Monetary policy tools: Reserve requirements, federal funds rate, and open market operations

The federal bank controls the economy by regulating country’s interest rates, aggregate demand, and money supply

The three functions of money are acting as store of value to transfer purchasing power from present to future, medium of exchange between buyers and sellers and a unit of account.

Money supply can be categorized into three groups or classes: The M1 consists of traveler’s checks and currency owned by individuals and businesses, M2 includes M1 and savings, time, and other types of deposits. M3 includes M1 and large scale, term and time deposits.

The three monetary policy tools

  • Reserve requirements
  • Federal funds rate
  • Open market operations

Reserve requirements

  • When the fed wants to lower the money supply in the economy, it raises the reserve requirements.
  • Reserves are the amount of money that each commercial bank holds in their vault
  • When reserve requirements increase, the commercial banks are supposed to hold more money which reduces the amount available to lend to borrowers.
  • Fewer loans mean there will be a shortage of loans, and commercial banks are forced to raise interest rates, this decreases loans and eventually decreases the money supply. Less money means the prices of goods and services will go down as well.
  • On the other hand, if the fed wants to raise money supply in the economy, it will do the opposite by decreasing reserve requirements allowing the commercial banks to lend more money.

Federal funds rate

  • Fed funds rate is the interest rates the commercial banks pay for overnight borrowing.
  • When the federal funds rate decreases, commercial banks also charge lower interest rates and more loans are made accessible to the borrowers
  • If the government wants to increase the money supply in the economy, it will raise the federal funds rate so that the commercial banks can charge borrowers more interest rates, decreasing demand for loans.
  • This will eventually lower the aggregate demand while stabilizing the economy.

Open market operations

  • Open market operations refer to the sale and purchase of government securities and bonds to the commercial banks
  • If the government wants to decrease the money supply to avoid inflation, it will decrease reserves in commercial banks by selling securities.
  • The commercial banks will then charge high-interest rates due to a shortage and less money will be available in the vault to lend out to borrowers
  • If the fed wants to stimulate the economy by raising money supply and aggregate demand, it will do so by purchasing securities from the commercial banks.
  • This will increase money in the banks’ vaults, hence lowering interest rates, Borrowers will be able and willing to borrow more and hence an increased investment and aggregate demand.
  • The three tools are used by the fed to control the economy and avoid fluctuations between deflation and inflation

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Federal funds rateThe interest rate on overnight loans of reserves from one bank to another
Demand curve for reservesConsists of required reserves (based on required reserve ratio and deposits) and excess reserves
Supply CurveConsists of nonborrowed reserves (from Fed’s open market operations) and borrowed reserves
Open Market OperationsPurchase increases federal funds rate, sale decreases federal funds rate
Discount lendingChanges in discount rate have little effect on federal funds rate
Reserve requirementsIncreasing requirements raises federal funds rate, decreasing requirements lowers federal funds rate
Conventional monetary policy toolsOpen market operations, discount lending, reserve requirements
Open market operations – DynamicIntended to change the level of reserves and the monetary base
Open market operations – DefensiveIntended to offset movements in factors affecting reserves and the monetary base
Repurchase agreementFed purchases securities with agreement for seller to repurchase within a short period
Matched sale-purchase transactionFed sells securities with agreement for buyer to sell them back in the near future
Discount windowFacility for banks to borrow reserves from the Federal Reserve
Standing lending facilityPrimary credit facility allowing healthy banks to borrow short maturities
Lender of last resortRole of the Fed to provide reserves to banks when no one else would, preventing bank and financial panics
Advantages of Open market operationsInitiative of the Fed, flexibility, reversibility, quick implementation
Zero-lower bound problemInability of central bank to further lower short-term interest rates due to reaching zero
Nonconventional monetary policy toolsLiquidity provision, asset purchases, commitment to future monetary policy actions
Liquidity provision componentsDiscount Window Expansion, Term Auction Facility, New Lending Programs
Quantitative easingExpansion of balance sheet leading to increased monetary base
Credit easingAltering Fed’s balance sheet to improve functioning of specific credit markets
Forward guidanceCommitting to keeping federal funds rate at zero to lower long-term interest rates
Target Financing RateSets target for the overnight cash rate
Overnight cash rateInterest rate for very short-term inter-bank loans
Main refinancing operationsPredominant form of open market operations, similar to repo transactions
Reverse transactionsCredit operations against eligible assets, reversed within two weeks
Longer-time refinancing operationsMonthly operations involving purchases/sales of securities with three-month maturity
Marginal lending facilityBanks can borrow overnight loans from national central banks at marginal lending rate
Deposit facilityFacility where banks are paid a fixed interest rate below the target financing rate
Functions of moneyStore of value, medium of exchange, unit of account
Money supply classificationsM1 (currency, traveler’s checks), M2 (M1 + savings, time deposits), M3 (M1 + large-scale deposits)
The three monetary policy toolsReserve requirements, federal funds rate, open market operations
Reserve requirementsIncreasing requirements reduces money supply, decreasing requirements increases money supply
Federal funds rateDecreasing rate increases money supply, increasing rate decreases money supply
Open market operationsSelling securities decreases money supply, purchasing securities increases money supply

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