2. Tools of Monetary Policy Open market operations Discount rate  borrowed reserves –LENDER OF LAST RESORT Reserve requirements –Affect the money multiplier…don’t touch/don’t matter Federal funds rate—the interest rate on overnight loans of reserves from one bank to another –Primary indicator of the stance of monetary policy Determined by Supply and Demand reserves As federal funds rate decreases, …the opportunity cost of holding excess reserves falls … the quantity of reserves demanded rises  Downward sloping demand curve

3. Supply of reserves by Fed: Nonborrowed + borrowed reserves Cost of borrowing from the Fed is the discount rate If i ff < i d, banks won’t borrow from the Fed; Borrowed reserves are zero  Supply curve is vertical As i ff rises above i d, banks will borrow more and more at i d The supply curve is horizontal (perfectly elastic) at i d Demand for reserves by banks: Banks will hold any amount of excess reserves at i er

4. B uy E ase S ell T ighten Open market purchase  federal funds rate falls Open market sale  federal funds rate rises Impact of discount rate on federal funds rate Impact of reserve requirement on federal funds rate

5. Response to an Open Market Purchase

6. Response to a Reduction in the Discount Rate

7. Response to a Change in Required Reserves

8. Open Market Operations Dynamic open market operations Defensive open market operations –Repurchase agreements –Matched sale-purchase agreements TRAPS (Trading Room Automated Processing System) Primary dealers Advantages of Open Market Operations The Fed has complete control Flexible and precise Easily reversed Quickly implemented

9. Discount Policy Primary credit—standing lending facility Secondary credit Seasonal credit Lender of last resort to prevent financial panics … moral hazard problem Cannot be controlled by the Fed; the decision maker is the bank Discount facility keeps the federal funds rate from rising too far above the target Reserve Requirements No longer binding for most banks Can cause liquidity problems Increases uncertainty Recommendations to eliminate

10. How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate