The Economics of Money, Banking, and
Financial Markets
Thirteenth Edition
Global Edition
Chapter 16
Tools of Monetary Policy
Copyright
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Pearson 2016 Ltd.
Education, Pearson Education, Ltd. All Rights Reserved
From the last FOMC statement
The Market for Reserves and the Federal
Funds Rate
• Demand and Supply in the Market for Reserves
• 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
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The Market for Reserves and the Federal
Funds Rate
• What happens to the quantity of reserves demanded by
banks, 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 interest rate that
could have been earned (iff) minus the interest rate
that is paid on these reserves (ior)
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Demand in the Market for Reserves
• Since the Fall of 2008, the Fed has paid interest on
reserves
• [Link]
[Link]
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Demand in the Market for Reserves
• When the federal funds rate is above the rate paid on
reserve balances, 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
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Supply in the Market for Reserves
• Two components:
(1) 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
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Supply in the Market for Reserves
• Two components:
(2) 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
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Supply in the Market for Reserves
• 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 relend at iff
• The supply curve is horizontal (perfectly elastic) at id
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Figure 1 Equilibrium in the Market for
Reserves
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How Changes in the Tools of Monetary
Policy Affect 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).
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How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate
• Open market operations have no effect on the federal
funds rate when intersection occurs at the flat section of
the demand curve.
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Figure 2 Response to an Open Market
Operation
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How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate
• 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.
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How Changes in the Tools of Monetary
Policy Affect 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.
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Figure 3 Response to a Change in the
Discount Rate
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How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate
• 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
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Figure 4 Response to a Change in Required
Reserves
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Aside: CBRT’s use of reserve requirements
• In the period after 2010 CBRT increased required reserves
while lowering interest rates
• The idea was to slow down capital inflows while
maintaining tight monetary policy
[Link]
/bankacilik+verileri/zorunlu+karsiliklar/zorunlu+karsilik+oranlari
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Figure 5 Response to a Change in the
Interest Rate on Reserves
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Application: How the Federal Reserve’s Operating
Procedures Limit Fluctuations in the Federal Funds Rate
• Supply and demand analysis of the market for reserves
illustrates how an important advantage of the Fed’s current
procedures for operating the discount window and paying
interest on reserves is that they limit fluctuations in the
federal funds rate.
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Figure 6 How the Federal Reserve’s Operating Procedures
Limit Fluctuations in the Federal Funds Rate
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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
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Discount Policy
• 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 (=id).
– Primary credit rate is typically set 100 bp over the
funds rate
• Example: An unanticipated change in RBd
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Conventional Monetary Policy Tools
• During normal times, the Federal Reserve uses three tools
of monetary policy—open market operations, discount
lending, and reserve requirements—to control the money
supply and interest rates, and these are referred to as
conventional monetary policy tools.
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Inside the Fed: A Day at the Trading Desk
• The manager of domestic open market operations
supervises the analysts and traders who execute the
purchases and sales of securities in the drive to hit the
federal funds rate target.
• Primarily, the idea is to offset the impact of autonomous
factors
– Float
– CIC
– Treasury’s balance
– FX operations
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Relative Advantages of the Different
Monetary Policy Tools
• Open market operations are the dominant policy tool of the
Fed since it has complete control over the volume of
transactions, these operations are flexible and precise,
easily reversed, and can be quickly implemented.
• The discount rate is less used since it is no longer binding
for most banks, can cause liquidity problems, and
increases uncertainty for banks. The discount window
remains of tremendous value given its ability to allow the
Fed to act as a lender of last resort.
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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
– Current practice
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CBRT’s interest payment on reserves
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Interest rate corridor of CBRT
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On the Failure of Conventional Monetary
Policy Tools in a Financial Panic
• When the economy experiences a full-scale financial crisis,
conventional monetary policy tools cannot do the job, for
two reasons.
• First, the financial system seizes up to such an extent that
it becomes unable to allocate capital to productive uses,
and so investment spending and the economy collapse.
• Second, the negative shock to the economy can lead to
the zero-lower-bound problem.
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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
– Term Auction Facility
– New Lending Programs
• Large-scale asset purchases: During the crisis, the Fed
started three new asset purchase programs to lower
interest rates for particular types of credit:
– Government Sponsored Entities Purchase Program
– QE2
– QE3
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Figure 7 The Expansion of the Federal
Reserve’s Balance Sheet, 2007–2020
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Nonconventional Monetary Policy Tools
During the Global Financial Crisis (2 of 2)
• Negative Interest Rates on Banks’ Deposits
– Setting negative interest rates on banks’ deposits is
supposed to work to stimulate the economy by
encouraging banks to lend out the deposits they were
keeping at the central bank, thereby encouraging
households and businesses to spend more.
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End of Chapter questions
• All but 12, 19
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End of chapter question 1
• Suppose the float will increase due to a snow strom. What
defensive OMO will the Fed undertake?
• Explain why and illustrate graphically
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End of chapter question 2
• During holiday season, when the public’s holding of
currency increase, what defensive operations typically
occur?
• Explain why and illustrate graphically
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Question 3
• Treasury pays a large bill. What OMO?
• Explain why and illustrate graphically
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End of chapter question 20
• If there is a switch from deposits into currency, what
happens to the funds rate?
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• 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).
• If this currency demand is permanent, then at the second
stage, reserve demand will decrease (but less than the
decline in supply)
• →Net increase in the funds rate
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End of chapter question 22
• Using the supply and demand analysis in the market for
reserves, indicate what happens to BR, NBR, iff
a) Increase in reservable deposits→ (SKIP THIS QUESTION)
b) Expected large withdrawal of deposits from banks→ER (up), Rd(up), iff (up)
c) Fed raises iff, →NBR (down), Rs (down)
d) Fed raises ior above iff →Flat section of Rs (up), iff (up)
e) Fed reduces r →RR (down), Rd(down)
f) Fed reduces r and sterilizes by OM sale → (e )+Rs (down)
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