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Understanding the Term Auction Facility: an in-class activity

This page authored by Dr. Stefan C. Mullinax, Department of Economics and Political Science, College of Lake County, Grayslake, IL.
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This material is replicated on a number of sites as part of the SERC Pedagogic Service Project

Summary

The purpose of this activity is to introduce students to alternative monetary policy instruments used by the Federal Reserve as a response to the Financial Crisis of 2007 – 2008. The students will participate in a classroom activity to understand how the Term Auction Facility was conducted by the Federal Reserve. The students will take the roles of distressed financial institutions and submit anonymous bids for new reserves to the Federal Reserve.

Learning Goals

The students should be able to describe and evaluate:
a. The structure of the Term Auction Facility
b. The reasons for the use of the Term Auction Facility
c. The effects of the Term Auction Facility on the liquidity of financial markets

Context for Use

This activity is designed for use in Principles of Macroeconomics classes when introducing the tools of monetary control by the Federal Reserve. This activity should be done in class and should last no more than 10-15 minutes. Any class size is appropriate for this activity and the activity requires no prior knowledge of monetary policy tools.

Description and Teaching Materials

The Term Auction Facility was a temporary program initiated by the Federal Reserve in December 2007 and was a variation of their discount window operations. The Fed began accepting anonymous bids on 28-day and, later, 84-day loans on a set amount of reserves they made available to financial institutions. All depository institutions able to borrow under the Federal Reserve's primary credit program were able to submit anonymous bids detailing the amount of reserves they wished to borrow as well as the interest rate that they would be willing to pay. The Fed allocated the funds beginning with the highest interest rate offered until all of the funds were borrowed or until all of the bids were satisfied. All institutions paid the same interest rate: the interest rate of the last (lowest) accepted bid. The last term auction was held in March 2010; however, the Fed could reinstate the term auction in response to some future financial collapse.

In this activity the instructor will announce that they (the Federal Reserve) are releasing a set quantity of funds to the financial sector (the instructor may determine the amount). Students will submit anonymous bids for funds. Depending on the intensity of the course, this game can be played at any of three levels; or, the instructor may use Level 1 as a demonstration of the activity before having the students participate in either Level 2 or Level 3.

Level 1 (Easy)
Each student will receive a randomly selected index card indicating the name of their institution, the quantity of funds they wish to borrow, and the interest rate that they are willing to pay. The information on the index cards can be made up by the instructor or taken from the Fed's Term Auction Facility dataset. The students write their name on their card and then turn them in to the instructor (submit their bid).

The instructor then lists the bids by their interest rate (highest to lowest). The auction ends when all of the available funds have been borrowed. The students whose bids are accepted in the auction may receive some reward (piece of candy, bonus points, etc.).

Level 2 (Intermediate)
Each student receives a randomly selected index card detailing the name of their institution and the quantity of funds the institution needs to borrow. The instructor announces the current value of the discount rate. The students must decide what interest rate they are willing to pay and write their name and the interest rate on the index card and return them to the instructor (submit their bid).

The instructor then lists the bids from highest to lowest interest rate. The auction ends when all of the available funds have been borrowed. The students whose bids are accepted in the auction may receive some reward (piece of candy, bonus points, etc.).

Level 3 (Advanced)
Each student receives a randomly selected index card detailing the name of their financial institution. The instructor announces the current value of the discount rate. The students must then decide how much their institution will borrow and what interest rate they are willing to pay. Note to instructor: You may want to consider placing an upper limit on the amount any one student may "borrow". The student writes their name on the card and returns the card to the instructor (submit their bid).

The instructor then lists the bids from highest to lowest interest rate. The auction ends when all of the available funds have been borrowed. The students whose bids are accepted in the auction may receive some reward (piece of candy, bonus points, etc.).

Materials Needed:
1. Index Cards with institution names, loan amounts, and interest rates
The institution names, loan amounts, and interest rates may be real or fictional. (level 1)
2. Index cards with institution names and loan amounts. Institution names and loan amounts may be real or fictional. (level 2)
3. Index cards with institution names. Institution names may be real or fictional. (level 3)
Term Auction Facility (Excel 954kB Apr28 13)

A dataset containing information on all of the Term Auctions held by the Fed has been provided. The spreadsheet contains the names of the borrower instiutions (column E), the amount of each loan (column H), and the interest rate paid by all borrowers (column I). The remaining columns are not neccessary for this activity.



Teaching Notes and Tips

The instructor can choose the level of difficulty for this activity based on the progress of the class. Moreover, the instructor may employ multiple levels in the same class to reinforce fundamental concepts. If you use the Term Auction Facility data set, the Fed only includes the final interest rate that all the institutions paid (lowest bid) so you must provide the interest rates for the higher bids that were accepted. If the instructor chooses to use the data set the columns of highest importance are those that list the Borrower institution (column E), the loan amount (column H), and the interest rate paid (column I). Loan amounts are presented as millions of dollars. Also, the total amount of the student bids can sum to be more than the quantity of funds auctioned so that some student bids are not accepted.

Assessment

Questions to ask students at the end of the activity:
1. Why do you think the Fed began taking anonymous bids for funds during the financial crisis?
2. What effect do you think this policy had on the liquidity and overall health of financial markets?

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