The Economics of Money, Banking, and

Financial Markets
Thirteenth Edition

Chapter 16
Tools of Monetary Policy

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Preview
• This chapter examines the tools used by the Federal
Reserve System to control the money supply and interest
rates

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Learning Objectives
15.1 Illustrate the market for reserves and demonstrate
how changes in monetary policy can affect the federal
funds rate.
15.2 Summarize how conventional monetary policy tools
are implemented and the advantages and limitations of
each tool.

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The Market for Reserves and the Federal
Funds Rate

• Demand and Supply in the Market for Reserves

• What happens to the quantity of reserves demanded by
banks, holding everything else constant, as the federal
funds rate changes?
• Excess reserves are insurance against deposit outflows
– The cost of holding these is the interest rate that
could have been earned minus the interest rate that is
paid on these reserves, i or

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Demand in the Market for Reserves
• Since the fall of 2008, the Fed has paid interest on
reserves at a level that is set at a fixed amount below the
federal funds rate target.
• When the federal funds rate is above the rate paid on
excess reserves, i or , as the federal funds rate decreases,
the opportunity cost of holding excess reserves falls, and
the quantity of reserves demanded rises.
• Downward sloping demand curve that becomes flat
(infinitely elastic) at i or

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Supply in the Market for Reserves
• Two components: nonborrowed and borrowed reserves
• Cost of borrowing from the Fed is the discount rate
• Borrowing from the Fed is a substitute for borrowing from other banks
• If i ff < i d , then banks will not borrow from the Fed and borrowed
reserves are zero
• The supply curve will be vertical
• As i ff rises above i d , banks will borrow more and more at id ,
and relend at i ff
• The supply curve is horizontal (perfectly elastic) at i d

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Figure 1 Equilibrium in the Market for
Reserves

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How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate (1 of 2)

• Effects of open an market operation depends on whether

the supply curve initially intersects the demand curve in
its downward sloped section versus its flat section.
• An open market purchase causes the federal funds rate
to fall whereas an open market sale causes the federal
funds rate to rise (when intersection occurs at the
downward sloped section).
• Open market operations have no effect on the federal
funds rate when intersection occurs at the flat section of
the demand curve.

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How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate (2 of 2)

• If the intersection of supply and demand occurs on the

vertical section of the supply curve, a change in the
discount rate will have no effect on the federal funds rate.
• If the intersection of supply and demand occurs on the
horizontal section of the supply curve, a change in the
discount rate shifts that portion of the supply curve and
the federal funds rate may either rise or fall depending on
the change in the discount rate.
• When the Fed raises reserve requirement, the federal
funds rate rises and when the Fed decreases reserve
requirement, the federal funds rate falls.
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Figure 2 Response to an Open Market
Operation

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Figure 3 Response to a Change in the
Discount Rate

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Figure 4 Response to a Change in
Required Reserves

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Figure 5 Response to a Change in the
Interest Rate on Reserves

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Application: How the Federal Reserve’s Operating
Procedures Limit Fluctuations in the Federal Funds Rate

• Supply and demand analysis of the market for reserves

illustrates how an important advantage of the Fed’s
current procedures for operating the discount window
and paying interest on reserves is that they limit
fluctuations in the federal funds rate.

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Figure 6 How the Federal Reserve’s Operating
Procedures Limit Fluctuations in the Federal Funds Rate

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Conventional Monetary Policy Tools
• During normal times, the Federal Reserve uses three
tools of monetary policy—open market operations,
discount lending, and reserve requirements—to control
the money supply and interest rates, and these are
referred to as conventional monetary policy tools.

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Open Market Operations
• Dynamic open market operations
• Defensive open market operations
• Primary dealers
• TRAPS (Trading Room Automated Processing System)
• Repurchase agreements
• Matched sale–purchase agreements

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Inside the Fed: A Day at the Trading Desk

• The manager of domestic open market operations

supervises the analysts and traders who execute the
purchases and sales of securities in the drive to hit the
federal funds rate target.

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Discount Policy and the Lender of Last
Resort

• Discount window
• Primary credit: standing lending facility
– Lombard facility
• Secondary credit
• Seasonal credit
• Lender of last resort to prevent financial panics
– Creates moral hazard problem

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Inside the Fed: Using Discount Policy to
Prevent a Financial Panic

• To prevent the collapse of the financial sector, the

Chairman of the Board of Governors announced before
the market opened on Tuesday, October 20, the Federal
Reserve System’s “readiness to serve as a source of
liquidity to support the economic and financial system.” In
addition to this extraordinary announcement, the Fed
made it clear that it would provide discount loans to any
bank that would make loans to the securities industry.
The outcome of the Fed’s timely action was that a
financial panic was averted

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Reserve Requirements
• Depository Institutions Deregulation and Monetary
Control Act of 1980 sets the reserve requirement the
same for all depository institutions.
• Reserve requirements are equal to zero for the first
$15.5 million of a bank’s checkable deposits, 3% on
checkable deposits from $15.5 to $115.1 million, and
10% on checkable deposits over $115.1 million. The
Fed can vary the 10% requirement between 8% and
14%.

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Interest on Excess Reserves
• The Fed started paying interest on excess reserves only
in 2008
• The interest-on-excess-reserves tool came to the rescue
during the crash as banks were accumulating huge
quantities of excess because it can be used to raise the
federal funds rate

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Relative Advantages of the Different
Conventional Monetary Policy Tools

• Open market operations are the dominant policy tool of

the Fed since it has complete control over the volume of
transactions, these operations are flexible and precise,
easily reversed, and can be quickly implemented.
• The discount rate is less well used since it is no longer
binding for most banks, can cause liquidity problems,
and increases uncertainty for banks. The discount
window remains of tremendous value given its ability to
allow the Fed to act as a lender of last resort.

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On the Failure of Conventional Monetary
Policy Tools in a Financial Panic

• When the economy experiences a full-scale financial

crisis, conventional monetary policy tools cannot do the
job, for two reasons.
• First, the financial system seizes up to such an extent
that it becomes unable to allocate capital to productive
uses, and so investment spending and the economy
collapse.
• Second, the negative shock to the economy can lead to
the zero-lower-bound problem.

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