Tuesday, July 7, 2009

monetary policy tools

The tree tools of monetary policy are:
1- Changing the reserve requirement.
2- Changing the discount rate.
3- Executing open market operation (buying and selling bonds) and thereby affecting the fed funds rate.
The total amount of money created from a given amount of cash depends on the percentage of deposits that a bank keeps in reserves (the bank's reserve ratio). By law, the fed controls the minimum percentage of deposits banks keep in reserve by controlling the reserve requirement of all U.S. banks. That minimum is called the reserve requirement- the percentage the Federal Reserve System sets as the minimum amounts of reserve a bank must have.
Required Reserve and excess Reserve, for checking accounts (also called demand deposits), the amounts banks keep in reserve depends partly on the Federal Reserve requirements and partly on how much banks feel they need for safety (the cash they need to keep on hand at any time to give to depositors who claim some of their deposits in the from of cash).the amount most banks need for safety is much smaller than what the fed requires. For them, it's the fed's reserve requirement that determines the amount they hold as reserves.
Banks hold as little in reserve as possible. Why? Because reserves earn no interest for a bank. And we all know that banks are in business to earn profits. How much is as little as possible? That depends on the type of liabilities the bank has. in the early 2000s, required reserves for large banks for their checking accounts were about 10 percent. The reserve requirement for all other accounts was zero, making the reserve requirement for total liabilities somewhat under 2 percent.
In the early 2000s, total reserves were about $41 billion and required reserves were about $40 billion. This means excess reserves (reserves in excess of requirements) were about $1 billion.
The reserve requirement and the money supply
by changing the reserve requirements, the fed can increase or decrease the money supply. if the fed increase the reserve requirement, it contracts the money supply; banks have to keep more reserves so they have less money to lend out; the decreased money multiplier contracts the money supply. If the fed decreases the reserve requirement, it expands the money supply; banks have more money to lend out; the increased money multiplier further expands the money supply.
The total effect on the money supply of changing the reserve requirement can be determined by thinking back to the approximate real world money multiplier. When banks hold no excess reserves and face a reserve requirement of 15 percentage, and people's cash to deposit ratio is 25 percent, the approximate money multiplier will be 1\0,4=2.5,so $1 million in reserves will support a total $2.5 million money supply. In reality the cash to deposit ratio is about 0, 4, the average reserve requirement for demand deposits is about 0.1, and banks hold little in the way of excess reserves. So the realistic approximate money multiplier for demand deposits is
A $100 increase of reserves will support a $200 increase in demand deposits. for other deposits the reserve requirement is zero, so the money multiplier is larger for those.
What does a bank do if it comes up short of reserve? It can borrow from another bank that has excess reserves in what's called the federal funds market. (The rate of interest at which these reserves can be borrowed is called the fed funds rate. As I will discuss below, this fed funds rate is a significant indicator of monetary policy.)But if the entire banking system is short of reserves, that option won't work since there's no one to borrow from. Another option is to stop making new loans and to keep as reserves the proceeds of loans that are paid off. Still another option is to sell treasury bonds to get the needed reserves. (Banks often hold some of their assets in Treasury bonds so that they can get additional reserves relatively easily if they need them.) Treasury bonds are sometimes called secondary reserve. They do not count as bank reserves-only IOUs of the fed count as reserves. But Treasury bonds can be easily sold and transferred into cash that does count as reserves. Banks use all these options.
A second tool of monetary policy concerns another alternative bank has to get reserves needed to maintain their required reserves. A bank can also go to the Federal Reserve (the banker's bank) and take out a loan.
The discount rate is the rate of interest the fed charge for loans it makes to banks. An increase in the discount rate makes it more expensive for banks to borrow from the fed. A discount rate decrease makes it less expensive for banks to borrow. Therefore, changing the discount rate is a second way the fed can expand or contract the money supply.
Up until 2002 the fed set the discount rate slightly lower than the cost of reserves for banks from other sources, relying on moral suasion to stop banks from borrowing unless they really needed it. Beginning in 2003, the fed changed this policy and now it sets the discount rate encourages the banks to borrow and increases the money supply.
Changes in the discount rate and the reserve requirement are not used in day-to-day fed operations. they are used mainly for major changes. For day-to-day operations, the fed used a third tool: open market operations- the fed's buying and selling of government securities (the only type of asset the fed is allowed by law to hold in any appreciable quantity). These open market operations are the primary tool of monetary policy.
When the Fed buys Treasury bills or bond (government securities), it pays for them with IOUs that serve as reserve assets for banks. This IOU doesn't have to be a written piece of paper. it may be simply a computer entry credit to the bank's account, say $1 billion. An IOU of the fed is money.
Because the IOU the fed uses to buy a government security serves as reserves to the banking system, with the simple act of buying a Treasury bond and paying for it with its IOU the fed can increase the money supply (since this creates reserves for the bank).
To increase the money supply, the fed goes to the bond market, buys a bond, and pays for it with its IOU. The individual or firm that sold the bond now has an IOU of the fed. When the individual or firm deposits the IOU IN A BANK-presto!-the reserves of the banking system are increased. if the fed buys $1 million worth of bonds, it increase reserves by $1 million and the total money supply by $1 million times the money multiplier.
When the fed sells Treasury bonds, it collects back some of its IOUs, reducing banking system reserves and decreasing the money supply. THUS,
To expand the money supply, the fed buys bonds.
To contract the money supply, the fed sells bonds.

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