Monetary Policy

Question 1

Monetary policy overview

Answer 1

• MP tools have effects on both money supply and the policy interest rate, and economic activity.
• » Policy interest rate changes alter: Public expectations.
  Money market rates (interbank).
• » Objective of CBs using MP tools is to achieve an interest rate that will help them meet their goals or objectives.

Question 2

MP tools overview

Answer 2

Following financial deregulation and liberalisation CBs moved away from direct monetary controls to indirect ones.
Indirect tools of monetary policy influence the behaviour of financial institutions by:
» First affecting the central bank’s own balance sheet - price and volume of reserves.
» Reserves in turn affect interest rates, quantity of money and credit in the banking system.

Question 3

Conventional MP tools

Answer 3

Open market operations (OMOs).
Discount window or standing facilities.
Reserve requirements.
Interest paid on reserves* - since 2008.

Question 4

Unconventional MP tools

Answer 4

Liquidity provision.
Large-scale asset purchases (LSAP).
Forward guidance.
Negative interest rates on banks’ deposits.

Question 5

Market for reserves

Answer 5

Market for reserves affect the policy interest rate.
Objective is to achieve an interest rate that is close to the target.

Question 6

Fed’s balance sheet: assets

Answer 6

Government securities are holdings by the FED that affect money supply and earn interest

Discount loans provide reserves to banks and earn the discount rate

Question 7

Fed’s balance sheet: liabilities

Answer 7

Currency in circulation: in the hands of the public

Reserves: bank deposits at the Fed and vault cash

Question 8

Monetary base (MB)

Answer 8

the sum of the two liabilities on the Fed’s balance sheet

MB = currency in circulation + total reserves in the banking system

CB affects the monetary base by conducting an open market purchase which can affect either C or R

Question 9

Effect of an open market purchase

Answer 9

reserves increase by purchase amount, currency doesn’t change, so MB increases by purchase amount

An open market sale would do the opposite and reduce the monetary base - in this case reserves would remain the same if it is bought by the public using currency

Question 10

other factors affecting the MB

Answer 10

• float
• treasury deposits at the Federal reserve
• Interventions in the forex market

Question 11

Non-borrowed Monetary base (NBR)

Answer 11

even though open market operations are controlled by the FED, it cant determine the amount of borrowing from it

therefore,

NBR = MB - BR (borrowed reserves from the Fed)

Question 12

Link between money supply (M) and the MB

Answer 12

define money as currency + checkable deposits (M1 in the US)

M = m x MB

m is the money multiplier

therefore, Money supply is positively correlated with both the NBR and BR of the FED

Question 13

Discount rate

Answer 13

denoted as id

interest rate charged by the Fed on discount loans

Cost of borrowing from the Fed is the discount rate. Borrowing from the Fed is a substitute for borrowing from other banks.
The primary cost of borrowing from the Fed is the interest rate charged by the Fed on these loans—the discount rate, id, which is set at a fixed amount above the federal funds target rate and thus changes when the target changes.

Question 14

Federal funds rate

Answer 14

denoted as iff

Interest rate on over night loans of reserves from one bank to another

Because borrowing federal funds from other banks is a substitute for borrowing (taking out discount loans) from the Fed,

if the federal funds rate iff is below the discount rate id, then banks will not borrow from the Fed. Borrowed reserves will be zero because borrowing in the federal funds market is cheaper.

Question 15

Interest rate earned on reserves

Answer 15

denoted as ior

interest rate on excess reserves

Required reserves is the number of deposits that banks must hold in reserve.
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 - their opportunity cost.

Question 16

Demand for reserves

Answer 16

the market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the level of the federal funds rate, the interest rate charged on the loans of these reserves.

holding everything else constant, as the federal funds rate changes?

Quantity of reserves demanded = required reserves (RR) + excess reserves (ER)

Question 17

Relationship between FFR and interest rate on excess reserves

Answer 17

Since 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 18

Relationship between FFR and discount rate

Answer 18

If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero.
The supply curve will be vertical.
As iff rises above id, banks will borrow more and more at id, and re-lend at iff.
The supply curve is horizontal at id.

Question 19

How MP tools affect the FFR

Answer 19

» An open market operation (purchase or sale).
» Change in discount rate.
» Change in reserve requirements.
» Change in interest on reserves.

Question 20

Open market operations on FFR

Answer 20

Effects of open a market operation depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section.
When intersection occurs at the downward sloped section:
» An open market purchase causes the federal funds rate to fall. an open market purchase leads to a greater quantity of reserves supplied; this is true at any given federal funds rate because of the higher amount of nonborrowed reserves
» An open market sale causes the federal funds rate to rise.
When intersection occurs at the flat section of the demand curve:
» Open market operations have no effect on the federal funds rate

Question 21

Change in discount rate

Answer 21

If the intersection of supply and demand occurs on the vertical section of the supply curve:
» a change in the discount rate will have no effect on the federal funds rate.
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.
» the federal funds rate may either rise or fall depending on the change in the discount rate.

Since the Fed now usually keeps the discount rate above its target
for the federal funds rate—the conclusion is that most changes in the discount rate
have no effect on the federal funds rate.

Question 22

Change in reserve requirements

Answer 22

When the required reserve ratio increases, required
reserves increase and hence the quantity of reserves demanded increases for any given interest rate. Thus, a rise in the required reserve ratio shifts the demand curve to the right from Rd1 to Rd2
in Figure 4, moves the equilibrium from point 1 to point 2, and in
turn raises the federal funds rate from i1ff to iff

The result is that when the Fed raises reserve requirements, the federal funds rate rises.
Similarly, a decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left, and causes the federal funds rate to fall.

When the Fed decreases reserve requirements, the federal funds rate falls.

Question 23

Change in interest rate on reserves

Answer 23

If supply and demand intersect in the downward-sloping section:

» If initially iff > ior, an increase in ior1 to ior2 causes horizontal part of
the demand curve to rise R2d
» Intersection remains at point 1.
» Funds rate remains unchanged.
If supply and demand intersect in the flat section:
» If initially iff = ior, an increase in ior1 to ior2 increases funds rate.
When the federal funds rate is at the interest rate paid on excess reserves, a rise in the interest rate on excess reserves raises the federal funds rate.

Question 24

Conventional monetary policy tools

Answer 24

1. open market operations.
2. discount lending.
3. reserve requirements.

Question 25

Open market operations

Answer 25

CBs use debt securities (short-term government debt usually used like treasury securities) for this

If CB sells government securities, the money supply decreases, interest rate increases

If CB buys government securities, the money supply increases, interest rate decreases

Buying Government Bonds from Bank

When the central bank buys government bonds, it increases the money supply in the economy.

Question 26

Advantages of OMOs on influencing short-term interest rates

Answer 26

• Initiated by CBs who have complete control over volume of transactions.
• Flexible and precise.
• Can be easily reversed.
• Undertaken quickly.
• Imposes no tax on the banking system.

Question 27

Open market operations - The Fed

Answer 27

Two categories of OMOs
1. Dynamic open market operations: changes level of reserves & MB.
2. Defensive open market operations: offset movement in other factors that affect reserves & MB.

• Repurchase agreements (repo).
• Matched sale purchase agreements (reverse repo).
  Fed conducts most of its OMOs in Treasury securities (T-bills) due to their high liquidity.

OMOs are directed by the FOMC and carried out by the Federal Reserve Bank of New York.

OMOs conducted electronically through primary dealers.

Computer system used is TRAPS (Trading Room Automated Processing System).

Question 28

Open market operations - ECB

Answer 28

ECB sets a target financing rate which sets a target for the overnight cash rate

Main refinancing operations are the predominant form of open market operations and are similar to the Fed’s repo transactions.
They involve weekly reverse transactions (purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral) that are reversed within two weeks.
Credit institutions submit bids, and the European Central Bank decides which bids to accept.

Like the Federal Reserve, the European Central Bank accepts the most attractively priced bids and makes purchases or sales up to the point at which the desired amount of reserves is supplied.

The Fed conducts open market operations in one location at the Federal Reserve Bank of New York, whereas the European Central Bank decentralizes its open market operations by conducting them through the individual national central banks.

Question 29

Longer-term refinancing operations - OMO

Answer 29

are a much smaller source of liquidity for the euro-area banking system
and are like the Fed’s outright purchases or sales of securities. These operations
are carried out monthly and typically involve purchases or sales of securities with a
maturity of three months.

They are not used for signalling the monetary policy stance,
but instead, are aimed at providing euro-area banks access to longer-term funds.

Question 30

Open market operations - BoE

Answer 30

Monetary policy stance is expressed as the level of the bank rate. Two types of OMOs used to supply reserves:

• » Short term - aimed to ensure the bank rate does not diverge from interbank rate.
• » Long term - provide liquidity insurance as BoE offers to lend reserves for longer period against a broad range of collateral.

BoE uses OMOs to supply funds to bank using repo agreements.
* » Gilt repo transactions.
* » Bank purchases gilted-edge securities.

From private sector counterparties with a legally binding commitment. The securities will be repurchased by the counterparties at a pre-determined price and date.

Question 31

Discount policy and the Lender of Last Resort

Answer 31

Discount window allows eligible financial institutions to borrow from a CB to meet short-term liquidity needs

The higher the discount rate, the lower the amount of funds that a bank will decide to borrow

The LOLR
» Discounting loans in preventing financial panics.
» Creates moral hazard problem.

Question 32

The Fed’s discount loans

Answer 32

Primary credit is the discount lending that plays the most important role in monetary policy. Healthy banks are allowed to borrow all they want at very short maturities (usually overnight) from the primary credit facility, and it is therefore referred to as a standing lending facility.

Fed sets discount rate above funds rate target.
» Secondary credit: banks in financial trouble.

» Seasonal credit: given to banks with seasonal patterns of deposits.

Question 33

ECB discount policy

Answer 33

Lending to banks or standing facilities carried out by national central banks.
Marginal lending facilities.
* » Provision of liquidity using reverse transactions (against collateral).
* » Maturity is overnight.
* » Interest rate is the marginal lending rate

Question 34

BoE discount policy

Answer 34

• » Uses overnight repo transactions against a highly liquid collateral.
  interest rate currently at 0.25% above bank rate.
• » Standing deposit facility - unsecured deposits with interest rate
  currently at 0.25% below bank rate.

The discount rate is less well used since it is no longer binding for most banks:
» can cause liquidity problems.
» increases uncertainty for banks.

However, the discount window remains of tremendous value given its ability to allow central banks to act as a lender of last resort.

Question 35

Reserve requirements and their advantages

Answer 35

Reserve requirements is an instrument of portfolio constraint.

Reserve requirements at central banks differ depending on terms and liquidity of deposits.

Advantages of reserves requirements:
» Affects all banks equally.
» Can have a strong influence in money supply.

Question 36

Disadvantages of reserve requirements

Answer 36

• » Difficult for CBs to make small changes to money supply.
• » Greater required reserves ratios can cause liquidity problems for banks who have no excess reserves.
  Reserve requirements are rarely used nowadays compared to the other 2 intervention MP tools.
  » Eliminated as a MP tool in Switzerland, New Zealand and Australia.

Question 37

Fed reserve requirements

Answer 37

Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions.

Reserve requirements were in 3 tiers up to to March 2020.
» 0% for the first $16.9 million of a bank’s checkable deposits
» 3% on checkable deposits from $16.9 to $127.5 million.
» 10% on checkable deposits over $127.5 million.
The Fed can vary the 10% requirement between 8% and 14%.

During the Covid-19 crisis reserve requirements reduced to zero. » To encourage bank lending.

Question 38

ECB reserve requirements

Answer 38

» 2% of the total amount of checking deposits and other short-term
deposits.
» Pays interest on those deposits.

BoE however do not use reserve requirements as an active MP tool

Question 39

The deposit facility

Answer 39

As in the United States, Canada, Australia, and New Zealand, the Eurosystem has another standing facility, the deposit facility, in which banks are paid an interest rate on excess reserves that is typically 100 basis points below the target financing rate.

The prespecified interest rate on the deposit facility provides a floor for the overnight market interest rate, while the marginal lending rate sets a ceiling.

The interest rate on excess reserves set by the ECB is not always positive.

Question 40

Interest on excess reserves

Answer 40

The interest-on-excess-reserves tool came to the rescue during the crash as banks were accumulating huge quantities of excess because it can be used to raise the federal funds rate.

The Fed started paying interest on excess reserves only in 2008.

Question 41

Lending to banks

Answer 41

Is carried out by the national central banks, just as discount lending is performed by the individual Federal Reserve Banks. This lending takes place through a standing lending facility called the marginal lending facility.

Through these facilities, banks can borrow (against eligible collateral) overnight loans from the national central banks at the marginal lending rate, which is set at 100 basis points above the target financing rate.

The marginal lending rate provides a ceiling for the overnight market interest rate in the European Monetary Union, just as the discount rate does in the United States.

Question 42

ECB deposit facility

Answer 42

• » Absorption of liquidity using deposits.
• » Maturity is overnight.
• » Interest rate paid on reserves set 100 basis points below the target financing rate.

Question 43

BoE deposit facility

Answer 43

BoE pays interest on reserves equal to the bank rate.
This implies that overnight cash rates stay close to bank rate as there is no incentive for banks to borrow or lend to each other at rates different to bank rate.

Question 44

Nonconventional monetary policy tools
Liquidity provision - BoE

Answer 44

Increased standing facilities than ‘normal times.’
In response to the Covid-19 crisis, BoE introduced new lending programmes.

» Covid corporate financing facility (CCFF).

BoE buys short-term debt from large companies to allow them finance their short-term liabilities.
Support corporate finance markets and ease the supply of credit to all firms.

During the 2008 global financial crisis (GFC):
» Introduced discount window facility.
» Banks can borrow up to 30 days – i.e. short-term liquidity support.

Question 45

Liquidity Provision

Answer 45

During the 2008 GFC, The Fed implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets:

» Discount window expansion.
Fed lowered discount rate to 50 basis points above funds rate.

» Term auction facility
Loans made at a rate determined through competitive auctions. Allowed banks to borrow at a rate below the discount rate

» New lending programs providing funds to assist J.P Morgan purchase Bear Stearns.
Bailed out AIG
Lending to investment banks
Even lended to non-financial institutions

Question 46

Liquidity provision - Fed

Answer 46

During the Covid-19 crisis, Fed set up a number of liquidity facilities to financial markets:

» Paycheck protection program liquidity facility to help small businesses.

» Main street lending program (MSLP) a set of five facilities.
support lending to both small & mid-sized businesses and non-profit organisations.

» Term asset-backed securities loan facility
Set in March 2020 to support flow of credit to consumers and businesses.

enables issuance of asset-backed securities (ABS) backed by student loans etc.

Discount window expansion
» primary credit rate lowered by 150 basis points to 0.25 percent.
» Borrowing terms extended for up to 90 days.

Question 47

Large Scale asset purchases - NCMP

Answer 47

CB purchases of longer-term financial assets.
» Government long term bonds (QE).
» Corporate bonds.

Objective is to reduce financial frictions and reduce long-term interest rates.

CBs large-scale asset purchases (LSAP):
» gives financial markets confidence.
» injects money into the economy.
» influences bank lending and spending in the economy.
» can help CBs meet their monetary objectives.

Question 48

BoE large scale asset purchases

Answer 48

BoE LSAP programme include gilt purchases, corporate bond purchases, Term Funding Scheme (TFS).

At the onset of the Covid-19 crisis:

» Launched a new Term Funding Scheme with additional incentives for SME lending (TFSME).
» Asset purchases of £200 billion of gilt and corporate bonds. carried out at a record pace of £13.5 billion per week as shown by Figure 2.
In June 2020, a further £100 billion of gilts purchases was done by the bank.

Question 49

Purpose of LSAPs

Answer 49

• » Lower long term interest rates, consequently stimulating the economy.
• » Counteract any tightening of the monetary and financial conditions

Question 50

During the Covid-19 crisis the Fed…

Answer 50

• » Purchased U.S Treasury securities approximately $1.7 trillion between mid-March and the end of June 2020.
• » Increased its purchases of mortgage-backed securities

Question 51

During the 2007-2009 global financial crisis (GFC)

Answer 51

• » BoE adopted QE in March 2009.
• » During the crisis the BoE had a ‘bank rescue package’ that totalled £500 billion for entire banking system.
• » Of that, £200 billion was made available by banks through special liquidity scheme.
• » As of February 2017:
  gilt purchases amounted to £445 billion. corporate bond purchases stood at £7.7 billion. £42.9 billion had been drawn in the TFS.

Question 52

Fed LSAP following 2008 GFC

Answer 52

QE1
Government Sponsored Entities Purchase Program which purchased $1.2 trillion mortgage-backed securities (2008).

Large-scale purchases of U.S. Treasury securities.

Asset purchases under QE1 totalled about $1.725 trillion

Quantitative easing (QE) 2
- purchased $600 billion long term treasury securities ($75 billion per month) aimed at lowering long term interest rates (2010)

• QE 3 - $40 billion mortgage-backed plus $45 billion long term Treasuries (2012).

In 2013, hints that asset purchases might begin to slow led to the 10-year yield rising.
» The Fed’s purchases did not end however until October 2014.

To address the severe strains in funding markets that persisted in part because stigma made banks less willing to use the primary credit facility, the Federal Reserve introduced a new lending facility for banks, the Term Auction Facility (TAF), in 2007

Question 53

ECB LSAP

Answer 53

In response to the Covid-19 crisis:
» Launched the pandemic emergency purchase programme (PEPP).
Temporary asset purchase programme of private and public sector securities.
Purchases of a total of 􏰀1,350 billion up to end of June 2021.

During the 2007-2009 GFC and Eurozone crisis:
» ECB faced political and legal opposition to asset purchases.

» First large QE program occurred in January 2015.

Question 54

Quantative easing definition

Answer 54

expansion of a CB’s balance sheet increasing their monetary base
» Leading to a huge increase in the monetary base. Could make potential argument for credit easing.
» Altering the composition of CB balance sheet in order to improve functioning of segments of credit market.

Question 55

Result of Fed’s QE

Answer 55

• Huge expansion of Fed’s balance sheet didn’t lead to large increase in monetary supply as most of the increase in the monetary base just flowed into holdings of excess reserves
• Secondly, as the federal funds rate had already fallen to the effective lower bound, the expansion of the balance sheet could not lower short-term interest rates and further
• Thirdly, an increase in a banks monetary base does not mean that banks will increase lending, because they can just add to their excess reserves instead

Question 56

Credit Easing

Answer 56

the altering of the composition of the Fed’s balance sheet to improve the functioning of particular segments of the credit markets

Question 57

Results of providing liquidity to a certain part of the credit market

Answer 57

When the Fed provides liquidity to a particular segment of the credit markets that has seized up, such liquidity can help unfreeze the market and thereby enable it to allocate capital to productive uses, consequently stimulating the economy.

Second, when the Fed purchases securities, it increases the demand for those
securities and, such an action can lower the interest rates on those securities relative to rates on other securities.

Thus, even if short-term interest
rates have hit a floor of the effective lower bound, asset purchases can lower interest rates for borrowers in particular credit markets and thereby stimulate spending.

Question 58

Effect of purchases of long-term government securities

Answer 58

Purchases of long-term government securities could also lower their interest rates relative to short-term interest rates, and because long-term interest rates are likely to be more relevant to investment decisions, these asset market purchases could boost investment spending.

Question 59

Forward Guidance

Answer 59

This involves communication from monetary policymakers about their economic outlooks and policy plans (‘open mouth operations’).
Objective is to manage financial market’s expectations of future short-term interest rates.

Two types of commitment to future policy actions:
» Conditional.
» unconditional.

Question 60

BoE forward guidance

Answer 60

BoE launched forward guidance in 2013: conditional on future developments.
In August 2020 a new forward guidance.
* » Provides commitment not to tighten MP until it is appropriate.
* » The economy is on the way to recovery.
* » Reinforces current market expectations of a low bank rate for some time

Question 61

Fed forward guidance

Answer 61

By committing to the future policy action of keeping the federal funds rate at zero for an extended period:
» The Fed could lower the market’s expectations of future short-term interest rates.
» Thereby causing the long-term interest rate to fall.
Previously, the Fed’s intention was to keep the Fed funds rate low for quite some time.

Question 62

Forward guidance explained

Answer 62

By committing to the future policy action of keeping the federal funds rate at zero for an extended period, the Fed could lower the market’s expectations of future short-term interest rates, thereby causing the long-term interest rate to fall.
The commitment to keep the federal funds rate at zero for an extended period starting in 2008 was conditional because it stated that the decision was predicated on a weak economy going forward. If economic circumstances changed, the FOMC was indicating that it might abandon the commitment.

Alternatively, the Fed could have made an unconditional commitment by just stating that it would keep the federal funds rate at zero for an extended period, without indicating that this decision might change depending on the state of the economy. An unconditional commitment is stronger than a conditional commitment because it does not suggest that the commitment will be abandoned and so is likely to have a larger effect on long-term interest rates. Unfortunately, it has the disadvantage that, even if circumstances change in such a way that it would be better to abandon the commitment, the Fed may feel that it can-not go back on its word and therefore cannot abandon the commitment.

Question 63

Negative interest rates on banks’ deposits

Answer 63

Commercial banks pay CBs to keep their money with them. Setting negative interest rates on banks’ deposits:
» Meant to stimulate the economy by encouraging banks to lend out the deposits they are keeping at the CB.
» Thereby encouraging households and businesses to spend more. However, there are doubts on the intended expansionary effect of negative interest rates on deposits.

Question 64

Doubts on the intended expansionary effect of negative interest rates on deposits.

Answer 64

First, banks might not lend out their deposits at the central bank, but instead move them into cash. There would be some cost to doing so because banks would have to build more vaults and hire security guards to protect the cash. Nonetheless, they still might prefer to do this rather than lend them out.

Second, charging banks interest on their deposits might be very costly to banks if they still have to pay positive interest rates to their depositors. In this case, bank profitability would fall. The result might then make banks less likely to lend. So instead of being expansionary, negative interest rates on banks’ deposits could cause banks to cut back on lending and therefore be contractionary.

Question 65

Monetary policy at the zero lower bound

Answer 65

• » In ‘normal times, CBs can attempt to reduce the real interest rate by lowering the policy rate.
• » But the policy rate, is stated in nominal terms, and therefore cannot fall below zero.
• » The zero floor on the policy rate is referred to as the zero lower bound (ZLB).
• » At the ZLB it is important to understand how nonconventional policies can be effective in stabilising the economy.

» In turning the ZLB into an effective lower bound well below zero. » in supporting bank lending.
» stimulating the economy and raising inflation.

Question 66

MP curve - demand side curve 1

Answer 66

Shows the relationship between the real interest rate set by the central bank and the inflation rate.

Question 67

IS curve

Answer 67

Shows the relationship between aggregate output and the real interest rates when the goods market is in equilibrium.

Question 68

AD curve

Answer 68

Shows the relationship between the inflation rate and the quantity of aggregate output when the goods market is in equilibrium. The AD curve is derived from the MP and IS curves.
When there is no ZLB, the curves are as shown in Figure 9.

Question 69

Demand side curves

Answer 69