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CHAPTER 10
Conduct of
Monetary Policy:
Tools, Goals,
Strategy, and
Tactics
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Chapter Preview
“Monetary policy” refers to the management
of the money supply. Although the idea is
simple enough, the theories guiding the
Federal Reserve are complex and often
controversial. But, we are affected by this
policy, and a basic understanding of how it
works is, therefore, important.
© 2012 Pearson Prentice Hall. All rights reserved.
10-1
Chapter Preview
We examine how the conduct of monetary policy
affects the money supply and interest rates. We
focus primarily on the tools and the goals of the
U.S. Federal Reserve System, and examine its
historical success. Topics include:
 The Federal Reserve’s Balance Sheet
 The Market for Reserves and the Federal Funds
Rate
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Chapter Preview (cont.)
 Tools of Monetary Policy
 Discount Policy
 Reserve Requirements
 Monetary Policy Tools of the ECB
 The Price Stability Goal and the Nominal Anchor
 Other Goals of Monetary Policy
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Chapter Preview (cont.)
 Should Price Stability be the Primary Goal of
Monetary Policy?
 Inflation Targeting
 Central Banks’ Responses to Asset-Price
Bubbles: Lessons from the 2007–2009
Financial Crisis
 Tactics: Choosing the Policy Instrument
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The Federal Reserve’s
Balance Sheet
The conduct of monetary policy by the Federal
Reserve involves actions that affect its balance
sheet. This is a simplified version of its balance
sheet, which we will use to illustrate the effects of
Fed actions.
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The Federal Reserve’s
Balance Sheet: Liabilities
 The monetary liabilities of the Fed include:
─ Currency in circulation: the physical currency in the
hands of the public, which is accepted as a medium of
exchange worldwide.
─ Reserves: All banks maintain deposits with the Fed,
known as reserves. The required reserve ratio, set by
the Fed, determines the required reserves that a bank
must maintain with the Fed. Any reserves deposited
with the Fed beyond this amount are excess reserves.
The Fed does not pay interest on reserves, but that
may change because of legislative changes for 2011.
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The Federal Reserve’s
Balance Sheet: Assets
 The monetary assets of the Fed include:
─ Government Securities: These are the U.S. Treasury
bills and bonds that the Federal Reserve has
purchased in the open market. As we will show,
purchasing Treasury securities increases the money
supply.
─ Discount Loans: These are loans made to member
banks at the current discount rate. Again, an increase
in discount loans will also increase the money supply.
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Open Market Operations
 In the next two slides, we will examine the impact
of open market operation on the Fed’s balance
sheet and on the money supply. As suggested in
the last slide, we will show the following:
─ Purchase of bonds increases the money supply
─ Making discount loans increases the money supply
 Naturally, the Fed can decrease the money
supply by reversing these transactions.
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The Federal Reserve
Balance Sheet
 Open Market Purchase from Public
Public
Assets
Securities
–$100
Deposits
+$100
The Fed
Liabilities
Assets
Securities
+$100
Liabilities
Reserves
+$100
Banking System
Assets
Liabilities
Reserves
Deposits
+$100
+$100
 Result R  $100, MB $100
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The Federal Reserve
Balance Sheet
 Discount Lending
Banking System
Assets
Liabilities
Reserves
Discount loans
+$100
+$100
The Fed
Assets
Discount loans
+$100
Liabilities
Reserves
+$100
 Result R  $100, MB $100
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Supply and Demand in the
Market for Reserves
we will examine how this change in reserves affects
the federal funds rate, the rate banks charge each
other for overnight loans.
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Supply and Demand in the
Market for Reserves
1. Demand curve
slopes down
because iff ,
ER  and Rd
up
2. Supply curve
slopes down
because iff ,
DL , Rs 
3. Equilibrium iff
where Rs = Rd
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Response to Open Market Operations:
Case 1—downward sloping demand
1. Open market
purchase shifts
supply curve to the
right (NBR1 to
NBR2).
2. Rs shifts down, fed
funds rate falls.
3. Reverse for sale.
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Response to Open Market
Operations: Case 2—flat demand
1. Open market
purchase shifts
supply curve to the
right (NBR1 to
NBR2).
2. Rs parallel, fed
funds rate
unchanged.
3. Reverse for sale.
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Tools of Monetary Policy
Now that we have seen and understand the
tools of monetary policy, we will further
examine each of the tools in turn to see how
the Fed uses them in practice and how useful
each tools is.
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Tools of Monetary Policy:
Open Market Operations
 Open Market Operations
1. Dynamic: Meant to change current reserve level
2. Defensive: Meant to offset other factors affecting Reserves,
typically uses repos
 Advantages of Open Market Operations
1. CB has complete control: OMOs initiated by CB, so the volume
is entirely under its control
2. Flexible and precise: Operations are flexible and concise,
useful for both small and large changes in the monetary base
3. Easily reversed: Unanticipated effects are easily reversed, if
needed
4. Implemented quickly: Once course of action approved, the
policy is implements quickly, avoiding administrative delays
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Tools of Monetary Policy: Open Market
Operations at the Trading Desk
 The trading desk typically uses two types of
transactions to implement their strategy:
─ Repurchase agreements: the Fed purchases
securities, but agrees to sell them back within about
15 days. So, the desired effect is reversed when the
Fed sells the securities back—good for taking defense
strategies that will reverse.
─ Matched sale-purchase transaction: essentially a
reverse repro, where the Fed sells securities, but
agrees to buy them back.
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Tools of Monetary Policy:
Discount Loans
 Discount window
─ CB facility at which discount loans are made
─ Discount rate: interest rate on discount loan
 3 types of discount loans:
─ Primary Credit
─ Secondary Credit
─ Seasonal Credit
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Tools of Monetary Policy:
Discount Loans
─ Primary Credit:
•
Borrowings from Central Bank by healthy banks
•
Also known as the standing lending facility
•
Interest rate on the primary credit is the discount rate and it is set higher
than the fed funds rate usually by 100 basis points
─ Secondary Credit:
• Given to troubled banks experiencing liquidity problems
• Rate: Set at 50 basis point above the discount rate – a penalty
─ Seasonal Credit:
• Designed for small, regional banks that have seasonal patterns of
deposits such as vacation area
• Rate: Tied to the average fed funds rate
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Tools of Monetary Policy :
Discount Loans
 Lender of Last Resort Function




Discounting important to prevent banking panics
Reserves are immediately channeled to the banks
Federal Deposit Insurance Corporation (insures depositors up to
$100,000 per account)- fund not big enough
– FDIC insurance amounts to 1% of the total deposit outstanding
– The people need the Fed for additional confidence in the system
To prevent nonbank financial panics
Examples: 1987 stock market crash, 2001 World Trade Center
destruction, 2007 Sub-prime crisis
 Announcement Effect

Problem: moral hazard: Banks and other financial institutions may
take on more risk (moral hazard) knowing the Fed will come to the
rescue
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Inside the Fed
 The 2007–2009 Financial Crisis tested the Fed’s
ability to act as a lender of last resort. Here are
some of the details of the Fed’s efforts during this
period to provide liquidity to the banking system:
─ The Fed lowered the discount rate to 0.5% above the
fed funds rate, and then by March 2008, lowered that
to just 0.25%.
─ Discount loan maturity was extended from overnight
loans to loans maturity in 30 days, and then 90 days.
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Impact of Discount Loans on CB’s
Balance Sheet
 Discount Lending: Fed giving out loans to the banks
Banking System
Assets
Reserves
Liabilities
Discount loans
+$100
+$100
The Fed
Assets
Liabilities
Discount loans Reserves
+$100
+$100
Result R  $100, MB $100
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Reserve Requirements
Reserve Requirements are requirements put on financial
institutions to hold liquid (vault) cash again checkable
deposits.
 Everyone subject to the same rule for checkable deposits:
─
─
3% of first $48.3M, 10% above $48.3M
Fed can change the 10%
 Rarely used as a tool
─
─
Raising causes liquidity problems for banks
Makes liquidity management unnecessarily difficult
FOMC calendar and meeting minutes
http://www.federalreserve.gov/fomc/#calendars
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Tools of Monetary Policy (3):
Reserve Requirements

Changing ratio of required reserve, thus changing the demand for
reserves
 Everyone subject to the same rule for checkable deposits:
─
─

3% of first $48.3M, 10% above $48.3M
Fed can change the 10%
Advantages
1. Powerful effect – being imposed on all banks

Disadvantages
1. Small changes have very large effect on Ms
2. Raising causes liquidity problems for banks: particularly for
banks with low excess reserve
3. Frequent changes cause uncertainty for banks
4. Tax on banks
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Goals of Monetary Policy
Ultimate objective of mp; end results of mp
implementation. What mp intends to achieve:
1.
2.
3.
4.
5.
6.
High employment
Economic growth
Price stability:
– many social and economic costs of inflation
– rising price level creates uncertainty, hampers economic
growth; complicates decision making
Interest rate stability
– Desirable: fluctuations create uncertainties; hard to plan for
future
Financial market stability
– Financial crisis interfere with ability of financial markets to
channel funds; lead to economic contraction
Foreign exchange market stability
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Goals of Monetary Policy
 Goals often in conflict
─
Economic growth and price stability: When economy
expands, inflation rising: achieve growth but instable price
─
Price and interest rate stability: To ensure price stability,
interest rate has to increase
─
Unemployment and inflation: Reduce unemployment,
inflation starts to rise
─
Decision by central bank
•
Check and balance
•
Depending on priority
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Central Bank Strategy:
Targets
 To achieve certain goals, CBs do not directly influence
goals, but use the tools at its disposal
 All CBs, then, are limited to aiming at variables that lie
between their tools and achievement of desired goals
 CB identifies intermediate targets which it aims to affect
via its operating targets
─
─
Easier to hit a goal by aiming at targets than aiming at goal directly
Allow for mid-course correction
 2 types of target variables:
─
─
interest rates
monetary/reserve aggregates
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Central Bank Strategy:
Choosing the Targets
 Fed has two options of target variables: interest rates
and aggregates.
─
Example: A 5% GDP growth can be achieved through 3%
increase in reserves/monetary aggregates or setting interest
rate at 2%
 But, can CB chooses both targets simultaneously?
─
─
─
Unfortunately, the Fed can only choose one of the two
variables.
The demand and supply analysis that follows will show why
this is the case.
Any action which affects one of the targets will have some
impact on the other target.
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Criteria for Choosing Policy
Instruments
 Criteria for Policy Instruments
1.Observable and Measurable
•
Some are observable, but with a lag (eg. reserve aggregates)
2.Controllable
•
Controllability is not clear-cut. Both aggregates and interest rates have
uncontrollable components.
3.Predictable effect on goals
•
Generally, short-term rates offer the best links to monetary goals. But
reserve aggregates are still used.
•
Interest rates aren't clearly better than Ms on criteria 1 and 2 because
hard to measure and control real interest rates
 Criteria for Operating Targets
1.
Same criteria as above
•
Reserve aggregates and interest rates about equal on
criteria 1 and 2, but for 3 if intermediate target is Ms
then reserve aggregate is better
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Fed Policy Procedures:
Historical Perspective
 Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 1920–1921
 Discovery of Open Market Operations
1. Made discovery when purchased bonds to get income
in 1920s
 Great Depression
1. Failure to prevent bank failures
2. Result: sharp drop in Ms
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Fed Policy Procedures:
Historical Perspective
 Targeting Monetary Aggregates: 1970s
1.
2.
Federal funds rate as operating target with narrow band
Procyclical Ms
 New Fed Operating Procedures: 1979–1982
1.
2.
3.
De-emphasis on federal funds rate
Nonborrowed reserves operating target
The Fed still using interest rates to affect economy and inflation
 De-emphasis of Monetary Aggregates: 1982–Early 1990s
1.
2.
3.
4.
Targeted 3% for the fed funds rate from late 1992–February of 1994.
Raised the rate to 6% by early 1995.
Lowered the rate in the face of a slowing economy and LTCM crisis.
Continued this trend in 2001, when the economy faced a recession.
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Monetary Targeting in Other Countries
 United Kingdom
1. Targets M3 and later M0
2. Problems of M as monetary indicator
 Canada
1. Targets M1 till 1982, then abandons it
2. 1988: declining π targets, M2 as guide
 Germany
1. Targets central bank money, then M3 in 1988
2. Allows growth outside target for 2–3 years, but then
reverses overshoots
3. 1990s: dilemma of restrain π, but keep exchange rate in EMS
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Monetary Targeting in Other Countries
 Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful
as monetary indicator
3. High money growth 1987–1989: “bubble economy,” then tight
money policy
 Lessons from Monetary Targeting
1. Success requires correcting overshoots
2. Operating procedures not critical
3. Breakdown of relationship between M and goals made Mtargeting untenable; led to inflation targeting
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The New International Trend in Monetary Policy
Strategy: Inflation Targeting
 New Zealand
─
─
─
Passed the Reserve Bank of New Zealand act (1990)
Policy target agreement set an annual inflation target in the
range of 0% to 2%
Target has adjusted based on current economic conditions
 Canada
─
─
Established formal inflation targets, starting in 1991
Targets have also been adjusted as needed
 United Kingdom
─
─
Established formal inflation targets, starting in 1992
Targets have also been adjusted as needed
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10-34
The New International Trend in Monetary Policy
Strategy: Inflation Targeting
 Lessons from Inflation Targeting
─
Decline in inflation still led to output loss
─
Worked to keep inflation low
─
Kept inflation in public eye—reduced political pressures for
inflationary policy
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