Lesson 15: Monetary Policy Tools |
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Upon completion of this lesson, you should be able to do the following:
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IntroductionMany people especially in the financial markets scrutinize the Fed's actions in order to determine monetary policy. The people are trying to determine how interest rates will change, which in turn affect the prices in the financial markets. The process of watching the Fed in order to determine monetary policy is called Fed watching. This lesson introduces the Federal Reserve's three most important tools for conducting monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements. Open Market OperationsOpen Market Operations is the most important tool of the Fed, which is the Fed's purchase and sale of U.S. government securities. The Fed can purchase any financial securities, and the impact is identical as if the Fed bought U.S. government securities. However, the Fed traditionally buys and sells highly liquid U.S. government securities. Open market operations will have an impact on the money supply and interest rates. The Fed can use two monetary policies.
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The important thing to notice is open market operations affect the interest rate. The T-bill is a short-term credit instrument. When the Fed conducts open-market operations for T-bills, it affects the price of T-bills and the T-bill's interest rates. This causes changes in other short-term interest rates, such as the federal funds rate and the interest rates on commercial paper and banker's acceptances. Therefore, short-term interest rates of all short-term credit instruments will rise and fall together. |
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The Fed can only control the growth rate of the money supply or short-term interest rates. It cannot control them both at the same time. For example,
Therefore, the Fed can control short-term interest rates or the money supply, but not both at the same time. The Federal Open Market Committee meets 8 times a year and issues a general directive . A general directive states the objective for the monetary aggregates and interest rates. The Federal Reserve Bank of New York is given the responsibility of carrying out the general directive. The Fed Bank of New York deals with about 40 dealers who specialize in U.S. government securities (i.e. secondary market). The New York Fed is electronically connected to the dealers and when the Fed is ready to buy or sell government securities, the Fed will ask these dealers to make an offer. The Fed buys or sells to the dealers with the best offer. The department at the Fed that buys and sells government securities is referred to as the Open Market Trading Desk. The Fed uses two types of methods to buy and sell U.S. government securities.
The Fed can also do the opposite of a REPO, which is called the Reverse REPO ( matched sale-purchase transactions ). The Fed sells securities to the dealers and the dealers sells them back to the Fed for a specific price and on a specific data in the future. The reserve REPO temporarily lowers excess reserves in the banking system, such as offsetting an increase in the Federal Reserve float. When the trading desk at the Fed conducts monetary action, it uses two types of transactions.
The open market operations is the most popular tool the Fed uses.
Many people who watch the Fed read the directives issued to the open market trading desk. However, these directives are vague and are not precise. The reason is the principal-agent problem. If the directives are vague, then the outcome does not matter. Any outcome can be deemed a success, making the Fed unaccountable for errors. Many European central banks including the European Central Bank uses open market operations very similar to the United States. Some countries have a small market for government securities, such as Japan. The Japanese central bank relies on interest rate controls to control the money supply. Discount PolicyThe second monetary tool the Fed uses is discount policy . The Fed can make loans to financial institutions. For example, a bank is experiencing financial problems and needs reserves. The bank sells a $10,000 T-bill to the Fed. The Fed increases bank's reserves by $9,000. The difference is called the discount. The T-bill acts as the collateral of the loan. Eventually the bank buys the T-bill back from the Fed for $10,000. The $1,000 difference reflects the interest rate the Fed charges for the loan, called the discount rate . Traditionally, the Fed will only lend money to banks that were members of the Federal Reserve System. Now days, any bank in the U.S. can borrow from the Fed and the Fed may not require any collateral for the loan. |
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Each Fed district bank provides loans, known as the "
discount window
." The Fed can use discount policy to influence the money supply and interest rates. This model will examine the interest rate in the federal funds market. The public and financial analysts scrutinize the federal funds market to predict monetary policy. The federal funds market is banks' deposits held at the Fed. One bank can lend some of its excess reserves to other banks. The deposits are electronically transferred through the Fedwire. When the Fed implements monetary policy, it has an immediate impact on the federal funds rate. When the public and financial analysts see the federal funds interest rate decrease, they infer that the Fed is using expansionary policy. If the federal funds rate increases, the public believes the Fed is using contractionary monetary policy. As you know from this lesson, the Fed cannot control the federal funds rate, but can only influence it. The demand curve is the banks' demand for federal funds. These banks borrow funds to ensure they are holding enough reserves to meet depositors withdrawals or satisfy the Fed's reserve requirements. The demand curve is downward sloping, because banks will want to borrow more funds, if the interest rate decreases. The supply curve is the banks' supply of federal funds to the market, because these banks are holding excess reserves. These banks temporarily lend out excess reserves, so they can earn interest income. The supply curve is upward sloping, because banks will lend more funds, if the interest rate is higher. The point where the demand and supply curves intersect is the equilibrium interest rate ( i* ) and amount of reserves ( R* ) changing hands in this market. |
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The Fed makes three types of loans.
The discount window has a potential for abuse. For example, a bank could borrow funds from the Fed at 5% and loan these funds out at 6%, earning 1% interest on these loans. The Fed counters this problem by investigating and auditing the bank more, making sure the bank is complying with regulations. The Fed can also impose fines or publicly criticize the bank. A bank borrowing from the Fed may indicate financial weakness. Finally, the Fed may stop lending to the bank, because borrowing from the Fed is a privilege and not a right! Many economists argue that the Fed should set the discount rate higher than short-term interest rates. That way, borrowing from the Fed is always a penalty, because the interest rate is higher than the market rate. The use of discount policy has many benefits.
Discount policy is not a good tool to control the money supply. If the Fed wants to increase the money supply, the Fed has to grant more discount loans to banks. What if the banks do not want these loans? In this case, discount policy fails to increase the money supply. Reserve RequirementsThe last monetary tool the Fed uses is reserve requirements . The reserve requirements can be satisfied by vault cash and/or deposits at the Fed. The Fed has the power to set reserve requirements for banks within the limits set by Congress. The Fed rarely changes the reserve requirements, because changes in the reserve requirements have a significant and disruptive impact on the banking system. Currently, the reserve requirements for checking accounts is 3% for the first $47.8 million. Banks are subjected to a reserve requirement of 10% for checking accounts exceeding $47.8 million. There are no reserve requirements for Eurodollar accounts and nonpersonal time deposits. The Fed can use reserve requirements to alter the money supply. Let's look at how this might happen:
Therefore, the Fed rarely changes the reserve requirement ratios, because this tool is too powerful! A small changes in the reserve requirement could have enormous impact on the banking system and the money supply. Economists and policymakers debate reserve requirements as an effective monetary policy tool, because this tool may be too powerful and required reserves are a cost to the banks. Banks are not able to lend these reserves to borrowers, and therefore, do not earn interest income on required reserves. Instead, the reserves sit in a vault as cash or as a deposit at the Fed. There are two reasons why the Fed wants to retain reserve requirement as a monetary tool.
Milton Friedman, a Nobel laureate, suggested that banks should have a 100% reserve requirement. The banks would hold all deposits as deposits at the Fed and/or vault cash. There would be no multiple deposit expansion and the money multiplier would be one. For example, if the Fed bought a $10,000 T-bill, the monetary base and the money supply would both increase by exactly $10,000. A 100% reserve requirement would give the Fed better control of the money supply. Banks would hold all deposits as reserves, so they could meet depositor's withdrawals. Federal deposit insurance could be eliminated. Also the Fed and Congress could substantially reduce bank regulations. This idea has one problem. Banks could not grant loans under this system, causing the financial intermediation process to break down. Banks link savers to the investors. The whole economy would need restructuring. |