Tools of Central Bank Policy. Unit 4: Financial Sector A.P. Economics Ms. Trimels

Transcription

1 Tools of Central Bank Policy Unit 4: Financial Sector A.P. Economics Ms. Trimels

2 Three tools for monetary policy: 1. Adjusting the RRR 2. Changes in the Discount Rate 3. Open-Bond Market Operations (OMO) used to influence the Federal Funds Rate (FFR)

3 Adjusting the RRR 1) Changing the RRR directly affects the quantity of excess reserves in the banking system. 2) Changing the RRR changes the size of the money multiplier a) This impacts the ability to create money (changes capacity for loans) *Due to the fact that changing the RRR would have such a large impact on the economy, it is rarely used as monetary policy.

4 3) When the Fed changes the RRR, banks are immediately affected; they either: a) Have more excess reserves (RRR ) i) More loans b) Have to keep more of their deposits (RRR ) i) Less loans 4) Impact on the Money Multiplier

5 Expansionary: Fed reduces RRR Ex:.2.1 (RRR) Before: The money multiplier was 1/.2 = 5 Now: The money multiplier is 1/.1 = 10 The bank can now loan out 90% of its deposits instead of only 80%. Draw three graphs demonstrating the effect this would have on the: 1) The Money Market 2) The Loanable Funds Market 3) The AD/AS Model

6 Contractionary: Fed raises RRR Ex:.1.2 (RRR) Before:The money multiplier is 1/.1 = 10 Now: The money multiplier was 1/.2 = 5 The bank can now only loan out 80% of its deposits instead of 90%. Draw three graphs demonstrating the effect this would have on the: 1) The Money Market 2) The Loanable Funds Market 3) The AD/AS Model

7 The Discount Rate The Fed is known as the lender of last resort. Commercial banks are encouraged to borrow from each other first. If banks fall short of their Required Reserves, they will find another bank to lend it enough money to meet the RR. Federal Funds Rate: (FFR) The interest rate that is charged to banks by other banks. However, some banks might not be able to/want to loan to other banks The Discount Rate: (DR) is the interest rate that the Fed charges the commercial banks for short-term loans borrowed from the Fed.

8 DR (cont.) Typically, the Discount Rate will be around.5-1% higher than the Federal Funds Rate. This encourages banks to try and borrow from each other first. Banks would rather borrow from each other because of this. So: 1. The Fed says: keep this much in Required Reserves. 2. Banks: We are not often able to. 3. Fed: Ok, borrow some money. (editorializing)

9 Changing the DR has a contractionary and expansionary effect on the economy. Expansionary monetary policy: Lower the Discount Rate Signals to banks that it s cheaper to borrow money to make up their Required Reserves Banks will be more willing to lend (if they run out of money, it s easier to acquire) Fed lowers DR Sm ir

10 Contractionary monetary policy: Raise the Discount Rate Tells banks it is more costly to borrow funds from the Fed Banks will be less likely to lend (it will cost more to make up for any lack of funds in their RR) Banks will demand a higher interest rate from their borrowers Fed raises DR Sm ir

11 Open-Market Operations Frequency of Use: Rarely will the Fed only change the DR as monetary policy Generally, it will be done alongside engaging in OMO Open-market Operations: the Fed s buying and selling of government bonds from commercial banks on the open market. Aimed at either increasing or decreasing the amount of excess reserves This influences the FFR influences other interest rates influences AD

12 OMO 1. Commercial banks will lend money to both the private and public sectors. a. Private sector = households and firms b. Public sector = the government Government bonds are certificates of debt issued by the gov t that allow it to borrow from the following to finance budget deficits: Households Banks International investors Other gov t institutions

13 OMO (cont.) When an individual/bank buys a gov t bond, they are lending money to the gov t in exchange for a bond which acts as a promise of future payment. Please buy We need more money these but we can t raise taxes. bonds.

14 OMO (cont.) 2. At any given moment in the U.S., commercial banks may hold hundreds of billions of dollars worth of U.S. gov t bonds. a. Money loaned to the gov t through bond purchases can t be loaned to the private sector (necessarily). i. So more gov t bonds less excess reserves higher ir b. If the Fed wants to increase the Sm, it will buy bonds from the gov t and commercial banks (expansionary monetary policy) i. Fed has the bond, gov t and commercial banks now have money c. If the Fed wants to decrease the Sm, it will sell bonds to the banks and the gov t (contractionary monetary policy) i. Now the banks and the gov t possess the bonds, and the Fed has the money

15 (cont.) 3. Open-Market Operations and the Federal Funds Rate a. Government bonds held by commercial banks and the public are not part of the money supply. i. (Theoretically, bonds could could be considered a form of money, but they are not) b. When the Fed buys/sells bonds, it affects the amount of excess reserves banks have i. affects the Federal Funds Rate 1. affects the ir banks charge their customers

16 Expansionary Monetary Policy Fed buys bonds on the open market. If the Fed wants to lower FFR,it should buy bonds from banks and the government. An open-market purchase of bonds by the Fed the supply of excess reserves. increase in loanable funds lower FFR lower interest rates for all borrowers

17 Contractionary Monetary Policy Fed sells bonds on the open market. If the Fed wants to raise FFR,it should sell bonds to banks and the government. An open-market sale of bonds by the Fed the supply of excess reserves. decrease in loanable funds higher FFR higher interest rates for all borrowers