1. The Tools Of Federal Reserve Policy
Chapter 18
The Tools Of Federal Reserve Policy
©Thomson/South-Western 2006

2. The Federal Reserve Goals and Tools
Goals (Ultimate Objectives)
influence greater output
lower the unemployment rate
prices level stability
Tools
Intermediate target variables
short-term interest rates
monetary aggregates (M1, M2, M3)

3. The Federal Reserve Goals and Tools
Tools (Instruments) of monetary policy
open market operations
discount window policy
reserve requirement policy

4. Open Market Operations
Buying and selling of securities in the open market
The Fed is empowered to buy or sell
U.S. Treasury securities
federal agency securities
banker's acceptances
other securities

5. Open Market Operations
To influence
Short-term interest rates
Bank reserves
Monetary Base (B)
Monetary Aggregates (M)
To earn interest income = =
Fed’s decision to buy or sell securities

6. Domain of the Fed's Open Market Activity
Federal Reserve's open market operations could be carried out in any asset.
To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances.
When the Fed buys Treasury bonds and bills from public,
reserves and the monetary base expand dollar-for-dollar, and
the money supply is directly increased
When the Fed buys Treasury bonds and bills from banks,
reserves and the monetary base expand dollar-for-dollar, but
the money supply is not directly or immediately affected.
This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.

7. Fed’ open market operations
If the Fed sells $225 million in U.S. Treasury bills to a government securities dealer
When the Fed buys $400 million in Treasury bonds and bills from banks,

8. The Effectiveness Of Open Market Operations
2. Impact on
Security Prices
Interest Rates (Yields)
1. Impact on Monetary Variables
Bank Reserves
Monetary Base
Monetary Aggregates
Fed buys securities
Prices ↑  Yields ↓
Spill over to other markets
Bank lending rates ↓
Borrowing, Spending ↑

9. Advantages of Open Market Operations
Precision:
firm and accurate control over aggregate bank reserves and the monetary base
Flexibility:
in the market each day, buying & selling large quantities of securities
very easy for the Fed to alter course, reverse the policy
Source of Initiative:
The Fed is able to dominate aggregate bank reserves & the monetary base.
Depends solely on the Fed.

10. Early Disadvantages of Open Market Operations
Signaling:
Changes in the discount rate and reserve requirements are superior to open market operations in signaling policy changes to the public.
Regional Bias:
Prior to well-developed financial markets, a regional bias operated in open market operations, because the effects were concentrated in select urban areas where security dealers were located; open market operations did not disperse across the nation.

11. Open Market Operations & the Federal Funds Rate
The effects of the Fed's open market operations transmit very quickly throughout the nation through the federal funds market
Banks with excess reserves = Supply federal funds
Federal funds rate
Banks with deficit reserves = Demand federal funds

12. Open Market Operations & the Federal Funds Rate
The supply of reserves is determined by Federal Reserve policy.
When the Fed purchases securities, bank reserves  dollar-for-dollar.
When the Fed sells securities, bank reserves  dollar-for-dollar.

13. Figure 18-1 Fed buys Securities  Banks Reserves ↑ S1 S2 Demand
Federal Funds Rate
4.0
3.5
Demand
Reserves

14. Technical Aspects Of Open Market Operations
Defensive Operations versus Dynamic Operations
Defensive open market operations
open market operations made for the purpose of "defending" bank reserves & the monetary base against the influence of outside forces
Dynamic open market operations
open market operations made to deliberately change the course of economic activity
To achieve goals (control unemployment, inflation, other economic variables)

15. Outright Transactions versus Repurchase Agreements
The Fed uses outright purchases to bring about long-run or permanent growth in reserves and the monetary aggregates.
Repurchase agreements (& reverse repurchase agreements)
The Fed uses repurchase agreements (repos) and reverse repurchase agreements to neutralize the impact on reserves and the monetary base of transitory changes.
Recall a repurchase agreement
a money market instrument wherein one party sells securities with an agreement to buy them back at a specified future date and price.

16. Discount Window Policy
The fed lends to depository institutions
Federal Reserve lends “Discount Loans”
discount rate
Commercial Banks borrow

17. Discount Window Policy
3 Classes of Credits
Primary Discount rate
Discount rate = Fed fund rate + 1%
Purpose: to impose an upper limit on the Fed fund rate
Secondary credit
Borrowing Rate = Discount rate + 0.5%
Purpose: to banks who have liquidity problems
Seasonal credit
Purpose: to banks having seasonal fluctuations in loan demand

18. Reserve Requirement Instrument
Fed has authority to change the rr
Serves as a “Tax” on DIs, DIs have to hold minimum reserves
 Limitation on making loans, buying securities
 Loss opportunity to earn more interest income from making loans