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Chapter Eight
THE CONDUCT OF MONETARY
POLICY: TOOLS, GOALS, AND
TARGETS
Copyright © 2000 Addison Wesley Longman
Slide #8-1
The Federal Reserve Balance
Sheet
Monetary Base = Currency + Reserves
Open Market Purchase from Bank
The Banking System
Assets
Securities
- $100
Reserves
+ $100
Liabilities
Copyright © 2000 Addison Wesley Longman
The Fed
Assets
Securities
+ $100
Liabilities
Reserves
+ $100
Result: R  $100, MB  $100
Slide #8-2
The Federal Reserve Balance
Sheet
Open Market Purchase from Public
Public
Assets
Liabilities
Securities
- $100
Deposits
+ $100
Banking System
Assets
Liabilities
Reserves
Deposits
+ $100
+ $100
Copyright © 2000 Addison Wesley Longman
The Fed
Assets
Liabilities
Securities
Reserves
+ $100 +$100
Result: R  $100, MB  $100
Slide #8-3
The Federal Reserve Balance
Sheet
Discount Loans
Banking System
Assets
Reserves
+ $100
Liabilities
Discount
loan + $100
The Fed
Assets
Discount
loan + $100
Liabilities
Reserves
+ $100
Result: R  $100, MB  $100
Copyright © 2000 Addison Wesley Longman
Slide #8-4
Market for Reserves and the Fed Funds Rate
1. Demand
curve
slopes
down
because iff
, ER 
and Rd up
2. Supply
curve
slopes
down
because iff
, DL , Rs

3. Equilibrium
iff where
Rd = Rs
Copyright © 2000 Addison Wesley Longman
Slide #8-5
Response to Open Market Operation or
Change in Discount Rate
1. Open
market
purchase,
Rs shifts to
right and iff

2. id , DL ,
Rs shifts to
right and iff

Copyright © 2000 Addison Wesley Longman
Slide #8-6
Response to Change in Required
Reserves
1. RR ,
Rd
shifts
to
right, iff

Copyright © 2000 Addison Wesley Longman
Slide #8-7
Tools of Monetary Policy
Open Market Operations
1. Dynamic:
Meant to change Reserves
2. Defensive:
Meant to offset other factors affecting Reserves,
typically uses repos
Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
Copyright © 2000 Addison Wesley Longman
Slide #8-8
Discount Loans
3 Types
1. Adjustment Credit
2. Seasonal Credit
3. Extended Credit
Lender of Last Resort Function
1. To prevent banking panics FDIC fund not big enough
Examples: Continental Illinois and Franklin National Banks
2. To prevent nonbank financial panics
Example: 1987 stock market crash
Announcement Effect
1. Problem: False signals
Copyright © 2000 Addison Wesley Longman
Slide #8-9
Reserve Requirements
Advantages
1. Powerful effect
Disadvantages
1. Small changes have very large effect on
Ms
2. Raising causes liquidity problems for
banks
3. Frequent changes cause uncertainty for
banks
4. Tax on banks
Copyright © 2000 Addison Wesley Longman
Slide #8-10
Goals of Monetary Policy
Goals
1. High Employment
2. Economic Growth
3. Price Stability
4. Interest Rate Stability
5. Financial Market Stability
6. Foreign Exchange Market Stability
Goals often in conflict
Copyright © 2000 Addison Wesley Longman
Slide #8-11
Central Bank Strategy
Copyright © 2000 Addison Wesley Longman
Slide #8-12
Money Supply Target
1. Md fluctuates
between Md'
and Md''
2. With Mtarget at M*,
i fluctuates
between i '
and i ''
Copyright © 2000 Addison Wesley Longman
Slide #8-13
Interest Rate Target
1. Md
fluctuates
between
Md' and
Md''
2. To set itarget at i*,
Ms
fluctuates
between
M ' and
M '’
Copyright © 2000 Addison Wesley Longman
Slide #8-14
Criteria for Choosing Targets
Criteria for Intermediate Targets
1. Measurability
2. Controllability
3. Ability to predictably affect goals
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
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
Copyright © 2000 Addison Wesley Longman
Slide #8-15
History of Fed Policy Procedures
Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 1920-21
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
Copyright © 2000 Addison Wesley Longman
Slide #8-16
History of Fed Policy
Procedures
Pegging of Interest Rates: 1942-51
1. To help finance war, T-bill at 3/8%, T-bond at
1/2%
2. Fed-Treasury Accord in March 1951
2
Money Market Conditions: 1950s and 60s
1. Free reserves = ER - DL
2. Interest rates
Copyright © 2000 Addison Wesley Longman
Slide #8-17
History of Fed Policy
Procedures
Targeting Monetary Aggregates: 1970s
1. Fed funds rate as operating target with narrow band
2. Procyclical Ms
New Operating Procedures: 1979-82
1. Deemphasis on fed funds rate
2. Nonborrowed reserves operating target
3. Fed still using interest rates to affect economy and
inflation
Deemphasis of Monetary Aggregates: 1982 -Early
1990s
1. Borrowed Reserves (DL) operating target
Copyright © 2000 Addison Wesley Longman
Slide #8-18
History of Fed Policy
Procedures
Fed Funds Targeting Again
1. Fed funds target now announced
International Considerations
1. M  in 1985 to lower exchange rate, M  in 1987 to
raise it
2. International policy coordination
Copyright © 2000 Addison Wesley Longman
Slide #8-19
Federal Funds Rate and Money Growth
Before and After October 1979
Copyright © 2000 Addison Wesley Longman
Slide #8-20
Monetary Targeting Abroad
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
Copyright © 2000 Addison Wesley Longman
Slide #8-21
Monetary Targeting Abroad
Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful as
monetary indicator
3. High money growth 1987-89: "bubble economy", then
tight money policy
Copyright © 2000 Addison Wesley Longman
Slide #8-22
Inflation Targeting
Lessons from Monetary Targeting
1. Success requires correcting overshoots
2. Operating procedures not critical
3. Breakdown of relationship between M and goals made M-targeting
untenable: Led to inflation targeting
Inflation Targeting: New Zealand, U.K., Canada
1. Announcement of numerical π goal
2. Commitment to price stability
3. Communication with "Inflation Report"
Lessons from Inflation Targeting
1. Decline in π still led to output loss
2. Worked to keep π low
3. Kept π in public eye: reduced political pressures for inflationary policy
Copyright © 2000 Addison Wesley Longman
Slide #8-23
Using a Fed Watcher
Fed watcher predicts monetary tightening, i 
1.
2.
Acquire funds at current low i
Buy $ in FX market
Fed watcher predict monetary loosening, i 
1.
2.
3.
Make loans now at high i
Buy bonds, price rise in future
Sell $ in FX market
Copyright © 2000 Addison Wesley Longman
Slide #8-24