Chapter 16
Tools of
Monetary Policy
(Chapter 15 in
the solutions
manual)
Tools of Monetary Policy
Tools that can change money supply and interest rates:
• Open market operations

Affect the quantity of reserves and the monetary base
• Changes in borrowed reserves

Affect the quantity of reserves and the monetary base
• Changes in reserve requirements

Affect the quantity of reserves, the monetary base, and the money
multiplier
Main operational tool:
• Federal funds rate (iff)—the interest rate on overnight loans of
reserves from one bank to another


Primary indicator of the stance of monetary policy
OMO and discount rate are adjusted to maintain the funds rate target
15-2
The Market For Reserve Balances
• This is the market where iff is determined
• Recall:

Banks need to hold a certain fraction of
deposits as reserves

When a bank is short of reserves it can
borrow these balances in the Federal Funds
Market, at a rate called iff
15-3
Demand in the Market for Reserve
Balances
• What happens to the quantity of reserves demanded,
holding everything else constant, as the federal funds
rate changes?
• Two components: required reserves and
excess reserves
 Required reserves are not sensitive to changes in
interest rates
 Excess reserves are insurance against deposit
outflows
• The cost of holding these is the spread between
the market interest rate (which would be earned
by lending these ER) and the interest rate that
the Fed pays on ER
15-4
Demand in the Market for Reserve
Balances
• Since the fall of 2008 the Fed has paid interest
on reserves at a level that is set at a fixed
amount below the federal funds rate target.
• When the federal funds rate is above the rate
paid on excess reserves, ior, as the federal
funds rate decreases, the opportunity cost of
holding excess reserves falls and the quantity
of reserves demanded rises
• Downward sloping demand curve that
becomes flat (infinitely elastic) at ior
15-5
Supply in the Market for Reserve Balances
• Two components:

non-borrowed reserves (NBR):
• provided by OMO
• NBR is provided by the Fed inelastically and it is not a
function of iff
• Interbank borrowing in the fed funds market is part of NBR

borrowed reserves (BR): provided via discount
window
• Cost of borrowing from the Fed is the discount rate (id)
• Borrowing from the Fed is a substitute for borrowing from
other banks at the rate iff
15-6
• If iff < id, then banks will not borrow from
the Fed and borrowed reserves are zero
• The supply curve will be vertical
• As iff rises above id, banks will borrow
more and more at id, and re-lend at iff

iff cannot exceed id
• The supply curve is horizontal (perfectly
elastic) at id
15-7
FIGURE 1 Equilibrium in the Market
for Reserves
15-8
Factors affecting the federal funds
rate
• Effects of open an market operation depends
on whether the supply curve initially intersects
the demand curve in its downward sloped
section versus its flat section.
• An open market purchase causes the federal
funds rate to fall whereas an open market sale
causes the federal funds rate to rise (when
intersection occurs at the downward sloped
section).
15-9
• Open market operations have no effect
on the federal funds rate when
intersection occurs at the flat section of
the demand curve.
15-10
Response to an open market
operation
15-11
Furthermore:
• If the intersection of supply and demand
occurs on the vertical section of the supply
curve, a change in the discount rate will have
no effect on the federal funds rate.
• If the intersection of supply and demand
occurs on the horizontal section of the supply
curve, a change in the discount rate shifts that
portion of the supply curve and the federal
funds rate may either rise or fall depending on
the change in the discount rate
15-12
Response to a change in the discount
rate
15-13
Affecting
the Federal Funds Rate (cont’d)
• When the Fed raises reserve
requirement,

demand curve shifts right  the federal
funds rate rises
• When the Fed decreases reserve
requirement,

Demand curve shifts left  the federal
funds rate falls
15-14
Response to a change in the reserve
requirement
15-15
Figure 5 Response to a Change in the Interest
Rate on Reserves
How are these tools used in practice?
• So far we have seen how the three tools
of the Fed affect the market for reserve
balances
• We will now investigate how the Fed
uses these tools in practice
15-17
Open Market Operations
• Most important monetary policy tool
• Two types of OMOs:
• Dynamic open market operations


They are permanent and aim to offset long-lasting changes in
reserves (such as increase in demand for currency)
Outright purchases (or sales) of securities
• Defensive open market operations



They are temporary and aim to offset temporary fluctuations
(=autonomous factors)
Repurchase agreements (temporary injection of reserves:
open market purchase)
Reverse repurchase agreements (temporary draining of
reserves: open market sale)
15-18
Advantages of
Open Market Operations
• The Fed has complete control over
the volume
• Flexible and precise

The exact magnitude of the operation can be
adjusted to any quantity
• Easily reversed

If economic conditions change or when there is a
forecast error, the operation can be reversed
• Quickly implemented
15-19
Discount Policy
• There are three types of loans from the
discount window:

Primary credit—standing lending facility
• 100 basis points over funds rate
• During to the financial turmoil, the Fed reduced the spread
to 25 basis points (at the moment it is back to 50 bp)

Secondary credit
• 150 basis points over funds rate
• For banks in financial trouble and liquidity problems
• Currently it is 100 bp. over the funds rate

Seasonal credit
• Average of funds rate and CD rate
15-20
• The idea is to stabilize fluctuations in the
funds market by providing an upper limit.
• When the funding needs increase and
the funds market tightens banks can
borrow at the primary credit rate.
• Example: An unanticipated change in
RBd (suppose a bank has wire problems
and cannot lend out)
15-21
Figure 6 How the Federal Reserve’s Operating
Procedures Limit Fluctuations in the Federal
Funds Rate
• The discount window is mostly used as a
lender of last resort to prevent financial
panics
• This may lead to a moral hazard problem

Financial institutions may take more risk if
they know that the Fed will come to the
rescue
15-23
Advantages and
Disadvantages of Discount Policy
• Used to perform the role of lender of
last resort
• The volume of borrowing cannot be
controlled by the Fed; the decision
maker is the bank
• Discount facility is used as a backup
facility to prevent the federal funds rate
from rising too far above the target
15-24
Reserve Requirements
• An increase r will decrease Deposits:
Contraction in Ms
However:
• This is not a tool for fine tuning fluctuations in Ms
• It is costly for banks to adjust to a low/high
reserves environment and even small changes in
r cause large movements in Ms
• r is adjusted to reduce the burden on banks in the
US


it is costly to hold reserves for banks
however the Fed needs reserves for financial stability
15-25
Disadvantages
of Reserve Requirements
• No longer binding for most banks

Less effective
• Changes in r can cause:

Liquidity problems

Increased uncertainty
• Recommendations to eliminate
15-26
Interest on reserves
• The Federal Reserve started paying
interest on reserves in 2008

Recent tool
• Provides a lower bound for the funds
rate
• When the funds rate is very close to the
lower bound, it is easier to increase it via
a change in ior than OMO
15-27
Nonconventional Monetary Policy Tools During
the Global Financial Crisis
• Liquidity provision: The Federal Reserve implemented
unprecedented increases in its lending facilities to provide
liquidity to the financial markets

Discount Window Expansion
• The Fed lowered the discount rate

Term Auction Facility
• An alternative lending facility for the banks where the interest rate is determined
competitively in an auction

New Lending Programs
• Direct lending to troubled financial institutions (not necessarily banks)
Nonconventional Monetary Policy Tools
During the Global Financial Crisis
• Asset Purchases (LSAPs): During the crisis the
Fed started two new asset purchase programs
to lower interest rates for particular types of
credit:

Government Sponsored Entities Purchase
Program
• Idea was to buy MBS from the market and lower
mortgage interest rates

QE2
• Purchases of long term Treasury securities to lower
their interest rates
15-29
End of Chapter questions
• All but 5,12, 14, 15, 16, 17, 22
15-30
End of chapter question 1
• Suppose the float will increase due to a
snowstrom. What defensive OMO will
the Fed undertake?
• Answer: Reverse Repurchase
agreement
15-31
End of chapter question 2
• During holiday season, when the public’s
holding of currency increase, what
defensive operations typically occur?
• As CIC increaes, reserves
decreaserepurchase agreement
15-32
Question 3
• Treasury pays a large bill. What OMO?
• If Treasury’s balance declines, reserves
increaseopen market sale
15-33
End of chapter question 23
• If there is a switch from deposits into
currency, what happens to the funds
rate?
15-34
• We know from the previous chapter that
a withdrawal of currency by the public
reduces bank deposits and bank
reserves (as CIC increases, reserve
supply decreases).
• At the second stage, reserve demand
will decrease (but less than the decline
in supply)
• Net increase in the funds rate
15-35
End of chapter question 25
• Using the supply and demand analysis in
the market for reserves, indicate what
happens to BR, NBR, iff
a) Increase in reservable deposits
b) Expected large withdrawal of deposits from banks
c) Fed raises iff
d) Fed raises ior above iff
e) Fed reduces r
f) Fed reduces r and sterilizes by OM sale
15-36
• a) Shift Rd to right
• b) Increase in ERShift Rd to right
• c) Shift Rs left
• d) Shift the horizantal section of Rd
above iff
• e) Shift Rd to left
• f) Shift Rd to left and Rs to left such that
iff remains constant
15-37