Econ 330 Final Study Guide Chapters 18 19 22 16 17 Chapter 18 Tools of Monetary Policy Using Interest Rates to Stabilize the Domestic Economy Questions About Monetary Policy and Interest Rates What are the tools used by the central bankers to meet their stabilization objectives How are the tools linked to the central bank s balance sheet How is the interest rate target chosen Federal Funds Rate iff the interest rate charged on the loan of reserves Discount Rate id primary costs of borrowing from the Fed is the interest rate the Fed charges on loans Three Tools of Monetary Policy Open market operations Discount lending Reserve requirements Open Market Operations An open market purchase causes iff to fall Open market sale causes iff to rise The interest rate paid on reserves ier sets floor to iff Discount Lending Lender of Last Resort Most changes in the discount rate have no effect on the federal funds rate If demand curve intersects supply curve in flat section a lowered discount rate will cause equilibrium to fall Reserve Requirement the level of balances a bank is required to hold either as vault cash on deposit or at a Federal Reserve Bank Federal funds rate interest rate on overnight loans of reserves from one bank to another primary instrument of monetary policy When Fed raises reserve requirements the iff rises demand shifts right When Fed lowers reserve requirements the iff falls demand shifts left New fourth Tool Interest on reserves both required and excess Open Market Operations and Impact on Reserves Federal funds are reserve balances at the Fed Reserve Banks that depository institutions can lend to one another The most common federal funds transaction is an overnight unsecured loan between two financial institutions bilateral agreements Without the federal funds market banks would need to hold a substantial amount of excess reserves OMO s are the Feds most flexible means of carrying out monetary policy Fed buys and sells US Government Securities in the secondary market in order to adjust the supply of reserves in the banking system The fed doesn t participate directly in the Federal Funds market credit risk Fed participates indirectly through OMO s to target Federal Funds Rate and influence short term interest rates and reach monetary policy goals Advantages of OMO s Implemented quickly Fed has complete control Flexible and Precise Easily reversed Intended to change level of reserves and monetary base Meant to offset other factors affecting monetary base Typically use Repurchase agreements and reverse repurchase agreements matched sale purchase Excess reserves are insurance against deposit outflows Cost of holding this insurance is the interest rate that could have been earned minus the interest rate that is paid on these reserves ier When iff is above the rate paid on excess reserves ier as the iff rate decreases the opportunity cost of holding excess reserves falls and the quantity of reserves demanded increases Downward sloping demand curve becomes flat infinitely elastic at ier Open Market Operations Dynamic Defensive transaction Demand for Reserves ier is a floor on iff Supply for Reserves if iff id then banks will not borrow from the Fed and borrowed reserves are zero supply curve will be vertical at the level of non borrowed resources as iff rises above id banks will borrow more and more at id but will still lend at iff supply curve is horizontal perfectly elastic at id Discount lending to commercial banks is the Feds primary toll for ensuring short term financial stability eliminating bank panic and preventing sudden collapse of Financial Institutions Discount Lending Types of Loans Primary Credit Secondary Credit Short term typically overnight Historically 100 basis points over target iff currently 50 basis points For banks that do not qualify for primary credit Historically 150 basis points above iff Seasonal Credit Small banks w cyclical farm loans Advantages and Disadvantages of Discount Policy Used to perform role of lender of last resort Important during subprime financial crisis of 07 08 Can t be controlled by Fed decision maker is bank Discount facility is used as a backup facility to prevent iff from rising too far above target Reserve Requirements doubled in 1936 by Fed Fed can set reserve requirement between 8 14 or so called transaction deposits Fed now pays interest on reserves To reduce burden on small banks first few million dollars in demand deposits are exempt then 3 up to about 40 million then 10 Advantages Main refinancing rate is set in a weekly auction of 2 week repo agreements Inject and withdraw reserves in the Powerful effect Disadvantages Small change have large effect on money supply Raising causes liquidity problems for banks Frequent changes cause uncertainty for banks Tax on banks Operational Policy at European Central Bank banking system Comparable to target Federal Funds rate Marginal lending facility 100 basis points above target refinancing rate Deposit rate banks can earn interest on excess reserves Reserve Requirements 2 applied to checking accounts Overnight cash rate market FFR Chapter 19 The Conduct of Monetary Policy Strategy and Tactics Linking Tools to Objectives Tools OMO Discount Loans Reserve Requirements Interest on Reserves Operating Policy Instruments Federal funds rate Monetary Base Intermediate Targets Short term and long term interest rates Monetary Aggregates M1 M2 Objectives Low Inflation Economic Growth Stable interest rates financial market Desired Features of a Policy Instrument Easily observable by everyone Controllable and quickly changed Highly linked to policy makers objectives short term interest rates are preferred instead of MP used to stabilize short term fluctuations in prices and output Inflation Targeting Bypasses intermediate targets and focuses on final objective Components Public announcement of numerical target Commitment to price stability as primary objective Frequent public communication Keep inflation low keep inflation expectations low and stable Anchor long term interest rates to promote growth i r 2 Hierarchical mandate inflation first everything else second Fed has a dual mandate and has shifted away from inflation targeting Monetary Targeting Central bank announce that it will target a certain rate of growth in a monetary aggregate Ex 5 growth in M1 In 1970 s monetary targeting was adopted by a number of central banks US Germany Cananda UK United States Monetary Targeting Fed