a $45 billion increase in the supply of loanable funds:
Prime rate
S1- lenders
S2- when banks lend to
the max, the loanable
funds supply shifts $45
to the right
$45 billion r1 r2
Demand- borrowers
Q of loanable funds
Note: when the Fed injects $5 billion reserves into the system, banks lend to the max
and everyone re-deposits in commercial banks, the supply of loanable funds rises a
huge amount, and there is a noticeable effect on the prime rate, a benchmark for all
sorts of traditional loans. When the prime falls, what happens to the macroeconomy
from a Keynesian perspective?

78. Effect of a decline in interest rates on the macroeconomy
Effect of a decline in interest rates on the macroeconomy. Keynesian View
Agg. Supply
Price Level
P1=P2
D before
D after y1 y2
Note: through its work on the loanable funds market, the open market purchase
of bonds has a large impact on I and C(for durables), and D shifts to the right,
the economy speeds up.