Transcript Discount rate

Chapter 19
The Instruments of Central Banking
Learning Objectives
 Reserve Requirements
 Discount window
 Open market operation
19-2
Introduction
 Available money supply in the economy is a multiple
to the level of bank reserves
 Federal Reserve exercises control over bank lending
and money supply:
 By altering the level of reserves in the system
 By influencing the deposit creation multiplier
 Fed accomplishes these objectives:
 By changing the reserve requirements
 By changing the actual amount of reserves
19-3
Reserve Requirements
 Reserves can be in two forms:
 Vault cash
 Deposits in regional bank (Earns no interest)
 Within limits established by Congress, Fed can
specify reserve requirements for depository
institutions.
 This applies even if the institution is not a member of
the Federal Reserve
19-4
Reserve Requirements
Percentage of required reserves varies with
type of account
 Demand Deposits
 Ranges between 8% to 14%
 For first $42.1 million: 3% (small banks)
 Above $42.1 million: 10% (currently)
 Business-owned time and savings deposits
 Can range between 0% to 9%
 Currently set at 0%
19-5
Reserve Requirements
Effect of lowering the reserve requirement
 Automatically increases all banks’ excess reserves
 Increases demand deposit (DD) through multiple
lending
 However, the ultimate impact depends on banks
desire to make loans
 Here is an element of discretion of the lenders
 Expands the money supply
19-6
Reserve Requirements
 Effect of raising the reserve requirement
 Decrease banks’ excess reserves and may force
them to take steps to correct a deficit reserve
position
 Restrains lending and deposit creation
 Contracts the money supply
19-7
Reserve Requirements
 Even without legal reserve requirements,
banks would still need to hold cash reserves as
vault cash or on deposit with Federal Reserve
 Cash to meet customer withdrawals
 Balances at Fed to clear checks
 Without legal reserve requirements, it is likely the
multiplier relationship between reserves and
money supply may fluctuate considerably
19-8
Discounting and the Discount Rate
 Discount rate: amount the Federal Reserve charges
banks for a temporary loan of reserves to cover a
deficiency
 Ability to borrow means that a bank does not need to
call in loans or sell securities (reduce money supply)
to deal with a deficit
 All depository institutions have access to borrowing
at the discount window, even if not a member of the
Fed
19-9
Discounting and the Discount Rate
 Federal Reserve influences banks’ desire to borrow
reserves by changing discount rate
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At a lower discount rate lenders would borrow more.
This will increase money supply
At a higher discount rate lenders would borrow less.
This will decrease money supply
 Actual borrowing (changes in money supply)
depends on banks’ willingness to use this facility of
the FED
19-10
Discounting and the Discount Rate
 Quantity of discount lending
 Central bank is the ultimate source of liquidity in
the economy
 Lender of last resort—Discount provision was
originally established to permit banks to borrow
from the Fed when threatened with cash drains
 Discount facility should not be used too often to
get banks out of reserve difficulties, primarily
when a bank is temporarily short of cash
19-11
Discounting and the Discount Rate
 Quantity of discount lending
 Banks should manage affairs in a way that they do
not need to use discount facility very often
 Discounting is a privilege, not a right
 Banks are supposed to use discount facility
because of need, not to make profit
 Prior to 2003, the Fed used extensive
administrative and surveillance procedures to
prevent “abuse” of discount window
19-12
Discounting and the Discount Rate
 Quantity of discount lending
 However, under the new discount lending
procedure, the Federal Reserve charges a penalty
rate above short-term market rates
 In return, the Fed removes conditions and
restrictions for banks that qualify for primary
credit
 The intent of the new policy is to improve access
to discount window borrowing by removing the
negative connotation of borrowing from the Fed
19-13
Discounting and the Discount Rate
 Quantity of discount lending
 In March 2008, the Federal Reserve opened the
discount window to investment banks
 This expanded role of lender of last resort was
aimed at preventing the collapse of Bear Stearns
 To prevent panic withdrawals from all financial
institutions
19-14
Discounting and the Discount Rate
 Discount Rate and Market Interest Rates
 Discounting is discouraged when the rate is above
other short-term rates, and encouraged when it is
below
 In some countries, the discount rate is often kept
above short-term market rates—a penalty rate as
a means of restraining excessive borrowing
 In US, discount rate is usually below Treasury bill
rate so Fed relies on surveillance to prevent “abuse
of the privilege”
19-15
Discounting and the Discount Rate
 Relationship between discount rate and other
market interest rates
 Discount rate is an “administered” rate, set by Fed
 The linkage between discount rate and reserves and money
supply is Weak
 Change in the discount rate generally occurs after a change
in the Treasury bill rate or federal funds rate
 Reactive rather than proactive tool
19-16
FIGURE 19.1 Movements in the discount rate
tend to come after Treasury bill rates.
19-17
Discounting and the Discount Rate
 Relationship between discount rate and
other market interest rates
 “Announcement” effect
 An unexpected change in discount rate will signal that
the Fed desires to change monetary policy
 The public, reacting to this expectation, takes action that
causes the Fed’s desire to occur
 Change in the discount rate usually confirms
what is happening, but does not initiate it
19-18
Open Market Operations
 Fed’s most important tool to alter reserves
 About $3,200 billion worth of marketable
government securities outstanding
 Held by individuals, corporations, and financial institutions
 Used by the US Treasury to borrow to finance budget
deficits
 The sale of government securities by the Treasury is
independent of the Fed and may work counter to the
Fed’s monetary policy
19-19
Open Market Operations
 Open market operations—Buying and
selling government securities to influence bank
reserves
 Purchase securities—expand reserves (money
supply)
 Sell securities—contract reserves (money supply)
 Does not matter whether Fed sells/purchases
government securities to/from:
 A bank
 Other financial institution,
 Or, individual
19-20
Open Market Operations
 Modifications to the simple multiplier
discussed in appendix to Chapter 19 will
impact the ultimate relationship between
changes in reserves and the money supply
 The Federal Reserve permits the market to set
the purchase/sales price of government
securities and, thereby, altering the rate of
interest on that class of securities
19-21
Conducting Open Market Operations
 The Federal Open Market Committee (FOMC) in
Washington decides on general aims and objectives of
monetary policy and sets monetary targets (bank
reserves, money supply, and interest rates)
 Buying/selling of government securities takes place at
Federal Reserve Bank of New York
 Located in the heart of the New York financial district
19-22
Conducting Open Market Operations
 Open Market Account manager keeps close contact
with securities dealers to get the “feel of the market”
and what is needed to meet targets
 Uses the federal funds rate as a barometer of reserve
supply relative to demand
 Tries to predict expected currency movements that can
affect reserve position of the banking system
 Contacts the US Treasury to determine what is
happening to Treasury balances in tax and loan
accounts at commercial banks
19-23
Conducting Open Market Operations
 Based on FOMC targets and projected changes in
reserve position of the banking system, decides on
appropriate sales/purchases of government
securities
 If changes in bank reserves are considered to be
temporary, the open market account manager will
use repurchase agreement to offset these
transitory reserve movement
 See Federal Fund Rate is determined using the
Demand and Supply curves of Reserve.
19-24