5. Tools of monetary policy Flashcards
What are the Fed’s tools for controlling the money supply during normal times?
Open-market operations and the discount rate affect the monetary base
Reserve requirements and interests on reserves influence the money multiplier
What is another purpose of open-market operations other than changing the money supply?
Keeping the money supply unchanged if the money multiplier changes
This is called a defensive open market operation
Discount loans are initiated by the borrowing banks, so how does the central bank influence borrowing?
The central bank can influence banks’ borrowing by changing the interest rate it charges, the discount rate
How do discount rates influence the money supply?
An increase in the discount rate discourages borrowing which decreases the monetary base and the money supply
Does the Fed use discount rates to affect money supply a lot? And how high is the discount rate?
No, it rather uses open-market operations. The discount rate is usually set 0.5% higher than the federal funds rate, the interbank lending rate.
–> if banks need reserves they borrow from other banks because it is cheaper
How do reserve requirements affect the money supply?
If reserve requirements increase, the reserve-deposit ration (R/D) increases.
An increase in R/D reduces the money multiplier, thus reducing the monetary base and money supply
What are the reserve requirements today and how much do banks usually keep in reserves?
The reserve requirements are at 0 since march 26, 2020 to encourage lending during the pandemic.
However, reserve requirements aren’t used as policy tools much because banks usually had excess reserves.
How do interests on the reserves affect the money supply?
If the interest rates rise, banks desire to hold more reserves so R/D rises causing the money multiplier to decrease.
What does the Fed really set - the interest rate or the money supply?
Fed chooses an interest rate and adjusts money supply to hit the interest rate target.
What interest rate does the Fed target?
It targets the federal funds rate, the rate that banks charge on loans when lending to another.
The federal funds rate is a very short-term rate.
How is the federal funds rate set?
It is set by the federal funds market. The Fed does not set the rate, but a target for this rate.
The federal funds rate and the Fed’s target rate deviate usually.
How is the target federal fund rate chosen?
The federal funds rate target is set in the FOMC meeting which occurs every 6 weeks in Washington D.C.
In the meeting, members discuss the state of economy and choose a target for the federal fund rate.
Once a target is set, it usually stays in place for 6 weeks.
How are the target federal funds rate implemented?
This is the job of the FRB of New York.
Group of bond traders at the open-market operation desk push the rate to its target level.
Open-market operations change supply and demand in the federal funds market because they change bank’s reserve levels
If the FRB sells bonds, the bond buyer needs cash that drains a bank’s reserves. This bank then needs to borrow reserves to maintain the reserve requirements leading to a higher demand and lower supply in the federal funds market leading to an increase of the rate.
How does the the Fed trade the Bonds?
Trades bonds with ca. 20 fin. institutions called primary dealers. They include commercial banks and investment banks.
When fed wants to make a trade, i notifies all of them and gives them 10-15 minutes to respond with a bid
Fed accepts the two most favorable bids.
How does the Fed perform the bond trades?
Outright open-market operation: buys or sell bonds and changes the bank reserves and monetary base permanently
Temporary open-market operation: Makes a repurchase agreement with bond dealer, which means that Fed buys or sells bond with an agreement to reverse the transaction in a certain number of days.
