Chapter 16: Monetary Policy ToolsSlide 2Slide 3Slide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16Chapter 16: Monetary Policy Tools1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesCentral banks have three primary tools for influencing the money supplyMoney supplyMoney supplyReserve requirementReserve requirementDiscount loansDiscount loansOpen market operationsOpen market operations1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesThe reserve requirementworks through the money multiplier, constraining multiple deposit expansion the larger it becomes. Central banks today rarely use it because most banks work around reserve requirements.1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesDiscount loans influence the monetary base (MB = C + R). Discount loans depend on banks (or non-bank borrowers, where applicable) first borrowing, then repaying loans. The central bank does not have precise control over MB.1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesOpen market operationsinfluence the monetary base (MB = C + R). Open market operations (OMO) are generally preferred. The central bank can easily expand or contract MB to a precise level. Using OMO, central banks can also reverse mistakes quickly.1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesThe Fed Funds Market: banks that need reserves can borrow them from banks that hold reserves they don’t need.Overnight bank borrowingOvernight bank borrowingFed Funds MarketFed Funds MarketLower ratesLower ratesDirectly from FedDirectly from FedHigher ratesHigher ratesMore Fed scrutinyMore Fed scrutiny1. The Federal Funds Market and Reserves1. The Federal Funds Market and ReservesIf Fed Funds rate < discount rate, banks borrow in Fed Funds MarketIf Fed Funds rate > discount rate,Arbitrage:Borrow at discount window/Lend in Fed Funds MarketThe discount rate sets an upper limit to ff* (the actual Fed Funds rate) because no bank would borrow reserves at a higher rate in the federal funds market than it could borrow directly from the Fed.2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowOpen market activity decisions: DailyFRBNY researches:•The level of reserves•The Fed Funds target•The actual market Fed Funds rate•Expectations regarding float•Treasury activities•Treasury market conditions –primary dealers, specialized firms, and banks2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowOpen market activity decisions: Each day,FRBNY determines buy or sell:•Outright–securities permanently join or leave Fed’s balance sheet•Repo (Repurchase agreement)–purchase with a guarantee that seller will repurchase•Reverse repo (matched sale-purchase transaction)–sell with guarantee that buyer will resell to Fed2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowDiscount windowis today primarily a backup facility used during crises when the federal funds market might not function effectively. As lender of last resort, the Fed has a responsibility to ensure that banks can obtain as much as they want to borrow provided they can post what in normal times would be considered good collateral security.2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowDiscount windowAs lender of last resort, the Fed has a responsibility to ensure that banks can obtain as much as they want to borrowProvided they can maintain good collateral securityTo ensure that banks do not rely too heavily on the discount window:•discount rate is usually set a full percentage point above ff*, a “penalty” of 100 basis points2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowDiscount window: Crisis of 2008Federal Reserve invoked its emergency powers to create additional lending powers and programs, including:•Term Auction Facility (TAF), a “credit facility” that allows depository institutions to bid for short term funds at a rate established by auction•Primary Dealer Credit Facility (PDCF), which provides overnight loans to primary dealers at the discount rate•Term Securities Lending Facility (TSLF) also helps primary dealers by exchanging Treasuries for riskier collateral for 28-day periods •Asset-Backed Commercial Paper Money Market Mutual Liquidity Facility, which helps money market mutual funds to meet redemptions without having to sell their assets into distressed markets2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowDiscount window: Crisis of 2008Federal Reserve invoked its emergency powers to create additional lending powers and programs, including:•Commercial Paper Funding Facility (CPFF) allows the FRBNY, through a special purpose vehicle (SPV), to purchase commercial paper (short term bonds) issued by non-financial corporations•Money Market Investor Funding Facility (MMIFF) is another lending program designed to help the money markets (markets for short term bonds) return to normal2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount Window•The financial crisis also induced the Fed to engage in several rounds of “quantitative easing” or Large Scale Asset Purchases (LSAP)–Goals:1. increase the prices of (decrease the yields of) Treasury bonds and the other financial assets purchased2. influence the money supply directly. •Due to LSAP, the Fed’s balance sheet swelled from less than a trillion dollars in early 2008 to about 3 trillion in just a year http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm2. Open Market Operations and the Discount Window2. Open Market Operations and the Discount WindowThe Discount windowis also used to provide moderately shaky banks a longer-term source of credit at an even higher penalty rate .5 percentage (50 basis) points above the regular discount rate.3. The Monetary Policy Tools of Other Central Banks3. The Monetary Policy Tools of Other Central BanksFederal Reserve•Uses Open Market Operations (OMO) to manage overnight interbank rates•Uses outright purchases, repos, and reverse repos•Lends at marginal lending rates•Pays interest on reservesEuropean Central