TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION

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Money & Banking MGT411

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

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

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

Operating

Intermediate Targets

Final Objectives

Instruments

Examples:

Low inflation

Interest Rates

Growth in Monetary

High Growth

Monetary Base

Aggregates

Link # 3

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