Chapter 15Tools of Monetary Policy© 2016 Pearson Educati.docx

Chapter 15
Tools of Monetary Policy
© 2016 Pearson Education, Inc. All rights reserved.
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1
Preview
This chapter examines the tools used by the Federal Reserve
System to control the money supply and interest rates
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Learning Objectives
Illustrate the market for reserves and demonstrate how changes
in monetary policy can affect the federal funds rate.
Summarize how conventional monetary policy tools are
implemented and the advantages and limitations of each tool.
Explain the key monetary policy tools that are used when
conventional policy is no longer effective.
Identify the distinctions and similarities between the monetary
policy tools of the Federal Reserve and those of the European
Central Bank.
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The Market For Reserves and the Federal Funds Rate
Demand and Supply in the Market for Reserves determines the
federal funds rate.
Interest rate on overnight loans of reserves from one bank to
another)
What happens to the quantity of reserves demanded by banks,
holding everything else constant, as the federal funds rate
changes?
Total Reserve= Excess reserves + Required Reserve
Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could have
been earned minus the interest rate that is paid on these
reserves, ior
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Demand in the Market for Reserves
Since the fall of 2008 the Fed has paid interest on reserves at a
level that is set at a fixed amount below the federal funds rate
target.
When the federal funds rate is above the rate paid on excess
reserves, ior, as the federal funds rate decreases, the
opportunity cost of holding excess reserves falls and the
quantity of reserves demanded rises.
Downward sloping demand curve that becomes flat (infinitely
elastic) at ior
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Supply in the Market for Reserves
Supply in the Market for Reserves have two components: non-
borrowed and borrowed reserves
Cost of borrowing from the Fed is the discount rate (id)
Borrowing from the Fed is a substitute for borrowing from other
banks
If iff < id, then banks will not borrow from the Fed and
borrowed reserves are zero
The supply curve will be vertical because total reserves equals
non-borrowed reserves (NBR)
As iff rises above id, banks will borrow more and more at id,
and re-lend at iff
The supply curve is horizontal (perfectly elastic) at id
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Figure 1 Equilibrium in the Market for Reserves
Rs
Rd
id

Federal
Funds Rate
Quantity of
Reserves, R
NBR
With excess supply of reserves, the federal funds rate falls to
With excess demand for reserves, the federal funds rate rises to
1
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7
How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate
Effects of open an market operation depends on whether the
supply curve initially intersects the demand curve in its

downward sloped section versus its flat section.
An open market purchase causes the federal funds rate to fall
whereas an open market sale causes the federal funds rate to
rise (when intersection occurs at the downward sloped section).
Open market operations have no effect on the federal funds rate
when intersection occurs at the flat section of the demand curve.
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Figure 2 Response to an Open Market Operation
Step 1. An open market purchase shifts the
supply curve to the right …
Step 2. causing the federal funds rate to fall.
Step 1. An open market purchase shifts the supply
curve to the right …
Step 2. but the federal funds rate cannot fall below
the interest rate paid on reserves.
(a) Supply curve initially intersects demand
curve in its downward-sloping section
(b) Supply curve initially intersects
demand curve in its flat section

1
2
Federal
Funds Rate
Federal
Funds Rate
Quantity of
Reserve, R
2

NBR1
NBR2
NBR2
NBR1
1
Quantity of
Reserves, R
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9
How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate
If the intersection of supply and demand occurs on the vertical
section of the supply curve, a change in the discount rate will

have no effect on the federal funds rate.
If the intersection of supply and demand occurs on the
horizontal section of the supply curve, a change in the discount
rate shifts that portion of the supply curve and the federal funds
rate may either rise or fall depending on the change in the
discount rate.
When the Fed raises reserve requirement, the federal funds rate
rises and when the Fed decreases reserve requirement, the
federal funds rate falls.
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10
Figure 3 Response to a Change in the Discount Rate
(a) No discount lending (BR = 0)
(b) Some discount lending (BR > 0)
Step 2. but does not lower the federal funds rate.
Step 1. Lowering the discount rate shifts the supply curve
down…
Step 1. Lowering the discount rate shifts the supply curve
down…
Step 2. and lowers the federal funds rate.
NBR
Quantity of Reserves, R

Federal Funds Rate
BR1
BR2
NBR
2

1
1
Federal Funds Rate
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11
Figure 4 Response to a Change in Required Reserves
NBR
Quantity of
Reserves, R

Federal
Funds Rate
id
ior
2
1
Step 1. Increasing the reserve requirement causes the demand
curve to shift to the right . . .
Step 2. and the federal funds rate rises.
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12
Figure 5 Response to a Change in the Interest Rate on Reserves
NBR
Quantity of
Reserves, R
NBR
Quantity of
Reserves, R
id
Federal
Funds Rate

id
Federal
Funds Rate
1
1
Step 2. leaves the federal funds rate unchanged.
Step 1. A rise in the interest rate on reserves from to
Step 1. A rise in the interest rate on reserves from to
Step 2. raises the federal funds
rate to

2
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Figure 6 How the Federal Reserve’s Operating Procedures Limit
Fluctuations in the Federal Funds Rate

Federal
Funds Rate
NBR*
Step 1. A rightward shift of the demand curve raises the federal
funds rate to a maximum of the discount rate.
Step 2. A leftward shift of the demand curve lowers the Fderal
funds rate to a minimum of the interest rate on reserves.
Supply and demand analysis of the market for reserves
illustrates how an important advantage of the Fed’s current
procedures for operating the discount window and paying
interest on reserves is that they limit fluctuations in the federal
funds rate.

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Conventional Monetary Policy Tools
During normal times, the Federal Reserve uses three tools of
monetary policy to control the money supply and interest rates,
and these are referred to as conventional monetary policy tools
open market operations,
discount lending, and
reserve requirements
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Open Market Operations
Dynamic open market operations
Intended to change the level of reserves and the monetary base
Defensive open market operations
Intended to offset movements in other factors (treasury deposits
and floats) that affect reserves and the monetary base
Open Market Operations are conducted by primary dealers-
specific set of dealers in government securities
TRAPS (Trading Room Automated Processing System)
Defensive open market operations are of two types
Repurchase agreements (repo): Fed purchases securities with an
agreement the seller will repurchase them in short period
Matched sale-purchase agreements: Fed sells securities and the
buyer agrees to sell them back to the Fed in the near future
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16

Discount Policy and the Lender of Last Resort
Discount window
The facility at which banks can borrow reserves from the
Federal Reserve
Backup source of liquidity for the federal funds market (market
where banks borrow from each other)
Three types of discount loans
1. Primary credit: standing lending facility
Lombard facility
Healthy banks can borrow all they want at very short maturity
2.Secondary credit is given to banks in financial trouble and
severe liquidity problems
3.Seasonal credit: seasonal borrowing
Lender of last resort to prevent financial panics
Creates moral hazard problem
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17
Reserve Requirements
Depository Institutions Deregulation and Monetary Control Act
of 1980 sets the
reserve requirement the same for all depository institutions.
3% of the first $48.3 million of checkable deposits; 10% of
checkable deposits over $48.3 million
The Fed can vary the 10% requirement between 8% to 14%.
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18
Relative Advantages of the Different Monetary Policy Tools
Open market operations are the dominant policy tool of the Fed
since it has complete control over the volume of transactions,
these operations are flexible and precise, easily reversed and
can be quickly implemented.
The discount rate is less well used since it is no longer binding
for most banks, can cause liquidity problems, and increases
uncertainty for banks. The discount window remains of
tremendous value given its ability to allow the Fed to act as a
lender of last resort.
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On the Failure of Conventional Monetary Policy Tools in a
Financial Panic
When the economy experiences a full-scale financial crisis,
conventional monetary policy tools cannot do the job, for two
reasons.
First, the financial system seizes up to such an extent that it
becomes unable to allocate capital to productive uses, and so
investment spending and the economy collapse.
Second, the negative shock to the economy can lead to the zero-
lower-bound problem
Central bank is unable to lower short-term interest rate further
because they hit a floor of zero
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Nonconventional Monetary Policy Tools During the Global
Financial Crisis
Liquidity provision: The Federal Reserve implemented
unprecedented increases in its lending facilities to provide
liquidity to the financial markets
Discount Window Expansion
Lowered discount rate to 0.50 basis point above the federal
funds rate in 2007 and to 0. 25 in March 2008
Term Auction Facility
Temporary loans made at rate set by competitive auctions
New Lending Programs: providing loans to financial institutions
outside banks
Example: Investment banks
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Nonconventional Monetary Policy Tools During the Global
Financial Crisis
Large-scale asset purchases: During the crisis the Fed started
three new asset purchase programs to lower interest rates for
particular types of credit:
Government Sponsored Entities Purchase Program
QE2
QE3
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Figure 7 The Expansion of the Federal Balance Sheet, 2007-
2014

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Monetary Policy Tools of the European Central Bank
Open market operations
Main refinancing operations
Weekly reverse transactions
Longer-term refinancing operations
Lending to banks
Marginal lending facility/marginal lending rate
Deposit facility
2% of the total amount of checking deposits and other short-
term deposits
Pays interest on those deposits so cost of complying is low
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24
Chapter 16
The Conduct of Monetary Policy: Strategy and Tactics
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25
Preview

This chapter examines the goals of monetary policy and then
considers one of the most important strategies for the conduct
of monetary policy, inflation targeting
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Learning Objectives
Identify the six potential goals that monetary policymakers may
pursue.
Compare and contrast the advantages and disadvantages of
inflation targeting.
Identify the key changes made over time to the Federal Reserve
monetary policy strategy.
List the four lessons learned from the global financial crisis and
discuss what they mean to inflation targeting.
Describe and assess the four criteria for choosing a policy
instrument.
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The Price Stability Goal and the Nominal Anchor
Over the past few decades, policy makers throughout the world
have become increasingly aware of the social and economic
costs of inflation and more concerned with maintaining a stable
price level as a goal of economic policy.
The role of a nominal anchor: a nominal variable, such as the
inflation rate or the money supply, which ties down the price
level to achieve price stability
The time-inconsistency problem

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28
Other Goals of Monetary Policy
Five other goals are continually mentioned by central bank
officials when they discuss the objectives of monetary policy:
High employment and output stability
Economic growth
Stability of financial markets
Interest-rate stability
Stability in foreign exchange markets
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Should Price Stability Be the Primary Goal of Monetary Policy?
Hierarchical Versus Dual Mandates:
Hierarchical mandates put the goal of price stability first, and
then say that as long as it is achieved other goals can be
pursued
Dual mandates are aimed to achieve two coequal objectives:
price stability and maximum employment (output stability)
Price Stability as the Primary, Long-Run Goal of Monetary
Policy
Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the long run
but not the short run.

15-‹#›
Inflation Targeting
Public announcement of medium-term numerical target for
inflation
Institutional commitment to price stability as the primary, long-
run goal of monetary policy and a commitment to achieve the
inflation goal
Information-inclusive approach in which many variables are
used in making decisions
Increased transparency of the strategy
Increased accountability of the central bank
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31
New Zealand (effective in 1990)
Inflation was brought down and remained within the target most
of the time.
Growth has generally been high and unemployment has come
down significantly.
Canada (1991)
Inflation decreased since 1991; some costs in term of
unemployment
United Kingdom (1992)
Inflation has been close to its target.
Growth has been strong and unemployment has been decreasing.
Inflation Targeting

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32
Figure 1 Inflation Rates and Inflation Targets for New Zealand,
Canada, and the United Kingdom, 1980–2014
15-‹#›
33
Advantages:
Does not rely on one variable to achieve target
Easily understood
Reduces potential of falling in time-inconsistency trap
Stresses transparency and accountability
Disadvantages:
Delayed signaling
Too much rigidity
Potential for increased output fluctuations
Low economic growth during disinflation
Inflation Targeting
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34

The Evolution of the Federal Reserve’s Monetary Policy
Strategy
The United States has achieved excellent macroeconomic
performance (including low and stable inflation) until the onset
of the global financial crisis without using an explicit nominal
anchor such as an inflation target.
History:
Fed began to announce publicly targets for money supply
growth in 1975
Paul Volker (1979) focused more in nonborrowed reserves
Greenspan announced in July 1993 that the Fed would not use
any monetary aggregates as a guide for conducting monetary
policy
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Strategy
There is no explicit nominal anchor in the form of an overriding
concern for the Fed.
Forward looking behavior and periodic “preemptive strikes”
The goal is to prevent inflation from getting started.
15-‹#›
Strategy
Advantages
Uses many sources of information

Demonstrated success
Disadvantages
Lack of accountability
Inconsistent with democratic principles
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The Fed’s “Just Do It” Monetary Policy Strategy
Advantages of the Fed’s “Just Do It” Approach:
forward-looking behavior and stress on price stability also help
to discourage overly expansionary monetary policy, thereby
ameliorating the time-inconsistency problem
Disadvantages of the Fed’s “Just Do It” Approach:
lack of transparency; strong dependence on the preferences,
skills, and trustworthiness of the individuals in charge of the
central bank
15-‹#›
Lessons for Monetary Policy Strategy from the Global Financial
Crisis
Developments in the financial sector have a far greater impact
on economic activity than was earlier realized.
The zero-lower-bound on interest rates can be a serious
problem.
The cost of cleaning up after a financial crisis is very high.
Price and output stability do not ensure financial stability.

15-‹#›
Lessons for Monetary Policy Strategy from the Global Financial
Crisis
How should Central banks respond to asset price bubbles?
Asset-price bubble: pronounced increase in asset prices that
depart from fundamental values, which eventually burst.
Types of asset-price bubbles
Credit-driven bubbles
Subprime financial crisis
Bubbles driven solely by irrational exuberance
15-‹#›
Should central banks respond to bubbles?
Strong argument for not responding to bubbles driven by
irrational exuberance
Bubbles are easier to identify when asset prices and credit are
increasing rapidly at the same time.
Monetary policy should not be used to prick bubbles.
15-‹#›
Macropudential policy: regulatory policy to affect what is
happening in credit markets in the aggregate.
Monetary policy: Central banks and other regulators should not
have a laissez-faire attitude and let credit-driven bubbles
proceed without any reaction.

Should central banks respond to bubbles?
15-‹#›
Tactics: Choosing the Policy Instrument
Tools
Open market operation
Reserve requirements
Discount rate
Policy instrument (operating instrument)
Reserve aggregates
Interest rates
May be linked to an intermediate target
Interest-rate and aggregate targets are incompatible (must chose
one or the other).
15-‹#›
43
Figure 2 Linkages Between Central Bank Tools, Policy
Instruments, Intermediate Targets, and Goals of Monetary
Policy
Open Market Operations
Discount Policy
Interest on Reserves
Large-scale Asset
Purchases
Forward Guidance

Tools of the
Central Bank
Policy
Instruments
Intermediate
Targets
Goals
Monetary Aggregates
(M1, M2)
Interest rates
(short-term and
long-term)
Price Stability
High Employment
Economic Growth
Financial Market Stability
Interest-Rate Stability
Foreign Exchange Market
Stability
Reserve Aggregates
(reserves, nonborrowed
reserves, monetary base,
nonborrowed base)
Interest rates
(short-term such as
federal funds rates)
15-‹#›
44

Figure 3 Result of Targeting on Nonborrowed Reserves
Step 1. A rightward or leftward shift
in the demand curve for reserves …
Quantity of
Reserves, R
Federal
Funds Rate
Rs
NBR*
Step 2. leads to fluctuations in the

federal funds rate between
Rd*
Rd′′
Rd′
15-‹#›
45
Figure 4 Result of Targeting on the Federal Funds Rate
Federal Funds
Rates Target,

id
ier
Federal
Funds Rate
Quantity of
Reserves, R
Step 1. A rightward or leftward shift in the demand curve for
reserves…
Step 2. lead the central bank to shift the supply curve of
reserves so that the federal rate does not change…
Step 3. with the result that non-borrowed reserves fluctuate
between NBR′ff and NBR′′ff.
15-‹#›

46
Criteria for Choosing the Policy Instrument
Observability and Measurability
Controllability
Predictable effect on Goals
15-‹#›
47
Tactics: The Taylor Rule
An inflation gap and an output gap
Stabilizing real output is an important concern
Output gap is an indicator of future inflation as shown by
Phillips curve
NAIRU
Rate of unemployment at which there is no tendency for
inflation to change
15-‹#›
48
Figure 5 The Taylor Rule for the Federal Funds Rate, 1970–

2014
Source: Federal Reserve Bank of St. Louis, FRED database:
http://research.stlouisfed.org/fred2/.
15-‹#›
49
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Chapter 15Tools of Monetary Policy© 2016 Pearson Educati.docx