Chapter+15+Tools+of+Monetary+Policy

Chapter+15+Tools+of+Monetary+Policy - Chapter 15 Tools of...

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Chapter 15 Tools of Monetary Policy - A Model: The Market for Reserves and the Federal Funds Rate -How changes in the three tools of monetary policy affect the Federal Funds Rate? - Open Market Operations: Adv and Disavd - Discount Policy: Adv and Disavd - Reserve Requirements: Adv and Disavd - Applications - Using Discount Policy to prevent a financial panic - Why Have Reserve Requirements Been Declining Worldwide? - The Channel/Corridor System for Setting Interest Rates in Other Countries Motivation : 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. Since February 1994, the Fed announces a federal funds rate target at each FOMC meeting, an announcement that is watched closely by market participants because it affects interest rates throughout the economy. A Model: The Market for Reserves and the Federal Funds Rate 1. From the demand side: Total Reserves = Required Reserves + Excess Reserves 2. From the supply side: Total Reserves = Nonborrowed reserves(NBR) + Borrowed reserves(BR) This Market for Reserves determines: Federal Funds rate (relative price) and Reservess (quantity) Demand in the Market for Reserves Excess reserves are insurance against deposit outflows The cost of holding these is the interest rate that could have been earned As the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises Downward sloping demand curve 1
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Supply in the Market for Reserves Cost of borrowing from the Fed is the discount rate The supply curve is horizontal (perfectly elastic) at i d Equilibrium in the market for reserves The Fed now keeps the discount rate i d substantially above the target for the fed funds rate. How changes in the three tools of monetary policy affect the Federal Funds Rate? Open market purchase 2
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Discount Lending a. No discount lending =>i d falls, i ff , NBR does not change, BR does not change. b. Some discount lending i d = i ff falls, BR increases. Reserve Requirement(reserve ratio) 3
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When Fed increases reserve ratio => required reserves increase which increases the demand for reserves. => demand curve shifts right. So i ff increases. Advantages of Open Market Operations -The Fed has complete control over the volume -Flexible and precise -Easily reversed -Quickly implemented Discount Policy Discount window: The Federal Reserve facility at which discount loans are made to banks The Fed’s discount loans to banks are of three types: primary credit, secondary credit, and seasonal credit 1. Primary credit— is the discount lending that plays the most important role in monetary policy. Healthy banks are allowed to borrow all they want from the primary credit facility, and it is therefore referred to as a standing lending facility. The interest rate on these loans is the discount rate, and as we mentioned before,
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Chapter+15+Tools+of+Monetary+Policy - Chapter 15 Tools of...

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