chapter 9 - Tools of monetary policy

chapter 9 - Tools of monetary policy - Chapter 9 Tools of...

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Chapter 9 Tools of Monetary Policy In recent years, the Federal Reserve has increased its focus on the federal funds rate (the interest rate on overnight loans of reserves from one bank to another) as the primary indicator of the stance of monetary policy. To fully understand how the Fed’s tools are used in the conduct of monetary policy, we must understand not only their effect on the money supply, but their direct effects on the federal funds rate as well. This chapter we explain how the Fed’s settings for the three tools of monetary policy determine the federal funds rate. A. The Market for Reserves and the Federal Funds Rate The market for reserves is where the federal funds rate is determined, and this is why we turn to a supply-and-demand analysis of this market to analyze how all three tools of monetary policy affect the federal funds rate. Demand Curve The amount of reserves can be split up into two components: (1) required reserved, and (2) excess reserves. Excess reserves are insurance against deposit outflows, and the cost of holding threes excess reserves is their opportunity cost, the interest rate that could be earned on lending these 9-1
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reserves out, which is equivalent to the federal funds rate. Thus as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and, holding everything else constant, including the quantity of required reserves, the quantity of reserves demanded rises. Consequently, the demand curve for reserves, d R , slopes downward in Figure 1. Supply Curve The supply of reserves, s R , can be broken up into two components: the amount of reserves that are supplied by the Fed’s open market operation, called non-borrowed reserves ( NBR ), and the amount of reserves borrowed from the Fed, called discount loans ( DL ). The primary cost of borrowing discount loans from the Fed is the interest rate the Fed charges on these loans, the discount rate ( d i ). Because borrowing federal funds is a substitute for taking out discount loans from the Fed, if the federal funds rate ff i is below the discount rate d i , then banks will not borrow from the Fed and discount loans will be zero because borrowing in the federal funds market is cheaper. Thus, as long as ff i remains below d i , the supply of reserves will just equal the amount of non-borrowed reserves supplied by the Fed, NBR , and so the supply curve will be vertical as shown in Figure 1. Market Equilibrium Market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied, d R = s R . Equilibrium therefore occurs at the intersection of the demand curve d R and the supply curve s R at point 1, with an equilibrium federal funds rate of * ff i . In the following three sections, we could examine how changes in the three
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chapter 9 - Tools of monetary policy - Chapter 9 Tools of...

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