14
Chapter
The Tools and Goals of
Central Bank Monetary Policy
Money and Capital Markets
Financial Institutions and Instruments in a Global Marketplace
Eighth Edition
Peter S. Rose
McGraw Hill / Irwin
Slides by Yee-Tien (Ted) Fu
14 - 2
 Learning Objectives 
 To understand how the policy tools available
to central banks work in carrying out a nation’s
money and credit policies.
 To explore the strengths and weaknesses of the
various monetary policy tools.
 To learn how the Federal Reserve System
controls U.S. credit and interest rate levels.
 To see how central bank policy actions affect a
nation’s economic goals.
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Introduction
 Central banks are given the task of regulating
the money and credit system in order to
achieve the economic goals of full
employment, a stable price level, sustainable
economic growth, and a stable balance-ofpayments position with the rest of the world.
 Although these objectives are not easy to
achieve and often conflict, the central bank has
powerful policy tools at its disposal.
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General versus Selective Credit Controls
 General credit controls affect the entire
banking and financial system.
Examples: reserve requirements, the discount
rate, open market operations
 Selective credit controls affect specific groups
or sectors of the financial system.
Examples: moral suasion, margin
requirements on the purchase of
listed securities
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Reserve Requirements
 In the U.S., all depository financial institutions
(including nonmembers) are required to
conform to the deposit reserve requirements
set by the Fed.
 Changes in reserve requirements are a very
potent, though little-used tool.
 Indeed, reserve requirements have recently
been reduced in the U.S., and eliminated in
Canada, New Zealand, and the U.K.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Reserve Requirements
Current Levels of Reserve Requirements
for Depository Institutions in the U.S.
2003 by The
McGraw-Hill Companies, Inc. All rights reserved.
McGraw
Source:
Board
Hill /of
Irwin
Governors of the Federal Reserve System,October
2001
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Reserve Requirements
 An increase in deposit reserve requirements

decreases the deposit and money multipliers,
slowing the growth of money, deposits and loans
 reduces the amount of excess legal reserves institutions deficient in required legal reserves will
have to sell securities, cut back on loans, or
borrow reserves
 increases interest rates, particularly in the money
market, as depository institutions scramble to
cover any reserve deficiencies
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Discount Rate
 The discount rate is the annual percentage
interest charge levied against those institutions
choosing to borrow reserves from the discount
window of the Federal Reserve bank in its
region.
 Frequent borrowing is discouraged and may be
penalized with a higher interest rate.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Discount Rate
 An increase in the discount rate

reduces the volume of loans from the discount
window (cost effect)
 makes borrowing from the Fed less attractive
(substitution effect)
 signals that the Fed is pushing for tighter credit
conditions (announcement effect), and market
participants may respond by curtailing their
spending plans or by accelerating their borrowings
(to secure the credit they need before interest rates
move even higher - negative psychological effect)
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Discount Rate
 Since the middle of 1999, the Fed’s discount
rate has followed the Federal funds interest
rate.
 Typically, the discount rate has been set half-apoint lower than the Federal funds rate, so as
to turn the discount rate and the discount
window into a passive tool in the conduct of
U.S. monetary policy.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Discount Rate
Note: Intended federal funds rate effective 12/11/2001 = 1.75%
Source: http://www.frbdiscountwindow.org/, April 2002
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Open Market Operations
 Open market operations in the U.S. consist of
the buying and selling of U.S. government and
other securities by the Federal Reserve System
to affect the quantity and growth of legal
reserves, and ultimately, general credit
conditions.
 Open market operations are a most flexible
policy tool, suitable for fine-tuning the
financial markets.
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Open Market Operations
 The open market tool has two major effects.

When the Fed is purchasing securities, the
additional demand for the securities in the market
tends to increase their prices and lower their
yields, so interest rates decline.
 A Federal Reserve purchase of government
securities increases the reserves of the banking
system and expands its ability to make loans and
create deposits, thereby increasing the growth of
money and credit.
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Types of Federal Reserve Open Market Transactions
Outright or Straight Open Market Transaction
(permanent change in the level of reserves held by
depository institutions)
Fed buys
securities
Fed sells
securities
McGraw Hill / Irwin
Federal
Reserve
bank
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Securities
Dealer
Reserves
Dealer’s
bank
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Types of Federal Reserve Open Market Transactions
RP or Reverse RP Transaction
(temporary change in the level of reserves held by
depository institutions)
RP: Fed buys securities
temporarily
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Later on:
Reserves
Securities returned
McGraw Hill / Irwin
Reverse RP: Fed sells
securities temporarily
Federal
Reserve
bank
Securities
Dealer
Reserves
Dealer’s
bank
Later on:
Reserves
Securities returned
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Types of Federal Reserve Open Market Transactions
Run-Off Transaction
(permanent reduction in the level of reserves held by
depository institutions)
Federal
Reserve
bank
Maturing Treasury
securities
Treasury
Pays cash
Reserves
McGraw Hill / Irwin
Sells more securities
to raise more cash
Dealer
Orders bank to pay
for the new securities
Dealer’s
bank
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Types of Federal Reserve Open Market Transactions
Agency Transaction (Type A)
(no change in the total level of reserves held by all
depository institutions)
Places order for securities
through a Federal Reserve bank
which then contacts dealer
Federal
Reserve
Dealer
customer
Delivers securities
Orders payment
to dealer
Customer’s
bank
McGraw Hill / Irwin
Reserves
Dealer’s
bank
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Types of Federal Reserve Open Market Transactions
Agency Transaction (Type B)
(permanent reduction in the level of reserves held by
depository institutions)
Federal
Reserve
customer
Places order for securities
Securities delivered from
Orders Fed’s own portfolio
payment
to Fed
Reserves
Customer’s
bank
McGraw Hill / Irwin
Federal
Reserve
bank
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Open Market Operations
 Defensive open market operations are technical
adjustments in market conditions to preserve
the status quo and to maintain the present
pattern of interest rates and credit availability.
 In contrast, dynamic open market operations
are designed to upset the status quo and to
change interest rates and credit conditions to a
level the Fed believes to be more consistent
with its economic goals.
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Selective Credit Controls Used by the Fed
 Moral suasion refers to the use of “armtwisting” or “jawboning” by central bank
officials to encourage lending institutions and
the public to conform with the spirit of its
policies.
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Selective Credit Controls Used by the Fed
 Margin requirements on the purchase of stocks
and convertible bonds and on short sales of
securities limit the amount of credit that can be
used as collateral for a loan.
 Since 1974, the U.S. margin requirement on
stocks, convertible bonds, and short sales has
been 50% of the market value of the securities.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Interest Rate Targeting
 In recent years, the Federal Reserve has given
increasing weight to targeting the cost and
availability of credit in the money market (in
particular, the daily average interest rate on
federal funds transactions).
 The Fed achieves its target through open
market operations that impact primarily the
nonborrowed reserves (and hence the total
reserves) available to the banking system.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Interest Rate Targeting
Federal
Funds
Interest
Rate
(%)
When the
demand for
D reserves  D’
S
The Fed
supplies
more
reserves
E
E’


S’
Such that the
federal funds rate
is maintained at
the desired level
Supply of
Reserves ($)
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Monetary Policy Targets
Operating Targets
(borrowed & nonborrowed reserves)
Instrumental Targets
(the federal funds rate & the growth of total reserves)
Intermediate Targets
(money & credit growth & long-term interest rates)
Final Targets
(low unemployment & inflation, sustainable economic growth,
& a stable international balance-of-payments position)
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The Federal Reserve and Economic Goals
The Goal of Controlling Inflation
 Inflation creates undesirable distortions in the
allocation of scarce resources.
 In the 1990s, several central banks (such as
New Zealand, Canada, and U.K.) began setting
target inflation rates or rate ranges.
 The U.S. has not set an explicit inflation rate
target – it pursues price stability and full
employment simultaneously.
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The Federal Reserve and Economic Goals
The Goal of Full Employment
 The Employment Act of 1946 committed the
U.S. government to minimizing unemployment
as a major national goal.
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The Federal Reserve and Economic Goals
The Goal of Sustainable Economic Growth
 The Federal Reserve has declared that one of
its most important long-term goals is to keep
the economy growing at a relatively steady and
stable rate – that is, a rate high enough to
absorb increases in the labor force and prevent
the unemployment rate from rising but slow
enough to avoid runaway inflation.
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The Federal Reserve and Economic Goals
Equilibrium in the U.S. Balance of Payments and
Protecting the Dollar
 In the international sector, the Fed pursues two
interrelated goals:
 protecting the value of the dollar in foreign
currency markets, and
 achieving an equilibrium position in the
U.S. balance of payments.
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The Trade-offs Among Economic Goals
 Economic goals conflict.
For example, controlling inflation and stabilizing
the U.S. international payments situation (sizable
trade deficits) usually require the Fed to slow
down the economy through restricted money
supply growth and higher interest rates.
 However, this policy threatens to generate more
unemployment and subdue economic growth.

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The Trade-offs Among Economic Goals
 However, there is growing research evidence
that full employment and price stability (the
absence of serious inflation) are compatible
with each other in the longer term.
 This definition of sustainable long-run full
employment is often referred to by economists
as the NAIRU – the non-accelerating inflation
rate of unemployment.
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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The Limitations of Monetary Policy
 Central banks cannot completely control
financial conditions or the money supply.
Changes in the economy feed back on the money
supply and the financial markets.
 The structure of the economy is changing due to
deregulation, internationalization, technological
developments, etc., such that changes in domestic
interest rates are probably not as potent a factor
affecting the economy as they were a decade ago.

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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Money and Capital Markets in Cyberspace
 Most central banks maintain comprehensive
websites, including information on what tools
they normally use to carry out their money and
credit policy. Visit, for example,

http://www.federalreserve.gov/

http://www.bankofcanada.ca/en/

http://www.bankofengland.co.uk/

http://www.rbnz.govt.nz/

http://www.bis.org/cbanks.htm
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 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 Introduction
 General versus Selective Credit Controls
 General Credit Controls of the Fed
Reserve Requirements
 The Discount Rate
 Open Market Operations

 Selective Credit Controls Used by the Fed
Moral Suasion by Central Bank Officials
 Margin Requirements

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 Interest Rate Targeting

The Federal Funds Rate
 The Federal Reserve and Economic Goals
The Goal of Controlling Inflation
 The Goal of Full Employment
 The Goal of Sustainable Economic Growth
 Equilibrium in the U.S. Balance of Payments and
Protecting the Dollar

McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Review
 The Trade-offs Among Economic Goals
 The Limitations of Monetary Policy
McGraw Hill / Irwin
 2003 by The McGraw-Hill Companies, Inc. All rights reserved.