1. Tools of Monetary Policy
Chapter 17
Tools of Monetary Policy

2. 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
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3. Supply and Demand for Reserves
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4. Response to Open Market Operations
Open Market Purchase
Non-borrowed reserves, Rn and shifts supply curve to right RS2: i to i2ff
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5. 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

6. Response to Change in Required Reserves
Demand for Reserves , RD shifts right and iff  to i2ff
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7. 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
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8. 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
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9. 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

10. 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
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11. 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.
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12. 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
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