25-04-2014, 12:09 PM
The Tools of Monetary Policy
Tools of Monetary .ppt (Size: 178.5 KB / Downloads: 125)
Open market operations
Affect the quantity of reserves and the monetary base
Changes in borrowed reserves
Affect the monetary base
Changes in reserve requirements
Affect the money multiplier
Target of Monetary Policy: Federal Funds Rate
- The interest rate on overnight loans of reserves from one bank to another.
The Demand for Bank Reserves
Why do banks demand reserves?
The Fed requires banks to hold a certain percentage of reserves as deposits
Banks may choose to hold excess reserves to ensure against increased deposit outflows.
Every dollar held in reserve is not earning interest as a loan
The federal funds rate represents the interest that could have been earned.
As the federal funds rate falls, the opportunity cost of holding reserves falls.
The Supply of Bank Reserves
Bank Reserve Supply consists of two components:
Non-Borrowed Reserves (NBR)
Supplied to the banking system through the Fed’s open market operations (i.e. the reserves banks earn by selling bonds to the Fed.)
Borrowed Reserves (BR)
Reserves borrowed from the Fed by banks.
The cost of borrowing from the Fed is the discount rate (id).
As long as the federal funds rate (iff) is less than the discount rate, BR = 0
It’s cheaper to borrow reserves from other banks than from the Fed.
When iff > id, it is cheaper to borrow from the Fed
We assume that the Fed is willing to lend as much as banks are willing to borrow at the discount window.
Open Market Operations
Suppose the Fed decided to purchase bonds on the open market
This would lead to an increase in NBR since the Fed is paying for bonds with money (that then gets classified as “non-borrowed bank reserves)
The increase in NBR causes the supply of reserves held by banks to shift right
There will be a decrease in the federal funds rate since banks will be more willing to lend to one another at lower rates.
Now suppose the Fed sold bonds on the open market
There would be a decrease in NBR since the Fed is replacing vault cash with bonds (not classified as reserves)
The supply of reserves will shift left as bank reserves fall
This forces the federal funds rate up
If the cut in NBR is large enough then the federal funds rate may go as high as the disocunt rate
It will not exceed the discount rate, since any ff rate above id will no longer be binding (banks will just borrow directly from the Fed at iff>id)