Money and Banking I

Lecture 7

The Tools and Conduct of Monetary Policy

(FM – Chapters 16 & 17; CS - Chapter 18;
Journal Article by Bernanke and Mishkin)

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 Learning Objectives
• Explain the market for reserves and demonstrate how changes
in monetary policy can affect the federal funds rate.
• Explain 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.
• Define and recognize the importance of a nominal anchor.
• Identify the six potential goals that monetary policymakers
may pursue.
• Explain the distinctions between hierarchical and dual
mandates.
• Compare and contrast the advantages and disadvantages of
inflation targeting.
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 Learning Objectives (cont’d)
• Describe and assess the four criteria for choosing a policy
instrument.
• Interpret and assess the performance of the Taylor rule as a
hypothetical policy instrument for setting the federal funds
rate.

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 The Market For Reserves and the Federal Funds Rate
Fed Funds Rate – Primary instrument of US monetary policy
• Interest rate on overnight loans of reserves from one bank to
another
• Determined by demand and supply in the market for reserves

Demand and Supply in the Market for Reserves

Demand for reserves - What happens to the quantity of reserves
demanded by banks, holding everything else constant, as the
federal funds rate changes?

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
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 Demand in the Market for Reserves
Since 2008, the Fed has paid interest on reserves (ior) at a level that
is set at a fixed amount below the federal funds rate (iff )
Opportunity cost of holding excess reserves = iff – ior

When federal funds rate (iff ) > interest on reserves (ior),

• As the federal funds rate decreases, the opportunity cost of
holding excess reserves falls hence the quantity of reserves
demanded rises
• Thus, demand for reserves is downward sloping up to ior

When federal funds rate (iff ) = interest on reserves (ior),

• Opportunity cost of holding excess reserves is zero implying
that banks can hold any amount of reserves they like at no cost
• Thus, demand for reserves becomes flat (infinitely elastic) at ior
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 Supply in the Market for Reserves
Supply of reserves has 2 components:
(a) Non-borrowed reserves (NBR)
(b) Borrowed reserves (BR)

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 (but instead borrow in
the Fed Funds market) – Hence borrowed reserves are zero and the
supply curve (Rs) will be vertical

As iff rises above id, banks will borrow more and more at id, and re-lend at
iff – Hence the supply curve (Rs) is horizontal (perfectly elastic) at id
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Equilibrium in the Market for Reserves

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 How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate
4 Tools of Monetary Policy – (a) open market operations (b) discount
rate (c) reserve requirements (d) interest paid on reserves

(a) Open Market Operations

• Effects of open an market operation depends on whether the supply
curve initially intersects the demand curve in its downward sloping
section versus its flat section.

• When intersection occurs at the downward sloping section, an open

market purchase increases the supply of reserves (NBR1 → NBR2)
thus causing the federal funds rate to fall

• When intersection occurs at the flat section of the demand curve,

open market operations have no effect on the federal funds rate 8
Response to an Open Market Operation

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 How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate (cont’d)
(b) Discount Rate
• If the intersection of supply and demand occurs on the vertical
section of the supply curve, a cut in the discount rate will shift
that portion of the supply curve downwards
– No effect on the federal funds rate

• If the intersection of supply and demand occurs on the horizontal

section of the supply curve, a cut in the discount rate will shift
that portion of the supply curve downwards
- The federal funds rate falls

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Response to a Change in the Discount Rate

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How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate (cont’d)
(c) Reserve Requirements
• When the Fed raises required reserve ratio
– demand curve (for reserves) shifts rightwards
– federal funds rate rises

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Response to a Change in Required Reserves

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 How Changes in the Tools of Monetary Policy Affect the
Federal Funds Rate (cont’d)
(d) Interest on Reserves
• If the supply curve intersects the demand curve in its
downward sloping section, an increase in the interest on
reserves will shift the horizontal section of the demand curve
(for reserves) upwards
– No effect on the federal funds rate

• If the supply curve intersects the demand curve on its flat

section, an increase in the interest on reserves will shift the
horizontal (flat) section of the demand curve upwards
- The federal funds rate rises

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Response to a Change in the Interest Rate on Reserves

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 Conventional Monetary Policy Tools
During normal times, the Federal Reserve uses 3 main tools of
monetary policy—open market operations, discount lending,
and reserve requirements—to control the money supply and
interest rates

• The 3 main tools are referred to as conventional monetary

policy tools

• Fed also uses an additional possible tool of paying interest on

reserves as a monetary policy tool

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 Open Market Operations (OMO)
Open market operations constitute the most important monetary
policy tool due to 4 advantages:
(a) The Fed can take the initiative and has complete control over the
volume of non-borrowed reserves – Unlike the discount rate in
which the Fed can only encourage banks to borrow reserves by
changing the discount rate

(b) Flexible and precise – Can be applied to any amount of changes

in the monetary base

(c) Easily reversed – If mistake is made in conducting an open

market operation, the Fed can immediately reverse it

(d) Quickly implemented – No administrative delays in the buying

and selling of bonds when conducting the open market operation
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 Discount Lending
Discount window – Facility at which banks can borrow reserves from the
Federal Reserve
• Cannot be completely controlled by the Fed as the decision maker is
the bank

• Discount facility is used as a backup facility to prevent the federal

funds rate from rising too far above the target

• Used to perform role of lender of last resort to prevent financial panics

– Important during the subprime financial crisis of 2007-2008.
– Creates moral hazard problem as it encourages banks to take on
more risks since they know Fed will provide discount loans when
they get into trouble

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 Reserve Requirements
• A rise in reserve requirements reduces the amount of deposits that
can be supported by a given level of monetary base thus leading to
a contraction of the money supply

• A reduction in reserve requirements increases the amount of

deposits that can be supported by a given level of monetary base
thus leading to an increase in the money supply

• The percentage is set at 10% and can be varied between 8% to 14%

at the Fed’s discretion

• Changes to reserve requirements take time to implement as banks

must be given advance warning so that they can adjust their
computer systems to calculate required reserves 19
 Interest on Reserves
• Federal Reserve began paying interest on reserves since 2008
(hence this monetary policy tool does not have a long history)

• Generally, the Fed has set the interest on reserves below the
federal funds target

• Serves to provide a floor under the federal funds rate

• This tool can be used to raise the federal funds rate when the Fed
wants to exit from the low interest rate policy (refer to Slide 13)

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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 – In Aug 2007, Fed lowered the
discount rate to 50bp above the Fed Funds rate (rather than the normal
100bp)
• Term Auction Facility (TAF) – Established in Dec 2007 to enable
banks to borrow at a rate lower than the discount rate
• New Lending Programs – Lending to investment banks such as J.P.
Morgan to assist in purchase of Bear Stearns
Asset Purchases – Fed established (a) Government Sponsored Entities
Purchase Program to buy US$1.25 trillion of mortgage-backed
securities (MBS) and (b) quantitative easing (QE) program to buy
long-term Treasury bonds so as to lower long-term interest rates 21
Assets of the Federal Reserve, 2007-2014

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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

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 Other Goals of Monetary Policy
Five other goals are continually mentioned by central bank
officials when they discuss the objectives of monetary policy:
(1) high employment and output stability – maintain output at
the natural rate of output which is consistent with the
natural rate of unemployment
(2) economic growth – encourage savings and investment
thereby promoting growth in the economy
(3) stability of financial markets – to channel funds for
productive investments
(4) interest-rate stability – to reduce uncertainty in savings and
investment decisions
(5) stability in foreign exchange markets – to support the
development of international trade

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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

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 Inflation Targeting
Recognition of price-stability as primary long-run goal of monetary policy
has led to monetary policy strategy known as inflation targeting

Inflation targeting involves 5 key elements:

(a) Public announcement of medium-term numerical target for inflation
(b) Institutional commitment to price stability as the primary, long-run
goal of monetary policy and a commitment to achieve the inflation
goal
(c) Information-inclusive approach in which many variables are used in
making decisions
(d) Increased transparency of the strategy through communication with
public and financial markets
(e) Increased accountability of the central bank for attaining its inflation
objectives 26
 Inflation Targeting (cont’d)
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 then, 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.

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Inflation Rates
and Inflation
Targets for
New Zealand,
Canada, and
the United
Kingdom,
1980–2011

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 Inflation Targeting (cont’d)
Advantages
– Reduces potential of falling in time-inconsistency trap
– Highly transparent and easily understood by the public
– Increased accountability of the central bank

Disadvantages
– Delayed signaling as lag effects of monetary policy imply
that outcomes are only revealed after substantial lags
– Too much rigidity which restricts monetary policymakers in
responding to unforeseen circumstances
– Potential for increased output fluctuations as sole focus on
inflation may lead to overly tight monetary policy
– Low economic growth even when low inflation is already
acheived

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 Journal Article on Inflation Targeting
Bernanke, B.S. and Mishkin, F.S., ‘Inflation Targeting: A New
Framework for Monetary Policy? ‘Journal of Economic
Perspectives, Vol. 11, No. 2, 1977, pp.97-116.
• Inflation targeting is a policy framework rather than a rule for
guiding monetary policy

• It does not provide simple and mechanical operational instructions to

central bank but requires central bank to use all information in
decision making process

• There is room for policy discretion within the constraints of inflation

targeting imposed by medium to long-term inflation targets

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 Journal Article on Inflation Targeting (cont’d)
Bernanke and Mishkin (1997) suggest some challenges with inflation
targeting:
• Problems in constructing a good measure of inflation which is
accurate, timely, readily understood by the public, and allows for one-
time price shocks which do not affect trend inflation

• Difficulties in sufficiently predictable and controlling the inflation

target, particularly given the long and unpredictable lags between
monetary policy actions and inflation response

• Is inflation the correct goal variable in the conduct of monetary

policy? Some economists such as Taylor and Mankiw argue that
central banks should target nominal GDP growth (rather than
inflation) as it puts some weight on output as well as prices.
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 The Federal Reserve’s Monetary Policy Strategy
The Federal Reserve does not use an explicit anchor such as an
inflation target

• Fed’s strategy involves an implicit (rather than explicit)

nominal anchor in the form of an overriding concern to control
inflation in the long run

• Forward looking behavior which involves close monitoring of

signs of future inflation and periodic “preemptive strikes” of
monetary policy against the threat of inflation

• The goal is to prevent inflation from getting started – hence

monetary policy needs to be forward-looking and preemptive
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 The Federal Reserve’s Monetary Policy Strategy (cont’d)
Advantages of the Fed’s “Just Do It” Approach:
– Uses many sources of information to determine the best
settings for monetary policy
– forward-looking behavior and stress on price stability help to
discourage overly expansionary monetary policy thereby
reducing the time-inconsistency problem

Disadvantages of the Fed’s “Just Do It” Approach:

– lack of transparency tends to generate a high level of
uncertainty thus leading to volatility in financial markets
– heavy dependence on the preferences, skills, and
trustworthiness of the individuals in charge of the central
bank
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 Tactics: Choosing the Policy Instrument
Central bank directly controls the 3 tools of monetary policy
– Open market operation
– Reserve requirements
– Discount rate

To examine whether monetary policy is easy or tight, we can

observe the policy instrument (operating instrument)
- policy instrument is a variable that responds to the central
bank’s tool and indicates the stance (easy or tight) of monetary
policy

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 Tactics: Policy Instruments, Intermediate Targets and Goals
The Fed uses 2 basic types of policy instruments
– Reserve aggregates
– Interest rates

The policy instrument could be linked to an intermediate target

such as a monetary aggregate like M2 or a long-term interest
rate

The intermediate target, in turn, is closely linked to the goals of

monetary policy such as price stability, employment and
economic growth

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Linkages Between Central Bank Tools, Policy Instruments,
Intermediate Targets, and Goals of Monetary Policy

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 Criteria for Choosing the Policy Instrument
There are 3 criteria in choosing a policy instrument
(a) Observability and Measurability – Quick observability and
accurate measurement of a policy instrument are important for
signaling the policy stance rapidly

(b) Controllability – Central bank must be able to have effective

control over the policy instrument (i.e. variable) to ensure that
the variable stays on target if it gets off track

(c) Predictable effect on Goals – This is critical to the usefulness of

the policy instrument hence is the most important characteristic
of a policy instrument

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 Tactics: The Taylor Rule
The Fed conducts monetary policy by setting a target for short-term
interest rates like the fed funds rate

• But how should the target fed funds rate be chosen?

• John Taylor (Stanford University) has developed a rule for

determining the target fed funds rate (Taylor rule)

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 Tactics: The Taylor Rule (cont’d)
Federal funds rate target =
inflation rate  equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
• Taylor assumed that the equilibrium real fed funds rate is 2%

• As the coefficient of the inflation gap is ½, it follows that when

inflation rises by 1 percentage point, the fed funds rate will have to
be raised by 1.5 percentage points

• The output gap indicates that the Fed does not only care about
keeping inflation under control but also about minimizing business
cycle fluctuations of output around the potential level

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 The Taylor Rule for the Federal Funds Rate, 1970–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

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