Economics 215: Money and Banking

Syllabus

Lectures

Outlines

Notes

 Chapter 17: Tools of Monetary Policy

Monetary Policy: The Fed’s deliberate changes in the money supply and interest rates to
achieve certain economic outcomes (economic goals).

Tools of Monetary Policy
a. Open Market Operations (OMO)
b. Discount loans and discount rate
c. Reserve Requirement raio

Open Market Operations (2 Types)
1. Dynamic: Meant to change MB to a new target
2. Defensive: Meant to offset other factors affecting MB; Uses repos and reverse repos

Advantages of OMO
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly

Discount Loans (3 Types)
1. Adjustment Credit
2. Seasonal Credit
3. Extended Credit

Market Interest Rates and the Discount Rate

Advantages and Disadvantages of Discount Loan Policy:
Advantages: Lender of Last Resort Function
1. To prevent banking panics (FDIC fund not big)
Examples: Continental Illinois and Franklin National
2. To prevent non-bank financial panics
Examples: 1987, 2000-01 stock market crash

Disadvantages
1. Confusion interpreting discount rate changes
2. Fluctuations in discount loans cause unintended fluctuations in money supply
3. Not fully controlled by Fed

Proposed Reforms in Discount Policy
1. Abolish discounting (Milton Friedman)
A. Eliminates fluctuations in Ms
B. However, lose lender of last resort role

2. Tie discount rate to market rate
A. i – id = constant, so less fluctuations of DL and Ms
B. Easier administration
C. No false announcement signals

Reserve Requirements
Advantages: Powerful effect
Disadvantages
1. Small changes have very large effect on Ms
2. Raising causes liquidity problems for banks
3. Frequent changes cause uncertainty for banks
4. Tax on banks

Proposed Reforms in Res. Requirements
1. Abolish reserve requirements
2. 100% reserve requirements (Milton Friedman)
Advantage: complete control of Ms
Disadvantage: Fed controls official Ms but not economically relevant Ms

The Market for Reserves and the Fed Funds Rate
Demand Curve for Reserves
1. R = RR + ER
2. i goes up, opportunity cost of ER goes up, ER goes down, demand for R goes down
3. Demand curve slopes down

Supply Curve for Reserves
1. i up, discount loans up, Reserves supplied up
2. Supply curve slopes up

Market Equilibrium
Rd = Rs at i*

Changes in Supply and Demand for Reserves
a. Response to Open Market Purchase
Open Market Purchase, Reserves up, Rs to right, i down from i1 to i2


b. Response to Lowering of Discount Rate
Discount Rate down, Discount Borrowing up , Reserves up, Rs to right, i down from i1 to i2

c. Response to Rise in Reserve Requirements
rD up, RR up, Rd shifts to right, i up from i1 to i2