Chapter 16 Notes

KUWAIT UNIVERSITY
COLLEGE OF BUSINESS ADMINISTRATION

DEPARTMENT OF ECONOMICS
Money & Banking

Econ240
Instructor Notes
Mahmoud Arab
TEACHING ASSISTANT
Kuwait University Econ240 Mahmoud Arab
Chapter 16: Tools of Monetary Policy
❖ The Market for Reserves and the Federal Funds Rate:

1. Demand and Supply in the Market for Reserves:
a. Participants: Only Banks
b. Banks of shortage of Reserves (Borrowers) → Demand
c. Banks of Excess of Reserves (Lenders) → Supply
2. Demand in the Market for Reserves:

Rd = RR + ER
(RR= required reserves, ER=excess reserves)
a. Excess reserves are insurance against deposit outflows

b. The cost of holding Excess Reserve (ER) is the interest rate that could have been
earned (i) minus the deposit rate (id) that is paid on these reserves by the Federal
Reserve
c. If (i) > relative to (id) → opportunity cost of holding ER ↑, demand of reserves

Rd ↓ (This implies a downward sloping demand curve)
d. If (i) < (id), then banks would rather hold excess reserves at the central bank than
lend to each other.
3. Supply of Reserves:
Rs= NBR + BR
NBR = non-borrowed (Open Market Operations)
BR = borrowed reserves (Discount Loans)
a. Cost of borrowing from the Fed is the discount rate
b. Borrowing from the Fed is a substitute for borrowing from other banks at federal
fund rate (iff)
c. If iff < id → then banks will NOT borrow from the Fed and borrowed reserves are
zero
d. As iff > id, → banks will borrow more and more at id
1
❖ Equilibrium in the Market for

Reserves:
1. The equilibrium interbank rate is determined by
the banks at the point of intersection between the
reserves supply and demand curves.
2. surplus of reserves: when the quantity supplied of
reserves > quantity demanded → leads to decline
in the federal fund rate (inter bank rate ) back to
the equilibrium.
3. shortage of reserves: when the quantity demanded
of reserves > quantity supplied → leads to increase
in the federal fund rate (inter bank rate ) back to
the equilibrium.
❖ Conventional Monetary Policy Tools for the Central Bank:

1. Open Markets Operations:
a) Open Markets Operations leads to changes in non-borrowed reserves in the reserve
market→ shifts the vertical part of the supply curve in the reserve market.
b) An open market purchase of bonds by the central bank “Expansionary Monetary Policy”
→ increases the quantity supplied in the reserves market → shifts the vertical part of
supply curve to the right → causes the federal funds rate (interbank rate) to decrease at
the new equilibrium.
c) An open market sale of bonds by the central bank “Contractionary Monetary Policy” →
decrease the quantity supplied in the reserves market → shifts the vertical part of the
supply to the left → causes the federal funds rate (interbank rate) to increase at the new
equilibrium.
2
d) Open Markets Operations Type:

i) Dynamic
ii) Defensive
e) Advantages:
i) The dominant policy tool of the Fed (Central Bank) because it has complete control
over the volume of transactions
ii) flexible and precise
iii) easily reversed
iv) quickly implemented
2. Discount Lending (Discount Loans):

a) Changes in discount rate leads to changes in borrowed reserves in the reserve market →
lead to shifts in the horizontal part of the supply curve in the reserve market.
b) Central Bank decreases in discount rate (id) → An increase in discount lending (discount
loans) → increase in the quantity supplied of reserves → shifts the horizontal part of the
supply curve downward → causes the federal funds rate (interbank rate) to decrease at
the new equilibrium.
c) Central Bank increases discount rate (id)→ A decrease in discount lending (discount
loans) → decrease the quantity supplied in the reserves market → shifts the horizontal
part of the supply curve upward → causes the federal funds rate (interbank rate) to
increase at the new equilibrium.
3
d) Discount window: where the discount loans are given.

e) Discount Loan Types:
i) Primary credit: Most common discount loans
ii) Secondary credit
iii) Seasonal credit
f) Advantages:
i) Lender of Last Resort
g) Disadvantages:
i) May create moral hazard problem
ii) discount rate is less well used.
iii) can cause liquidity problem and increases uncertainty for banks
3. Reserve Requirements:
a) Required Reserve Ratio:
i) Changes in the reserve requirement ratio leads to shifts in the downward sloping part
of the reserve demand curve in the market.
ii) Central Bank raises in the reserve requirement ratio “Contractionary monetary
policy” → increases the required reserves and decreases in the excess reserves at the
banks → increases the quantity demanded of reserves in the reserve market → shifts
the reserves demand to the right → causes the federal funds rate (interbank rate) to
increase at the new equilibrium.
iii) Central Bank lowers in the reserve requirement ratio “Expansionary Monetary
Policy” → decreases the required reserves and increases in the excess reserves at the
banks → decreases the quantity demanded of reserves in the reserve market → shifts
the reserves demand to the left → causes the federal funds rate (interbank rate) to
decrease at the new equilibrium.
4
b) Interest Rate on Reserves:

i) Changes in the interest on reserves lead to shifts in the horizontal part reserve
demand curve in the market.
ii) Central Bank increases the interest rate on reserves at the Central Bank → shifts the
horizontal part of the demand curve upward.
iii) Central Bank decreases the interest rate on reserves → shifts the horizontal part of the
demand curve downward.
❖ Nonconventional Monetary Policy Tools During the Global

Financial Crisis:
1. Liquidity provision
2. Large-scale asset purchases
3. Quantitative Easing Versus Credit Easing
4. Forward Guidance
5. Negative Interest Rates on Banks’ Deposits

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KUWAIT UNIVERSITY

COLLEGE OF BUSINESS ADMINISTRATION

Money & Banking

Chapter 16: Tools of Monetary Policy

❖ The Market for Reserves and the Federal Funds Rate:

2. Demand in the Market for Reserves:

a. Excess reserves are insurance against deposit outflows

c. If (i) > relative to (id) → opportunity cost of holding ER ↑, demand of reserves

a. Cost of borrowing from the Fed is the discount rate

d. As iff > id, → banks will borrow more and more at id

❖ Equilibrium in the Market for

❖ Conventional Monetary Policy Tools for the Central Bank:

d) Open Markets Operations Type:

2. Discount Lending (Discount Loans):

d) Discount window: where the discount loans are given.

b) Interest Rate on Reserves:

❖ Nonconventional Monetary Policy Tools During the Global

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