Appendix_1B - Confirming Pages Appendix 1B Monetary Policy...

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Appendix 1B MONETARY POLICY TOOLS In the body of this chapter, we referred briefly to tools or instruments that the Federal Reserve uses to implement its monetary policy. These included open mar- ket operations, the discount rate, and reserve requirements. Regardless of the tool the Federal Reserve uses to implement monetary policy, the major link by which monetary policy impacts the macroeconomy occurs through the Federal Reserve influencing the market for bank reserves (required and excess reserves held as depository institution reserves balances in accounts at Federal Reserve Banks plus vault cash on hand of commercial banks). Specifically, the Federal Reserve's mon- etary policy seeks to influence either the demand for, or supply of, excess reserves at depository institutions and in turn the money supply and the level of interest rates. Specifically, a change in excess reserves resulting from the implementation of monetary policy triggers a sequence of events that affect such economic factors as short-term interest rates, long-term interest rates, foreign exchange rates, the amount of money and credit in the economy, and ultimately the levels of employ- ment, output, and prices. Depository institutions trade excess reserves held at their local Federal Reserve Banks among themselves. Banks with excess reserves—whose reserves exceed their required reserves—have an incentive to lend these funds (gener- ally overnight) to banks in need of reserves since excess reserves held in the vault or on deposit at the Federal Reserve earn no interest. The rate of interest (or price) on these interbank transactions is a benchmark interest rate, called the federal funds rate or fed funds rate, which is used in the United States to guide monetary policy. The fed funds rate is a function of the supply and demand for federal funds among banks and the effects of the Fed's trading through the FOMC. In implementing monetary policy, the Federal Reserve can take one of two basic approaches to affect the market for bank excess reserves: (1) it can target the quan- tity of reserves in the market based on the FOMC's objectives for the growth in the monetary base (the sum of currency in circulation and reserves) and, in turn, the money supply (see below), or (2) it can target the interest rate on those reserves (the fed funds rate). The actual approach used by the Federal Reserve has var- ied according to considerations such as the need to combat inflation or the desire to encourage sustainable economic growth (we discuss the various approaches below). Since 1993, the FOMC has implemented monetary policy mainly by tar- geting interest rates (mainly using the fed funds rate as a target). Indeed, to reduce the effects of an economic slowdown in the United States, the Fed decreased the fed funds rate 11 times in 2001. To combat the effects of the financial crisis, in December 2008, the Fed decreased the fed funds rate to a range between 0.00 and 0.25 percent. Even into June 2010 the FOMC took the unusual step of foreshadow- ing its future policy course by announcing that the historically low interest rates could be maintained for a considerable period.
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This note was uploaded on 03/01/2012 for the course FINS 3630 taught by Professor Yip during the Three '09 term at University of New South Wales.

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Appendix_1B - Confirming Pages Appendix 1B Monetary Policy...

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