Thus, with the broadest and most active of all U. In early August , depository institutions faced the possibility that emerging pressures in financial markets could have significant effects on their balance sheets, and this uncertainty generated a considerable increase in demand for short-term funds.
On August 10, the Federal Reserve underscored its commitment to providing ample liquidity to facilitate the orderly functioning of financial markets, stating: "The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate" Board of Governors, a.
As is clear in chart 1 , the Federal Reserve was generally successful in keeping the federal funds rate from spiking above the target rate; indeed, the effective federal funds rate was somewhat below the target rate at times. Nonetheless, the volatility of the federal funds rate in recent months reflects the extent to which daily changes in demand for reserve balances have been unusually difficult to predict.
Tool 2: Overnight lending through the discount window The Federal Reserve's second tool for supplying liquidity during a financial disruption is to provide fully collateralized overnight loans directly to commercial banks and other depository institutions, which I will refer to collectively as banks. The Federal Reserve extends this credit through the discount window --that is, the lending facility at each of the regional Federal Reserve Banks. The phrase "discount window" harks back to the good old days when loans were provided by a human being sitting behind a bank window.
The primary credit facility is the main program under which the Federal Reserve extends loans to depository institutions. As a tool for providing liquidity to the financial system, the discount window is distinct from open market operations in two important respects.
First, open market operations influence the supply of short-term funds to the market as a whole, whereas loans through the discount window are made directly to individual institutions with particular needs for liquidity. Second, open market operations are conducted using U. Treasury and agency securities, whereas loans through the discount window can be made against a much wider range of collateral.
In its August 10 announcement, the Federal Reserve reaffirmed that it stood ready to provide liquidity not only through open market operations but also via discount lending by stating: "As always, the discount window is available as a source of funding" Board of Governors, a. By August 17, the Federal Reserve had determined that the significant strains in short-term money markets warranted further accommodation in the provision of liquidity through the discount window; thus, the spread between the discount rate and the target federal funds rate was reduced to 50 basis points, rather than the customary basis points, and the lower spread has been maintained since then Board of Governors, b.
In addition, the Federal Reserve adjusted its practices to facilitate the provision of discount window financing at terms of up to thirty days, renewable at the request of the borrower. These changes were aimed at assuring banks of the availability of a backstop source of liquidity. Banks subsequently borrowed only moderate amounts at the discount window but some institutions placed additional amounts of collateral with the Federal Reserve Banks, suggesting that these institutions perceived the discount window as a potentially significant source of liquidity under some contingencies.
Nonetheless, the discount window has two notable limitations as a tool for easing strains in money markets. First, a bank may be reluctant to borrow from the discount window, worrying that such borrowing might come to light and lead market participants and other institutions to draw adverse inferences about the bank's financial condition. This so-called stigma problem may largely account for the extent to which discount window borrowing has generally remained at moderate levels in recent months.
Second, lending through the discount window can pose challenges for keeping the federal funds rate close to its target, especially during periods of financial market disruption. The Federal Reserve's open market desk--that is, the staff at the Federal Reserve Bank of New York who actually conduct open market operations on a daily basis--must take into account the fact that loans made through the discount window add reserves to the banking system, and thus, all else equal, could tend to push the federal funds rate below the target set by the FOMC.
In ordinary circumstances, these borrowings are relatively small and predictable, and this influence can be offset using open market operations to drain a corresponding quantity of reserves from the system.
But in times of financial market strains, these borrowings can become larger and more difficult to predict. Tool 3: The new Term Auction Facility Despite the Federal Reserve's provision of liquidity through open market operations and the discount window, strains in term funding markets persisted and became particularly elevated in early December in response to year-end pressures.
The magnitude of these strains can be gauged using the spread between Libor--that is, the London interbank offered rate--and the overnight indexed swap OIS rate at the same maturity, because the OIS rate reflects the average overnight interbank rate expected over that maturity but is not subject to pressures associated with credit and liquidity risks to the same degree as Libor.
As shown in chart 2 , the one-month and three-month Libor-OIS spreads were at low levels through the month of July but increased markedly in August and early September at the onset of the financial market turmoil. In association with these wider spreads, liquidity in term bank funding markets deteriorated substantially.
As with primary credit, a depository institution is eligible to participate in a TAF auction if the bank is judged to be in generally sound financial condition, and a wide variety of collateral can be used to secure the loan. The minimum bid rate for each auction is established at the OIS rate corresponding to the maturity of the credit being auctioned.
The resulting interest rate in both cases was about 50 basis points above the minimum bid rate but well below the one-month Libor rate prevailing in financial markets at that time. All four affect the amount of funds in the banking system. The Fed can influence the money supply by modifying reserve requirements, which generally refers to the amount of funds banks must hold against deposits in bank accounts.
By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy. The Board is a seven member panel appointed by the President and approved by the Senate.
Thus the determinants of money supply are both exogenous and endogenous which can be described broadly as: the minimum cash reserve ratio, the level of bank reserves, and the desire of the people to hold currency relative to deposits. Also, a money supply that does not grow fast enough can lead to decreases in production, leading to increases in unemployment.
Since the economy does not influence the quantity of money, money supply is considered perfectly vertical on models. The central bank buys securities from private banks and puts money in their reserve accounts.
The main difference being that the customer essentially creates the money from thin air. So, when central banks purchase securities from private banks, money goes into their reserve account.
When the central bank buys securities, we call this an expansionary monetary policy. This is because it is expanding the money supply. In turn, they have more money to circulate throughout the economy. Meaning there is more money to lend and invest. Open market operations have the potential to cause inflation , so central banks must exercise extreme caution. They normally take place during periods of economic decline, with the aim of boosting the money supply and decreasing its value.
Ultimately, the central bank provides liquid funding to private banks. The aim is for them to lend to businesses to create jobs and invest in the economy.
What we saw in was an example of open market operations, but on a scale unseen before. The aim was to reduce the impact of the financial crisis and preserve aggregate demand. The second tool of monetary policy that a central bank has is the reserve requirement. For instance, the reserve requirement may be 10 percent. For example, if the Federal Reserve wants to stimulate the economy by increasing the money supply, it can do so by lowering the discount rate.
That allows commercial banks to borrow money more cheaply, which enables them to make more loans at lower rates. As a result, the amount of currency in circulation increases.
Similarly, if the Federal Reserve wants to reduce inflation e. This motivates them to make fewer loans at higher rates, which reduces the money supply. Please note that the name of the discount rate differs across central banks. However, despite the different names, they all describe the same interest rate.
Reserve requirements are a means to control the money supply by setting a minimum amount of cash reserves all commercial banks must hold in relation to their deposits. That means, the central banks can increase the amount of cash commercial banks must keep in their vaults to decrease the amount of money in circulation and vice versa. It can do this by increasing the reserve requirements.
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