Department of Economics
Saint Louis University
Professor: Rapach
Fall 2008
ECON 420
Money and Banking

Chapter Outline for “Chapter 15—Tools of Monetary Policy,” Frederic S. Mishkin, The Economics of Money, Banking, and Financial Markets, Eighth Edition (New York, N.Y.: Addison-Wesley, 2006)

THE MARKET FOR RESERVES AND THE FEDERAL FUNDS RATE

Supply and Demand in the Market for Reserves

Demand Curve

Supply Curve

See Figure 1

Market Equilibrium

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

Open Market Operations

See Figure 2

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

Discount Lending

See Figure 3

Most changes in the discount rate have no effect on the federal funds rate.

Reserve Requirements

See 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.

OPEN MARKET OPERATIONS

dynamic open market operations: intended to change the level of reserves and the monetary base

defensive open market operations: intended to offset movements in other factors that affect reserves and the monetary base, such as changes in U.S. Treasury deposits with the Fed or float

A Day at the Trading Desk

primary dealers: government dealers (who operate out of private firms or commercial banks) that the open market desk trades with

repurchase agreement (repo): Fed purchases securities with an agreement that the seller will repurchase them in a short period of time, anywhere from 1 to 15 days from the original date of purchase

matched sale-purchase transaction (reverse repo): Fed sells securities and the buyer agrees to sell them back to the Fed in the near future

Advantages of Open Market Operations

DISCOUNT POLICY

discount window: the facility at which banks can borrow reserve from the Federal Reserve

Operations of the Discount Window

See Figure 5

Lender of Last Resort

lender of last resort: to prevent bank failures from spinning out of control, Fed was to provide reserves to banks when no one else would, thereby preventing bank and financial panics

Advantages and Disadvantages of Discount Policy

RESERVE REQUIREMENTS

Disadvantages of Reserve Requirement Changes

APPLICATION Why Have Reserve Requirements Been Declining Worldwide?

APPLICATION The Channel/Corridor System for Setting Interest Rates Used in Other Countries

See Figure 6

MONETARY POLICY TOOLS OF THE EUROPEAN CENTRAL BANK

target financing rate: the target for the overnight cash rate

overnight cash rate: the interest rate for very short-term interbank loans

Open Market Operations

main refinancing operations: predominant form of open market operations

reverse transactions: purchase or sale of eligible assets under repurchase or credit operations against eligible assets as collateral

longer-term refinancing operations: similar to the Fed’s outright purchase or sales of securities

Lending to Banks

deposit facility: a standing facility in which banks are paid a fixed interest rate that is 100 basis points below the target financing rate

Reserve Requirements

Questions and Problems: 2, 6, 8, 10, 12, 14