The Reserve Market
Open Market Operations
Discount Policy
CHAPTER 15
Tools of Monetary Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Tools of Monetary Policy
1. Open market operations
→ Affect the quantity of reserves and the monetary base
2. Changes in borrowed reserves (discount lending)
→ Affect the monetary base
3. Changes in reserve requirements
→ Affect the money multiplier
In recent years, the focus is increasingly on the Federal Funds
rate, i.e. the interest rate on overnight loans of reserves from one
bank to another
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Tools of Monetary Policy
The Federal Funds rate is regarded as the primary indicator of
the stance of monetary policy
The Federal Funds rate target is announced at each FOMC
meeting (since 1994).
But the Effective Federal Funds rate is an equilibrium
interest rate that equates demand and supply in the Federal
Funds market
→ Supply and Demand Shifts in the FF market (the market
for reserves)
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Target and Effective Funds rate since 1994
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1/1/2006
1/1/2004
1/1/2002
1/1/2000
1/1/1998
1/1/1996
1/1/1994
EFFECTIVE
TARGET
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Subprime Mortgage Crisis
5.60
5.40
5.20
5.00
4.80
4.60
4.40
4.20
4.00
10/7/2007
9/23/2007
9/9/2007
8/26/2007
8/12/2007
7/29/2007
7/15/2007
7/1/2007
EFFECTIVE
TARGET
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
9-11 Attacks
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
10/24/2001
10/10/2001
9/26/2001
9/12/2001
8/29/2001
8/15/2001
8/1/2001
EFFECTIVE
TARGET
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Demand in the Market for Reserves
What happens to the quantity of reserves demanded, holding
everything else constant, as the federal funds rate changes?
Two components: required reserves RR and excess reserves
ER
TR d = RR + ER
Excess reserves ER are insurance against deposit outflows
The cost of holding these is the interest rate that could have
been earned, i.e. the funds rate iff
As iff ↓, the opportunity cost of holding excess reserves falls
and ER ↑→ TR d ↑
→ Downward sloping demand curve
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Supply in the Market for Reserves
TR s = NBR + BR
Two components: non-borrowed (NBR) and borrowed reserves
(BR)
Cost of borrowing from the Fed is the discount rate id
Borrowing from the Fed is a substitute for borrowing from other
banks
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
The supply curve is horizontal (perfectly elastic) at id
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Affecting the Federal Funds Rate: OMOs
An open market purchase causes the federal funds rate to
fall
→ the supply curve shifts to the right
An open market sale causes the federal funds rate to rise
→ the supply curve shifts to the left
The Reserve Market
Open Market Operations
Discount Policy
An open market purchase
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Affecting the Federal Funds Rate: Discount Rate
If the intersection of supply and demand occurs on the
vertical section of the supply curve, a change in the
discount rate id 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 id shifts that portion of the supply curve and
the federal funds rate is affected
A decrease in id lowers the funds rate
An increase in id raises the funds rate
The Reserve Market
Open Market Operations
Lowering id
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Affecting the Federal Funds Rate: Reserve Requirements
When the Fed raises the reserve requirement, the federal
funds rate rises
→ shifting the demand curve to the right
When the Fed decreases the reserve requirement, the federal
funds rate falls
→ shifting the demand curve to the left
The Reserve Market
Open Market Operations
Discount Policy
Increasing reserve requirements
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
More on Open Market Operations
Two types:
1. Dynamic open market operations: to change the level of
reserves and the monetary base
2. Defensive open market operations: to offset movements in
other factors that affect reserves and the monetary base e.g.
float, Treasury deposits, ER fluctuations
Mostly in US Treasury and government agency securities,
especially T-bills.
→ Liquid and large trading volume, does not lead to
disruptive price fluctuations.
A repurchase agreements (repo): Fed purchases with an
agreement that the seller will repurchase within a short period
of time (1 to 15 days) → usually for defensive OMOs
Matched sale-purchase agreements (reverse repo): Fed sells
and the buyer agrees to sell back
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Advantages of Open Market Operations
The Fed has complete control over the volume (in contrast
with BR)
Flexible and precise
Easily reversed (in case of mistakes)
Quickly implemented
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Discount Policy
Operation of the discount window:
1. Primary credit or standing lending facility
Primary credit rate
for healthy banks
mostly as a backup source
puts a ceiling on the federal funds rate, in case of a sudden
large increase in demand for reserves
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Discount Policy
Operation of the discount window:
2. Secondary credit:
for banks that are in financial trouble or with severe liquidity
problems
Secondary credit rate: usually 50 basis points above the
primary credit rate
3. Seasonal credit
for (small) banks in vacation of agricultural areas with strong
seasonal patterns of deposits
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Discount Policy
Operation of the discount window
Discount lending is important in preventing financial crisis
Lender of last resort: provide reserves to banks when no one
else will (Continental Illinois, Subprime mortgage crisis)
Lender of last resort: for the financial system as a whole
(1987 crash, 9/11 attacks) → Controversial: creates moral
hazard problem
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Advantages and Disadvantages of Discount Policy
Useful to perform role of lender of last resort, despite the
existence of the Federal Deposit Insurance Corporation
Moral hazard
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
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Reserve Requirements
Depository Institutions Deregulation and Monetary Control
Act of 1980 sets the reserve requirement the same for all
depository institutions
3% of the first $48.3 million of checkable deposits; 10% of
checkable deposits over $48.3 million
The Fed can vary the 10% requirement between 8% to 14%
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Disadvantages of Using Reserve Requirements
No longer binding for most banks
Can cause liquidity problems
Increases uncertainty, complicates liquidity management
Recommendations to eliminate, as in other countries
(Eurozone)
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Tools created in the current financial crisis
Interest on Required Reserve Balances and Excess Balances
Term Auction Facility
Primary Dealer Credit Facility
Term Securities Lending Facility
ABCP MMMF Liquidity Facility
Commercial Paper Funding Facility
Money Market Investor Funding Facility
Term Asset-Backed Securities Loan Facility
See Boards’ website (click Policy Tools)
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Fed’s Current Balance Sheet
Federal Reserve System
Assets
Liabilities
Government Securities Currency in Circulation
Discount Loans
Reserves
Other Assets
Borrowing from the Treasury
Tools of the ECB
The Fed financed these investments by selling about $300 billion of Treasury securities it owned
Open Market Operations Discount Policy Reserve Requirements Recent Changes Tools of the ECB
and by borrowing huge amounts from the Treasury (currently about $400 billion in deposits from
the Treasury at the Fed) and from banks, in the form of vastly expanded reserves (almost $800
billion at yearend). Reserves are just another form of borrowing at this point and have no special
role in the monetary system. The reason that many commentators have mistakenly thought that
the Fed was printing money was that reserves used to function like money, under previous
monetary institutions.
The Reserve Market
Fed’s Balance Sheet
2,000
1,800
Other assets
1,600
1,400
1,200
1,000
800
Liability: Currency
Liability: Deposits by banks (reserves)
600
400
Asset: Treasury securities
Liability: Deposits by Treasury
200
Other liabilities
-
Figure 6. Federal Reserve Assets and Liabilities. Source
The first major event in the financial crisis was a run on Bear Stearns in March 2008. Though
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Channel/Corridor System
Sets up a standing lending facility (lombard facility) and
stands ready to loan overnight any amount banks ask for at a
fixed interest rate (lombard rate)
The supply of reserves is infinitely elastic at this interest rate
Another standing facility is set up that pays banks a fixed
interest rate on any deposits they would like to keep at the
central bank
The demand for reserves is infinitely elastic at this interest rate
In between these two interest rates the quantity supplied is
equal to the non-borrowed reserves
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
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Effects of an open market operation
Recent Changes
Tools of the ECB
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Monetary Policy Tools of the European Central Bank
Open market operations
The rate on the main refinancing operations (MRO), which
provide the bulk of the liquidity to the banking system →
Weekly reverse transactions
Longer-term refinancing operations
Lending to banks
The rate on the deposit facility, which banks may use to
make overnight deposits with the Eurosystem.
The rate on the marginal lending facility, which offers
overnight credit to the banks of the Eurosystem.
Reserve Requirements
2% of the total amount of checking deposits and other
short-term deposits
Pays interest on those deposits so cost of complying is low
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
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Tools of the
ECB
of
The Reserve Market
Open Market Operations
Discount Policy
Reserve Requirements
Recent Changes
Tools of the ECB
Money Market Rates in Europe
EONIA (Euro OverNight Index Average)
EURIBOR (Euro Interbank Offered Rate) (interbank term
deposits)