Chapter 10
Conduct of
Monetary Policy:
Tools, Goals,
Strategy, and
Tactics
Reserves
• All banks have an account at the Fed in
which they hold deposits. Reserves consist
of deposits at the Fed plus currency that is
physically held by banks (called vault cash
because it is stored in bank vaults).
• Total reserves can be divided into two
categories: reserves that the Fed requires
banks to hold (required reserves) and any
additional reserves the banks choose to hold
(excess reserves).
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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.
─ Reserves: All bank deposits with the Fed. The
Fed sets the required reserve ratio. Any
reserves deposited with the Fed beyond this
amount are excess reserves.
─ The sum of these two items is the monetary
base (C+R=MB).
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The Federal Reserve’s
Balance Sheet: Assets
• The monetary assets of the Fed include:
─ Government securities: U.S. Treasury bills and
bonds that the Federal Reserve has purchased in
the open market.
─ Loans to financial institutions: Loans to member
banks at the current discount rate. The loans
are referred to as borrowings from the Fed or
borrowed reserves.
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Open Market Operations
• Now, we will examine the impact of open
market operations conducted through
primary dealers (government securities
dealers). 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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Federal Funds Rate
• The federal funds rate, the interest rate on
overnight loans of reserves from one bank to
another.
• The federal funds rate is particularly
important in the conduct of monetary policy
because it is the interest rate that the Fed
tries to influence directly.
• Thus, it is indicative of the Fed’s stance on
monetary policy
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Supply and Demand in the
Market for Reserves
Equilibrium iff
where Rs = Rd
Figure 10.1
Equilibrium in the
Market for Reserves
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Response to Open Market
Operations
Figure 10.2 Response to an Open Market Operation
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Response to Change in
Discount Rate
Figure 10.3 Response to a Change in the Discount Rate
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Response to Change in
Required Reserves
Figure 10.4 Response to a Change in Required Reserves
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Response to Change in
Interest Rate on Reserves
Figure 10.5 Response to a Change in the Interest Rate on Reserves
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Tools of Monetary Policy:
Open Market Operations
• Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
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Tools of Monetary Policy:
Discount Policy
• The Fed’s discount loans, through the
discount window, are:
─ Primary Credit: Healthy banks borrow as they
wish from the primary credit facility or standing
lending facility.
─ Secondary Credit: Given to troubled banks
experiencing liquidity problems.
─ Seasonal Credit: Designed for small, regional
banks that have seasonal patterns of deposits.
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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:
•Rarely used as a tool
─ Raising causes liquidity problems for banks
─ Makes liquidity management unnecessarily difficult
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Price Stability Goal
& the Nominal Anchor
Policymakers have come to recognize the
social and economic costs of inflation.
•Price stability, therefore, has become a
primary focus.
•High inflation seems to create uncertainty,
hampering economic growth.
•Indeed, hyperinflation has proven damaging
to countries experiencing it.
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Price Stability Goal
& the Nominal Anchor
• Policymakers must establish a nominal
anchor which defines price stability. For
example, “maintaining an inflation rate
between 2% and 4%” might be an anchor.
• An anchor also helps avoid the time-
inconsistency problem.
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Price Stability Goal
& the Nominal Anchor
• The time-inconsistency problem is the
idea that day-by-day policy decisions lead to
poor long-run outcomes.
─ Policymakers are tempted in the short-run to
pursue expansionary policies to boost output.
However, just the opposite usually happens.
─ Central banks will have better inflation control by
avoiding surprise expansionary policies.
─ A nominal anchor helps avoid short-run
decisions.
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Other Goals of Monetary Policy
• Goals
─ High employment
─ Want demand = supply, or natural rate of
unemployment
─ Economic growth (natural rate of output)
─ Stability of financial markets
─ Interest-rate stability
─ Foreign exchange market stability
• Goals often in conflict
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Inflation Targeting
Inflation targeting involves:
[Link] a medium-term inflation target
[Link] to monetary policy to achieve
the target
[Link] of many variables to make
monetary policy decisions
[Link] transparency through public
communication of objectives
[Link] accountability for missed targets
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Inflation Targeting:
Pros and Cons
• Advantages
─ Easily understood by the public
─ Helps avoid the time-inconsistency problem since
public can hold central bank accountable to a
clear goal
─ Forces policymakers to communicate goals and
discuss progress regularly
─ Less political pressure
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Inflation Targeting:
Pros and Cons
• Disadvantages
─ Signal of progress is delayed
• Affects of policy may not be realized for several
quarters.
─ Policy tends to promote too much rigidity
• Limits policy makers ability to react to unforeseen
events
─ Potential for increasing output fluctuations
• May lead to a tight policy to check inflation at the
expense of output
─ Usually accompanied by low economic growth
• Probably true when getting inflation under control
• However, economy rebounds
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Macroprudential Policies
• Macroprudential policies are financial policies
aimed at ensuring the stability of the financial
system as a whole to prevent substantial
disruptions in credit and other vital financial
services necessary for stable economic growth.
• For example, countercyclical capital
requirements would dampen credit-booms.
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