Topic 17 - Tools of Monetary Policy

• Required reserve ratio


  The percentage of a bank's deposits that must be held as reserves
• Currency in circulation


  The total amount of currency (bills and coins) that has been issued by the central bank and is currently in the hands of the public
• Checkable deposits


  Deposits that can be easily withdrawn or spent, such as checking account balances
• Excess reserves


  Reserves held by banks in excess of the required reserve ratio
• Central bank conducts an unusually large open market purchase of bonds


  Leads to a sharp contraction in the economy
• Central bank conducts the same open market purchase, but banks choose to hold all proceeds as excess reserves


  Excess reserves increase, excess reserve ratio increases, money supply decreases, money multiplier decreases
• Following the 2008 financial crisis, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011.
• Conventional monetary policy tools

  Open market operations, discount lending, and reserve requirements
• Open market operations

  • Dynamic open market operations to change the level of reserves and monetary base, Defensive open market operations to offset other factors affecting reserves and monetary base, Conducted through primary dealers and TRAPS, Use of repurchase agreements and matched sale-purchase agreements
• Discount window


  Facility where banks can borrow reserves from the Federal Reserve
• Types of discount loans


  • Primary credit (standing lending facility), Secondary credit (for banks in financial trouble), Seasonal credit (for small banks with seasonal deposit patterns)
• Lender of last resort


  The Federal Reserve's role in providing liquidity to prevent financial panics
• The Federal Reserve announced its readiness to serve as a source of liquidity to support the economic and financial system during the 2008 financial crisis
• Reserve requirements


  • 0% on first $15.5 million of checkable deposits, 3% on $15.5 to $115.1 million, 10% on over $115.1 million (can be varied by Fed between 8-14%)
• Interest on excess reserves


  The Federal Reserve started paying interest on excess reserves in 2008 to help raise the federal funds rate
• Relative advantages of conventional monetary policy tools

  • Open market operations are dominant, flexible, precise, easily reversed, and quickly implemented
  • Discount rate is less well used as it is no longer binding for most banks, can cause liquidity problems, and increases uncertainty
  • Discount window remains valuable for Fed's role as lender of last resort
• When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job
• Nonconventional monetary policy tools used during the global financial crisis

  • Liquidity provision through expanded lending facilities
  • Large-scale asset purchase programs like QE2 and QE3
• Quantitative easing vs. credit easing

  Quantitative easing focused on expanding the monetary base, while credit easing focused on easing credit conditions in specific markets
• Negative interest rates on banks' deposits are intended to encourage lending, but there are doubts about their effectiveness
• Monetary policy tools of the European Central Bank


  • Open market operations (main refinancing operations, longer-term refinancing operations)
  • Lending to banks (marginal lending facility, deposit facility)
  • Reserve requirements (2% of checking deposits and short-term deposits, with interest paid)