Lecture 10

Tools of Monetary
Policy
Contents

 To demonstrate how changes in monetary policy can

affect the equilibrium federal funds rate

 To explain how conventional monetary policy tools are

implemented and the relative advantages and
limitations of each tool

 To explain the key monetary policy tools that are used

when conventional policy is no longer effective

 To compare the policy tools of the Fed and ECB

The Market for Reserves and Federal
Funds Rate
 The market for reserves is where the federal funds rate is determined

 A supply and demand analysis of this market would be used to

analyze how tools of monetary policy affect the federal funds rate

1. Supply of reserves:

 Supply of reserves can be broken up into two components:

 The amount of reserves that supplied by the Fed’s open market operations
(nonborrowed reserves)

 The amount of reserves borrowed from the Fed (borrowed reserves)

The Market for Reserves and Federal
Funds Rate

1. Supply of reserves:

 The primary cost of borrowing from the Fed is the discount rate

 If disocunt rate is higher than federal funds rate, iff, then banks will not
borrow from the Fed, borrowed reserves will be zero, and the supply of
reserves will just equal the amount of nonborrowed reserves, and so the
supply curve is vertical

 If the federal funds rate begins to rise above the discount rate, banks will
want to keep borrowing more and more at id, and then lending out the

proceeds in the federal funds market at the higher rate iff, so the supply

curve becomes flat at id.

The Market for Reserves and Federal
Funds Rate

2. Demand for reserves:

 Demand for reserves can be split up into two components:

required reserves and excess reserves

 Excess reserves are insurance against deposit outflows, and the

cost of holding these excess reserves is their opportunity cost –
the interest rate that could have been earned on lending these
reserves minus the interest rate that is earned on these reserves,
ior.
The Market for Reserves and Federal
Funds Rate
2. Demand for reserves:

 When the federal funds rate is above the rate paid on reserves,
then as federal funds rate decreases, the opportunity cost of
holding reserves falls, so the quantity of reserves demanded rises,
and the demand curve for reserves slopes downward.

 When the federal funds rate falls below the rate paid on reserves,
then banks do not lend in the overnight market at a lower interest
rate. Instead, they just keep on adding to their holding of excess
reserves indefinitely, so the demand curve for reserves becomes
flat at ior.
The Market for Reserves and Federal
Funds Rate
 The market equilibrium occurs when the quantity of reserves
demanded equals the quantity of reserves supplied, Rs = Rd,

 The equilibrium federal funds rate is

 If the federal funds rate is above this level, more reserves are supplied
than are demanded (excess supply), so the federal funds rate would fall.

 If the federal funds rate is below this level, more reserves are demanded
than are supplied (excess demand), so the federal funds rate would rise.
The Market for Reserves and Federal
Funds Rate
 Now we will examine how changes in the tools of monetary policy - open market
operations, discount rate, reserve requirement, and the interest rate paid on
reserves – affect the market for reserves

1. Open Market Operations

 An OMO purchase leads to a greater quantity of reserves supplied, so the supply

curve shifts to the right → the equilibrium federal funds rate falls from to (in
the condition that iff is above the interest rate paid on reserves ior)

 If iff is initially equal to the ior, then OMO purchase has no impact on the equilibrium i ff.

 The interest paid on reserves ior sets a floor for the federal funds rate.
The Market for Reserves and Federal
Funds Rate
2. Discount lending

 The effect of a discount rate change depends on whether the demand

curve intersects the supply curve in its vertical or its flat section.

 If the intersection occurs on the vertical section of the supply curve,

so that there is no discount lending, and borrowed reserves are zero,
and there is no change in the federal funds rate
 Because the Central Bank usually keeps the discount rate above its target
for the federal funds rate, so most changes in the discount rate have no
effect on the federal funds rate.
The Market for Reserves and Federal
Funds Rate
2. Discount lending

 The effect of a discount rate change depends on whether the demand

curve intersects the supply curve in its vertical or its flat section.

 If the intersection occurs on the horizontal section of the demand

curve, so that there is some discount lending, and borrowed reserves
are positive (increasing by BR2 – BR1, and the federal funds rate now
falls to the new discount rate
3. Reserve requirements
The Market for Reserves and Federal
Funds Rate

4. Interest on reserves

 The effect of a chnge in the interest rate paid by the Central Bank on
reserves depends on whether the supply curve intersects the
demand curve in its downward-sloping section or its flat section.
 If the intersection occurs on the downward-sloping section of the demand
curve, i.e. the equlibrium federal funds rates is above the interest rate on
reserves. Then, if the interest rate on reserves increases (but still below
the current equilibrium federal funds rate), the intersection between two
curves will remain unchanged, and the federal funds rate does not
change.
The Market for Reserves and Federal
Funds Rate

4. Interest on reserves

 The effect of a change in the interest rate paid by the Central Bank
on reserves depends on whether the supply curve intersects the
demand curve in its downward-sloping section or its flat section.
 If the intersection occurs on the flat section of the demand curve, i.e.
the equlibrium federal funds rates is equal to the interest rate on
reserves. Then, if the interest rate on reserves increases, the federal
funds rate will also rise and equal to the new interest rate on reserves..
The Market for Reserves and Federal
Funds Rate
Conventional Monetary Policy Tools

 During normal times, the Central Bank can use these

convetional tools
 Open Market Operations

 Discount Lending

 Reserve Requirement

 Paying Interest on Reserves

Conventional Monetary Policy Tools

1. Open Market Operations

 The most important tool – the primary determinants of changes in

interest rates and monetary base

 Two ways of the operations

 Open Market Purchases: purchasing government securities to expand
reserves and the monetary base, thereby increasing the money supply
and lowering short-term interest rates

 Open Market Sales: selling government securities to shrink reserves and

the monetary base, thereby decreasing the money supply and raising
short-term interest rates
Conventional Monetary Policy Tools

1. Open Market Operations

 Two categories of OMO:
 Dynamic OMO: to change the level of reserves and monetary base

 Defensive OMO: to offset movements in other factors that affect

reserves and the monetary base
 Repurchasing agreement (repo): Central Bank purchases securities with an
agreement that the seller will repurchase them in a short period of time, 1-15
days

 Matched sales-purchase transaction (reverse repo): Central Bank sells securities

and the buyer agrees to sell them back to the Central Bank in the near future.
Conventional Monetary Policy Tools

2. Discount Policy and the Lender of Last Resort

 Operation of Discount Window: The discount loans to banks are of
three types:
1. Primary credit:
 Healthy banks are allowed to borrow all they want at very short
maturities (also called standing lending facility)
 The interest rate on these loans is the discount rate, set higher than
federal funds rate (about 100 basis points or 1 percentage point), so
the amount of lending under this primary credit facility is very small
because banks mainly borrow from each other.
 This facility put a ceiling on the federal funds rate at id.
Conventional Monetary Policy Tools

2. Discount Policy and the Lender of Last Resort

 Operation of Discount Window: The discount loans to banks
are of three types:
2. Secondary credit:
 Given to banks that are in financial troubles and are
experiencing severe liquidity problems.
 The interest rate on secondary credit is set at 50 basis points
above the discount rate.
Conventional Monetary Policy Tools

2. Discount Policy and the Lender of Last Resort

 Operation of Discount Window: The discount loans to banks
are of three types:
3. Seasonal credit:
 Given to meet the needs of a limited number of small banks in
vacation and agricultural areas that have a seasonal pattern
of deposits.
 The interest rate charged on seasonal credit is tied to the
average of the federal funds rate and certificate of deposits.
Conventional Monetary Policy Tools

2. Discount Policy and the Lender of Last Resort

 Discounting is important in preventing and coping with financial panics.

 Central Bank provides reserves to banks when no one else would, so

during a bank crisis reserves are immediately channeled to the banks
that need them most.

 However, this role can encourage banks to take on more risk (moral
hazard problem), especially severe for large banks, which may believe
that Central Bank views them as “too big to fail”, so they will certainly
receive loans from Central Bank when they are in trouble.
Conventional Monetary Policy Tools

3. Reserve Requirements
 A rise in reserve requirements will reduce the money multiplier
and lead to a contraction of the money supply.
 It also raise the demand for reserves and federal funds rate

 Different reserve requirement ratios can be imposed on

different types of deposits, different bracket of checkable
deposits that banks receive
Conventional Monetary Policy Tools

4. Interest on Reserves
 This tool does not have a long history, only implemented in
2008 in US.

 This interest rate is set below the federal funds rate, and be
used as the floor for federal funds rate.
Relative Advantages of
Conventional Monetary Policy Tools
 OMO constitute the most important tool because they have several basic
advantages over the other tools:

1. This tool can completely control over the volume of reserves

2. This tool is flexible and precise: No matter how large or small a change in
reserves is required, this tool can achieve it with the corresponding
purchase or sale of securities

3. This tool can be easily reversed. If a mistake is made in conducting, the

Central Bank can immediately reverse it.

4. This tool can be implemented quickly without administrative delays.

Relative Advantages of
Conventional Monetary Policy Tools
 The other tools can have advantages in two situations

1. Central Bank wants to raise interest rate after banks have accumulated
large amounts of excess reserves. Instead of conducting massive open
market sales to reduce reserves, the Central Bank can raise the
interest on reserves, which can lead to a higher federal funds rate.

2. The discount policy would be used to perform its role as lender of last
resort to prevent the collapse of the whole banking system from
happening
Nonconventional Monetary Policy
Tools
 In normal times, conventional tools are enough to stabilize the economy

 In case of a full-scale financial crisis, these tools cannot do the job:

 The financial system becomes unable to allocate capital to productive uses

 Zero-lower-bound problem arises, in which the Central Bank is unable to lower

its policy interest rate (federal funds rate) further because it has hit a floor of
zero.

 In this circumstance, Central Banks need non-interest-rate tools, known

as non-conventional monetary policy tools, to stimulate the economy
 Liquidity Provision/Asset Purchases/Forward guidance/Negative interest rates
on bank deposits at central bank
Nonconventional Monetary Policy
Tools
1. Liquidity Provision

 The Central Bank implements unprecedented increases in its lending

facilities to provide liquidity to the financial markets.

i. Discount Window Expansions: lowering the discount rate to very close

to the federal funds rate target, however, borrowing from the discount
windown can suggest that the borrowing bank is in trouble)

ii. Term Auction Facility: Central Bank makes loans at a rate determined
through competitive auctions, so banks can borrow at a rate lower than
the discount rate
Nonconventional Monetary Policy
Tools
1. Liquidity Provision

i. Discount Window Expansions:

ii. Term Auction Facility:

iii. New Lending Programs: Central Bank broadens its provision of

liquidity, not only traditional lending to banking institutions, but also
to investment banks or lending to promote purchases of commercial
papers or asset-backed securities
Nonconventional Monetary Policy
Tools
2. Large-Scale Asset Purchases

 OMO normally involve only the purchase of short-term government

securities.

 However, during the crisis, the Central Bank can extend to large-scale asset
purchase programs to lower interest rates for particular types of credit
 Purchasing Mortgage-Backed-Securities to lower interest rates on residential
mortgages to stimulate the housing market

 Purchasing long-term Treasury securities to lower long-term interest rate, which

are more relevant to investment decisions.
Nonconventional Monetary Policy
Tools
 This tool leads to a huge increase in monetary base (known as
Quantitative Easing), resulting in an expansion of money supply,
and be a powerful force in stimulating the economy but possibly
producing inflation

 Someone can be skeptical of this effect:

 Increase in monetary base can flow into banks’ holding of excess
reserves instead of making loans, so money supply will not increase
much, short-term interest rate will not lower further because of
lower-zero-bound, thereby impact on the economy is very limited.
Nonconventional Monetary Policy
Tools
 Someone who supports for this tool argues that this tool is not to direct
to the target of quantitative easing, but rather of credit easing, that is,
to improve the functioning of particular segments of the credit markets.
 Providing liquidity to a particular segment of the credit markets can help
unfreeze the market and enables it to allocate capital to productive uses

 Purchasing particular securities can help lower the interest rates on those
securities relative to rates on other securities and thereby stimulate
spending in those markets

 Purchasing long-term government securities could lower the long-term

interest rates and can boost investment spending
Nonconventional Monetary Policy
Tools
3. Forward Guidance
 The Central Bank commits to keep the federal funds rate at zero for a
long period of time, so the long term interest rates (an average of the
short term interest rates that markets expect to occur over the life of
the long term bond) will fall
 Two types of forward guidance:
 Conditional commitment: it commits to keep the federal funds rate at zero
if the economic conditions are weak. If not, it will abandon the
commitment
 Unconditional commitment: it commits to keep the federal funds rate at
zero without indicating that this decision might change depending on the
state of the economy
 Uncondtional commitment is stronger and has a larger effect on long-
term interest rates
Nonconventional Monetary Policy
Tools
4. Negative Interest Rates on Banks’ Deposits

 With inflation very low and weak economy, Central Bank can set interest
rate on deposits held by banks at their central bank to be negative

 This nonconventional tool encourages banks to lend out the deposits they
were keeping at the central bank, thereby encouraging households and
businesses to spend more
 Banks might not lend out this deposits but instead move them into cash.

 Banks’ profitability would fall because they have to pay interest to both
depositors and to Central Bank, and this might make banks less likely to lend.