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Monetary control
Economics Letters 7 (1981) 159- 165 North-Holland Publishing Company
159
MONETARY CONTROL The Role of the Discount Rate and Other Supplemental Monetary Instruments Michael
G. HADJIMICHALAKIS
*
Fdwl Reserw Bourd. Wushingtm. DC .?0551. L’SA f~‘tmer-?~y of Wu.\hitrgron, Secrttle. WA 98195, USA Received
2 I April
This paper aggregates. procedures. pre-October multipliers, targets can
I98 I
examines the role of supplemental instruments on interest rates and monetary and hence on monetary control, in view of the recent switch in operating It is found that a change in the structure has occurred which has contaminated 1979 data. To the extent that the Federal Reserve has used relations, such as estimated from data generated by the old regime. the recent misses of monetary be explained partly by this factor.
1. Introduction
and summary
On October 6, 1979 the Federal Reserve changed its procedures of monetary control, switching from a federal funds to a (non-borrowed) reserves operating procedure. In Hadjimichalakis (1981) it was shown that as far as the primary tool of monetary policy, open market operations, is concerned, the two regimes amount to the same thing, anal+ tally. However, operationally they differ because the new regime enhances the role of borrowed reserved and neglect of this fact can be an important reason for substantial loss of precision of monetary control. In this paper we focus on the supplemental tools of monetary control, especially the discount rate, the reserve-requirement ratio and the rate on demand deposits (NOW accounts). First, it is shown that under the
* I have benefited from the comments of Hadjimichalakis, Lewis 0. Johnson, Peter A. views expressed in this paper are solely mine of the Board of Governors or the staff of the
01651765/81/0000-0000/$02.50
James Barth. Jerry Enzler, Karma Cr. Tinsley, and Peter von zur Muehlen. The and do not necessarily reflect the opinions Federal Reserve System.
0 1981 North-Holland
160
M.G. Hudjrmichalukis
/ Monerarl, cow-01
new regime, which treats non-borrowed reserves as a parameter, an increase in the discount rate raises the three rates, that is, the federal funds rate, the loan rate and the equity capital rate. Under the old regime, which treats the federal funds rate as a parameter, the increase in the discount rate raises only the loan and the equity capital rates. Under both regimes, these interest rate increases have further effects on monetary aggregates. However, this analysis is contrary to accepted doctrine which emphasized the opposite direction of causation, namely, that an increase in interest rates puts pressure on the Central Bank to raise the discount rate. ’ We further show that an increase in the other supplemental instruments similarly raises the endogenously determined interest rates under both regimes. The most important new result, however, is the proof that an increase in any of the supplemental instruments increases the amount of nonborrowed reserves under the old regime, while under the new regime non- borrowed reserves remain fixed. This result has serious repercussions: the monetary data have been contaminated and are now less useful, since the federal funds operating target has been in existence for a long time and the discount rate and reserves-requirement ratios have been used repeatedly. To the extent that relations, such as money multipliers, estimated from the old data are used, substantial loss of precision of monetary control occurs.
2. The model As in Hadjimichalakis (1980, 1981) the model employed is an adaptation of the works of Tobin, Brainard, Brunner-Meltzer and others. 2 We examine four financial assets markets: reserves, R, loans, L, T-bills, B, and equity capital, K. Equilibrium is attained only when the excess demands in all these assets markets are zero;
ER=O,
EB=O,
EL=O,
EK=O
(1)
’ See Hadjimichalakis (1980) and Federal Reserve (198I). * See, for example, Brainard-Tobin (1968), Tobin (1969), Brunner-Meltzer (1968). For simplifying and other reasons explained in great detail in Hadjimichalakis (1980) (a), we shall assume that the demand for currency is fixed, (b) we shall identify the federal funds interest rate with the bill rate, (c) we shall carry the analysis under the assumption of contemporaneous required reserve accounting, and (d) we shall abstract from interactions between the financial and the real hector.
M.G. HadJim~chalakis
/ Monetq
cor~trol
161
(where E denotes excess demand and R, B, L, and K denote reserves, bills, loans and equity capital, respectively). By Walras’ Law we need examine explicitly only three markets. We choose to eliminate the first, reserves, although occasionally, we bring it into the forefront for extra clarity. It should be pointed out here that the excess demand for reserves, ER, is demand minus supply, that is, requires reserved, kD (i.e., the reserve-requirement ratio, k, times demand deposits, D) minus non-borrowed reserves, R*, and borrowed reserves, R B, with the latter depending positively on the spread between the bill (federal funds) rate, r,, and the discount rate, d; that is R, = RR( r, - d ), Rh > 0. The behavioral equations, demands for and, occasionally, supplies of assets depend on the bill (federal funds) rate, rB, the loan rate, rL, the equity capital, rK, and on non-borrowed reserves, R,, the discount rate, d, the reserver-requirement ratio, k, the deposit rate, ro, wealth, W, and possibly other variables, assumed fixed in this analysis. The key difference between the old and the new monetary regimes is a structural one, namely under the new regime non-borrowed reserves are a policy instrument (parameter) while the federal funds (or bill) rate, rB, is endogenous, whereas under the old regime the roles are reversed; the federal funds rate is a policy instrument and non-borrowed reserves an endogenous variable.
3. Reserves operating target vs. Federal funds operating target: the equations of change We start with the non-borrowed reserves operating procedure, when (r,, r,_, rK) are endogenous, market-determined variables and (R,, d, k, ro) are policy instruments. R, is the primary and the rest are the supplemental instruments of control. For the reserves operating regime the equations of change are (2) aEB arB
aEB arL
aEB arK
ab
aEB
-aEL ar,
-aEL arL
~aEL arK
arL.
aEL
aEK ar,
aEK arL
aEK arK
ajic
aEK
aa,
aa, i
aa,
aa, aa, aa,
(2)
M.G. Hud/imichulukis
162
/ Monetmy
cotrtrol
Table 1 Non-borrowed reserves operating target. Effects on endogenous variables ar,
h
au,
au,
-ark au,
aR,
dTR
8D
aM
aa,
au,
au,
au,
Chotlge in rnstrunzerlt. 0, _
_
+
+
+
_
+ _
+
0, =d o,=k
+
+
+
+
+
_
-
u4 -rll
+
+
+
+
+
+
+
(i, =R,
+ _
(i = 1, 2, 3, 4, where a, = a2 d, = k, = rD). signs of solutions of EIrB/aa,, 8rL/8ai, for i 1, 2, 4, are in the three columns table 1. these solutions, can proceed find the on the endogenous variables, the following aggregates: borrowed R,, total TR, defined TR = + R,, deposits, D, hence, the supply, M. under the funds operating (R*, r,, are endogenously and (r,, k, rD) exogenous, policy ments. The of change aEB --ar, -aEL art7 aEK ---
aR*
aEB a’K
8%
aa,
-aEL arK
-85.
aEL
aEK arL
aEB
arK
aat
a+
aa,
=-
aa,
(3)
aEK aff,
I = 1, 2, 3, 4, where (Y, = rB, CQ= d, txg = k, q = rD. Again, the signs of &,/au,, i3r,/h,, for I= 1. 2, 3, 4, are captured the solutions aR,/aq, by the respective entries in the first three columns of table 2. The implied effects on the (remaining) monetary aggregates, R,, TR, D, and M, are depicted in the last four columns.
M.G. Hudjimichulukls Table 2 Federal funds operating
a, =r
,,I
163
target.
Effects on endogenous
variables
BR,
art. aq
ar,
+
+
+
+ +
+ +
+ +
an, Chut7gr
/ Moneturr; mrtrol
aa,
aR” acx,
;)TR an,
aD aq
aM aa,
ltlstrunletlt.a,
&
+
n,=X a, =rn
+ +
+
+
_
_ + +
_ +
+
The qualitative effects of all monetary instruments on the interest rates and on monetary aggregates, under the two rival operating regimes, are summarized in tables 1 (for the reserves regime) and 2 (for the funds rate regime). Comparing the first row of each table, we see that the two regimes are analytically the same as far as the primary instrument, open market operations, is concerned. The operational difference and the crucial role of the negative relation between borrowed and non-borrowed reserves are highlighted in Hadjimichalakis (198 1). Here we want to compare the two regimes in terms of the supplemental instruments. Comparing the second row of each table, we see that an increase in the discount rate raises all three interest rates under the new regime, while under the old regime it raises only the loans and the equity capital rates, r, and r,, leaving, by design, the funds (bill) rate unchanged. Under both regimes, the effects on the monetary aggregates, borrowed reserves, R B, total reserves, TR, demand deposits, D, and the money supply, M, are of the same sign, namely, negative. 3 The onlyand crucial-difference is that in the federal funds regime the increase in the discount rate is accompanied by an increase in non-borrowed reserves and an unchanged funds rate, whereas in the new regime the increase in the ’ The result, that under a federal funds operating
target total reserves fall has some bite since, as we shall see immediately below. the component ‘non-borrowed reserves’ rises: dTR/ad=aR,/ad+aR8/ad=aR,/ad-R;tO: hence. Rh>aR,/ad>O, i.e., the direct effect (on borrowed reserves, Rh) of an increase in the discount rate outweighs the indirect effect (on non-borrowed reserves, aR,/ad).
164
M.G. Hudjimichalukis
/ Monetmy cmtrol
discount rate is accompanied by an increase in the funds rate and an unchanged amount of non-borrowed reserves. (A comparable result is derived when one of the other two instruments, k, and rD, is changed as can be ascertained This
by inspection
of their respective
rows in tables 1 and
regime, has important policy implications: first, under the new regime the Central Bank regains full control of non-borrowed reserves; second, and most important, it renders the monetary data from the previous regime less useful for useless. The reason is that supplemental policies have always been used in conjunction with the primary instrument, open market operations, and hence they have distorted the effect of this primary instrument. To the extent that the Central Bank has used relations between (non-)borrowed reserves and the money supply, that is, multipliers, estimated from data generated by the old regime, the recent misses of monetary targets can be explained partly by this factor.
References Brainard. William C. and James Tobin. 1968, Pitfalls in financial model building, American Economic Review Papers and Proceedings, May. 99% 122. Brunner, Karl and Allan H. Meltzer. 1968. Liquidity traps for money. bank credit, and interest rates, Journal of Political Economy, Jan. Feb., l-37. Federal Reserve Staff Study, 1981, New monetary control procedures, Vols. I and II. Feb. (Board of Governors of the Federal Reserve System. Washington, DC). HadJimichalakis, Michael Cr., 1980. Precision of monetary control and volatility of rates: A comparative analysis of the reserves and the federal funds operating procedures, Special Studies Paper no. 150. Dec. (Board of Governors of the Federal Reserve System. Washington, DC). Hadjimichalakia, Michael G., 1981, Reserves vs federal funds operating procedures: A general equilibrium analysis, March (Board of Governors of the Federal Reserve System, Washington. DC). Tobin, James, 1969, A general equilibrium approach to monetary theory, Journal of Money, Credit, and Banking I, no. I, Feb., 15-29.
159
MONETARY CONTROL The Role of the Discount Rate and Other Supplemental Monetary Instruments Michael
G. HADJIMICHALAKIS
*
Fdwl Reserw Bourd. Wushingtm. DC .?0551. L’SA f~‘tmer-?~y of Wu.\hitrgron, Secrttle. WA 98195, USA Received
2 I April
This paper aggregates. procedures. pre-October multipliers, targets can
I98 I
examines the role of supplemental instruments on interest rates and monetary and hence on monetary control, in view of the recent switch in operating It is found that a change in the structure has occurred which has contaminated 1979 data. To the extent that the Federal Reserve has used relations, such as estimated from data generated by the old regime. the recent misses of monetary be explained partly by this factor.
1. Introduction
and summary
On October 6, 1979 the Federal Reserve changed its procedures of monetary control, switching from a federal funds to a (non-borrowed) reserves operating procedure. In Hadjimichalakis (1981) it was shown that as far as the primary tool of monetary policy, open market operations, is concerned, the two regimes amount to the same thing, anal+ tally. However, operationally they differ because the new regime enhances the role of borrowed reserved and neglect of this fact can be an important reason for substantial loss of precision of monetary control. In this paper we focus on the supplemental tools of monetary control, especially the discount rate, the reserve-requirement ratio and the rate on demand deposits (NOW accounts). First, it is shown that under the
* I have benefited from the comments of Hadjimichalakis, Lewis 0. Johnson, Peter A. views expressed in this paper are solely mine of the Board of Governors or the staff of the
01651765/81/0000-0000/$02.50
James Barth. Jerry Enzler, Karma Cr. Tinsley, and Peter von zur Muehlen. The and do not necessarily reflect the opinions Federal Reserve System.
0 1981 North-Holland
160
M.G. Hudjrmichalukis
/ Monerarl, cow-01
new regime, which treats non-borrowed reserves as a parameter, an increase in the discount rate raises the three rates, that is, the federal funds rate, the loan rate and the equity capital rate. Under the old regime, which treats the federal funds rate as a parameter, the increase in the discount rate raises only the loan and the equity capital rates. Under both regimes, these interest rate increases have further effects on monetary aggregates. However, this analysis is contrary to accepted doctrine which emphasized the opposite direction of causation, namely, that an increase in interest rates puts pressure on the Central Bank to raise the discount rate. ’ We further show that an increase in the other supplemental instruments similarly raises the endogenously determined interest rates under both regimes. The most important new result, however, is the proof that an increase in any of the supplemental instruments increases the amount of nonborrowed reserves under the old regime, while under the new regime non- borrowed reserves remain fixed. This result has serious repercussions: the monetary data have been contaminated and are now less useful, since the federal funds operating target has been in existence for a long time and the discount rate and reserves-requirement ratios have been used repeatedly. To the extent that relations, such as money multipliers, estimated from the old data are used, substantial loss of precision of monetary control occurs.
2. The model As in Hadjimichalakis (1980, 1981) the model employed is an adaptation of the works of Tobin, Brainard, Brunner-Meltzer and others. 2 We examine four financial assets markets: reserves, R, loans, L, T-bills, B, and equity capital, K. Equilibrium is attained only when the excess demands in all these assets markets are zero;
ER=O,
EB=O,
EL=O,
EK=O
(1)
’ See Hadjimichalakis (1980) and Federal Reserve (198I). * See, for example, Brainard-Tobin (1968), Tobin (1969), Brunner-Meltzer (1968). For simplifying and other reasons explained in great detail in Hadjimichalakis (1980) (a), we shall assume that the demand for currency is fixed, (b) we shall identify the federal funds interest rate with the bill rate, (c) we shall carry the analysis under the assumption of contemporaneous required reserve accounting, and (d) we shall abstract from interactions between the financial and the real hector.
M.G. HadJim~chalakis
/ Monetq
cor~trol
161
(where E denotes excess demand and R, B, L, and K denote reserves, bills, loans and equity capital, respectively). By Walras’ Law we need examine explicitly only three markets. We choose to eliminate the first, reserves, although occasionally, we bring it into the forefront for extra clarity. It should be pointed out here that the excess demand for reserves, ER, is demand minus supply, that is, requires reserved, kD (i.e., the reserve-requirement ratio, k, times demand deposits, D) minus non-borrowed reserves, R*, and borrowed reserves, R B, with the latter depending positively on the spread between the bill (federal funds) rate, r,, and the discount rate, d; that is R, = RR( r, - d ), Rh > 0. The behavioral equations, demands for and, occasionally, supplies of assets depend on the bill (federal funds) rate, rB, the loan rate, rL, the equity capital, rK, and on non-borrowed reserves, R,, the discount rate, d, the reserver-requirement ratio, k, the deposit rate, ro, wealth, W, and possibly other variables, assumed fixed in this analysis. The key difference between the old and the new monetary regimes is a structural one, namely under the new regime non-borrowed reserves are a policy instrument (parameter) while the federal funds (or bill) rate, rB, is endogenous, whereas under the old regime the roles are reversed; the federal funds rate is a policy instrument and non-borrowed reserves an endogenous variable.
3. Reserves operating target vs. Federal funds operating target: the equations of change We start with the non-borrowed reserves operating procedure, when (r,, r,_, rK) are endogenous, market-determined variables and (R,, d, k, ro) are policy instruments. R, is the primary and the rest are the supplemental instruments of control. For the reserves operating regime the equations of change are (2) aEB arB
aEB arL
aEB arK
ab
aEB
-aEL ar,
-aEL arL
~aEL arK
arL.
aEL
aEK ar,
aEK arL
aEK arK
ajic
aEK
aa,
aa, i
aa,
aa, aa, aa,
(2)
M.G. Hud/imichulukis
162
/ Monetmy
cotrtrol
Table 1 Non-borrowed reserves operating target. Effects on endogenous variables ar,
h
au,
au,
-ark au,
aR,
dTR
8D
aM
aa,
au,
au,
au,
Chotlge in rnstrunzerlt. 0, _
_
+
+
+
_
+ _
+
0, =d o,=k
+
+
+
+
+
_
-
u4 -rll
+
+
+
+
+
+
+
(i, =R,
+ _
(i = 1, 2, 3, 4, where a, = a2 d, = k, = rD). signs of solutions of EIrB/aa,, 8rL/8ai, for i 1, 2, 4, are in the three columns table 1. these solutions, can proceed find the on the endogenous variables, the following aggregates: borrowed R,, total TR, defined TR = + R,, deposits, D, hence, the supply, M. under the funds operating (R*, r,, are endogenously and (r,, k, rD) exogenous, policy ments. The of change aEB --ar, -aEL art7 aEK ---
aR*
aEB a’K
8%
aa,
-aEL arK
-85.
aEL
aEK arL
aEB
arK
aat
a+
aa,
=-
aa,
(3)
aEK aff,
I = 1, 2, 3, 4, where (Y, = rB, CQ= d, txg = k, q = rD. Again, the signs of &,/au,, i3r,/h,, for I= 1. 2, 3, 4, are captured the solutions aR,/aq, by the respective entries in the first three columns of table 2. The implied effects on the (remaining) monetary aggregates, R,, TR, D, and M, are depicted in the last four columns.
M.G. Hudjimichulukls Table 2 Federal funds operating
a, =r
,,I
163
target.
Effects on endogenous
variables
BR,
art. aq
ar,
+
+
+
+ +
+ +
+ +
an, Chut7gr
/ Moneturr; mrtrol
aa,
aR” acx,
;)TR an,
aD aq
aM aa,
ltlstrunletlt.a,
&
+
n,=X a, =rn
+ +
+
+
_
_ + +
_ +
+
The qualitative effects of all monetary instruments on the interest rates and on monetary aggregates, under the two rival operating regimes, are summarized in tables 1 (for the reserves regime) and 2 (for the funds rate regime). Comparing the first row of each table, we see that the two regimes are analytically the same as far as the primary instrument, open market operations, is concerned. The operational difference and the crucial role of the negative relation between borrowed and non-borrowed reserves are highlighted in Hadjimichalakis (198 1). Here we want to compare the two regimes in terms of the supplemental instruments. Comparing the second row of each table, we see that an increase in the discount rate raises all three interest rates under the new regime, while under the old regime it raises only the loans and the equity capital rates, r, and r,, leaving, by design, the funds (bill) rate unchanged. Under both regimes, the effects on the monetary aggregates, borrowed reserves, R B, total reserves, TR, demand deposits, D, and the money supply, M, are of the same sign, namely, negative. 3 The onlyand crucial-difference is that in the federal funds regime the increase in the discount rate is accompanied by an increase in non-borrowed reserves and an unchanged funds rate, whereas in the new regime the increase in the ’ The result, that under a federal funds operating
target total reserves fall has some bite since, as we shall see immediately below. the component ‘non-borrowed reserves’ rises: dTR/ad=aR,/ad+aR8/ad=aR,/ad-R;tO: hence. Rh>aR,/ad>O, i.e., the direct effect (on borrowed reserves, Rh) of an increase in the discount rate outweighs the indirect effect (on non-borrowed reserves, aR,/ad).
164
M.G. Hudjimichalukis
/ Monetmy cmtrol
discount rate is accompanied by an increase in the funds rate and an unchanged amount of non-borrowed reserves. (A comparable result is derived when one of the other two instruments, k, and rD, is changed as can be ascertained This
by inspection
of their respective
rows in tables 1 and
regime, has important policy implications: first, under the new regime the Central Bank regains full control of non-borrowed reserves; second, and most important, it renders the monetary data from the previous regime less useful for useless. The reason is that supplemental policies have always been used in conjunction with the primary instrument, open market operations, and hence they have distorted the effect of this primary instrument. To the extent that the Central Bank has used relations between (non-)borrowed reserves and the money supply, that is, multipliers, estimated from data generated by the old regime, the recent misses of monetary targets can be explained partly by this factor.
References Brainard. William C. and James Tobin. 1968, Pitfalls in financial model building, American Economic Review Papers and Proceedings, May. 99% 122. Brunner, Karl and Allan H. Meltzer. 1968. Liquidity traps for money. bank credit, and interest rates, Journal of Political Economy, Jan. Feb., l-37. Federal Reserve Staff Study, 1981, New monetary control procedures, Vols. I and II. Feb. (Board of Governors of the Federal Reserve System. Washington, DC). HadJimichalakis, Michael Cr., 1980. Precision of monetary control and volatility of rates: A comparative analysis of the reserves and the federal funds operating procedures, Special Studies Paper no. 150. Dec. (Board of Governors of the Federal Reserve System. Washington, DC). Hadjimichalakia, Michael G., 1981, Reserves vs federal funds operating procedures: A general equilibrium analysis, March (Board of Governors of the Federal Reserve System, Washington. DC). Tobin, James, 1969, A general equilibrium approach to monetary theory, Journal of Money, Credit, and Banking I, no. I, Feb., 15-29.