Chapter 6 The Monetary System
LECTURE VIDEO学习视频9:
The Fed’s Tools of Monetary Control
(1) Open Market Operations: the purchase and sale of U.S. government bonds by the Fed.
a. If the Fed wants to increase the supply of money, it creates dollars and uses them to purchase government bonds from the public in the nation's bond markets.
Open Market Purchase (OMP): these new dollars the Fed pays for the bonds increases the money supply; while, some held in currency increases the MS by the same amount, and some deposited in banks increases the MS by a larger amount due to the money multiplier effect.
b. If the Fed wants to lower the supply of money, it sells government bonds from its portfolio to the public in the nation's bond markets. Money is then taken out of the hands of the public and the supply of money falls.
Open Market Sale (OMS): the public pays for these bonds with currency or deposits. As people withdraw from banks to buy bonds from the Fed, eventually it would reduce a larger amount of deposits in banks. Because the process of money creation can reverse itself.
Thus, If the sale or purchase of government bonds affects the amount of deposits in the banking system, the effect will be made larger by the money multiplier.
Open market operations are easy for the central bank to conduct and the central bank can conduct it in any day without disrupting the banker's business and changing any law or regulations. Therefore, it is the tool of monetary policy that the central bank uses most often.
(2) Fed Lending to Banks
The Fed can also lend money to banks, increasing their money to loan out.
Traditionally, banks can borrow from the Fed's discount window and pay an interest rate on that loan called discount rate.
A smaller discount rate will encourage banks more borrowing from the Fed, then banks could loan more money out to the public, thus the MS increases.
A higher discount rate discourages banks from borrowing from the Fed and likely encourages banks to hold onto larger amounts of reserves. This in turn lowers the money supply.
Thus, the Fed can control the MS by changing the discount rate.
In recent years, the Fed has set up new mechanisms for banks to borrow from the Fed.
At the term auction facility, the Fed sets a quantity of funds it wants to lend to banks; and, eligible banks bid to borrow those funds; finally, loans go to the highest eligible bidders who have acceptable collateral and can pay the highest interest rate.
Under discount window, the Fed sets the price of loan and banks determine the quantity of borrowing;
At term auction facility, the Fed sets the quantity of borrowing and competitive bidding among banks determines the price of loan.
The Fed uses such lending not only to control MS but also to help financial institutions when they are in trouble.
In 2008 and 2009, a fall In housing prices throughout the U.S. led to a sharp rise in the number of homeowners defaulting in their mortgage loans, and many financial institutions holding those mortgages ran into trouble. To prevent more serious economic recession, the Fed put billions of dollars into financial system as a form of Fed's lending to banks.
(3) Reserve Requirements
Recall that the bigger the reseve ratio, the smaller the money multiplier, and the smaller the money supply.
Since the banking system can influence the money supply by the money multiplier effect, the Fed can change the money supply by influencing the reserve ratio.
One way the Fed can influence the reserve ratio is by changing the reserve requirements.
This can affect the size of the money supply through changes in the money multiplier.
a. When the Fed increases reserve requirements, some banks may find themseleves short of reserves; as a result, they have to reduce the lending or sell some of securities investments, so as to meet a higher reserve ratio; thereby, lower money multiplier and decreases the money supply.
b. When the Fed decreases reserve requirements, some banks may find themselves with sufficient excess reserves; it allows the banks to make more loans, thus creating more dollars, increases the money supply.
However, The Fed rarely uses this tool because of the disruptions in the banking industry that would be caused by frequent alterations of reserve requirements. .
Moreover, in rencent years, this tool becomes less effective because many banks already hold excess reserves.
(4) Paying interest on reserves
Traditionally, banks did not earn any interest on the reserves they hold required by the Fed.
Since Oct 2008, when a bank holds reserves on deposit at the Fed, the Fed pays the bank interest on those reserve deposits.
The higher the interest rate, the more reserves a bank will want to hold. This will reduce the money multiplier. Thereby paying interest on reserves decreases the money supply.
(5) Problems in Controlling the Money Supply
a. The Fed does not control the amount of money that consumers choose to deposit in banks.
The more money that households deposit, the more reserves the banks have, and the more money the banking system can create.
The less money that households deposit, the smaller the amount of reserves banks have, and the less money the banking system can create.
b. The Fed does not control the amount that bankers choose to lend.
The amount of money created by the banking system depends on loans being made.
If banks choose to hold onto a greater level of reserves than required by the Fed (called excess reserves), the money supply will fall.
Therefore, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers.
Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly control the money supply.
ACTIVE LEARNING:
Additional video about monetary policy and the Federal Reserve:
