Financial Markets and Institutions (2-downloads)

raises reserve requirements, the federal funds rate rises.

Conversely, a decline in the required reserve ratio lowers the quantity of

reserves demanded, shifts the demand curve to the left, and causes the federal

funds rate to fall. When the Fed decreases reserve requirements, the federal

funds rate falls.

i

2

ff

i

1

ff

R

d

2

R

d

1

i

2

ff

1⫽ i

2

d

2

i

1

ff

R

s

2

i

2

d

i

1

d

i

1

ff

⫽ i

1

d

i

1

ff

R

s

2

i

2

d

i

1

d

Quantity of

Reserves, R

NBR

Federal

Funds Rate

R

2

(a) No discount lending (BR = 0)

Quantity of

Reserves, R

NBR

i

ff

= i

d

1

2

i

ff

= i

d

i

er

i

er

Federal

Funds Rate

(b) Some discount lending (BR

⬎ 0)

i

d

1

i

ff

1

i

d

2

R

1

d

1

R

1

s

s

R

1

s

R

1

d

R

2

s

BR

1

BR

2

1 1

2  

2

F I G U R E   1 0 . 3

Response to a Change in the Discount Rate

In panel (a) when the discount rate is lowered by the Fed from 

to  , the horizontal section of the supply

curve falls, as in 

, and the equilibrium federal funds rate remains unchanged at  . In panel (b) when the

discount rate is lowered by the Fed from 

to  , the horizontal section of the supply curve 

falls, and the

equilibrium federal funds rate falls from 

to 

as borrowed reserves increase.

i

2

ff

i

1

ff

R

s

2

i

2

d

i

1

d

i

1

ff

R

s

2

i

2

d

i

1

d

Access

www.federalreserve

.gov/monetarypolicy/

reservereq.htm

to find

historical data and a

discussion about reserve

requirements.

G O   O N L I N E

---

Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

223

Quantity of

Reserves, R

NBR

i

d

1

2

i

ff

Federal

Funds Rate

i

er

R

1

s

R

2

d

R

1

d

i

ff

1

2

F I G U R E   1 0 . 4

Response to a Change in Required Reserves

When the Fed raises reserve requirements, required reserves increase, which increases the

demand for reserves. The demand curve shifts from 

to 

, the equilibrium moves from

point 1 to point 2, and the federal fund rate rises from 

to 

.

i

2

ff

i

1

ff

R

d

2

R

d

1

C A S E

How the Federal Reserve’s Operating

Procedures Limit Fluctuations in the

Federal Funds Rate

An important advantage of the Fed’s current procedures for operating the discount win-

dow and paying interest on reserves is that they limit fluctuations in the federal funds

rate. We can use our supply-and-demand analysis of the market for reserves to see why.

Suppose that initially the equilibrium federal funds rate is at the federal funds rate

target of 

in Figure 10.5. If the demand for reserves has a large unexpected increase,

the demand curve would shift to the right to 

where it now intersects the supply

curve for reserves on the flat portion where the equilibrium federal funds rate, 

, equals the discount rate, i

d

. No matter how far the demand curve shifts to the right,

the equilibrium federal funds rate, 

, will just stay at i

d

because borrowed reserves

will just continue to increase, matching the increase in demand. Similarly, if the

demand for reserves has a large unexpected decrease, the demand curve would shift

to the left to 

and the supply curve intersects the demand curve on its flat por-

tion where the equilibrium federal funds rate,  , equals the interest rate paid on

reserves i

er

. No matter how far the demand curve shifts to the left, the equilibrium

federal funds rate 

will stay at i

er

because excess reserves will just keep on increas-

ing so that the quantity demanded of reserves equals the quantity of nonborrowed

reserves supplied.

Our analysis therefore shows that the Federal Reserve’s operating 

procedures limit the fluctuations of the federal funds rate to between i

er

and i

d

.

If the range between i

er

and i

d

is kept narrow enough, then the fluctuations

around the target rate will be small.

i

¿

ff

i

¿

ff

R

d

¿

,

i

–

ff

i

–

ff

R

d

–

,

i

*

ff

---

Access

www.federalreserve

.gov/fomc

for a discussion

about the Federal Open

Market Committee, list of

current members, meeting

dates, and other current

information.

224

Part 4 Central Banking and the Conduct of Monetary Policy

Tools of Monetary Policy

Now that we understand how the three tools of monetary policy—open market oper-

ations, discount lending, and reserve requirements—can be used by the Fed to

manipulate the money supply and interest rates, we will look at each of them in turn

to see how the Fed wields them in practice and how relatively useful each tool is.

Open Market Operations

Open market operations are the primary tool used by the Fed to set interest rates.

There are two types of open market operations: Dynamic open market operations

are intended to change the level of reserves and the monetary base, and defensive