TOOLS OF MONETARY POLICY

The Fed has three main policy tools, which it uses to influence the level of bank reserves and the monetary base, and through them the money supply and interest rates and the economy:
(1) changes in banks' required reserve ratio
(2) discount loans / changes in the discount rate
(3) open market operations

A. CHANGES IN BANKS' REQUIRED RESERVE RATIO (RRR)
-- The required reserve ratio (RRR) is now 3% of each bank's first $50 million in checking deposits, 10% of the rest of their checking deposits.  It was lowered from 12% in early 1990's.
-- The RRR on savings account, CD's, and money-market deposit accounts is zero.
-- Changes in the RRR have large effects on money supply: increasing RRR causes decrease in m, decrease in money supply. Because this tool's effects are so powerful as to preclude "fine tuning" (making small changes in monetary policy as needed), it is the Fed's least-used policy tool.
-- A key disadvantage of changing reserve requirements as a policy tool: it is too blunt a policy instrument, since it has such a dramatic effect on the money supply (by changing the money multiplier). It is also not practical, due to administrative costs and the problems it creates for banks (ex.: 1936, when a doubling of bank reserve requirements hammered the banks and induced a severe recession).
-- A number of people advocate abolishing bank reserve requirements (i.e., setting RRR at zero), just like many other industrialized countries (Canada, Switzerland, Australia) have done. The rationale for this is that having to keep 10% of deposits as reserves hurts the competitiveness and profitability of American banks, since they only need to keep about 1-2% of deposits as reserves to meet deposit outflows. If RRR were set to zero, banks would still hold some excess reserves, but could loan out more of their deposits and reap higher profits.

B. DISCOUNT LOANS / CHANGES IN THE DISCOUNT RATE
Discount loans: loans (of reserves) made by regional Fed banks to commercial banks.
-- An increase in discount loans increases bank reserves (and the MB) and increases the money supply
-- A decrease in discount loans decreases bank reserves (and the MB) and decreases the money supply
The Fed controls the discount rate, i.e. the interest rate at which it loans money to banks.
-- The Fed also controls the volume, or quantity, of discount loans, since its regional banks have discretion over whether to grant or deny any particular discount-loan request
-- Discount loans are the essence of the Fed's lender of last resort function.
---- They were originally envisioned as the Fed's main policy tool, back when the Fed was chartered in 1913. (More recently, OMO has overtaken discount loans in importance.) The Fed can help prevent financial and bank panics by providing reserves.

C. OPEN MARKET OPERATIONS (OMO)
In OMO, the Fed buys or sells bonds, usually from the banks, in order to affect the level of bank reserves and the federal funds rate (the interest rate at which commercial banks loan each other reserves, on an overnight basis). In turn, the money supply and other interest rates will be affected, too.
-- OMO is the Fed's most important and most-used policy tool.
-- Depending on whether the Fed is trying to conduct an expansionary monetary policy or a contractionary monetary policy, it will use one of the following types of OMO:
---- (1) open-market purchases - when the Fed buys securities from banks and pays for them by crediting the banks' reserve accounts at the Fed, thus creating reserves -> reserves increase, MB increases -> money supply increases, i decreases (expansionary monetary policy).
---- (2) open-market sales - when the Fed sells securities to banks and collects payment by debiting the banks' reserve accounts at the Fed, thus destroying reserves -> reserves decrease, MB decreases -> money supply decreases, i increases (contractionary monetary policy).

There are two basic types of OMO (aside from the purchases-vs.-sales distinction):

(1) DYNAMIC OMO: change MB, change money supply, interest rates
---- goes with a definite shift in Fed policy (e.g., a decision to lower interest rates).  Dynamic OMO can be either expansionary or contractionary.
------ (a) EXPANSIONARY OMO: goal is to stimulate the economy and reduce unemployment.  Sequence:
Fed makes open-market purchases of bonds from banks, pays for them by crediting banks' reserve accounts at the Fed --> reserves increase, MB increases --> money supply increases, interest rates fall --> business investment and household consumption rise --> real GDP and employment rise.
------- (b) CONTRACTIONARY OMO: goal is to reduce inflation by slowing down the economy.  Sequence:
Fed makes open-market sales of bonds to banks, collects payment by debiting banks' reserve accounts at the Fed --> reserves fall, MB falls --> money supply decreases, interest rates increase --> business investment and household consumption fall --> real GDP and employment fall (or grow more slowly) --> inflation rate falls.

(2) DEFENSIVE OMO: offset other factors affecting bank reserves (e.g., stock market crash of 1987); maintain current federal funds rate
---- does not go with any major policy shift; Fed conducts defensive OMO nearly every day

OMO directly influences the FEDERAL FUNDS MARKET (the market where banks loan their excess reserves to each other, usually on an overnight basis), by affecting the supply of bank reserves.  The federal funds rate, which is the interest rate that banks charge each other on loans of reserves, is the equilibrium interest rate in the federal funds market, so it is determined by the intersection of the supply and demand curves for reserves.
-- [See Mishkin's Chapter 17, Figure 1, "Equilibrium in the Market for Reserves."]
---- Open-market purchases increase the supply of bank reserves, causing the supply curve for reserves to shift out and the federal funds rate to decrease.  In the case of expansionary OMO, the Fed conducts open-market purchases on a large scale, in order to decrease the federal funds rate.
---- [See Mishkin's Chapter 17, Figure 2, "Response to an Open Market Operation..."]
---- Open-market sales decrease the supply of bank reserves, causing the supply curve for reserves to shift in and the federal funds rate to increase.  In the case of contractionary OMO, the Fed conducts open-market sales on a large scale, in order to increase the federal funds rate.
------ [The graph is like Mishkin's Chapter 17, Figure 2, but with the supply curve of reserves shifting inward, or leftward.]
---- In the case of defensive OMO, the Fed tries to keep the federal funds rate constant by (1) making open-market purchases to offset an increase in banks' demand for reserves, or (2) making open-market sales to offset a decrease in banks' demand for reserves.

Q: What kind of bonds should the Fed buy and sell in its OMO?
A:  Treasury bills are ideal -- they have high liquidity, and they are such a high-volume market that the Fed's OMO does not distort the market much. Also, unlike corporate securities, exchanges of Treasury bills do not create any possible conflicts of interest (or the appearance thereof) for the Fed.
-- The Federal Open Market Committee (FOMC) makes the decisions (note: Federal Open Market Committee, Open Market Operations).
-- The Federal Reserve Bank of New York conducts OMO, via its Trading Desk

Advantages of OMO:
* has a precise impact on the MB, leaving it completely in the Fed's control
* flexible and easily reversed
* quickly implemented