Money and Banking
Money and Banking ECN 135
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This 12 page Class Notes was uploaded by Madie Schinner on Tuesday September 8, 2015. The Class Notes belongs to ECN 135 at University of California - Davis taught by Kevin Salyer in Fall. Since its upload, it has received 85 views. For similar materials see /class/191864/ecn-135-university-of-california-davis in Economcs at University of California - Davis.
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Date Created: 09/08/15
The Lender of Last Resort Gets Creative Maybe Too Creative Kevin D Salyer ECN 135 Spring 2009 Monetary Policy Overview The Three Basic Tools for Policy 1 Open market operations 2 Discount Window 3 Reserve Requirements To understand these and their macroeconomic effects k we need to first understand the Fed s balance sheet Spring 2009 K D Saiyer ECN 135 2 Monetary Policy Overview We now turn to the three traditional tools of monetary policy 1 Open market operations This is an outright purchase or sale of government securities from or to banks When conducting this operation the central bank increases its assets and credits banks reserve balances Eventually banks Withdraw from their reserves at the central bank and turn them into cash So an open market operation amounts to Withdrawing government securities from the economy and replacing them with cash The central bank can also reduce the amount of cash in circulation by doing just the opposite selling government securities and absorbing cash By far an open market operation is the best known of Q3 central bank s tools J Spring 2009 K D Salyer ECN 135 3 Monetary Policy Overview This is a simplified version of the US Federal Reserve s balance sheet on August 15 2007 Federal Reserve39s balance sheet millions Aug 15 2007 US government securities 789601 Repurchase agreements 24000 Assets Reverse repurchase agreements 31941 Direct loans 264 Other assets 37058 Liabilities Currency in circulation 813085 Reserve balances 5897 k Spring 2009 K D Salyer ECN 135 4 Monetary Policy Overview Suppose that on August 16 20077 the Fed pumped 1000 million in the system through an open market operation The Feds balance sheet would experience the following changes7 once banks have Withdrawn the new funds from their reserve accounts Changes in the Fed39s balance sheet after a 1000M open market operation US government securities 1000 Repurchase agreements 0 Assets Reverse repurchase agreements 0 Direct loans 0 Other assets 0 Liabilities Currency in circulation 1000 Reserve balances 0 k Spring 2009 K D Salyer ECN 135 5 Monetary Policy Overview 2 Discount Window The central bank simply lends money to a bank The central bank increases its balance of loans and simultaneously credits the reserves of the borrowing bank Then the bank withdraws from its reserves effectively turning them into currency in circulation Asking for a direct loan usually means that the bank was not able to obtain liquidity in the inter bank market Moreover borrowers are also subject to scrutiny by the central bank and watched by other banks Before 2003 the interest rate charged for direct loans technically called the primary lending ratequot was lower than FF rate but lending was discouraged Now the rate is higher and any bank can borrow k that is willing to pay the premium Spring 2009 K D Salyer ECN 135 6 Monetary Policy Overview Open Market Operations and the Discount Window Since both involve changes in the Fed s asset position and bank reserves these are often thought of as identical But two differences 1 Only Primary Security Dealers 19 of these participate in open market operations Any bank can borrow from the discount Window 2 Open market operations are usually done in the form of repurchase agreements discussed belowthe underlying collateral is typically US government securities In contrast a broad range of assets can be used as collateral for discount k Window borrowings Spring 2009 K D Salyer ECN 135 7 Monetary Policy Overview 3 Reserve requirements Banks are required to keep a certain amount of reserves at the central bank If the central bank increases that requirement banks are forced to Withdraw currency from the economy and put it in their reserve account The central bank can also do the opposite ie increase the amount of currency in circulation by lowering the reserve requirement This tool is the least often used K Spring 2009 K D Salyer ECN 135 J Monetary Policy Overview Normally banks obtain liquidity for their daily operations in the Fed Funds market In the summer of 2007 some US banks started experiencing losses from their portfolios of mortgages and securitized mortgages Nobody knew which banks would suffer losses in the future or how large they could be So banks starting growing wary of lending to each other and it became more expensive or just plain impossible to raise as much liquidity as needed The Fed stepped in to help Instead of providing liquidity through outright open market operations it increased the use of an operation that is more frequently used yet less well known repurchase agreements These are short term loans usually overnight extended by the Fed to banks As collateral banks transfer high quality securities to the central bank for the duration of the loan At expiration the loan is repaid and the bank takes back its securities Spring 2009 K D Salyer ECN 135 9 Monetary Policy Overview k Spring 2009 From an accounting perspective the repo increases the central bank s assets and potential currency in circulation much like an open market operation does This for example is what happened between August 8 and August 15 of 2007 Soon after the Fed decided that it didn t want to increase the potential amount of liquidity in the system Which affects short term interest rates and inflation So it offset the repurchase agreements by selling some of its own government securities or letting them expire Without purchasing more and thus Withdrawing cash from the system So the repos didn t have any bottom line effect on liquidity they merely changed the composition of the Fed s assets and provided temporary cash to the borrowing banks K D Salyer ECN 135 10 Moneyless Monetary Policy Here s how a repurchase agreement would Change the Fed s balance sheet after offsetting it with an open market operation Changes in the Fed39s balance sheet after a 1000M repurchase agreement offset by an open market operation US government securities 1000 Repurchase agreements 1000 Assets Reverse repurchase O agreements Direct loans 0 Other assets 0 Liabilities Currency in circulation 0 13238039 Reserve balances O k Spring 2009 K D Salyer ECN 135 11
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