Tools Of Monetary Policy

Question 1

Recall: 3 conventional MP tools of FED

Answer 1

Open market operations
Discount lending
Reserve requirements

To manipulate money supply and interest rate

Question 2

Open market operations - 2 types

Answer 2

Dynamic - conducted to change reserves and monetary base

Defensive - conducted to offset movements in other factors which affect reserves and the base (e.g treasury deposits - moving deposits to the Fed reduces reserves, floats-delay between cheque being cleared increases money in circulation!)

Question 3

Who buys and sells OMO and where

Answer 3

Primary dealers via trading room automatic processing system (TRAPS)

Question 4

2 types of defensive open market operations

Answer 4

Repurchase agreements

Matched sale-purchase agreements

Question 5

2nd conventional tools: Discount lending policy

What is a discount window

Answer 5

Where banks can borrow reserves from the Fed

Question 6

3 types of discount loans

Answer 6

Primary credit

Secondary credit

Seasonal credit

Question 7

Primary credit

Answer 7

Standing lending facility - banks borrow at short maturities at a discount rate higher than federal funds to encourage banks to borrow amongst each other.

Question 8

Secondary credit - who for and what rate is set

Answer 8

For banks in financial trouble/severe liquidity issues.

Interest rate is higher than discount rate as a penalty. (Like a premium)

Question 9

Seasonal credit - who for and what rate is set?

Answer 9

Small banks in vacation and agricultural areas with seasonal deposit patterns

Rate is tied to the average federal funds rate (rarely used)

Question 10

Lender of last resort

Answer 10

Fed provide reserves at last resort to avoid financial panics

Question 11

Problem with lender of last resort

Answer 11

Moral hazard - banks behaviour changes since know will get bailed out by Fed - take on greater risks!

Question 12

Example of discount policy preventing a financial panic

Answer 12

1987 - Chairman of board of governors (BoG role is to regulate and supervise members!) announced Feds readiness to serve as a source of liquidity, and provide discount loans.

So financial panic was averted following the announcement

Question 13

3rd conventional : Reserve requirements

Answer 13

10% requirement on checkable deposits over $115.1M

Fed can vary this between 8-14%

Question 14

Unconventional one: interest on excess reserves WHY?

Answer 14

Interest on excess reserves reduces incentive to lend. (Remember money supply negatively related to ER! If ER high, MS low, so interest is high thus incentivised to keep keep at the Fed, thus increasing the federal funds rate which continually increased the opportunity cost of lending reserves.

Question 15

Pros of OMO

Answer 15

Complete control over volume of transactions

Flexible and precise (change in base is = to the OMO size)

Easily reversed

Question 16

Key pro, and 4 cons of discount policy

Answer 16

Allows Fed to act as lender of last resort. (As seen in 1987 announcement to avoid financial panic! Eval: moral hazard!)

No longer binding for most banks

Can cause liquidity problems

Increases uncertainty for banks

Moral hazard

Question 17

2 reasons why conventional monetary policy is not sufficient in a full-scale crisis

Answer 17

Financial system seizes up so becomes unable to allocate capital to productive uses, so investment spending and the economy collapse

Negative shock can lead to the zero lower bound problem

Question 18

Hence recall unconventional tools: (3)

Answer 18

Emergency liquidity assistance (ELA)

QE

Negative interest rates

Question 19

3 QE programs of the Fed and their aim

Answer 19

Government sponsored entities purchase program
QE2
QE3

Aim to lower interest rates for particular types of credit

Question 20

Quantitative easing vs credit easing

How did the Fed view QE - a success?

Answer 20

QE increased monetary base, but not money supply because it became excess reserves

Feds believe intervention was a success since their aim was to ease credit, not to expand the money supply and balance sheet.

Question 21

Negative interest rates

Answer 21

Encourages commercial banks to lend out the deposits they keep at the central bank (charged for keeping money there!) , to stimulate and boost economy

Question 22

Why are there doubts over negative interest rates

Answer 22

Rather than lend out to households/businesses , may just keep in cash.

Can be costly if banks still have to pay positive interest to their savers, so may actually reduce their lending, (so more contractionary!)

Question 23

Now tools of ECB (3)

Answer 23

OMO

Lending to banks (by the NCBs to their domestic commercial banks, Fed do it via their 12 banks)

Reserve requirements - 2% of checkable deposits

So similar to Fed