Tools and goals of monetary policy

1
Tools and goals of monetary policy

• Chap 15-16, Mishkin

2

• Chap 15 discusses
• Supply and demand in the market for reserves
• Tools of monetary policy and equilibrium in the
  market for reserves
• Advantages and disadvantages of (i) open market
  operations, (ii) discount lending and (iii)
  changes in reserve requirements as tools of
  monetary policy

3
I. Demand, supply and equilibrium in the market
for reserves
Federal funds rate
supply
id
if
demand
Quantity of reserves
NBR
4
II. Market for reserves effect of an open
market operation
Federal funds rate
supply
id
if1
if2
demand
NBR1
NBR2
Quantity of reserves
Open market purchase increases non-borrowed
reserves, lowering the equilibrium federal funds
rate
5
II. Market for reserves effect of a change in
the discount rate
Federal funds rate
supply
id1
id2
if
demand
Quantity of reserves
a decrease in the discount rate does not affect
the federal funds rate if the initial
intersection is on the vertical part of the
supply curve
6
II. Market for reserves effect of a change in
the discount rate
Federal funds rate
if1
supply
if2
demand
Quantity of reserves
a decrease in the discount rate lowers the
federal funds rate if the initial intersection is
on the horizontal part of the supply curve
7
II. Market for reserves effect of a change in
required reserves
Federal funds rate
supply
id
if2
if1
demand
Quantity of reserves
an increase in the required reserve ratio
increases the demand for reserves and hence the
federal funds rate
8

• III. Advantages and disadvantages of the
  different tools
• Open market operations is the monetary policy
  tool of choice because,
• the FED has more control over the actual outcome
• tool has flexibility can be used in small or
  large extents
• tool is reversible
• quick implementation
• FED uses discount rate policy not to implement a
  targeted federal funds rate but to prevent the
  federal funds rate from rising too far above its
  target as the next diagram shows.
• Discount lending is used by FED in times of
  crisis, in its role as a lender of last resort.
  recent examples 1987 Black Monday, 9/11 attacks
  
• Reserve requirements are generally kept low
  because this has negative effects on banks
  profitability. Increasing them too much can cause
  immediate liquidity problems. Hence this tool
  lacks flexibility.

9
III. Market for reserves discount lending and
upper bound on federal funds rate
Federal funds rate
supply
id
if
demand
Quantity of reserves
NBR