Monetary Policy Tools

 Instruments that initiate monetary

policy

 Open Market Operations

 The Discount Rate
 Reserve Ratios
Open Market Operations

 Defined as the buying or selling of

bonds by the Federal Reserve in the
open market.
 Expansionary -- Fed buys bonds (injects
reserves)
 Contractionary -- Fed sells bonds
(drains reserves)
 Done at the Federal Reserve Bank of
New York
Open Market Operations:
How They’re Actually Done
 Example -- Federal Reserve buys a
$1000 bond from Salomon
Brothers and pays with a check.
The check in turn is deposited in
checkable deposits at Chase,
which is Salomon Brothers bank.
Balance Sheet Portrayal
Salomon Brothers
Bonds -$1000
D +$1000

Chase
R +$1000 D +$1000

Federal Reserve Bank of NY

Bonds +$1000 R +$1000
Characteristics of
Open Market Operations
 Sometimes done for temporary
periods
 (Fed) Repurchase Agreement -- Fed
buys bond with agreement to sell it
back.
 Matched-Sale Purchase -- Fed sells
bond with agreement to buy it back.
Open Market Operations --
An Effective Policy Tool
 Occurs at the initiative of the Fed.
 Fed is in complete control.
 They are flexible: Fed can do small or
large amounts.
 They are reversible: Fed can undo policy
mistakes.
 Very low-key policy instrument: difficult
to tell what Fed has done.
The Discount Rate (iDISC)

 Defined as the rate of interest

charged to banks that borrow from
the Federal Reserve.
 Expansionary -- Fed lowers
discount rate.
 Contractionary -- Fed raises
discount rate.
Effects of
Discount Rate Changes
 Example -- Effect of Decrease in the
Discount Rate (iDISC).

iDISC  DL  M2

 Increase in discount rate has the

reverse effect.
Types of Discount
Window Borrowing
 Primary Credit -- borrowing for
short-term reserve adjustments.
 Seasonal Credit -- borrowing for
seasonal needs.
 Secondary Credit -- large, longer-
term borrowing for banks facing
financial difficulties.
Discount Rate Policy --
Characteristics
 DL done at the discretion of banks, not
the Fed.
 Discount Window can be abused by
banks, borrowing for profit (actively or
passively).
 Sometimes is regarded as signal of
monetary policy, “the announcement
effect.”
Discount Rate Policy --
Its Diminished Role
 Larger volume of borrowing from other
sources -- Federal Funds, RPs,
Eurodollars  banks hardly use the
Federal Reserve for short-term reserve
adjustments.
 Announcement effect now involves the
Federal Funds rate target.
 Recent change in procedure (generally):
iDISC = Target iFF + 0.5%.
Reserve Ratios (rD, rT)

 Designed to change the amount of

required reserves.
 Expansionary Policy -- Fed lowers
reserve ratios.
 Contractionary Policy -- Fed raises
reserve ratios.
 Affects M2 by changing the multiplier.
Characteristics of
Reserve Ratio Policy
 rT = 0 for Savings and Time
Deposits (including MMDAs)
 DIDMCA  Uniform Reserve
Requirements (based upon deposit
size)
Reserve Ratio Policy --
Rarely Used
 Too blunt -- needs tiny changes for
reasonable adjustments in money
growth.
 Too Disruptive -- affects all banks
balance sheets.
The Market For
Bank Reserves
 Demand for Reserves (RD) -- Banks
wishing to borrow reserves in the
Federal Funds market, generally in
response to loan demand.

 Downward sloping curve when plotted

against iFF, (i.e. iFF  RD). It can shift
rightward (increase in demand) or
leftward (decrease in demand).
 Supply of Reserves -- Banks offering
reserves to the Federal Funds market
+ the Federal Reserve changing
reserves using open market
operations.
 Upward sloping curve when plotted
against iFF, (i.e. iFF  RS). It can
shift rightward (increase in supply)
or leftward (decrease in supply).
Determination of
the Federal Funds Rate
 The Federal Funds Rate (iFF) is
determined by equilibrium in the market
for bank reserves (where RD = RS).

 The Federal Funds Rate changes due to

shifts in the Demand for Bank Reserves
or the Supply of Bank Reserves.