Monetary Policy Tools

When the Federal Reserve Bank is concerned with unemployment, the appropriate policy is an expansionary monetary policy. An expansionary monetary policy aims at reducing interest rates in order to increase investment, thus causing an increase in aggregate expenditures, equilibrium GDP and aggregate demand.

When the Federal Reserve Bank is concerned with inflation, the appropriate policy is an contractionary monetary policy. A contractionary monetary policy aims at increasing interest rates in order to decrease spending, thus causing an decrease in aggregate expenditures and aggregate demand in order to bring them into pace with aggregate supply thus reducing inflation.

The Fed uses the following tools to change interest rates:

1. Open market operations. These refer to purchase or sale of government securities -we will call them through this lecture "bonds" the textbook calls them "t-bills", short for treasury bills.

A bond is a note issued by the US government promising to pay the bearer the price paid for the bond plus interest at a determined maturity date.

Once the government issues (sells) these bonds, they can be resold in an "open" market. It is called an open market, because anyone can buy or sell bonds in this market: The Federal reserve bank, the public and commercial banks all, can buy or sell bonds in this market.

Each commercial bank has an account at the Fed where the Fed holds the bank's reserves:

In the example I used in the power point, I assumet that there are only five banks in the entire banking system and total reserves are 20,000.

The slide titled "The Federal Reserve Banks Combined Statements" shows the Fed's holdings of US bonds previously purchased in the open market as part of the Fed's assets and it also shows bank's reserves in the liabilities side. Bond holdings are an asset to the Fed because they represent money that is owed to the bond holder by the US government. Reserves represent a liability to the Fed, because they belong to the banks and are simply held as deposits by the Fed.

When the Fed purchase $100 in bonds from the public (from Mr. Anderson) Mr. Anderson gives the Fed the bond and the Fed pays him with a check and Mr. Anderson deposits this check in his checking account at his bank (say bank A). Bank A sends the check to the Fed for clearing. When the Fed receives his own check it destroys the check and credits Bank A's reserve account with +100 and Bank A then credits Mr. Anderson's checking account with the $100.

The Fed simply "creates" the 100 as an electronic transaction which provides bank A with excess reserves which bank A will use to make loans and the money supply increases by the multiplier effect.

In summary, when the Fed makes a bond purchase, it injects reserves in the banking system, which banks use to multiply via loans. For this reason, when calculating the expansion in the money supply resulting from an open market bond purchase, consider the entire amount of the purchase of bonds an increase in reserves DR = 100. Then use the deposit expansion formula to calculate the expansion in deposits: DD = DR (1/r)= 100*(1/0.2) = 500.

If the Fed sells $100 in bonds from the public (from Mr. Anderson) Mr. Anderson gives the Fed a check drawn on his account at bank A and the Fed gives him a bond. To clear this check from Mr. Anderson, the fed decreases Bank A's reserve account by 100: The Fed simply "erases" the 100 from reserves. This electronic transaction results in that now, bank A has 100 less in reserves than required. In order to increase reserves, bank A will slow down loans thus reducing the amount of deposits through the banking system.

In summary, when the Fed makes a bond sale, it reduces reserves throught the banking system. For this reason, when calculating the contraction in the money supply resulting from an open market bond sale, consider the entire amount of the sale of bonds a decrease in reserves DR = -100. Then use the deposit contraction formula to calculate the contraction in deposits: DD = DR (1/r)= -100*(1/0.2) = -500.

The interest rate the Fed targets is called the Federal funds rate. At the end of each business day, banks must comply with reserve requirements. When a bank is short of reserves for the day, the bank has two options:

1. To borrow funds from other banks or

2. To borrow funds from the Fed.


Borrowing funds from other banks

The bank can borrow funds overnight from other banks that have excess reserves and are in a position to lend out excess reserves they have. For these overnigh loans of funds deposited at the fed, the bank pays what is known as the Federal funds rate. The Federal funds rate is determined by supply and demand for funds. It is a market determined rate. The supply of funds in this market comes from banks with excess reserves and the demand for funds comes from banks short of reserves.

When banks borrow from other banks, the Fed decreases the amount of reserves in the lender bank's account and increases the amount of reserves in the borrower bank's account. This transaction merely involves a "transfer" of funds from the lender bank's reserve account to the borrower bank's reserve account so there is no change in the overall amount of reserves in the banking system.

Most interest rates to consumers and firms are tied to the Federal funds rate. In a way, the Federal funds rate is the cost of money to banks and banks will lend to the public at this rate plus a premium.

When the Fed is concerned with unemployment, the Fed orchestrates a decrease in the Federal funds rate (to cause all rates through the economy to decrease thus stimulating investment and growth). In order to do this, the Fed buys bonds in the open market. This action floods the banking system with excess reserves (there will be more banks with funds to lend and fewer banks in need of reserves) making money abundant and easy to obtain and thus decreasing the Federal funds rate.

When the Fed buys bonds it injects reserves into the system and causing a decrease in the Federal funds rate. This decreases all other short term interest rates and hopefully the drop in short term rates causes long term rates to decrease. Investment spending is tied to long term rates. If long term rates decrease, then investment spending increases and the resulting increase in aggregate spending will cause an increase in GDP. In practice, long term rates do not seem to react as fast and as easily as short term rates and if they do not, then investment does not increase and the economy is left with an expansion in demand for goods and services that can not be matched by an equal increase in production of goods and services and inflation may result.

When the Fed is concerned with inflation, the Fed orchestrates an increase in the Federal funds rate (in order to cause all rates through the economy to increase, thus slowing down aggregate demand for goods and services). In order to do this, the Fed sells bonds in the open market. This action reduces reserves in the banking system (there will be fewer banks with funds to lend and more banks in need of reserves) making money scarce and difficult to obtain and thus increasing the Federal funds rate.

When the Fed sells bonds it decreases reserves in the system causing an increase in the Federal funds rate. This increases all other short term interest rates. The resulting decrease in aggregate spending slows down inflation.

The Federal funds rate has increased since 2004. The Fed changed direction in August 2007 in response to recession forecasts. This means that the Fed was concerned with inflation up until August 2007 and thus was tightening funds availability by selling bonds in the open market. See in the slide what has happened with the federal funds rate since then.

 

2. The Fed also uses changes in the discount rate to manage interest rates. The discount rate is the rate commercial banks pay when they borrow reserves from the Fed.

In 2003, the fed stopped making loans at an interest rate BELOW market rates. Because of this change in procedure, they changed the name of the interest rate charged by the fed to banks on loans. Instead of calling this rate the discount rate, they renamed it the "primary credit rate". See slide for an explanation of why the fed decided to make this change. Now, the interest rate charged by the fed on loans is always HIGHER than the market rate (the federal funds rate). In practice, then, changes to the primary credit rate will work similarly as changes in the discount rate.

If the Fed increases the primary credit rate (thus making the spread with the federal funds rate) banks find it more expensive to borrow from the Fed and beef up their reserves (hold more excess reserves) to prepare themselves in case they run short of reserves thus avoiding having to borrow at a the high rate from the Fed. As banks hold more reserves, they decrease the amount of loans (as loans are paid back the bank does not make a new loan but puts the money into reserves) this will cause a decrease in deposits via the multiplier and a contraction in the money supply.

If the Fed decreases the primary credit rate (thus decreasing the spread with the federal funds rate), banks find it cheaper to borrow from the Fed and hold less excess reserves. The reasoning is that if/when they find themselves short of reserves they can borrow at a 'low' rate from the Fed. As banks hold less in reserves, they increase the amount of loans (as they lend out money that was previously held in reserve) this will cause an increase in deposits via the multiplier and an expansion in the money supply.

Additionally, when banks borrow from the Fed, the Fed credits the bank's reserve account with the amount of the loan thus increasing reserves and generating an expansion in loans and deposits via the money multiplier.

See in the slide presentation what has been happening with this rate this past year.

Prime Rate: The rate at which banks will lend money to their most-favored customers

Primary credit Rate: The interest rate at which an eligible financial institution may borrow funds directly from a Federal Reserve bank. Banks whose reserves dip below the reserve requirement set by the Federal Reserve's board of governors use that money to correct their shortage. The board of directors of each reserve bank sets the discount rate every 14 days. It's considered the last resort for banks, which usually borrow from each other.


Fed Funds Rate: The interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis.

11th District Cost of Funds: A monthly cost-of-funds index (COFI) reflecting the weighted-average interest rate paid by 11th Federal Home Loan Bank District savings institutions for savings and checking accounts. The 11th district covers Arizona, California and Nevada. The index is published on the last day of the month and reflects the cost of funds for the prior month.

3. Another tool used by the Fed to cause changes in the Federal funds rate is changes in the required reserve ratio.

See the example in the slide presentation: the Fed reduces the required reserve ratio from 20% to 10%. This action creates now 10,000 in excess reserves which banks use to make loans thus generating a multiple expansion in deposits.

I included in the presentation a slide which shows the "before" T account, where banks hold 20,000 in reserves. These 20,000 supports 100,000 in deposits (and 80,000 in loans). When the Fed decreases required reserves to only 10%, the same 20,000 in reserves can now support more deposits (and more loans):

Before:

20,000 = 0.2 D (20,000 must be 20% of deposits. Solving for D we get D = 100,000)

After:

20,000 = 0.1 D (20,000 must be 10% of deposits. Solving for D we get D = 200,000)

The important point here is that when the Fed changes r, reserves in the banking system do not change. Reserves begin at 20,000 and end at 20,000. All that happens, is that when banks find they have now excess reserves they loan out these excess reserves. Once banks use these reserves to make loans, they will create an expansion in deposits that is a multiple of these excess reserves. In a sense, reserves that were locked in the bank's vault (or as a deposit at the Fed) are now let out as loans. These loans become deposits and piece by piece these reserves come back to the vault as reserves (as each bank in the chain keeps 10% of the new deposit it receives), but in the process of going out of the vault and back in, banks generated a multiple expansion in deposits.

See the actual value of the required reserve ratio in the slide presentation.

4. Another tool used by the Fed is Margin Requirements. These are the "down payment" on stock purchases. When the Fed is concerned with inflation, is restricts stock purchases thus increasing the margin requirement. When the Fed is concerned with unemployment, it decreases margin requirements to facilitate stock purchases.

5. Moral suasion is an important tool the Fed uses mostly to respond to crises. Many times a bank is in trouble (short of reserves) because loans are not paid back on time. In these cases, all that is needed to avert a crisis is to introduce a "pause" which allows the bank to find funding. In these cases, all that is needed is for the Fed to call the creditor bank to ask for a "grace period" on behalf of the debtor bank. Clearly, the implication is that if the Fed is mediating the "pause" the creditor bank's understanding is that the Fed is ready to "support" the bank in need...which introduces another example of what we discussed before as the moral hazard problem.

All countries have a "central bank" in charge of controlling the supply of money and supervising the banking system. How independent from the government the central bank is varies from country to country. On one end of the spectrum, some countries have a central bank that is simply a branch of the government and thus monetary policy decisions are made entirely by the government. At the other end of the spectrum, some countries give complete autonomy to the central bank to conduct policy without any direct control from the government.

http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_dec94/bu_1294_1.pdf

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