Topic 6 Flashcards
4 conventional monetary policy tools and brief descriptions?
1) target interest rate: the rate one FI lends to another in an overnight sale of balances (decided by CB)
2) discount rate: rate at which banks borrow off CB
3) deposit rate: rate of interest which FIs pay deposit account holders
4) reserve requirements
What is the target federal fund rate and how is it determined?
The rate at which US banks lend reserves to each other overnight - a target is set by the FOMC but it is determined by market forces (the prevailing rate is called the MARKET FEDERAL FUNDS RATE)
FED: why do banks need to lend to each other?
- banks have target reserves they must meet by the end of each day
- without the reserves market, banks would have to hold substantial quantity of excess resources as insurance for shortfalls
- tf bilateral transaction agreements are needed between banks
FED: why must the borrowing bank be considered creditworthy?
Because the loans are unsecured
FED: learn diagram showing marker for reserves?
Now
Explain the shape of the reserve supply curve?
Vertical portion: banks have target amount of reserves, beyond this they won’t lend regardless of the rate tf supply is fixed
Horizontal portion: at the discount rate the CB steps in and will lend to banks; essentially they will lend an ‘unlimited’ amount at this level tf horizontal supply
Explain the shape of the fed reserve demand curve?
Downward sloping: at high rates, less quantity of reserves are demanded and vice versa
Flat: below the deposit rate no quantity of reserves are demanded because banks won’t borrow if it means ???
How do the CB keep the target rate?
They buy issued securities back/issue more securities, this changes the supply of reserves tf shifting the supply curve to meet the target rate
3 things a CB can control by controlling the quantity of loans made?
Size of reserves
Size of monetary base
Interest rates
When is discount lending large?
Only during crisis periods
What do the fed use discount lending for?
Ensuring short term financial stability
Eliminating bank panics
Preventing collapse of institutions experiencing financial difficulties
What is the role of the federal reserve board?
They set the minimum levels of reserves banks must hold (since 1935)
What was the initial reason for reserves?
To assure depositors they could withdraw currency on demand
What are the main 2 functions of reserve requirements today?
Stabilise the demand for reserves
To help Fed to keep federal funds rate close to target
ECB: what four things are in the ECB’s monetary policy toolbox?
Overnight interbank rate
Rate at which CB lends to commercial banks
Reserve deposit rate
Reserve requirement
How does the ECB avoid buying securities outright?
Repurchase agreements
Explain how the ECB repo works?
A weekly auction of 2 week repurchase agreements in which the ECB, through other national CBs, provides reserves to banks in exchange for securities
What is the minimum interest rate?
The policy tool used by the ECB; the minimum rate refinancing auctions can use
In a financial crisis, how might the CB change repos to steady the markets?
They might make them long term refinancing operations
Explain what the ECBs marginal lending facility is?
It provides overnight loans to banks if they face a reserve deficiency that they can’t satisfy more cheaply in the market place
Marginal lending rate»_space; target refinancing rate
What is the ECBs deposit facility?
The rate the ECB will pay banks for their excess reserves
Deposit facility rate much less than target refinancing rate
What is the function of the ECB deposit facility?
It provides a floor on the rate of interest that can be charged on reserves
Explain the ECBs reserve requirements?
Minimum level of reserves based on liabilities; ECB pays interest on required reserves
How is the rate the ECB pays on reserve requirements determined?
It is based on the monthly average interest rate from refinancing auctions
3 differences between the ECBs refinancing operations and the fed’s daily OMOs?
Operations are done at NCBs simultaneously
Hundreds of European banks participate in the ECBs weekly auctions
Accepted collateral varies between CBs due to different financial structures
3 consensus estimate among monetary policy experts regarding CB policy?
Reserve requirements not that useful as operational instrument
CB lending necessary for financial stability
Short term interest rates are a good tool stabilise short term fluctuations in prices and output
3 desirable features of a MP instrument?
- easily observable
- controllable and quickly changeable
- tightly linked to policymakers’ objectives
Define operating instruments?
Instruments the CB controls directly (eg. Interest rates, monetary base)
Define intermediate targets?
Instruments not directly controlled by CB (eg. Growth in monetary aggregates)
2 reasons to use unconventional monetary policy?
When lowering the target interest rate to zero doesn’t sufficiently stimulate the economy
When an impaired financial system -> failure of interest rate policy in supporting the economy (eg. High default rates -> loans not being made)
3 types of unconventional monetary policy tools and brief explanation?
Forward guidance: CB communicates intentions regarding future MP
Quantitative easing: CB supplies aggregate reserves beyond quantity required to lower policy rate to zero
Targeted asset purchases: CB alters mix of assets on the balance sheet to change their relative prices in a way that stimulates economic activity
Explain how forward guidance works?
Eg. State aim to keep policy target low for long period -> increased ability of firms to plan -> increased investment -> increased growth
3 issues with forward guidance?
Needs to be credible guidance or won’t work!!!
Can be difficult to calibrate (can’t always predict future conditions tf hard to make promises)
Can have disturbing side effects
Explain how quantitative easing works?
The CB buys assets off banks -> expansion of their balance sheet -> increased reserves for banks -> increased lending
(Increases liquidity in commercial banks)
3 issues with quantitative easing?
Difficult to predict effects due to little experience; how much to spend? Will banks actually lend?
Pension funds notes
Raises inflation rate tf can’t be used if inf rate > target inf rate
Quantitative easing diagram?
Shows supply of reserves going right, check online
Explain how TAP might work?
CB buys a risky asset -> credit where there was none before
3 issues with TAP?
Harder to sell off risky assets after tf difficult to unwind
CB may not be able to get rid of them exactly when they want
Also difficult to tell exactly what will happen (risky assets -> defaulting loans etc)
How can QE and TAP exits be more effective?
CB will want to sell off assets to increase interest rate, but this can be difficult to do quickly tf CB can raise deposit rate that it pays on reserves tf increase floor of MFFR
See: exciting QE by hiking deposit rate diagram
Now
Explain why CBs pay interest on reserves?
It allows them to use two powerful policy tools independently of each other:
1) can adjust interbank loans target rate without changing size and composition of its balance sheet
2) can prevent banks from quickly selling all their assets by increasing the deposit rate on reserves
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