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Chapter 18

The Tools Of Federal Reserve Policy

©Thomson/South-Western 2006 2

The Federal Reserve Goals and Tools

Goals (Ultimate Objectives)1. influence greater output2. lower the unemployment rate 3. prices level stability

Intermediate target variables

1. short-term interest rates

2. monetary aggregates (M1, M2, M3)

Tools

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The Federal Reserve Goals and Tools

Tools (Instruments) of monetary policy

1. open market operations

2. discount window policy

3. reserve requirement policy

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Open Market Operations

Open market operations

Buying and selling of securities in the open market

The Fed is empowered to buy or sell

U.S. Treasury securities

federal agency securities

banker's acceptances

other securities

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Open Market Operations

Fed’s decision to buy or sell securities

To influence • Short-term interest rates• Bank reserves• Monetary Base (B)• Monetary Aggregates (M)

To earn interest income

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Domain of the Fed's Open Market Activity

Federal Reserve's open market operations could be carried out in any asset.

To avoid favoritism, politics, and unintentional signals, the Fed only buys U.S. government and agency securities and banker's acceptances.

When the Fed buys Treasury bonds and bills from public,reserves and the monetary base expand dollar-for-dollar, and

the money supply is directly increased

When the Fed buys $400 million in Treasury bonds and bills from banks,

reserves and the monetary base expand dollar-for-dollar, but

the money supply is not directly or immediately affected.

This happens when banks initiate the multiple deposit-expansion process by making loans and buying securities.

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The Effectiveness Of Open Market Operations

1. Impact on Monetary Variables

• Bank Reserves

• Monetary Base

• Monetary Aggregates

2. Impact on

• Security Prices

• Interest Rates (Yields)

Fed buys securities

Prices ↑ � Yields ↓Spill over to other markets

Bank lending rates ↓

Borrowing, Spending ↑

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Advantages of Open Market Operations

Precision:

firm and accurate control over aggregate bank reserves and the monetary base

Flexibility:

in the market each day, buying & selling large quantities of securities

very easy for the Fed to alter course, reverse the policy

Source of Initiative:

The Fed is able to dominate aggregate bank reserves & the monetary base.

Depends solely on the Fed.

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Early Disadvantages of Open Market Operations

Signaling:

Changes in the discount rate and reserve requirements

are superior to open market operations in signaling policy

changes to the public.

Regional Bias:

Prior to well-developed financial markets, a regional bias

operated in open market operations, because the effects

were concentrated in select urban areas where security

dealers were located; open market operations did not

disperse across the nation.

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Open Market Operations & the Federal Funds Rate

The effects of the Fed's open market operations transmit

very quickly throughout the nation through the federal funds

market

Banks with excess reserves = Supply federal funds

Banks with deficit reserves = Demand federal funds

Federal funds rate

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Open Market Operations & the Federal Funds Rate

The supply of reserves is determined by Federal

Reserve policy.

When the Fed purchases securities, bank reserves ↑

dollar-for-dollar.

When the Fed sells securities, bank reserves ↓

dollar-for-dollar.

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Figure 18-1

Demand

S1

Reserves

Federa

l Funds Rate

4.0

Fed buys Securities � Banks Reserves

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Technical Aspects Of Open Market Operations

Defensive Operations versus Dynamic Operations

Defensive open market operations

open market operations made for the purpose of

"defending" bank reserves & the monetary base against

the influence of outside forces

Dynamic open market operations

open market operations made to deliberately change the

course of economic activity

To achieve goals (control unemployment, inflation, other

economic variables)

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Outright Transactions versus Repurchase Agreements

Outright transactions

The Fed uses outright purchases to bring about long-run or

permanent growth in reserves and the monetary aggregates.

Repurchase agreements (& reverse repurchase agreements)

The Fed uses repurchase agreements (repos) and reverse repurchase

agreements to neutralize the impact on reserves and the monetary

base of transitory changes.

Recall a repurchase agreement

a money market instrument wherein one party sells securities with an

agreement to buy them back at a specified future date and price.

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Discount Window Policy

The fed lends to depository institutions

Federal Reserve lends “Discount Loans”

Commercial Banks borrow

discount rate

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Discount Window Policy

3 Classes of Credits

Primary credit @ Discount rate

Discount rate = Fed fund rate + 1%

Purpose: to impose an upper limit on the Fed fund rate

Secondary credit

Borrowing Rate = Discount rate + 0.5%

Purpose: to banks who have liquidity problems

Seasonal credit

Purpose: to banks having seasonal fluctuations in loan

demand

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Reserve Requirement Instrument

Fed has authority to change the rr

Serves as a “Tax” on DIs, DIs have to hold minimum

reserves

� Limitation on making loans, buying securities

� Loss opportunity to earn more interest income

from making loans