Econ315 Money and Banking: Learning Unit 23: Monetary Policy - Tools and Conduct (2014)

Learning Unit #23
Monetary Policy: Tools &
Conduct

Objectives of Learning Unit
This Learning Unit explores three tools for the
monetary policy and explains how the Federal
Reserve System conducts its monetary policy,
using its tools through its money supply model.
 Three Monetary Policy Tools
 Open Market Operations
 Discount Window Operations
 Reserve Requirements
 Conduct of Monetary Policy
 Goals of Monetary Policy
 Strategy to Achieve Price Stability
 Tools-Instruments-Targets-Goals Framework
 Instruments and Targets of Monetary Policy

Monetary Policy Framework
The Fed controls Policy tools to achieve its goals through
affecting and monitoring targets and instruments.

Tools of Monetary Policy
 The Federal Reserve System uses three tools of
monetary policy to manipulate the money supply
and interest rates.
 Each tool is used in different manner and has
advantages and disadvantages as tools of
monetary policy.
 The Federal Reserve System uses three tools to
provide various functions to the financial system
and the economy beyond simply affecting the
money supply and interest rates.

Open Market Operations
 Open market operation: The Federal Reserve purchases
from and sells Treasury securities to dealers in the open
market.
 The open market operation directly and immediately
affects the amount of reserves in the banking system,
initiating the deposit creation/contraction process to
eventually affect the money supply in the economy.
 Through sales and purchases of Treasury securities
which affect the demand for Treasury securities in the
market, the open market operation also directly and
immediately affects the interest rates, in particular the
federal funds rate, then eventually other market interest
rates.

Conducts of Open Market Operations
The Federal Reserve implements open market operations in
two different ways:
■ Permanent transactions
■ Outright purchases and sales: The Fed purchases
from or sells to dealers Treasury securities.
■ Temporary transactions
■ Repurchase agreement (repos): The Fed
purchases Treasury securities from dealers and the
dealers agree to buy them back from the Fed.
■ Matched sale-purchase transactions (reversed
repos): The Fed sells Treasury securities to dealers
and the dealers agree to sell them back to the Fed.

Permanent Transactions
 Permanent transactions are used when the Fed needs to
affect the reserves or the federal funds rate permanently.
● Permanent transactions are final. No further
transactions follow.
■ Example: The Fed wants to increase the reserves to
stimulate the economy more spending to bring it out
from a recession.
● It will take a long time see full effects of the
transaction on the economy (the deposit creation
process takes a long time). The Fed does not want to
reverse its action until it sees the economy getting out
of a recession.

Temporary Transactions
 Temporary transactions are used when the Fed needs to
affect the reserves or the federal funds rate temporarily.
● Temporary transactions always involve two transactions.
The second transaction reveres what the first
transaction has done to reserves, leaving no permanent
effect on reserves.
● Repos usually have short maturities of few weeks, so
effects of temporary transactions are very short.
● The Fed can engage in two separate permanent
transactions (e.g. Outright purchase, then outright sale)
to have the same effect as temporary transactions.
■ Example: There is need for temporal increase in reserves
during a shopping season when many shops and
consumers withdraw funds from banks. Once the shopping
season is over, banks will not need excess reserves. The
Fed may engage in repos over the shopping season.

The Federal Reserve engages in open market
operations either to maintain the money supply or to
change the money supply.
■ Dynamic transactions: The Fed intends to change
the level of the monetary base and the money
supply to a target level.
■ Defensive transactions: The Fed intends to offset
movements in other factors that affect the monetary
base and the multiplier in order to maintain the level
of the money supply constant.
Two Types of Open Market Operations

Dynamic Transactions
 The Fed wants to change the level of money supply (M)
or the federal funds rate because it believes that the
current level of money supply or the federal funds rate is
either too low or too high.
 Example: The Fed wants to increase the money supply
by $10 billion. Given a money multiplier equal to 2, the
Fed engages in $5 billion of open market purchase to
increase the monetary base.
 Example: The Fed wants to decrease the federal funds
rate by 0.25%. The Fed engages in open market sales
to increase reserves and continues to do so until it
lowers demand for the federal funds and reduces the
federal funds rate to its target rate.

Defensive Transactions
 Because market forces or economic conditions push the
level of money supply or the federal funds rate away from
its target levels, the Fed engages in defensive transactions
to maintain the current level of money supply or the federal
funds.
 Example: If the money multiplier changes due to changes in
banks’ behavior or depositors’ behavior, the Fed needs to
change the monetary base to counter.
● Currently, m = 2 and MB = $1 trillion. The Fed wants to maintain
the money supply at $2 trillion, but the money multiplier changes to
2.5. Then, it engages in $200 billion of the open market sales in
order to decrease the monetary base to $800 billion.
■ Example: Because of sudden deposit outflows, banks need
more reserves, raising the federal funds rate. The Fed
counters it by engaging in open market purchases to
provide more reserves in the banking system, bringing back
the federal funds rate to the previous level.

Use of Open Market Operation beyond
Depository Institutions
 Open market operations can be used for other
functions of the Fed.
 When any financial institutions, not limited to
commercial banks, the Fed can engage in open market
operations to purchase security holdings of the
institution and to provide liquidity to the institution.
 Example: Investment banks and other non-depository
financial institutions hold too much high risk securities
whose market values fell significantly and cannot find
any buyers. On March 27, 2008, the Fed started a
swap program where the Fed sells Treasury securities
to financial institutions with those hard-to-sell securities
as collateral from those financial institutions, which in
turn sell Treasury securities to get needed cash.

Discount Window Operations
 The Federal Reserve System controls the monetary base
and the money supply through its discount window
operations at regional Federal Reserve banks.
● The Fed can provide reserves through discount loans.
 Borrowing banks must pay discount rate on the loans.
● The Fed can influence the behavior of banks through the
moral suasion.
● The Fed sets rules for use of the discount window.
● If a bank sets too low excess reserves and requests
too often discount loans, the Fed may refuse to lend
funds, forcing the bank to hold more excess reserves.

Types of Discount Loans
 The Federal Reserve System provides three types of
discount loans for different purposes:
 Primary credit is given to sound banks for very short
maturity (overnight).
 Secondary credit is given to banks in financial trouble
experiencing severe liquidity problem, for an extended
period of time (28 days).
 On August 11, 2008, the Fed made available 84-days
extended loans.
 Seasonal credit is given to small banks in vacation and
agricultural areas that have a seasonal pattern of
deposits and loans.

Discount Loans: Primary Credit
 Primary credit: healthy banks are allowed to borrow all
they want at very short maturity (overnight) to meet their
reserve requirements.
● Due to constant inflows and outflows of deposits,
banks may be in short of reserves to meet their
requirement. The Fed stands ready to provide
necessary funds (standing lending facility).
● The discount rate on primary credit is usually set 100
points (one percentage point) above the federal funds
rate.
● The standing lending facility is intended to be a
backup source of liquidity for sound banks for smooth
daily operation.

Three Functions of Discount Window
Operations
 Control the monetary base and the money supply.
 Lender of last resort: The Fed stands by to make loans
to failing banks during a financial crisis when other
banks cannot.
 Signal Fed’s monetary policy (announcement effect): A
change in the discount rate signals the Fed’s intention
to the market.
● The Fed and many other central banks do not
explicitly set their targets of monetary policy and do
not clearly tell what they are going to do.
● Instead, through its action on discount window
operations, the Fed signals what it plans to do.

Use of Lending Facilities beyond
 In 2008, the Federal Reserve expanded its loan
program beyond the commercial banking
industry.
● As a result of sub-prime loan crisis, many investment
banks faced liquidity problems like banks.
● On March 17, 2008, the Fed introduced an
emergency loan program similar to discount loans
available for brokerage firms which held too much
risky securities and faced liquidity problems. The
program was intended to ease short-term credit
crunch problem.

In March 2008,the Fed made a loan to J.P. Morgan Chase to purchase
Bear Sterns (Investment bank).

In September 2008, the Fed made a loan to AIG (insurance firm).
In November 2008, the Fed expanded its loans to issuers of asset-
backed securities, mainly banks and hedge funds.

Reserve Requirements
 The Federal Reserve sets a required reserve ratio for all
depository institutions.
 Any changes in the required reserve ratio affects a money
multiplier, thus the money supply.
 In reality, the Fed rarely changes the reserve
requirements. Hence, the Fed does not use the reserve
requirements as main monetary policy tool, which may
requires frequent maneuvers and adjustments.
● Since April 1992, the Fed has not changed required
reserve ratios. Currently, required reserve ratios are
 0% on the first $9.3 million of transaction deposits.
 3% on more than $9.3 million up to $43.9 million of transaction
deposits.
 10% on all transaction deposits above $43.9 million.
 0% on time deposits.

Reserve Requirement in Other
Countries
 Reserve requirements vary significantly from one country
another. Currently, required reserve ratios are
 0% in Canada, Mexico, & U.K.
 1.3% in Japan
 2% in Euro zone
 17.5% in China
 80% in Jordan
 High reserve requirements impose huge operational
costs to banks, making them disadvantage in the global
financial market.
 Higher the requirement, less funds banks can use to generate
revenues through loans and securities investment.

Criteria for Monetary Policy Tool
A monetary policy tool should have the following
desirable characteristics as an effective and
efficient tool.
■ Control: The Fed can initiate the tool and has a
complete control of volumes.
■ Flexibility: The Fed can choose any volumes
and can reverse the course of action.
■ Ease of Implementation: The Fed can
implement the tool quickly and affect the
monetary base immediately.

Advantages of Open Market Operations
 Open Market Operations are the most important tools
● 3/4 of fluctuations in money supply are caused by the
Open Market Operations.
 Open market operation is the versatile tool of monetary
policy for the Fed.
● The Fed can use open market operations to change
the course of its monetary policy permanently by
engaging in dynamic and permanent open market
operations.
● The Fed can use open market operations to offset
any temporal deviation from its target by engaging in
defensive and temporal open market transactions.

Advantages of Open Market Operations
 Open market operations have three desirable
characteristics of monetary policy tool:
● Control: The Fed can initiate open market operations and has a
complete control of volumes.
 If the Fed wants to increase reserves by $100 million, it simply
engages in open market operation, purchasing $100 million of
Treasury securities.
● Flexibility: The Fed can choose any volumes in open market
operations and can reverse the course of action.
 If the Fed has overdone, it can reverse its action by engaging in open
market sales of $100 million. It will completely offset the previous
transaction and its effect on reserves.
● Ease of Implementation: The Fed can implement open market
operations quickly and affect the monetary base immediately.
 All the Fed needs to do is to make transactions through telephone or
online through bond dealers.

Advantages of Discount Window
Operations
 One important function of discount window operations is
its function as Lender of last resort.
● Since banks experiencing severe liquidity problem are
more likely to be in financial trouble for an extended
period of time, no other banks want to commit to help
them in fear of illiquidity and potential loss of such
loans.
● These trouble banks are usually insolvent and many
of their assets are defaulted or risky and low market
value, making difficult to raise enough funds to meet
deposit outflows.
● Only the Fed, through its discount window operations,
can provide needed funds to ease problems of
liquidity and insolvency.

Disadvantages of Discount Window
Operations
 Unpredictable announcement effects
● Since Fed’s actions have immediate and significant effects on
financial markets and the economy, traders and investors try to
predict, or even worse speculate, Fed’s future actions from its
words. Such reactions by traders and investors may have
unintended consequence to the U.S. financial markets.
 Unintentional monetary policy
● Primary credits are usually given automatically, so they may increase or
decrease reserves in the banking system, leading monetary expansion or
contraction without Fed’s intention.
 The Fed cannot control the volume of discount loan,
reverse easily, nor affect the monetary base quickly.
● When the Fed wants to increase reserves, it cannot force banks to
borrow from the Fed. The Fed cannot make banks borrow an
amount of discount loans that the Fed wants.

Advantage of Reserve Requirement
 One important advantage of reserve requirement as
monetary policy tool is that it affects all banks equally.
 Open market operations directly affect balance sheets
of banks involved in the transactions, but not others.
 Discount window operations directly affect borrowing
banks, but not others.
 These operations may benefit or create liquidity
problems to banks involved in operations.
 When the Fed changes a required reserve ratio, it will
affect every banks in the country, giving no advantage
or disadvantage to any banks.
■ A small change in a required reserve ratio has a
significant effect on the money supply.

Disadvantage of Reserve Requirement
■ The Fed cannot control a small change in money supply.
 In order to change $10 million of reserves in the
banking system, the Fed needs to change only a
fraction of required reserve ratio. (It’s like controlling a
super-tanker by a miniature joystick)
■ It creates a liquidity problem to many banks.
 When a required reserve ratio is raised, all banks in
the banking system need more reserves and it will
create chaos among banks trying to borrow funds to
meet new requirements at the same. (Every banks
want to borrow, but no bank is willing to lend.)
■ It creates uncertainty for banks.
 Banks must be prepared for the worst, keeping
unnecessary high amount of excess reserves.

Nonconventional Monetary Policy Tools
during the Financial Crisis
■ The conventional monetary policy tools (e.g. open market
operations and discount windows operations) are
designed to help the banking industry, but ineffective to
respond to the financial crisis involving non-banking
financial institutions (e.g. Lehman Brothers – investment
banks, AIG – Insurance, and hedge funds).
■ The Fed set the federal funds rate to near zero percent,
but it could not help many mortgage-backed debt-ridden
banks and financial institutions.
■ The Fed expanded its role through
 Liquidity Provision
 Asset Purchases
 Quantitative Easing

Liquidity Provision
■ Discount Window Expansion: The Fed set the discount
rate to 0.25% (near zero).
■ Term Auction Facility: Like the discount loans, the Fed
directly provided loans without stigma of discount loan
(Borrowing discount loans indicate trouble).
■ New Lending Program: The Fed expanded its provision of
liquidity to the financial system beyond the banking
industry.
 Assist J.P. Morgan Chase to purchase failing Bear
Sterns (Investment bank); Loan to AIG (insurance) to
prevent from failing

Asset Purchases and Quantity Easing
■ Asset Purchases: Instead of directly loaning funds to
non-banking financial institutions, the Fed purchased or
swapped the risky mortgage-backed securities with safer
Treasury bonds (like what AIG was supposed to do for
CDSs).
 In November 2008, the Fed purchased $1.25 trillion of
mortgage-backed securities guaranteed by Fannie Mae
and Freddie Mac.
■ Quantity Easing: Through purchases of mortgage-backed
securities, the Fed’s balance sheet ballooned and resulted
in flood of the reserves in the banking system.
 An increase of monetary base was expected to expand
loans and M1, stimulating the economy in the near term
and possibly producing inflation in future.

Goals of Monetary Policy
 Mandate goals of the Federal Reserve System by
the Congress are spelled on the Federal Reserve
Act of 1913:
“The Board of Governors of the Federal Reserve System
and the Federal Open Market Committee shall maintain
long run growth of the monetary and credit aggregates
commensurate with the economy's long run potential to
increase production, so as to promote effectively the
goals of maximum employment, stable prices, and
moderate long-term interest rates.” (Section 2a.
Monetary Policy Objectives)

Goals of Monetary Policy
 The Federal Reserve System has many goals to
achieve on its monetary policy.
 Main monetary policy goal of the Fed
 Price stability
 Other monetary policy goals
 High employment
 Economic growth
 Financial market stability
 Interest rate stability
 Foreign exchange market stability

Goals of Monetary Policy: Price Stability
 Price stability means low, stable, and predictable inflation.
 Price stability is important because the stable price foster
efficient and effective economic transactions, hence, high
employment, production, and growth.
 Prices convey important information for buyers and
producers of goods and services. Households and firms
allocate their resources based on price information.
High and erratic inflation creates uncertainty and
impedes economic transaction and efficient allocation of
resources.
 The central bank affects an inflation in economy because
in long run an inflation is a result of money creation.
 When money is created too much, its value decreases
greatly, that is, hyper-inflation!

Goals of Monetary Policy: High
Employment and Economic Growth
 High employment
 High employment is good for workers who earn incomes and for
the economy because economy’s limited resources are utilized
efficiently to produce maximum output which can be consumed.
 Economic growth
 Economic growth means a constant improvement of standard of
living.
 Although the monetary policy may not affect these two
goals directly, it can affect them through maintaining
stable price which encourages efficient allocation of
resources in economy.
 More lending & borrowing mean more productive activities
undertaken in economy, which lead to more employment and
increase in production.

Goals of Monetary Policy: Stability in
Financial System
 Stability of financial markets
 Unstable financial markets mean too much risk for savers and
impedes flows of funds into the financial system.
 Interest rates stability
 Unstable interest rates make difficult for business firms to
assess profitability of their projects and create risk in financial
industries, in particular banks.
 Stability in foreign exchange markets
 Unstable foreign exchange markets create risk to business firms
which compete with foreign firms and make more difficult to
invest foreign countries or borrow from foreigners.
 The Federal Reserve can affect these through directly
participating markets (e.g. open market operation in
bond market & foreign exchange market intervention) or
providing liquidity and credit to troubling financial
institutions.

Conflict among goals in short run
 With limited tools the Federal Reserve may not be able
to achieve all goals at the same time in short run.
 Price stability vs. High employment: In short run, the Fed can
pump credit and money in economy to spur spending and
production, but results in high inflation.
 Stability in foreign exchange markets vs. interest rates stability:
The Fed may intervene the foreign exchange markets to
change the value of dollar, but such intervention changes the
money supply in economy and affects interest rates adversely.
 In long run, however, these goals go together.
 Price stability fosters high employment and economic growth.
 High inflation causes interest rates up and dollar fell in foreign
exchange markets.
 Stability in interest rates is key for stable financial markets and
foreign exchange markets.

Price Stability as Primary Goal?
The central bank may be asked to achieve these goals
together or in order.
Hierarchical mandate: Place the goal of price stability
first, and then aim other goals once the price stability goal
is achieved.
 Bank of England, Bank of Canada, the Reserve Bank of New
Zealand, and the European Central Bank (ECB)
 Regardless of the level of unemployment, the primary concern
of the central bank is a price stability. It tries to achieve the
price stability goal for whatever it may cost.
Dual Mandate: Achieve two or more goals
simultaneously.
 Federal Reserve in the U.S.

Strategy to Achieve Price Stability
To achieve the price stability goal in the long
run, the Fed sets a nominal anchor as its
monetary policy strategy.
Nominal anchor
A nominal variable such as the inflation rate or
the money supply, which ties down the price
level to achieve price stability.

Three Monetary Strategies
 Monetary targeting
 The monetary policymaker announces a target of
the annual growth rate of a monetary aggregate.
 Ex. 5% growth rate of M1
 Inflation targeting
 The monetary policymaker announces a medium-
term target or target range for inflation.
 Ex. 1-4% annual inflation rate for 5 years
 Implicit nominal anchor
 No announcement of specific target, but an
apparent long-run monetary policy goal of price
stability.

Nominal Anchor and Price Stability
 When the Fed sets a nominal anchor for its
monetary policy, it can achieve the price stability
goal easier.
 Inflation rate target: If the Fed has a (low) target rate
of inflation rate, then it will assure the public keeping
low inflation expectation and will achieve the stable
price in economy.
 Money supply target: Because in long run the
money supply is a major determinant of price level
(higher the money supply growth, higher the inflation
rate), a stable money supply growth means a stable
inflation rate in long run.

Time Inconsistency of Monetary
Strategy
 The monetary policymaker must set a strategy to
achieve a long-run price stability, but such strategy
may be abandoned in order to gain another goals in
short-run.
 Sudden increase in money supply growth rate above
a set growth rate may spur the economy and rising
employment in short run.
 Such increase in money supply growth rate will cause
rising inflation rate, which affects adversely the
economy (e.g. Lenders will earn less real interest rate
than expected).

Time Inconsistency of Monetary
Strategy
 A time-inconsistent policy dose not provide
credibility to the monetary policymaker, and the
public and the markets will not believe its strategy,
making its strategy ineffective.
 Repeated deviations from its target by the monetary
policymaker creates distrust by the public (e.g.
Remember the story of “boy who cried wolf”?).
 Eventually, the public raises inflation expectation,
which pushes prices of all goods and services to go
up, causing unstable price level (or even worse,
hyperinflation).

Successful Monetary Strategy
 In order to achieve the price stability goal through
nominal anchor, the Federal Reserve must commit
to its strategy and adhere its promise.
 Only when the public fully believe the Fed’s
commitment to its strategy and trust its conduct of
monetary policy, the monetary strategy works to
achieve the price stability goal.
 Three key elements of successful monetary strategy
 Flexibility, Transparency, and accountability

Three Key Elements of Monetary
Strategy
 Flexibility
 A rigid policy rule limits the policymaker’s ability to
respond to unforeseen circumstances.
 Transparency
 Clear, simple, and understandable
 Communication with the public and the markets
about the plans and objectives of monetary
policymakers
 Accountability
 The public and the government can evaluate the
performance of the monetary policymaker.
 Accountable monetary strategy is less susceptible
to the time-inconsistent problem.

Inflation Targeting
 Several countries adopted an inflation targeting as
their monetary strategy. After adoption, in most cases
an inflation rate fell and became stable, achieving a
price stability goal.

Comparison of Monetary Policy
Strategies
 Each strategy has advantages and disadvantages.

Achieving Monetary Policy Goals in
Practice
 Whether the Federal Reserve sets an inflation rate
target, money supply target, or implicit nominal
anchor, the Federal Reserve faces a difficulty
achieving its goal of price stability by using its tools
of monetary policy (i.e. open market operations,
discount window operation).
 Two main problems of implementing the monetary
policy and achieving its goals are
 Uncertain relationship between tools and goals
 Time lag

Uncertain Relationship between Tools
and Goals
 The Fed cannot directly affect the goals by its tools.
 By engaging in open market operations or discount
window operation, the Fed can only directly affect
reserves or the federal funds rate, but not the price
level, production, or employment.
 An economic process affecting the price level,
production, and employment by reserves and the
federal funds is complex and lengthy.
 Although the advancement of economic theory helps us
understand this complex process, we are still far from
fully understanding all mechanisms.
 It is like when you have a cold, you eat chicken-noodle
soup and hope it will cure your cold. You know it woks
based on your experience, but you don’t know how.

Time Lag of Monetary Policy
 Time lag: a period between when an economic problem
occurs and when a full effect of its solution is observed.
When an economy gets in a recession, it will take few
months to know exactly the economy is in a recession. It
will take some time for a policymaker to implement an
economic policy against recession. It will take even longer
time to have its effect on the economy, bringing the
economy out of recession. And, it will take few more
months for the policymaker to actually observe its effect.
It is like when you catch a cold, it will take few days to see
symptoms, then you decide to take some medicine, and
wait to see its effect. The medicine will work, but you don’t
know when you will be fully recovered.

Time Lag of Monetary Policy
 It takes few months to collect the economic data (GDP)
to determine an actual state of economy.
 Although tools of monetary policy have immediate
effects on reserves and the federal funds rate, it takes a
long time to spread that effect economy wide.
 A multiple deposit creation process involves many borrows and
banks, so its effect on the money supply and economic activities
(spending) is not instantaneous.
 A change in interest rate affects decisions of borrowers, but it
will take a long time for many firms to undertake new projects
and actually borrow and spend fully to affect the economy.
 The Federal Reserve System does not have full control on this
process which involves decision makings by firms and
households.
 In reality, monetary policy takes over a year to affect
output and over two years to have a significant effect on
inflation.

Problems in achieving monetary policy
goals
 Because of problems of uncertain relationship between
tools and goals and a time lag, the Fed faces uncertainty
when it conducts the monetary policy.
 When the Fed increases reserves by $100 million, it knows that
eventually it will affect the price level, production, and
employment, but doesn’t know precisely when it has full effect
and how much the effect will be.
 It is like you are on a boat in middle of ocean and trying to shoot
an arrow to hit a target on another boat at night with lightning
and whirling wind. Your boat is constantly moving, so as the
target. Unexpected whirling wind pushes you arrow away from
your planned trajectory to the target. And, only when lightning,
you can see your target and trajectory of arrow.
 Therefore, It is difficult to implement its tools and to
achieve the goals by directly aiming the goals.

Monetary Policy Framework:
Tools-Instruments-Targets-Goals
 Because aiming its targets directly to achieve its goals is
difficult, the Federal Reserve sets up a framework to
aims targets that makes easier to achieve the goals.
• By using the instrument, the Fed can more quickly judge
whether its policy is on the right track and can make a
mid-course correction if necessary.
 It is like you trying to make A on a course, which has only one
final examination to evaluate your grade. Until the end of the
semester, you do not have any idea whether you are making A
or not.
 Instead, if the course offers many quizzes and assignments, you
know exactly how you are performing in the course. You targets
each quiz and assignment to make A. If you make C on one
quiz, you know immediately that you need to study more on that
subject, so that you can bring back yourself to a right path to
make A at the end of semester.

Choice of Policy Instruments
 To be an effective policy instruments for achieving ultimate
goals, an instrument must have characteristics of
 Measurability: Measurable in short time
 The Fed must be able to observe its effect on target, so that it
can make adjustment if necessary before too late.
 Controllability: Direct control by its tools
 The Fed must be able to affect the target directly by using its
tools, so it can change quickly and observe its effect
immediately.
 Predictability: Predictable impact on goals
 The Fed must be able to predict an effect of its tools on the
target, so it can aim precisely and change exactly to the target.

Instruments
Policy instrument: Instrument that the Fed can directly
affect by its tools.
It must be measurable and there must be
controllability and predictability between tools and an
intermediate target.
Two commonly used policy instruments are
 Monetary base or reserves
 Federal funds rate

Targets
Intermediate target: Target that a policy instrument
can affect and that affects goals.
It must be measurable and there must be
controllability and predictability between a policy
instrument and goals.
Two commonly used intermediate targets are
 Monetary aggregates (e.g. M1, M2)
 (Long-term) interest rates

Summary of Monetary Policy Framework
Targets and instruments must provide immediate feedbacks,
so the Fed can make any adjustment to achieve its goals.

Applying the Framework with Monetary
Policy Tools
 The Fed may use either open market operation or
discount window operation and set either money
aggregates or interest rates as its instrument & target.
Tools Policy Instrument Intermediate target
Open Market Operation Reserves M1
Open Market Operation Federal Funds Rate Long-term Interest Rate
Discount Window Operation Reserves M1
Discount Window Operation Federal Funds Rate Long-term Interest Rate

Applying the Framework with Open Market
Operations through Reserves and Money Supply
 When the Fed engages in an open market purchase of
Treasury securities
 Reserves in the banking system increases immediately
by the same amount (measurable, controllable,
predictable).
 Through the multiple deposit creation process, the
money supply (M1) increases as the money supply
model indicates (measurable, controllable, predictable).
 Along the process it increases borrowing and spending
of consumers and firms, which will eventually increase
investment consumption, then aggregate demand,
resulting in higher incomes, higher employment, higher
production, and higher price level.

Applying the Framework with Open Market
Operations through Interest Rates
 When the Fed engages in an open market purchase of
Treasury securities
 the federal funds rate decreases as demand for
reserves decreases (measurable, controllable,
predictable).
 Lower federal funds rate bring all interest rates down
as banks are able to lend at lower interest rates.
 As long term interest rates fall, firms borrow more for
investment projects as well as households borrow
more for purchasing durables (e.g. car, appliances). It
will eventually increase investment and consumption,
then aggregate demand, resulting in higher incomes,
higher employment, higher production, and higher
price level.

Applying the Framework with Discount Window
Operations through Reserves and Money Supply
 When the Fed lowers a discount rate
 Banks borrow more discount loans, which increase
reserves in the banking system immediately by the
same amount (measurable, controllable, predictable).
 Through the multiple deposit creation process, the
money supply (M1) increases as the money supply
model indicates (measurable, controllable,
predictable).
 Along the process it increases borrowing and spending
of consumers and firms, which will eventually increase
investment consumption, then aggregate demand,
resulting in higher incomes, higher employment, higher

Applying the Framework with Discount Window
Operations through Interest Rates
 When the Fed lowers a discount rate
 the federal funds rate decreases as demand for
federal funds decreases (measurable, controllable,
predictable).
 Lower federal funds rate bring all interest rates down
as banks are able to lend at lower interest rates.
 As long term interest rates fall, firms borrow more for
investment projects as well as households borrow
more for purchasing durables (e.g. car, appliances).
It will eventually increase investment and
consumption, then aggregate demand, resulting in
higher incomes, higher employment, higher

Conflict between Targets
 The Fed has two possible intermediate targets for
its conduct of monetary policy in the tools-targets-
goals framework.
 However, the Fed cannot aim precisely two
targets (monetary aggregate and interest rate) at
the same time.
 Its tools affect both monetary aggregate and
interest rate.
 If the fed wants to raise one, the other will
automatically fall.

Money Supply Target
 When the Fed has the money supply target, the
Fed uses its tools to maintain a level of money
supply at its target level.
 Whenever the money supply changes for any
reasons, the Fed must engage in open market
operations or discount windows operations to
counter.
 However, the Fed will not respond to any
changes in market interest rates as long as the
money supply remains at its target level.

Example of Conduct of Money Supply Target
 When a demand for bonds decreases, the equilibrium bond
price decreases and the equilibrium interest rate increases.
Since there is no change in money supply, the Fed lets the
interest rate stay high (possibly away from its target rat).
P iS
D1
E1 i1
E0
i0
D0

Interest Rate Target
 When the Fed has the interest rate target, the
Fed uses its tools to maintain the market
interest rate at its target level.
 Whenever the market interest rate changes for
any reasons, the Fed must engage in open
market operations or discount windows
operations to counter.
 However, the Fed will not respond to any
changes in money supply as long as the market
interest rate remains at its target level.

Example of Conduct of Interest Rate
Target
 When a demand for bonds decreases, the equilibrium interest rate
increases. If the Fed wants to maintain the market interest rate
(interest rate target), it engages in open market purchases of
bonds to bring back the equilibrium interest rate to the original
level. The open market purchases will increase reserves in the
banking system, and eventually increases the money supply.
P iS
D1
E1 i1
E0
i0
D0
E2
D2
= i2

Setting Target under Conflict between
Targets
 The Fed is one of many participants in financial markets
and the economy. The market interest rate and money
supply are jointly determined by the Fed and all other
participants (e.g. households, financial institutions) in
financial markets.
 Given choices made by other participants in markets,
the Fed can choose certain (feasible) combinations of
level of money supply and interest rate.
 Since the Fed cannot aim precisely two targets at the
same time, the Fed must choose either
 one target (e.g. federal funds rate at 3% or M1 growth
rate at 5%)
 a feasible combination of two with a range (e.g.
federal funds rate between 2% and 4% and M1
growth rate between 3% and 7%)

Federal Government and Monetary
Policy
 One prime participant in the bond market is the
federal government.
 The federal government needs to issue Treasury
bonds whenever it runs deficits. Such action affects
the supply of bonds and its market interest rate
 The federal government may not consider what the
Federal Reserve is trying to achieve by its monetary
policy, so it’s action may adversely affect the
conduct of monetary policy.

Federal Budget Deficit and Interest Rate
 When the government runs deficits, it issues
bonds and increase the supply of bonds.
 The equilibrium price of bonds decreases.
 The equilibrium interest rate increases.
P
D0
S0
P0
P1
i0
E0
i1
E1
S1

Interest Rate Target and Deficit Financing
 If the Fed pursues an interest rate target and wants
to maintain at the original rate, the Fed will
purchase bonds to raise the demand.
 The equilibrium price of bonds increases.
 The equilibrium interest rate decreases.
P D0
S0
P0
P1
i0
E0
i1
E1
S1
D2
E2 = i2

Monetizing Debt
 When the Fed pursues the interest rate target, the
federal government’s deficit financing results in the
Fed’s purchase of Treasury bonds in market.
 Practically, bonds issued by the federal government
is replaced by money issued by the Fed (monetizing
debt).
 It is nothing different from the federal government borrowing
money directly from the Fed and spending it.
 Since any interest rate payments made to the Fed will be
turned in to the federal government, it is like the government
printing money to finance its deficits.

Monetizing Debt
 As a result of monetization of debt, the money supply
increases. In long run, such increase in money
supply only results in high inflation.
 Although the central bank may have its independence from
the government, its monetary policy is influenced and
compromised by the act of the government.
 However, if the Fed pursues the money supply target,
the Fed will not respond to the federal government’s
deficit financing and will not lead to the high inflation
rate in long run.
 Many monetarists including Milton Friedman advocate the
money supply target to alleviate a high inflation.

Federal Reserve and Target
 The Federal Reserve hardly announces its
choice of target, its target level, or its operational
rule to achieve its target, many economists
observe the Fed’s behavior and conclude that
the Fed has been set a federal fund rate target.

Taylor Rule
 Taylor rule: The Fed sets the federal fund
rate target equal to
+ inflation rate
+ real federal fund rate
+ (1/2) inflation gap (current π - target π)
+ (1/2) output gap (current GDP - Potential GDP)
 Taylor rule indicates Fed’s goals include
 keeping inflation under control
 minimizing business cycle

Taylor Rule for Federal Funds
 Taylor rule seems to work well to predict
movements of the federal funds rate over time.
 It indicates the Fed implicitly sets an interest rate target
with price stability and high employment goals.

Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University

Econ315 Money and Banking: Learning Unit 23: Monetary Policy - Tools and Conduct (2014)

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Econ315 Money and Banking: Learning Unit 23: Monetary Policy - Tools and Conduct (2014)

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