FED- Conduct of Monetary Policy Tools

It is important to understand the conduct of monetary policy because it not only affects the money supply and interest rates, but also the level of economic activity and the national well-being.

The Federal Reserve System’s Balance Sheet

ASSETS
Government Securities: US Treasuries
Discount Loans: Loans made through the Discount Window

LIABILITIES
Currency in Circulation: Amount of currency in the hands of the public (outside banks)
Reserves: Bank deposits at the Fed + currency physically held by banks (called vault cash)

TOOL 1: Open Market Operations

The central bank’s purchase and sale of US Treasuries is the most important monetary policy tool because it is the primary determinant of changes in reserves in the banking system and interest rates.

An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply.
An open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply.

TOOL 2: Discount Lending

Discount lending is another tool that the Fed can use to affect the amount of reserves.

A discount loan leads to an expansion of reserves, which can be lent out as deposits, thereby leading to an expansion of the monetary base and the money supply.
When a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply.

TOOL 3: Reserve Requirements

Reserve requirements are the regulations making it obligatory for depository institutions to keep a certain fraction of their deposits as reserves with the Fed. Reserves can be further classified into required and excess reserves. Required reserves are those that the Fed requires the banks to hold and excess reserves are the additional reserves that the bank chooses to hold.

Supply and Demand in the Market for Reserves

Demand Curve

To derive the demand curve for reserves, we need to ask what happens to the quantity of reserves demanded, holding everything else constant, as the federal funds rate changes. As the federal funds rate decreases, the opportunity cost of holding excess reserves falls, and therefore, holding everything else constant, the quantity of reserves demanded rises. This is why the demand for reserves (Rd) is downward sloping.

Supply Curve

The Supply of reserves (Rs) can be broken down into two components. First, the amount of reserves that are supplied by the Fed’s open market operations are called nonborrowed reserves. And second, the amount of reserves borrowed from the Fed (discount loans) are referred to as borrowed reserves.

The cost of borrowing discount loans is the discount rate (Id). Because borrowing federal funds is a substitute for taking out discount loans from the Fed, if the federal funds rate (Iff) is below the discount rate (Id), then banks will not forr from the Fed and discount loans will be zero because borrowing from the federal funds market is cheaper. Therefore, as long as IffId, then banks will borrow more from the discount window at the lower Id and lend the proceeds in the federal funds market at the higher Iff. The result is a flat supply curve. Refer to Figure 1.

Figure 1







How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

Open Market Operations

An open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federal funds rate to rise. Refer to Figure 2.

Figure 2



Discount Lending

The effect of discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section.

Vertical Section

Most changes in the discount rate have no effect on the federal funds rate. Refer to Panel (a) in Figure 3.

Horizontal Section

If the demand curve interests the supply curve in the flat section, then the federal funds rate is affected. Refer to Panel (b) in Figure 3.

Figure 3



Reserve Requirements

When the required reserve ratio increases, required reserves increase, and hence the quantity of reserves demanded increases for any given interest rate. Refer to Figure 4.

When the Fed raises reserve requirements, the federal funds rate rises.
When the Fed decreases reserve requirements, it leads to a fall in the federal funds rate.

Figure 4



Refer to Central Banking and the Conduct of Monetary Policy (Mishkin) for a complete review of the FRS. All credits to Mishkin.

Conclusion

This post primarily examined how the Federal Reserve System can use open market operations, discount lending and reserve requirements to conduct its monetary policy. Refer to my previous post- Fed-Structure of the Federal Reserve System- to understand the basic structure of the Fed.

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Sanjeet Parab
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