Fed Making a Discount Loan to a Bank (provide liquidity to banks)
--Monetary liabilities of the Fed have increased by $100
--Monetary base also increases by this amount
--Potential monetary expansion if reloaned
Paying Off a Discount Loan from the Fed
--Net effect on monetary base is a reduction
--Monetary base changes one-for-one with a change in the borrowings from the Federal Reserve System
--Potential decrease in money supply
=====
Other Factors Affecting the Monetary Base: temporary (no effect on Fed’s ability to essentially control the monetary base):
--Float (“time for check clearing’ = the period between Fed’s payment for a check and deducting its amount--between two private parties) –> temporary increase in reserves in bank sector
--Treasury deposits at the Federal Reserve(when Treasury {like Ministry of Finance} moves funds from commercial banks to the Fed) can reduce monetary base and reserves for period of time
--{NOTE: Interventions in the foreign exchange market….can also affect the system but see chs. 17 & 18}
Fed’s Ability to Control the Monetary Base
--Open market operations are controlled by the Fed
--The Fed cannot determine the amount of borrowing by banks from the Fed
--Split the monetary base into two components Non-borrowed (open market sales/purchases determined) and borrowed (via Fed discount window borrowing by banks at will and by Fed by setting price/discount interest rate settings)
--The money supply is positively related to both the non-borrowed monetary base and to the level of borrowed reserves, from the Fed
Critique of the Simple Model
--Holding cash (currency) stops the process
------Currency has no multiple deposit expansion (most of it exits the banking system)
--Banks may not always use all of their excess reserves to buy securities or make loans.
--Depositors’decisions (how much currency to hold) and banks’decisions (amount of excess reserves to hold) also cause the money supply (and multiplier) to change.
Summary: Factors that Determine the Money Supply
--Changes in the required reserves ratio
------The money supply is negatively related to the required reserve ratio.
--Changes in currency holdings
------The money supply is negatively related to currency holdings.
--Changes in excess reserves
------The money supply is negatively related to the amount of excess reserves.
--Behavioral decisions by households and banks(changing previous behaviors due to variety of factors….esp. uncertainty in times of economic distress/crisis)
Also:
--Changes in the nonborrowed monetary base (i.e. bonds bought/sold by the FED in its open market operations)
------Money supply is positively related to the non-borrowed monetary base (currency or reserves created by open market FED purchases from banks)
--Changes in borrowed reserves from the Fed (i.e. banks may borrow as they like from the FED’s ‘discount’ window at the interest rate fixed by the FED in advance).
------The money supply is positively related to the level of borrowed reserves, BR, from the Fed
Lecture
Application: The Great Depression Bank Panics, 1930 - 1933.
--Bank failures (and no deposit insurance) determined:
-------Increase in deposit outflows and holding of currency (depositors)
-------An increase in the amount of excess reserves (banks)
--For a relatively constant monetary base (currency & reserves with Fed) the money supply decreased due to the fall of the money multiplier (i.e. bank lending collapsed)
TODAY Problems
-2008 Credit Freeze in USA; Spreading Uncertainty; Real Economic slowdown/recessions; Increased Focus on Bond Markets Risks lead to widening Credit System Woes in Europe as earnings plunge and stock markets rise in volatility:
--Bank crisis of Sept. 2008. Loss of trust in financial institutions.
--Collapse of securities markets (mortgage backed securities primarily but then leading to general rise in mistrust of financial institutions generally) and fear of balance sheets being on verge of insolvency;
--Credit ‘Freeze’: unwillingness to lend among financial institutions or to real economy sectors….bringing real economy into downward spriral with no end in sight
--Massive monetary access provided by FED (trying to avoid the collapse of credit system as occurred in 1930-33.
--Still in operation (Dec. 2011) since real economies of developed countries still at serious risk of further downward spriraling due to widespread reduced spending (‘austerity programs’ and ‘budget balancing strategies’ among most of G-20 countries).
--New Focus on Europe: Public (Greece) and Private (Ireland, Spain) Debt problems and now spreading to other countries sovereign debt problems as their real economies slow (leading to lower budget revenues and repayment abilities…etc.)
*Contrast: Two biggest economies of world and their central bank policies in this crisis:
--US FED massive lending of last resort (& Quantitative Easing)
--UK Bank of England doing similar things as US Fed
BUT Not ECB:
--EU ECB minimal lending of last resort (only indirectly via collaboration with IMF plus sovereign debt writedowns beginning in Greece and trying to invent a new institution to do the same as the US FED does in crisis etc.)
KEY IDEAS for Chapters in Book for Students to focus on for Learning & exams
The full chapter is Mishkin, 8th edition, Money, Banking and Financial Markets, but published in 2007. To bring this up-to-date, Rock has added some comments--summarized below--from lecture and discussions in meetings with students. Also, notice that Mishkin’s own updated information is available on webpages (CrockFL site) for some 2008-2010 crisis coverage in zMish9ed folder. This is only the chapters and only the pagesthat have been changed by this author in this new 9th Edition (2010)—most of this new material concerns the recent crises and the huge increase in central bank interventions.
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Ch15 (8th edition) [CENTRAL BANK'S] TOOLS OF MONETARY POLICY
--(Note: In the 9th edition, this chapter is the same number—Mish9ed_c15...)
-text material (Mish8ed), pages: 373-390
-Questions at end of chapter: 390
==========================
NOTES ON CHAPTER:
This chapter (15) examines in detail the tools at the Fed’s (and the European Central Bank’s) disposal for conducting monetary policy.
To fully understand how the Fed’s tools are used in the conduct of monetary policy, this chapter shows how they affect the federal funds rate directly (the interest rates private banks charge each other for short-term loans among themselves).
There is discussion of debates on whether Fed policymaking could be made more effective by altering their use of these tools.
One basic conclusion is that open market operations (buying/selling assets/bonds from private owners) have been the Fed’s primary tool in conducting monetary policy in NORMAL TIMES (NON-CRISIS)
{NOT IN THIS—2007—8TH ---EDITION of Textbook}: Post-2008: The FED has acted in extraordinary ways (Unusual…dealing with EXTRA-ORDINARY or ABNORMAL economic problems)during and after the CRISIS OF 2008 and continues to do so right up until the END OF 2011.}
The chapter starts with an analysis of how Federal Reserve actions influence the federal funds rate(the interest rates private banks charge each other for short-term loans among themselves). The Fed now {post-2008) pays interest on reserves (deposits by banks at the Fed), but in the past it did not.
Also, reserve requirements have been declining throughout the world.
There is some discussion of the channel/corridor approach for setting interest rates that is used by other (non-USA) countries.
Another focus is on the central bank’s role as the lender-of-last-resort and this is usually carried out through the use of discounting (lending by the central bank directly to private sector banks).
{NOT IN THIS—2007—8TH---EDITION of Textbook} {Recently (from 2008-2011 and still continuing in early December 2011) massive operations by the Fed (direct lending and ‘quantitative easing’ by purchasing balance sheet assets from private financial institutions) during and after September-October 2008 credit freeze following as part of the subprime financial crisis.}
There are many real-world examples of discounting (direct lending by central bank to private banks) to avoid banking and financial panics.
====================
*TOOLS OF MONETARY POLICY
-1.Open market operations
-----Affect the quantity of reserves and the monetary base
-2. Changes in borrowed reserves
-----Affect the monetary base
-3. Changes in reserve requirements
-----Affect the money multiplier
-4. Federal funds rate (= “interbank overnight rate”): the interest rate on overnight loans of reserves from one bank to another
-----Primary instrument of monetary policy
-----Mainly affected (lower bound) by the Discount Rate that the Fed charges banks to borrow from the Fed.
===================================
DEMAND & SUPPLY in the Market for RESERVES:
*DEMAND IN THE MARKET FOR RESERVES
-What happens to the quantity of reserves demanded by banks, holding everything else constant, as the federal funds rate changes?
------The demand for reserves is combination of demand for (a) Required reserves and (b) Excess reserves.
-Excess reserves are insurance against deposit outflows
------The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, {ier} by the Fed.
-Since the fall of 2008 (beginning) the Fed has paid interest on reserves at a level that is set at a fixed amount BELOW the federal funds rate target.
-When the federal funds rate is above the rate paid on excess reserves, ier,as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises
-Downward sloping demand curve that becomes flat (infinitely elastic) atier
*SUPPLY IN THE MARKET FOR RESERVES
-Two components: non-borrowed and borrowed reserves
-Cost of borrowing from the Fed is the discount rate {id}
-Borrowing from the Fed is a substitute for borrowing from other banks (the market rate for interbank borrowing among private banks is the ‘federal funds rate’ {iff}
-If iff < id, (cheaper to borrow from another bank than from the Fed) then banks will not borrow from the Fed and borrowed reserves are zero
-The supply curve will be vertical
-As iff rises aboveid, banks will borrow more and more at id,and re-lend at iff
-The supply curve is horizontal (perfectly elastic) atid
----------------------------------
==GRAPHICAL ANALYSIS of the MARKET for RESERVES (S&D):
--{Vertical-axis is Federal Funds Rate (i)}
--{Horizontal-axis is the Quantity of Reserves (R) }
--“Supply Curve”: {FED} first vertical (at NBR), then horizontal at id(BR):
------(1)NBR = Non-borrowed Reserves(vertical curve part of ‘supply’ curve for Reserves) supplied by the Fed’s ‘open market operations’ (=OMO = buying bonds in particular and creating potential reserves for banks);
------------so, Ceteris paribus, an OMO (sales>left; purchases->right) will shift this vertical portion of curve
------ (2) BR = Borrowed Reservesat the vertical id point at which (interest rate) the supply is potentially ‘infinite’ (Fed Discount Rate); so,
------------so, Ceteris paribus, a Change in Discount rate (increase/decrease) will shift up/down this flat/horizontal portion of supply curve:
--“Demand Curve”: {Private banks}: first downward sloping along horizontal axis, ; then demand is flat/horizontal-> i.e. it is potentially infinite at some very low cost (interest rate)
-------Ceteris paribus, a change (e.g. Increase/decrease) in Required Reserves will shift the demand curve (e.g. up/down)
--Equilibrium concept in this market:
------(a) if the Fed Funds (interbank) rate is lower than the Discount rate (Fed lending to banks rate), then equilibrium is on vertical part of ‘supply’ curve and private banks do not borrow from the Fed at all.
------(b) if the Fed Funds (interbank) rate is HIGHER than the Discount rate (Fed lending to banks rate), then equilibrium is on horizontal part of ‘supply’ curve and private banks DO BORROW from the Fed
--------------------------
**USING the GRAPH of the MARKET FOR RESERVES for ANALYZING FED (Central Bank) POLICY EFFECTS
-----{Describing the effects on S&D interaction and the equilibrium interest rates}
*AFFECTING THE FEDERAL FUNDS RATE
-(a)Effects of open market operation depends on whether the supply curve initially intersects the demand curve in its downward-sloped section versus its flat section.
-(b)An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward-sloped section).
-(c)Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve.
-(d)If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate.
-(e)If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate
-(f)When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.
----
#1 POLICY:
*OPEN MARKET OPERATIONS
-Dynamic (OMO)open market operations {to affect reserves and the monetary base}
-------‘Outright’ {i.e. PERMANENT} buy/sell--sales or purchases (there is NO REPURCHASE element, neither re-buying or re-selling to these trades} that are not reversed by any later Fed-transaction
-Defensive (OMO)open market operations (to offset other factors affecting reserves and the monetary base}
-------Buy&Resell by Fed: Repurchase agreements {REPO} {Fed buys security with private party agreeing to repurchase it in future, usually short term 1-15 days in normal times}
-------Sell&Rebuy by Fed: Matched sale-purchase agreements {also called REVERSE REPO} {Fed sells security to private party and this party agrees to sell them back when Fed wants to re-purchase them, usually short term contract}
-How this OMO works in Practice in USA:
------Primary dealers {private buyer/seller of US government securities the Fed uses}
------ONLine Trading (Live time, instantaneous communication)….{In USA this system is called ‘TRAPS’ (Trading Room Automated Processing System), but other developed countries also have this kind of central bank electronic live time trading}
*ADVANTAGES of open market operations
-The Fed has complete control over the volume (initiative)
-Flexible and precise (any size transaction; any type of buy/sell, repo, etc.)
-Easily reversed (easy to correct mistakes or faulty information problems)
-Quickly implemented (quick; any time}
-----
#2 POLICY:
*DISCOUNT POLICY
-Discount window (private banks borrow from Fed here at the price (interest rate) called the discount rate that is fixed by the Fed)
-Primary credit: ‘standing lending facility’ (for good-standing banks)
------Lombard credit: refers to the situation (as currently) when discount rate is below the interbank or federal funds rate; may require some form of collateral or cost in order to minimize possibility ofarbitrage of banks borrowing from the Fed in order to relend to other banks at higher rate
-Secondary credit: lending to banks in some financial difficulty (more stringent, restrictive conditions imposed)
-Seasonal credit
-Lender of last resort to prevent financial panics
------Creates moral hazard problem
=ADVANTAGES and DISADVANTAGES of Discount Policy
-Used to perform role of lender of last resort
------Important during the subprime financial crisis of 2007-2008.
-Cannot be controlled by the Fed; the decision maker is the bank
-Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target
-----
#3 POLICY:
*RESERVE REQUIREMENTS
-Since 1980 (the Depository Institutions Deregulation and Monetary Control Act of 1980) the reserve requirement is set the same level for all depository institutions:
----3% of the first approximately $60 million of checkable deposits; 10% of checkable deposits over approximately $60 million
-The Fed can vary the 10% reserve requirement between 8% to 14%
=DISADVANTAGES of Reserve Requirements
-No longer binding for most banks
-Can cause liquidity problems
-Increases uncertainty for banks
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SPECIAL SECTION (from Rock):
Fed as the LENDER OF LAST RESORT in CRISES
*U.S. CENTRAL BANK (The FED) SPECIAL PROGRAMS POST-Housing Bubble and esp. post-credit-freeze of 2008
{NOT IN THIS—2007—8TH---EDITION of Textbook}
Students are NOT RESPONSIBLE FOR THESE DETAILS BELOW:It shows the creativity of the U.S. Central Bank (Fed) in responding to an EXTRAORDINARY CRISIS and the ways in which the Chair, Ben Bernanke, thought he could avoid a repetition of the BANKING COLLAPSE OF THE GREAT DEPRESSION OF 1933 (and the very negative effects he, and others believe, it had on the U.S. “REAL ECONOMY” in terms of EMPLOYMENT, PRODUCTION, INCOMES, and hence GDP during the 1930s). of
*BRIEF LIST OF FED PROGRAMS 2008-2011:
-1. TERM AUCTION FACILITY (began Dec.2007): (to inject cash into the banking system)
-----bi-weekly auction of credit for depository institutions
-2. TERM SECURITIES LENDING FACILITY (began March, 2008): (to inject US Treasury securities into the banking system)
-----an auction of a fixed of lending of ‘Treasury general collateral’ in exchange for OMO-eligible and AAA/Aaa rated private residential mortgage-backed securities.
-3. PRIMARY DEALER CREDIT FACILITY (began March 16, 2008): (allows the Fed to lend directly toprimary dealers)
-----allows eligible primary dealers (in US Treasury securities) to borrow at the Discount Rate for up to 120 days.
-4. TERM DEPOSIT FACILITY (approved April 30, 2010; effective June 4, 2010): (can be used to drain reserves from the banking system; a tool to be used especially [after 2011 some time] when economy recovers and Fed has to worry about inflation again which might be difficult due to massive injections of liquidity into financial system by Fed from 2008 onward)
-----Fed system offers term deposits to institutions eligible to receive earnings on their balances at the Fed (analogous to Certificates of Deposits banks sell to customers/households)
-5. FED PAYS INTEREST ON RESERVES HELD WITH IT BY BANKS (and some others)(began in mid-2008; was planned in 2006 to come into practice in 2011 but was advanced due to the financial crisis of 2008);
-----this appears likely to continue even after the worries about the financial crisis have disappeared in the future
-6. The ASSET BACKED COMMERCIAL PAPER MONEY MARKET MUTUAL FUND LIQUIDITY FACILITY (also called AMLF) (began Sept.22, 2008; closed Feb. 1, 2010) (to inject cash and liquidity into US financial markets/institutions affected by the financial crisis
-----allowed lending (discretionary by Fed) to all depository institutions, bank holding companies(parents of U.S. broker-dealer affiliates), U.S. branches of foreign banks; collateral required of variety of kinds.
-7. COMMERCIAL PAPER FUNDING FACILITY (CPFF; began Oct.7, 2008; closed)) (to inject cash and liquidity into non-financial businesses)
-----Fed bought corporate debt (‘commercial paper’ of which about 80% of total was eligible for this program) instruments in order to revive that market; by time of closure Fed had bought just under $800 billion worth of commercial paper (about 50% of total market value at inception; 45 of 81 companies using this were non-U.S. companies)
-8. TARP (Troubled Asset Relief Program); (Congress created this “BAIL OUT” FUND of some $700-$800 Billion) (The Fed participated in this program indirectly by setting up intermediaries ‘Maiden Lane’ companies to hold the ‘toxic’ or nearly illiquid assets of 2008-2009 crisis peak. Fed holds assets from these intermediaries, since Fed cannot be full/direct owner of corporations, but in effect the Fed is helping finance the bail out by this indirect participation)
-9. QUANTITATIVE EASING programs by Fed: (began in Nov. 2008…continues in 2011) (Fed buys corporate bonds and mortgage-backed-securities from banks and other financial institutions injecting liquidity into financial system in attempt to revived and promote private lending and increased real economic activity including real investments) (The amount of financing was very large under this title, sometimes called “QE”; also practiced by U.K. as well)
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OTHER CENTRAL BANKS
p.388f
EUROPEAN MONETARY SYSTEM (EMS) with EURO CURRENCY & COLLECTIVE (17 COUNTRIES) ‘EUROPEAN CENTRAL BANK’ (ECB)
*MONETARY POLICY TOOLS of the (ECB) EUROPEAN CENTRAL BANK
-1. Open market operations (essentially the same as OMO by the U.S. Fed but with different names for the operations)
------Main refinancing operations
------------these are Weekly reverse transactions { similar to U.S. ‘REPO’ and ‘Reverse REPO’ transactions}
------Longer-term refinancing operations {similar to U.S. ‘outright’ or permanent purchases/sales of securities}
-2. Lending to banks
-with a goal of influencing the private sector “overnight cash rate”{ = US ‘federal funds rate’}
-by the setting of the ECB “target financing rate”
------Marginal lending facility {= U.S. ‘discount window’} lends to banks at the marginal lending rate {= U.S. ‘discount rate’} set at 100 basis points (1%) ABOVE the ‘target financing rate’ that they hope will equal the ‘overnight cash rate’ between banks if the ECB is successful
------Deposit facility { similar to reserves kept by U.S. banks at the Fed that now, since 2008, earn interest paid by the Fed} In Europe the ECB also pays interest that is set at 100 basis points (1%) BELOW the ECB’S ‘target financing rate’
=>Thus, the ECB is setting a lower minimum and an upper maximum on their goal for the private sector ‘overnight cash rate’ (or interbank lending interest rates)
-3. Reserve Requirements
------2% of the total amount of checking deposits and other short-term deposits (smaller than the US; larger than a few countries that have eliminated RR entirely since banks tend to hold cash anyway to service customer needs)
------The ECB pays interest on those deposits so cost of complying is low {= what Fed does with reserves: pays interest on them to private banks owning them)
KEY IDEAS for Chapters in Book for Students to focus on for Learning & exams
The full chapter is Mishkin, 8th edition, Money, Banking and Financial Markets, but published in 2007. To bring this up-to-date, Rock has added some comments--summarized below--from lecture and discussions in meetings with students. Also, notice that Mishkin’s own updated information is available on webpages (CrockFL site) for some treatment of the 2008-2009 years of the crisis zMish9ed folder. These documents include only the chapters and only the pages in each of those chaptersthat have beenchanged by this author in this new 9th Edition (2010) compared to the previous (Mish8ed) version. Most of this new material concerns the recent crises, ‘systemic risk’ and the huge increase in central bank interventions.
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Ch16 (8th edition) WHAT SHOULD CENTRAL BANKS DO?