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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 36
TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
The central bank chooses to control the federal funds rate by manipulating the quantity of
reserves through open market operations: the central bank buys or sells securities to add or drain
reserves as required.
Figure: The Market for Bank Reserves
Reserve Supply
Target Rate
Reserve Demand
Quantity of Reserves
Discount Lending, the Lender of Last Resort and Crisis Management
Lending to commercial banks is not an important part of the central bank's day-to-day monetary
policy.
However, such lending is the central bank's primary tool for ensuring short-term financial
stability, for eliminating bank panics and preventing the sudden collapse of institutions that are
experiencing financial difficulties.
The central bank is the lender of last resort, making loans to banks when no one else can or will,
but a bank must show that it is sound to get a loan in a crisis.
The current discount lending procedures also help the central bank meet its interest-rate stability
objective.
The central bank makes three types of loans:
Primary credit,
Secondary credit,
Seasonal credit
Primary credit is extended on a very short-term basis, usually overnight, to sound institutions.
It is designed to provide additional reserves at times when the day's reserve supply falls short of
the banking system's demand.
The system provides liquidity in times of crisis, ensures financial stability, and restricts the
range over which the market federal funds rate can move (helping to maintain interest-rate
stability).
Secondary credit is available to institutions that are not sufficiently sound to qualify for primary
credit.
Banks may seek secondary credit due to a temporary shortfall in reserves or because they have
longer-term problems that they need to work out.
Seasonal credit is used primarily by small agricultural banks to help in managing the cyclical
nature of farmers' loans and deposits
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Money & Banking ­ MGT411
VU
Reserve Requirements
By adjusting the reserve requirement, the central bank can influence economic activity because
changes in the requirement affect deposit expansion.
Unfortunately, the reserve requirement turns out not to be very useful because small changes in
the reserve requirement have large (really too large) impacts on the level of deposits.
Today, the reserve requirement exists primarily to stabilize the demand for reserves and help the
Central bank to maintain the market federal funds rate close to target; it is not used as a direct
tool of monetary policy.
The central bank's Monetary Policy Toolbox
The Tools of Monetary Policy
What is it?
How is it controlled?
What is its impact?
Changes interest rates
Interest rate charged on
Supply of reserves adjusted
Target Federal
throughout the
overnight loans between
through open market
Funds Rate
economy
banks
operations to meet
expected demand at the
target rate
Interest rate charged by the  Set as a premium over the
Provides short-term
Discount rate
central bank on loans to
target federal funds rate
liquidity to bank in
commercial banks
times of crisis and aids
in controlling the
federal funds rate
Fraction of deposits that
Set by the central bank
Stabilizes the demand
Reserve
bank must keep either on
within a liquidity imposed
for reserves
requirement
deposit at the central bank
range
or as cash in their vaults
Linking Tools to Objectives
Desirable Features of a Policy Instrument
Easily observable by everyone
Controllable and quickly changed
Tightly linked to the policymakers' objectives
These requirements leave policymakers with few choices, and over the years central banks have
switched between controlling the quantity and controlling the prices.
Figure: The Market for Bank Reserves when the central bank targets the quantity of reserves
When central bank targets the quantity of reserves, a shift in reserve demand causes the market federal
funds rate to move. An increase in reserve demand forces the interest rate up, while a fall in reserve
demand forces the interest rate down.
Reserve Supply
Increase in Reserve Demand
Fall in
Reserve
Demand
Reserve Demand
Target Quantity Quantity of Reserves
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Money & Banking ­ MGT411
VU
Targets and Instruments
Operating instruments refer to actual tools of policy, instruments that the central bank controls
directly.
Intermediate target refers to instruments that are not directly under the control of the central
bank but that lie between their policymaking tools and their objectives.
Over the last two centuries, central bankers largely abandoned intermediate targets, having
realized that they didn't make much sense.
Instead, policymakers focus on how their actions directly affect their target objectives
Instruments, Targets and Objectives
Using policy instruments to target objectives directly
Link
Link
Operating
Intermediate Targets
Final Objectives
#1
#2
Instruments
Examples:
Examples:
Examples:
Low inflation
Interest Rates
Growth in Monetary
High Growth
Monetary Base
Aggregates
Link # 3
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY