Chapter 10
Conduct of monetary policy: tools, goals, strategy, and tactics.
Reserves
Reserves: deposits at the Fed + physical currency held by bank
Required reserves: portion of deposits banks must hold in cash, determined
by the required reserve ratio.
Excess reserves: deposits that exceed the required amount.
Ways the fed controls money supply in banking systems:
Goal: balance economy & ensure smooth monetary operations.
1. Open market operations (primary dealers)
- Purchase bonds, buybacks = Increase
- Selling bonds = decrease
Balance sheet results:
- Market purchase for banking system = ↑ reserves, ↓
securities
- Market purchase for the fed = ↑ reserves, ↑ securities
-
2. Loans to banks (discount loans)
- Making discount loans for banks = Increase
- Calling in discount loans = decrease
Balance sheet results:
- Discount lending for the banking system = ↑ reserves, ↑ loans.
- Discount lending for the fed = ↑ reserves, ↑ Discount loans
Changes in reserves & the federal funds rate:
Federal fund rate FFR: the rate banks charge each other for overnight loans
Federal fund rate is the interest rate that the fed tries to influence directly
- Excess supply of reserves = FFR falls
- Excess demand for reserves = FFR rises
Supply Supply of reserves FFS
curve
Purchase of bonds Shifts Right Increases Falls
Shift left Decreases Rises
Sale of Bonds
Lowering discount Shift Down Effective increases Falls
rate (supply (cheaper for banks
curve more to borrow from fed)
elastic)
Raising discount Shift up Effective decrease Rises
rate (more expensive for
banks to borrow
from the fed)
Lowering RR Shift right Increases (excess Falls
reserves from
existing balance)
Increase RR Shift left Decreases (turns Rises
excess reserves into
required reserves)
Conventional Tools of monetary policy
1. Open Market Operations
Goal: Keep reserves steady
Repurchase agreement: buys securities temporarily with an
agreement to sell them back within 15 days. or Reverse Repos: fed
sells securities, but agrees to buy them back.
Advantages:
- Fed has complete control
- flexible and precise.
- Easily reversed
- Implemented quickly.
2. Discount Policy
Provide reserves to banks and act as a lender of last resort to
maintain stability.
Discounts loans through a discount window, 3 types:
1. Primary credit: for healthy banks, borrowed freely at the
discount rate
2. Secondary credit: for troubled banks facing liquidity issues.
3. Seasonal credit: for small or regional banks with seasonal
deposit fluctuations.
Advantages:
- Prevents banking panics
- Supports banks during emergencies
- Maintains confidence in the financial system.
3. Reserve requirements RR
Ensures banks hold a minimum amount of liquid reserves (vault cash
or deposits at the Fed) against checkable deposits.
Reserve Ratio Requirement the % of deposits that must be kept as
reserves
Advantages:
- Provides a foundation of liquidity
- Ensures banks always have cash to meet withdrawals.
-
Disadvantages:
- Rarely used
- Makes liquidity management more difficult.
Nonconventional Monetary Policy Tools
1. Quantitative Easing (QE)
Inject a large amount of money into the financial system to stimulate
the economy when traditional policy tools (like lowering short-term
rates) are no longer effective.
- Works through central bank purchase of government bonds
and other safe financial securities in bulk.
Advantages:
- lowers long-term interest rates,
- making borrowing cheaper
- Encourages investment, lending, and spending
Disadvantages:
- Risk of inflation
- May distort asset prices
- Hard to reverse without market disruption
2. Credit Easing (CE)
Improve the flow of credit to specific troubled markets or sectors
that are struggling to access funds.
Targeted asset purchases — the central bank buys private-sector
financial assets such as:
- Corporate bonds.
- Mortgage backed securities
- Commercial paper.
Advantages:
- reduce risk spreads ( difference between risky and safe
interest).
- making borrowing cheaper
- Encourages lending and investment
- focuses on specific markets
Disadvantages:
- Can distort market signals
- More complex to manage and harder to unwind
3. Negative interest rates
Charges on banks for keeping their money with the central bank
(instead of paying them interest), to encourage banks to lend.
Monetary policy goals
Price stability
High employment (conflicts with increase in inflation)
Economic growth
Stability of financial markets
Interest rate stability (low interest rates decrease economic growth)
Foreign exchange market stability (dollar reserves)
Goals conflict!
The Nominal Anchor
Nominal Anchor: a tool for price stability, for example maintaining an
inflation rate between 2% and 4%. helps avoid the time-inconsistency
problem.
Time-inconsistency problem: day-by- day policy benefits lead to poor
long-run outcomes.
Price stability goals:
The European Central Bank
- Hierarchical mandate: places the goal of price stability above
all other goals.
- Can lead to increased employment and output, but also
increases long-run inflation
The Fed
- Dual Mandate: equal importance for all goals. “Maximising
employment, stable price, moderate long term interest rate”
- can lead to over-emphasis on inflation alone - even in the short-
run.
Long-run inflation control should be the focus.
Inflation targeting
The central bank sets a clear inflation goal (like 2%) and adjusts
monetary policy to reach it.
How it works:
1. Announce target inflation rate.
2. Commit to achieving it.
3. Use many indicators (not just inflation).
4. Be transparent and communicate clearly.
5. Be accountable if the target is missed.
Asset-Price Bubbles
1. Credit-driven bubble: Caused by easy lending.
Dangerous if it bursts → big financial damage.
2. Optimism-driven bubble: Caused by overly optimistic
expectations.
Less dangerous; mainly causes wealth transfers.
Possible Tools to control it:
1. Macroprudential Regulation: Strengthen rules for banks and financial
institutions. (More disclosure, higher capital requirements, risk
management, close supervision.)
Countercyclical capital: require more capital when asset prices rise.
2. Monetary Policy:
Low interest rates → “risk-taking channel” → more borrowing,
riskier projects.
- Could worsen bubbles.
Conclusion:
It may be better to use macroprudential tools instead of general
monetary policy.
Macroprudential rules are hard to enforce: political pressure, impact
on profits, and firms finding loopholes.