economics_of_money_banking__financial_markets

Lender of Last

Resort

Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. This interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers. Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates. The Federal Reserve has questioned the need for the seasonal credit facility because of improvements in credit markets and is thus contemplating eliminating it in the future.

In addition to its use as a tool to influence reserves, the monetary base, and the money supply, discounting is important in preventing financial panics. When the Federal Reserve System was created, its most important role was intended to be as the lender of last resort; to prevent bank failures from spinning out of control, it was to provide reserves to banks when no one else would, thereby preventing bank and financial panics. Discounting is a particularly effective way to provide reserves to the banking system during a banking crisis because reserves are immediately channeled to the banks that need them most.

Using the discount tool to avoid financial panics by performing the role of lender of last resort is an extremely important requirement of successful monetary policymaking. As we demonstrated with our money supply analysis in Chapter 16, the bank panics in the 1930Ð1933 period were the cause of the sharpest decline in the money supply in U.S. history, which many economists see as the driving force behind the collapse of the economy during the Great Depression. Financial panics can also severely damage the economy because they interfere with the ability of financial intermediaries and markets to move funds to people with productive investment opportunities (see Chapter 8).

Unfortunately, the discount tool has not always been used by the Fed to prevent financial panics, as the massive failures during the Great Depression attest. The Fed learned from its mistakes of that period and has performed admirably in its role of lender of last resort in the postÐWorld War II period. The Fed has used its discount lending weapon several times to avoid bank panics by extending loans to troubled banking institutions, thereby preventing further bank failures. The largest of these occurred in 1984, when the Fed lent Continental Illinois, at that time one of the ten largest banks in the United States, more than $5 billion.

At first glance, it might seem that the presence of the FDIC, which insures depositors up to a limit of $100,000 per account from losses due to a bankÕs failure, would make the lender-of-last-resort function of the Fed superfluous. (The FDIC is described in detail in Chapter 11.) There are two reasons why this is not the case. First, it is important to recognize that the FDICÕs insurance fund amounts to around 1% of the amount of these deposits outstanding. If a large number of bank failures occurred, the FDIC would not be able to cover all the depositorsÕ losses. Indeed, the large number of bank failures in the 1980s and early 1990s, described in Chapter 11, led to large losses and a shrinkage in the FDICÕs insurance fund, which reduced the FDICÕs ability to cover depositorsÕ losses. This fact has not weakened the confidence of small depositors in the banking system because the Fed has been ready to stand behind the banks to provide whatever reserves are needed to prevent bank panics. Second, the nearly $1 trillion of large-denomination deposits in the banking system are not

Advantages and

Disadvantages of

Discount Policy

C H A P T E R 1 7 Tools of Monetary Policy 403

guaranteed by the FDIC, because they exceed the $100,000 limit. A loss of confidence in the banking system could still lead to runs on banks from the large-denomination depositors, and bank panics could still occur despite the existence of the FDIC. The importance of the Federal ReserveÕs role as lender of last resort is, if anything, more important today because of the high number of bank failures experienced in the 1980s and early 1990s.

Not only can the Fed be a lender of last resort to banks, but it can also play the same role for the financial system as a whole. The existence of the FedÕs discount window can help prevent financial panics that are not triggered by bank failures, as was the case during the Black Monday stock market crash of 1987 and the terrorist destruction of the World Trade Center in September 2001 (see Box 1).

Although the FedÕs role as the lender of last resort has the benefit of preventing bank and financial panics, it does have a cost. If a bank expects that the Fed will provide it with discount loans when it gets into trouble, as occurred with Continental Illinois, it will be willing to take on more risk knowing that the Fed will come to the rescue. The FedÕs lender-of-last-resort role has thus created a moral hazard problem similar to the one created by deposit insurance (discussed in Chapter 11): Banks take on more risk, thus exposing the deposit insurance agency, and hence taxpayers, to greater losses. The moral hazard problem is most severe for large banks, which may believe that the Fed and the FDIC view them as Òtoo big to failÓ; that is, they will always receive Fed loans when they are in trouble because their failure would be likely to precipitate a bank panic.

Similarly, Federal Reserve actions to prevent financial panic, as occurred after the October 1987 stock market crash and the September 11, 2001 terrorist attacks, may encourage financial institutions other than banks to take on greater risk. They, too, expect the Fed to ensure that they could get loans if a financial panic seemed imminent. When the Fed considers using the discount weapon to prevent panics, it therefore needs to consider the trade-off between the moral hazard cost of its role as lender of last resort and the benefit of preventing financial panics. This trade-off explains why the Fed must be careful not to perform its role as lender of last resort too frequently.

The most important advantage of discount policy is that the Fed can use it to perform its role of lender of last resort. Experiences with Continental Illinois, the Black Monday crash, and September 11, 2001 indicate that this role has become more important in the past couple of decades. In the past, discount policy was used as a tool of monetary policy, with the discount rate changed in order to affect interest rates and the monetary market. However, because the decisions to take out discount loans are made by banks and are therefore not completely controlled by the Fed, while open market operations are completely controlled by the Fed, the use of discount policy to conduct monetary policy has little to recommend it. This is why the Fed moved in January 2003 to the current system in which the discount facility is not used to set the federal funds rate, but is only a backup facility to prevent the federal funds rate from rising too far above its target.

Advantages and

Disadvantages

of Reserve

Requirement

Changes

C H A P T E R 1 7 Tools of Monetary Policy 405

the amount of deposits that can be supported by a given level of the monetary base and will lead to a contraction of the money supply. A rise in reserve requirements also increases the demand for reserves and raises the federal funds rate. Conversely, a decline in reserve requirements leads to an expansion of the money supply and a fall in the federal funds rate. The Fed has had the authority to vary reserve requirements since the 1930s; this is a powerful way of affecting the money supply and interest rates. Indeed, changes in reserve requirements have such large effects on the money supply and interest rates that the Fed rarely resorts to using this tool to control them.

The Depository Institutions Deregulation and Monetary Control Act of 1980 provided a simpler scheme for setting reserve requirements. All depository institutions, including commercial banks, savings and loan associations, mutual savings banks, and credit unions, are subject to the same reserve requirements, as follows: Required reserves on all checkable depositsÑincluding non-interest-bearing checking accounts, NOW accounts, super-NOW accounts, and ATS (automatic transfer savings) accountsÑare equal to 3% of the bankÕs first $42.1 million of checkable deposits5 and 10% of the checkable deposits over $42.1 million, and the percentage set initially at 10% can be varied between 8 and 14%, at the FedÕs discretion. In extraordinary circumstances, the percentage can be raised as high as 18%.

The main advantage of using reserve requirements to control the money supply and interest rates is that they affect all banks equally and have a powerful effect on the money supply. The fact that changing reserve requirements is a powerful tool, however, is probably more of a curse than a blessing, because small changes in the money supply and interest rates are hard to engineer by varying reserve requirements. With checkable deposits currently around the $600 billion level, a 12-percentage-point increase in the reserve requirement on these deposits would reduce excess reserves by $30 billion. Because this decline in excess reserves would result in multiple deposit contraction, the decline in the money supply would be even greater. It is true that small changes in the money supply could be obtained by extremely small changes in reserve requirements (say, by 0.001 percentage point), but because it is so expensive to administer changes in reserve requirements, such a strategy is not practical. Using reserve requirements to fine-tune the money supply is like trying to use a jackhammer to cut a diamond.

Another disadvantage of using reserve requirements to control the money supply and interest rates is that raising the requirements can cause immediate liquidity problems for banks with low excess reserves. When the Fed has raised these requirements in the past, it has usually softened the blow by conducting open market purchases or by making the discount window more available, thus providing reserves to banks that needed them. Continually fluctuating reserve requirements would also create more uncertainty for banks and make their liquidity management more difficult.

The policy tool of changing reserve requirements does not have much to recommend it, and it is rarely used.

5The $42.1 million figure is as of the end of 2002. Each year, the figure is adjusted upward by 80% of the percentage increase in checkable deposits in the United States.

Application

Why Have Reserve Requirements Been Declining Worldwide?

In recent years, central banks in many countries in the world have been reducing or eliminating their reserve requirements. In the United States, the Federal Reserve eliminated reserve requirements on time deposits in December 1990 and lowered reserve requirements on checkable deposits from 12% to 10% in April 1992. As a result, the majority of U.S. depository institutionsÑbut not the largest ones with the bulk of depositsÑfind that reserve requirements are not binding: In order to service their depositors, many depository institutions need to keep sufficient vault cash on hand (which counts toward meeting reserve requirements) that they more than meet reserve requirements voluntarily. Canada has gone a step further: Financial market legislation taking effect in June 1992 eliminated all reserve requirements over a two-year period. The central banks of Switzerland, New Zealand, and Australia have also eliminated reserve requirements entirely. What explains the downward trend for reserve requirements in most countries?

You may recall from Chapter 9 that reserve requirements act as a tax on banks. Because central banks typically do not pay interest on reserves, the bank earns nothing on them and loses the interest that could have been earned if the bank held loans instead. The cost imposed on banks from reserve requirements means that banks, in effect, have a higher cost of funds than intermediaries not subject to reserve requirements, making them less competitive. We have already seen in Chapter 10 that additional market forces have been making banks less competitive, weakening the health of banking systems throughout the world. Central banks have thus been reducing reserve requirements to make banks more competitive and stronger.6 The Federal Reserve was explicit about this rationale for its April 1992 reduction when it announced it on February 18, 1992, stating in its press release that the reduction Òwill reduce funding costs for depositories and strengthen their balance sheets. Over time, it is expected that most of these cost savings will be passed on to depositors and borrowers.Ó

F I G U R E 6 The Channel/

Corridor System for Setting Interest

Rates

In the channel/corridor system standing facilities result in a step function supply curve, Rs. Then if the demand curve shifts between R1d and R2d, the overnight interest rate iff always remains between ir and il.

1.A supply and demand analysis of the market for reserves yields the following results. When the Fed makes an open market purchase or lowers reserve requirements, the federal funds rate declines. When the Fed makes an open market sale or raises reserve requirements, the federal funds rate rises. Changes in the discount rate may also affect the federal funds rate.

2.The amount of an open market operation conducted on any given day by the trading desk of the Federal Reserve Bank of New York is determined by the amount of the dynamic open market operation intended to change reserves and the monetary base and by the amount of the defensive open market operation used to offset other factors that affect reserves and the monetary base. Open market operations are the primary tool used

by the Fed to control the money supply because they occur at the initiative of the Fed, are flexible, are easily reversed, and can be implemented quickly.

3.The volume of discount loans is affected by the discount rate. Besides its effect on the monetary base and the money supply, discounting allows the Fed to perform its role as the lender of last resort. However, because the decisions by banks to take out discount loans are not controlled by the Fed, the use of discount policy to conduct monetary policy has little to recommend it.

4.Changing reserve requirements is too blunt a tool to use for controlling the money supply, and hence it is rarely used.

QUIZ Questions and Problems

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

*1. If the manager of the open market desk hears that a snowstorm is about to strike New York City, making it difficult to present checks for payment there and so raising the float, what defensive open market operations will the manager undertake?

2.During Christmastime, when the publicÕs holdings of currency increase, what defensive open market operations typically occur? Why?

*3. If the Treasury has just paid for a supercomputer and as a result its deposits with the Fed fall, what defensive open market operations will the manager of the open market desk undertake?

4.If float decreases below its normal level, why might the manager of domestic operations consider it more desirable to use repurchase agreements to affect the monetary base rather than an outright purchase of bonds?

*5. Most open market operations are currently repurchase agreements. What does this tell us about the likely volume of defensive open market operations relative to dynamic open market operations?

6.ÒThe only way that the Fed can affect the level of discount loans is by adjusting the discount rate.Ó Is this statement true, false, or uncertain? Explain your answer.

*7. Using the supply and demand analysis of the market for reserves, show what happens to the federal funds rate, holding everything else constant, if the economy is surprisingly strong, leading to a rise in the amount of checkable deposits.

8.If there is a switch from deposits into currency, what happens to the federal funds rate? Use the supply and demand analysis of the market for reserves to explain your answer.

*9. ÒDiscounting is no longer needed because the presence of the FDIC eliminates the possibility of bank panics.Ó Discuss.

10.The benefits of using Fed discount operations to prevent bank panics are straightforward. What are the costs?

*11. You often read in the newspaper that the Fed has just lowered the discount rate. Does this signal that the Fed is moving to a more expansionary monetary policy? Why or why not?

12.How can the procyclical movement of interest rates (rising during business cycle expansions and falling during business cycle contractions) lead to a procyclical movement in the money supply as a result of Fed discounting? Why might this movement of the money supply be undesirable?

*13. ÒIf reserve requirements were eliminated, it would be harder to control interest rates.Ó True, false, or uncertain?

14.ÒConsidering that raising reserve requirements to 100% makes complete control of the money supply possible, Congress should authorize the Fed to raise reserve requirements to this level.Ó Discuss.

*15. Compare the use of open market operations, discounting, and changes in reserve requirements to control the money supply on the following criteria: flexibility, reversibility, effectiveness, and speed of implementation.

Web Exercises

1.Go to www.federalreserve.gov/fomc/. This site reports activity by the open market committee. Scroll down to Calendar and click on the statement released after the last meeting. Summarize this statement in one paragraph. Be sure to note whether the committee has decided to increase or decrease the rate of growth of reserves. Now review the statements of the last two meetings. Has the stance of the committee changed?

2.Go to www.federalreserve.gov/releases/h15/update/. What is the current Federal Funds Rate (define this rate as well)? What is the current Federal Reserve Discount rate (define this rate as well)? Is the difference between these rates similar to what is usually observed, based on Figure 4? Have short-term rates increased or declined since the end of 2002?

PREVIEW

Now that we understand the tools that central banks like the Federal Reserve use to conduct monetary policy, we can proceed to how monetary policy is actually conducted. Understanding the conduct of monetary policy is important, because it not only affects the money supply and interest rates but also has a major influence on the level of economic activity and hence on our well-being.

To explore this subject, we look at the goals that the Fed establishes for monetary policy and its strategies for attaining them. After examining the goals and strategies, we can evaluate the FedÕs conduct of monetary policy in the past, with the hope that it will give us some clues to where monetary policy may head in the future.

www.federalreserve.gov/pf /pf.htm

Review what the Federal Reserve reports as its primary purposes and functions.

High Employment

Six basic goals are continually mentioned by personnel at the Federal Reserve and other central banks when they discuss the objectives of monetary policy: (1) high employment, (2) economic growth, (3) price stability, (4) interest-rate stability, (5) stability of financial markets, and (6) stability in foreign exchange markets.

The Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (more commonly called the Humphrey-Hawkins Act) commit the U.S. government to promoting high employment consistent with a stable price level. High employment is a worthy goal for two main reasons: (1) the alternative situationÑhigh unemploymentÑcauses much human misery, with families suffering financial distress, loss of personal self-respect, and increase in crime (though this last conclusion is highly controversial), and (2) when unemployment is high, the economy has not only idle workers but also idle resources (closed factories and unused equipment), resulting in a loss of output (lower GDP).

Although it is clear that high employment is desirable, how high should it be? At what point can we say that the economy is at full employment? At first, it might seem that full employment is the point at which no worker is out of a job; that is, when unemployment is zero. But this definition ignores the fact that some unemployment, called frictional unemployment, which involves searches by workers and firms to find suitable matchups, is beneficial to the economy. For example, a worker who decides