Week 4 Flashcards
What are conventional monetary policy tools?
-Open market operations (mainly used)
- discount lending
- reserve requirements
- paying interest on reserves
What are two types of open market operations?
-Dynamic open market operations are intended to change the level of reserves
- Defensive open market operations are intended to offset
movements in other factors that affect reserves
What are Treasury and government bills?
Liquid and capable of absorbing large volumes of transactions
What does the trading desk typically uses two types of transactions to
implement their strategy?
- Repurchase agreements: the Fed purchases securities, but agrees to sell them back within about 15 days. So, the desired effect is reversed when the Fed sells the securities back—good for taking defense strategies that will reverse.
- Matched sale-purchase transaction: essentially a reverse
repro, where the Fed sells securities, but agrees to buy them
back
What are Advantages of Open market operations?
- Fed has complete control (i.e. volume)
- In case of discount loans, banks determine how much to
borrow from the fed - Flexible and precise (both small and large change in interest
rates) - Easily reversed (through the opposite operation)
- Implemented quickly (no admin delays)
What are discount loans?
- Discount Policy and the Lender of Last Resort
- The facility at which banks can borrow reserves from the
Federal Reserve is called the discount window - The Fed’s discount loans, through the discount window, are of three types:
1. Primary Credit
2. Secondary Credit
3. Seasonal Credit
Primary Credit?
- Primary Credit discount loans:
- Healthy banks borrow as they wish from the primary credit
facility or standing lending facility - At very short maturity (usually overnight) at the discount rate
- Usually small amount
- a backup source of liquidity for sound banks so that the federal
funds rate never rises too far above the federal funds target set by the FOMC - Impose ceiling on the federal funds rate if there is an
unexpected large demand for reserves
Secondary credit discount loans?
-Given to banks that are in financial trouble and are
experiencing severe liquidity problems
- Interest charged is higher than the discount rate to reflect the
condition of the borrower
Seasonal credit discount loans?
- Designed for small, regional banks (i.e. in vacation or
agricultural areas) that have seasonal patterns of deposits - The interest rate charged is usually the average federal funds
rate - The fed is contemplating to discontinue this as the credit market improves
What is a lender of last resort?
In addition to its use as a tool to influence reserves and
interest rates, the Fed also act as Lender of last resort through the discount policy:
- To prevent banking panics
- To provide reserves to banks when no one else would
- Most effective way to during a banking crisis
- This created a moral hazard problem
- Deposit insurance agency (Financial Services Compensation
Scheme in the UK): up to 85,000 pounds per account in the
UK
What are Reserve requirements?
-Reserve Requirements are requirements put on financial institutions to hold liquid (vault) cash again checkable
deposits.
-Rarely used as a tool
- Raising causes liquidity problems for banks
- Makes liquidity management unnecessarily difficult
- The Fed usually softened the blow by conducting open market purchases or by making the discount loan window more available, thereby providing reserves to banks that needed them.
How does interest on reserves help?
Interest on reserves comes to the rescue, as raising the
interest on reserves can help raise the federal funds rate
What is a zero-lower-bound problem?
- Occurs when the interest rate is almost zero, while the
economy is still underperforming, and people are unwilling to
invest on higher-yielding investments and spend less on
products - The problems called for the use of non-conventional tools.
What are liquidity provisions?
- Discount window expansion
- Term auction facility
- New lending programs
What is discount window expansion?
Discount window expansion: discount rate lowered several
times from 2007-2008; since borrowing from the discount
window has a ’stigma’ because it suggests that the borrowing
bank may be desperate for funds and thus in trouble, its use was limited during the crisis
What is Term auction facility?
another loan facility, offering loans loans at a rate determined through competitive auctions. This rate is lower than the discount rate
What is new lending programs?
included lending to Investment Banks, and lending to promote purchase of asset-backed securities.
What is quantitative easing?
QE involves us buying bonds to push up their prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services.
What is Criticism of QE?
-the federal funds rate had already fallen to zero, the expansion of the balance sheet and the monetary base could not lower short-term interest rates any further and thereby stimulate the economy
- The increased reserves did not result in increase in lending
as banks just added to their holdings of excess reserves
Is QE ineffective?
-The fed targets particular segments of the credit market in
order to improve the liquidity of particular market, enable it to
allocate capital to productive uses and consequently stimulate the economy.
- Helps lower the interest rate in that market for borrowers, and
thereby encouraging spending
What is forward guidance?
- By committing to maintain short-term rates near zero, future short-term rates should also be zero, meaning long-term rates fall.
- It is a tool to manage people’s expectations about future
interest rate
What is Negative interest rates?
- A negative interest rate is when a central bank sets interest rates below zero percent. This policy is used to stimulate economic growth and is usually only considered in extreme circumstances.
- Supposed to encourage banks to lend deposits they hold at
the central bank, thereby encouraging households and
businesses to spend more - However, Banks could just hold cash instead of depositing
money with the central bank. But the costs of that (vaults,
guards, security systems) is high. - Lower profitability might lead to banks to lend less.
