Chapter 15: Tools of Monetary Policy

Question 1

The Market for Reserves and the Federal Funds Rate

Answer 1

Excess reserves are insurance against deposit outflows
-The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ior

Question 2

Demand in the market for reserves

Answer 2

• Since the fall of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target
• When the federal funds rate is above the rate paid on excess reserves, ior, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises
• Downward sloping demand curve that becomes flat (infinitely elastic) at ior

Question 3

Supply in the market for reserves Figure 1

Answer 3

• Two components: borrowed and non-borrowed reserves
• Cost of borrowing from the Fed = discount rate
• Borrowing from the Fed is substitute for other banks
• If iff

Question 4

How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

Answer 4

• depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section
• An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise
• No effect when intersection occurs at flat section of demand curve
• If occurs on the vertical section of the supply curve, no effect
• If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate
• When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls

Question 5

Response to an open market operation: Scenario 1

Answer 5

Supply curve initially intersects demand curve in its downward-sloping section => Open market purchase shifts the supply curve to the right causing the federal funds rate to fall
SEE FIGURE 2

Question 6

Response to an open market operation: Scenario 2

Answer 6

Supply curve initially intersects demand curve in its flat section => Open market purchase shifts the supply curve to the right but the federal funds rate cannot fall below the interest rate paid on reserves
SEE FIGURE 2

Question 7

Response to a change in the discount rate: Scenario 1

Answer 7

No discount lending (BR = 0) => . Lowering the discount rate shifts the supply curve down…but does not lower the federal funds rate
SEE FIGURE 3

Question 8

Response to a change in the discount rate: Scenario 2

Answer 8

Some discount lending (BR > 0) => . Lowering the discount rate shifts the supply curve down…. and lowers the federal funds rate
SEE FIGURE 3

Question 9

Response to a change in required reserves

Answer 9

Increasing the reserve requirement causes the demand curve to shift to the right and the federal funds rate rises
SEE FIGURE 4

Question 10

Response to a change in the interest rate on reserves

Answer 10

SEE FIGURE 5

Question 11

How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate

Answer 11

SEE FIGURE 6

Question 12

Conventional Monetary Policy Tools

Answer 12

Used to control the money supply and interest rates

1) Open market operations
2) Discount lending
3) Reserve requirements

Question 13

Open market operations

Answer 13

1) Dynamic open market operations
2) Defensive open market operations
3) Primary dealers
4) TRAPS (Trading Room Automated Processing System)
5) Repurchase agreements
6) Matched sale-purchase agreements

Question 14

Discount lending

Answer 14

1) Discount window
2) Primary credit: standing lending facility
- Lombard facility
3) Secondary credit
4) Seasonal credit
5) Lender of last resort to prevent financial panics
- Creates moral hazard problem

Question 15

Reserve requirements

Answer 15

1) Depository Institutions Deregulation and Monetary Control Act of 1980 - same reserve requirement for all depository institutions
2) 3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million
3) The Fed can vary the 10% requirement between 8% to 14%

Question 16

Relative Advantages of the Different Monetary Policy Tools

Answer 16

-Open market operations = dominant bc flexible, precise, easily reversed, and quickly implemented
-Discount rate = less well used bc no longer binding, can cause liquidity problems, and increases uncertainty
+still valuable though bc it lets the Fed act as a lender of last resort

Question 17

Failure of conventional monetary policy tools in a financial panic

Answer 17

Cannot get the job done in a time of financial crisis bc:

1) the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse
2) the negative shock to the economy can lead to the zero-lower-bound problem

Question 18

Nonconventional monetary policy tools during the global financial crisis see Figure 7

Answer 18

1) Liquidity provision: Fed implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets
- Discount Window Expansion
- Term Auction Facility
- New Lending Programs
2) Large-scale asset purchases: During the crisis the Fed started three new asset purchase programs to lower interest rates for particular types of credit:
- Government Sponsored Entities Purchase Program
- QE2
- QE3

Question 19

Monetary Policy Tools of the European Central Bank

Answer 19

1) Open market operations
-Main refinancing operations
+Weekly reverse transactions
-Longer-term refinancing operations
2) Lending to banks
-Marginal lending facility/marginal lending rate
-Deposit facility
3) Reserve requirements
-2% of the total amount of checking deposits and other short-term deposits
-Pays interest on those deposits so cost of complying is low