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CHAPTER 10

Conduct of Monetary

Policy: Tools, Goals, Strategy,

and Tactics

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“Monetary policy” refers to the management of the money supply. Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.

Although the idea is simple enough, the theories guiding the Federal Reserve are complex and often controversial. But, we are affected by this policy, and a basic understanding of how it works is, therefore, important.

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We examine how the conduct of monetary policy affects the money supply and interest rates. We focus primarily on the tools and the goals of the U.S. Federal Reserve System, and examine its historical success. Topics include:

The Federal Reserve’s Balance Sheet

The Market for Reserves and the Federal Funds Rate

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Chapter Preview (cont.)

Tools of Monetary Policy

Discount Policy

Reserve Requirements

Monetary Policy Tools of the ECB

The Price Stability Goal and the Nominal Anchor

Other Goals of Monetary Policy

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Chapter Preview (cont.)

Should Price Stability be the Primary Goal of Monetary Policy?

Inflation Targeting

Central Banks’ Responses to Asset-Price Bubbles: Lessons from the 2007–2009 Financial Crisis

Tactics: Choosing the Policy Instrument

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Monetary Policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment.

Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy, which refers to taxation, government spending and associated borrowing.

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Monetary Policy

Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

Exchange Rate

Credit Quality;

Bonds and Equities (corporate ownership and debt);

government versus private sector spending/savings;

international capital flows of money on large scales;

financial derivatives such as options, swaps, future contracts, etc

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Monetary Policy

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnight debt

A given rate of change in the CPI

Price Level TargetingInterest rate on overnight debt

A specific CPI number

Monetary AggregatesThe growth in money supply

A given rate of change in the CPI

Fixed Exchange RateThe spot price of the currency

The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the gold price

Mixed Policy Usually interest ratesUsually unemployment + CPI change

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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, which is accepted as a medium of exchange worldwide.

─ Currency in circulation can be thought of as "currency in hand", meaning that it is used to buy goods and services. Central banks pay attention to the amount of physical currency in circulation because it is present in the most liquid asset class. The more money that comes out of circulation and into longer-term investments, the less money is available to fund shorter-term consumption - a major component of GDP.

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The monetary liabilities of the Fed include: Reserves: In Financial Accounting, the term reserve is most commonly used to

describe any part of shareholder’s equity, except for basic share capital. In nonprofit accounting, an "operating reserve" is commonly used to refer to unrestricted cash on hand availabto sustain an organization, and nonprofit boards usually specify a target of maintaining several months of operating cash or a percentage of their annual income, called an Operating Reserve Ratio.

Sometimes, reserve is used in the sense of the term provision; such a use, however, is inconsistent with the terminology suggested by International Accounting Standard. For more information about provisions, see provision .All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves. The Fed does not pay interest on reserves, but that may change because of legislative changes for 2011.

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The monetary liabilities of the Fed include: Reserves: There are different types of reserves used in financial accounting like

capital reserves, revenue reserves, statutory reserves, realized reserves, unrealized reserves.

Equity reserves are created from several possible sources:

Reserves created from shareholders' contributions, the most common examples of which are:

legal reserve fund - it is required in many legislations and it must be paid as a percentage of share capital

Share Premium- amount paid by shareholders for shares in excess of their nominal value

Reserves created from profit, especially retained earnings, i.e. accumulated accounting profits, or in the case of nonprofits, operating surpluses. However, profits may be distributed also to other types of reserves, for example:

legal reserve fund from profit - many legislations require creation of the fund as a percentage of profits

remuneration reserve - will be used later to pay bonuses to employees or management.

translation reserve - arises during consolidation of entities with different reporting currencies

Reserve is the profit achieved by a company where a certain amount of it is put back into the business which can help the business in their rainy days.

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The monetary liabilities of the Fed include: 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 company. An increase in reserves lead to increase in level of deposits and hence in money supply.

Total Reserves can be divided into two categories:

Required Reserves: That FED requires bank to hold

Excess Reserves: Any Additional Reserves the bank choose to hold

Required Reserve Ratio: FED require that for every dollar of deposits at a depository institution, a certain fraction must be held as reserves and this is known as required reserve ratio.

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The Federal Reserve’s Balance Sheet: Assets

The monetary assets of the Fed include:─ Government Securities: Government securities promise

repayment of principal upon maturity as well as coupon or interest payments periodically. Examples of government securities include savings bonds, treasury bills and notes. Government securities are usually used to raise funds that pay for the government's various expenses, including those related to infrastructure development projects.

Because they are low risk, the return on the securities is generally low. These are the U.S. Treasury bills and bonds that the Federal Reserve has purchased in the open market. As we will show, purchasing Treasury securities increases the money supply.

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The Federal Reserve’s Balance Sheet: Assets

The monetary assets of the Fed include:─ Discount Loans: A discount loan is a loan arrangement where the

interest and any other related charges are calculated at the time the loan is granted. At the same time, the total of the interest and other charges are subtracted from the face amount of the discounted loan. Instead of receiving the face value of the loan, the borrower receives the reduced amount, but is still responsible for repaying the full face value of the loan.

─ These are loans made to member banks at the current discount rate. Again, an increase in discount loans will also increase the money supply.

─ Discount loans are normally written as short-term loans. The idea is that the borrower needs resources quickly to cover expenses in the near future, and will be able to repay the face value of the loan within a period of anywhere between three months to one calendar year.

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Open Market Operations

The central bank's purchase or sale of bonds in the open market are the most important monetary policy tool because they are the primary determinant changes in reserves in the banking system and interest rate.

open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to manipulate the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation

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Open market operations, or OMOs, are the Federal Reserve's most flexible and frequently used means of implementing U.S. monetary policy.

Since most money now exists in the form of electronic records rather than in the form of paper, open market operations are conducted simply by electronically increasing or decreasing (crediting or debiting) the amount of base money that a bank has in its reserve account at the central bank. Thus, the process does not literally require new currency. However, this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.

The process works because the central bank has the authority to bring money in and out of existence. They are the only point in the whole system with the unlimited ability to produce money. Another organization may be able to influence the open market for a period time, but the central bank will always be able to overpower their influence with an infinite supply of money

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In the next two slides, we will examine the impact of open market operation on the Fed’s balance sheet and on the money supply. As suggested in the last slide, 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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The Federal Reserve Balance Sheet

Open Market Purchase from Public

Result R $100, MB $100

Banking System Assets Liabilities

Reserves Deposits +$100 +$100

Public Assets Liabilities

Securities –$100 Deposits +$100

The Fed Assets Liabilities

Securities Reserves +$100 +$100

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The Federal Reserve Balance Sheet

Discount Lending

Result R $100, MB $100

Banking System Assets Liabilities

Reserves Discount loans +$100 +$100

The Fed Assets Liabilities

Discount loans Reserves +$100 +$100

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Discount Lending

Discount Lending:

A discount loan leads to an expansion of reserves which can be lent out as deposits thereby leading to an expansion of the monetary base and the money supply. When a bank repays its discount loan and so reduces the total amount of discount lending, the amount of reserves decreases along with the monetary base and the money supply.

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An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply.

When a central bank conducts an open market sale, the public pays for the bonds by writing a check that causes deposits and reserves in the banking system to fall.

An open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply.

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Supply and Demand in theMarket for Reserves

We now have some understanding of the effect of open market operations and discount lending on the Fed’s balance sheet and available reserves. Next, we will examine how this change in reserves affects the federal funds rate, the rate banks charge each other for overnight loans. Further, we will examine a third tool available to the Fed—the ability to set the required reserve ratio for deposits held by banks.

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Demand and Supply in the Market for Reserves

The analysis of the market for reserves proceeds in a similar fashion to the analysis of the bond market.

A demand and supply curve for reserves is derived, then the market equilibrium in which the quantity of reserves demanded equals the quantity of reserves supplied determines the federal fund rate the interest rate charged on the loans of these reserves.

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Demand and Supply in the Market for Reserves

Demand Curve:

To derive the demand curve for reserves, it is required to know the quantity of reserves demanded, holding everything else constant as the federal funds rate changes.

Reserves can be split into two components:

Required Reserves: which equals the required reserve ratio times the amount of deposits on which reserves are required.

Excess Reserves: The additional reserves banks choose to hold.

The quantity of reserves demanded equals required reserves plus the quantity of excess reserves demanded.

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1. Demand curve slopes down because iff , ER and Rd up

2. Supply curve slopes down because iff , DL , Rs

3. Equilibrium iff where Rs = Rd

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As the federal funds rate begins to rise above the discount rate, the banks would want to keep borrowing more and more at interest rate and the lending out the proceeds in the federal fund market at the higher rate and as the result the supply curve becomes flat (infinitely elastic).

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Response to Open Market Operations:Case 1—downward sloping demand

1. Open market purchase shifts supply curve to the right (NBR1 to NBR2).

2. Rs shifts down, fed funds rate falls.

3. Reverse for sale.

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Response to Open Market Operations: Case 2—flat demand

1. Open market purchase shifts supply curve to the right (NBR1 to NBR2).

2. Rs parallel, fed funds rate unchanged.

3. Reverse for sale.

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The effect of an open market operations depends on whether the supply curve initially intersects the demand curve in its downward –sloped section versus its flat section.

An open market purchases leads to a greater quantity of reserves supplied, this is true at any given federal funds rate because of higher amount of nonborrowed reserves.

The conclusion is that an open market purchase causes the federal funds rate to fall, whereas an open market sale causes the federla fund to rise.

In case if supply curve initially intersects the demand curve on its flat section, open market operations have no effect on the federal funds rate.

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Response to Change in Discount Rate: Case 1—no intersection

1. The Fed lowers id, and does not cross the demand curve

2. Rs shifts down

3. iff is unchanged

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Response to Change in Discount Rate: Case 2—demand intersected

1. The Fed lowers id, and does cross the demand curve

2. Rs shifts down

3. iff falls

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RR , Rd shifts to right, iff

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Market Equilibrium

Market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied, Rs=Rd. Equilibrium therefore occurs at the intersection of the demand curve Rd and the supply curve Rs at point 1 with an equilibrium federal fund rate. When the federal fund rate is above the equilibrium rate, there are more reserves supplied than demanded (excess supply).

When the federal funds rate is below the equilibrium rate there are more reserves demanded than supplied (excess demand)

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How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate

How changes in the three tools of monetary policy_open market operations, discount lending and reserve requirements affect the market for reserves and the equilibrium federal fund rate. The first two tools open market operations and discount lending affect the federal funds rate by changing the supply of reserves while the third tool reserve requirements affects the federal fund rate by changing the demand for reserves.

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CASE: How Operating Procedures Limit Fluctuations in Fed Funds Rate

An advantage of current operating procedures. Any changes in the demand for reserves will not affect the fend funds rate because borrowed reserves will increase to match the demand increase. This is true whether the demand increases, or decreased, as seen in Figure 10.5 (next slide).

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CASE: How Operating Procedures Limit Fluctuations in Fed Funds Rate

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Tools of Monetary Policy

Now that we have seen and understand the tools of monetary policy, we will further examine each of the tools in turn to see how the Fed uses them in practice and how useful each tools is.

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Tools of Monetary Policy: Open Market Operations

Open Market Operations1. Dynamic: Strategies in open market operations that are

implemented to increase or decrease the level of funds available in the economy Meant to change Reserves

2. Defensive: Strategies used in open market operations in order to offset other anticipated market conditions that would probably affect the level of funds in the economy. For example, if a foreign country is expected to sell its US treasury securities holding in exchange for US dollars, the Federal Reserve may decide to buy treasury securities in advance in order to maintain the same level of US dollars.

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Tools of Monetary Policy: Open Market Operations

Advantages of Open Market Operations1. Fed has complete control

2. Flexible and precise

3. Easily reversed

4. Implemented quickly

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Disadvantages of OMO

This method is adopted by the central bank to expand or contrast credit money in the market. Under this method the bank either sells or purchases government securities to control credit. When it wants to expand credit it starts purchasing government securities with the result that more money is pumped into the market. This money in return, is deposited with the commercial banks which become more competent to grant a greater amount of loans thereby expanding credit in the market.

On the other hand when the central bank wants to contrast credit it starts selling the government securities owing to which market money goes to the central bank with the result that money in the market is reduced. The deposits of commercial banks go down, weakening their power to lend.

This method will work when the following conditions are fulfilled.1. The method should affect the reserves of commercial banks. They should contract or expand as a result of Open Market Operations (OMO). The method would fail if the bank reserves remain unaffected.

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Disadvantages of OMO

2. Demand for bank loans should increase or decrease in line with the increase or decrease in the bank cash reserves and rate of interest.

3. Circulation of bank credit should remain unchanged.

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Chapter Summary

The Federal Reserve’s Balance Sheet: the Fed’s actions change both its balance sheet and the money supply. Open market operations and discount loans were examined.

The Market for Reserves and the Federal Funds Rate: supply and demand analysis shows how Fed actions affect market rates.

Tools of Monetary Policy: the Fed can use open market operations, discount loans, and reserve ratios to enact Fed directives.

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Chapter Summary

In conclusion, even though the Fed has three tools of monetary policy, the one that is used the most is open market operations. The other tools are only used on very rare occasions. The role of the Fed in the banking system and in our economy is a very important one. They formulate and execute monetary policy, supervise depository institutions, provide an elastic currency, assist the federal governments finance operations, and serve as the banker of the United States government. They remain to this day independent of our nation's government which makes them less susceptible to bribery. All in all, they form an excellent system that protects our nation's economy and banks. They do most of this by using open market operations which is the tool that works the fastest. It will remain the most important tool until a more efficient way one is discovered.

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