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Money and Banking > Week 6 Deck > Flashcards

Week 6 Deck Flashcards

1
Q

Explain how the indirect tools of monetary policy influence the behavior of financial institutions by:

A

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 affects interest rates, quantity of money and banking system

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2
Q

What are the conventional monetary policy tools (4)

A
  • Open market operations (OMOs)
  • Discount window or standing facilities
  • Reserve requirements
  • Interest paid on reserves* - since 2008
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3
Q

What are the non conventional monetary policy tools: (5)

A
  • Liquidity provision
    - Large-scale asset purchases (LSAP)
    - Forward guidance
    - Negative interest
    - rate on bank’s deposits
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4
Q

Explain the market for reserves

A
  • Market for reserves affect the policy interest rate

* Objective is to achieve an interest rate that is close to the target

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5
Q

Who are the three players who can influence money supply:

A
  • The central bank
  • Banks: depositary institutions: financial intermediaries
  • Depositors: individuals and institutions
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6
Q

What are the assets and liabilities on a fed’s balance sheet

A

• Assets
- Government securities: holdings by the Fed that affect money supply and earn interest
- Discount loans: provide reserve to banks and earn the discount rate
• Liabilities
- Currency in circulation: in the hands of the public
- Reserves: bank deposits at the fed and vault cash

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7
Q

Equation for monetary base (MB)

A

The sum of the two liabilities on the Fed’s balance sheet is called the monetary base (MB) or high powered money

MB = C + R

C = currency in circulation
R = total reserves in the banking system

The CB affects the MB by conducting an open market purchase or sale which affect C or R

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8
Q

3 other factors that affect the monetary base (MB)

A
  • Float
  • Treasury deposits at the federal reserve
  • Interventions in the foreign exchange market
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9
Q

Although the OMOs are controlled by the Fed, it cannot determine the amount of borrowing by banks from it

Therefore, the monetary base is split into two components:

NBR = ?

A

NBR = MB - BR

Where:
NBR = nonborrowed monetary  base BR = borrowed reserves from fed
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10
Q

What is the link between money supply (M) and the MB (equation)

A

M = m x MB

Where: m is money multiplier

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11
Q

What is the link between money supply (M) and the MB (equation)

A

M = m x MB

Where: m is money multiplier

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12
Q

What are the three different interest rates in the market for reserves

A
  1. Discount rate, denoted as id, interest rate charged by the Fed on discount loans
  2. Federal funds rate (Fed rate), denoted as iff, interest rate on over night loans of reserves from one bank to another
  3. Interest rate earned on reserves, denoted as ior, interest rate on excess reserves
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13
Q

what is quantity of reserves demanded

A

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

  • Required reserves is the amount 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, I or there opportunity cost

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14
Q

Supply in the market for reserves

Explain and use diagram

A

diagram - see notes

• Recall that the supply consists of two components:

1. Nonborrowed reserves (NBR)
2. Borrowed reserves (BR)
  • Cost of borrowing from the Fed is the discount rate
  • Borrowing from the Fed is a substitute for borrowing from other banks
  • 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 relend at iff

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15
Q

How changes in MP tools affects the federal funds rate

What are 4 possible MP tools?

A

Any change in reserve market will change the federal funds rate

  • An open market operation (purchase or sale)
  • Change in discount rate
  • Change in reserve requirements
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16
Q

Explain an open market operation and use a diagram

A

Effects of open 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 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
17
Q

Draw the diagram for a change in the discount rate

A

draw the diagram for Change in reserve requirements

18
Q

draw the diagram for a change in interest on reserves

A

see notes

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

	- If initially iff > ior, an increase in ior to ior2, causes horizontal part of the demand curve to rise Rd2
	- 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
19
Q

What are the three conventional mp tools

A

• To control the money supply and interest rates during normal times, central bank uses three tools of monetary policy:

	1. Open market operations
	2. Discount lending 3. Reserve requirements
20
Q

What are the three conventional mp tools

A

• To control the money supply and interest rates during normal times, central bank uses three tools of monetary policy:

	1. Open market operations
	2. Discount lending 3. Reserve requirements
21
Q

Explain open market operations and draw diagram

A
  • CBs use debt securities mainly treasury securities (short-term government debt) in open market operations
    • Most important and common tool by which CBs can influence the amount of money and interest rate in the economy
    • Principle of OMOs are the same in all countries
    - CBs operates in the market and purchases or sells government debt to the non-bank private sector or bank sector

diagram - see notes

22
Q

What are the advantages of using OMOs to influence short-term interest rates

A
  • 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
23
Q

Detail the Fed’s open market operations

A

• Primary determinant of interest rates and MB
• Two categories of OMOs
1. Dynamic open market operations: changes level of reserves and MB
2. Defensive open market operations: offset movement in other factors that affect reserves and 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)
24
Q

Detail the open market operations of the ECB

A

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

25
Q

Detail the open market operations of the BoE

A

• 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
- Short 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
26
Q

Explain the discount policy and the lender of last resort

A
  • Discount window: second most important MP tool
  • Discount window allows eligible banking institutions to borrow money from a CB usually to meet short term liquidity needs
  • For a discount window:

the higher the discount rate, the lower the amount of funds that banks will decide to borrow —> Discount window —> The lower the discount rate, the higher the amount of funds that banks will decide to borrow

27
Q

Explain the Feds discount policy

A

• The fed offers 3 types of discount loans:

- Primary credit: standing lending facility (interest rate is discount rate)
		- Fed sets discount rate above funds rate target

	- Secondary credit: banks in financial trouble
	- Seasonal credit: given to banks with seasonal patterns of deposits

• Lender of last resort to prevent financial panics
- Discounting loans in preventing financial panics

28
Q

Explain the ECB’s Discount policy and the lender of last resort

A

• Lending to banks or standing facilities carried out by national centre banks
• Marginal lending facilities
- Provision of liquidity using reverse transactions (against collateral)
- Maturity is overnight
- Interest rate is the marginal lending rate set 100 basis points above the target financing rate

29
Q

Explain the BoE’s Discount policy and the lender of last resort

A 
• Operational standing facilities
	• Two facilities:
		- Uses overnight repo transactions
			§ Against a highly liquid collateral
			§ Interest rate 1% above bank rate

Standing deposit facility - unsecured deposits with interest below bank rate

30
Q

What are reserve requirements?

A
  • Reserve requirements is an instrument of portfolio constraint
  • Reserve requirements at central banks differ depending on terms and liquidity of deposits
31
Q

What are the advantages of reserves requirements:

A
  • Affects all banks equally

- Can have a strong influence in money supply

32
Q

What are the disadvantages of reserves requirements?

A
  • 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

33
Q

Are reserve requirements used these days?

A

• Reserve requirements are rarely used nowadays compared to other 2 intervention MP tools
Eliminated as a MP tool in Switzerland, NZ and Australia

34
Q

Explain the Fed, ECB and BoEs reserve requirements

A

Fed

• Depositary institutions Deregulation and Monetary control act of 1980 sets the reserve requirement the same for all depository institutions

ECB

• Reserve requirements:

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

BoE

• BoE follows Prudential Regulation Committee (PRC) and sterling Monetary framework (SMF) in setting reserve requirements BoE do not actively use reserve requirement as a monetary policy tool
35
Q

Explain the Fed, ECB and BoEs interest on excess reserves

A

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

ECB
• Deposit facility
- Absorption of liquidity using deposits
- Maturity is overnight
- Interest rate paid on reserves set 100 basis points below target financing rate

BoE
• 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

36
Q

What is the main problem with conventional monetary policy tools:

A
  • When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job
  • This is due to 2 reasons:
  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
37
Q

What are c

A

Money and Banking (10 decks)

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