Money and Banking: Lecture 36

Money and Banking: Lecture 36 provides students with content about: target federal funds rate and open market operation; discount lending, the lender of last resort and crisis management; reserve requirements; linking tools to objectives;... Please refer to the lesson for details!

Money and

Banking

Lecture 36

Review of the Previous Lecture

• Deposit Multiplier and Money Multiplier

• Central Bank’s Monetary Policy Toolbox

• Target Federal Funds Rate and Open Market

Operation

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

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

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

Central bank

Central bank

Central bank

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

Reserve targets

make interest

rates volatile.

Central bank

Centra

l bank

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

Targets and Instruments

• 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