Chapter 8
Conduct of Monetary Policy: Tools,
Goals, and Targets
The Federal Reserve Balance Sheet

Monetary Base = Currency + Reserves
2
The Federal Reserve Balance Sheet

Open Market Purchase from Public
The Fed
Public
Assets
Liabilities
Securities
–$100
Deposits
+$100
Assets
Liabilities
Securities
Reserves
+$100
+$100
Banking System
Assets
Reserves
Liabilities
Deposits
+$100
+$100
Result R  $100, MB $100
3
The Federal Reserve Balance Sheet

Discount Loans
Banking System
Assets
Reserves
Liabilities
Discount loans
+$100
+$100
The Fed
Assets
Liabilities
Discount loans Reserves
+$100
+$100
Result R  $100, MB $100
4
Market for Reserves and the Fed Funds
Rate
1.
Demand
curve slopes
down
because iff ,
ER  and Rd
up
2.
Supply curve
slopes down
because iff ,
DL , Rs 
3.
Equilibrium iff
where Rd = Rs5
Figure 7.1: Equilibrium in the Market for Reserves
Figure 7-2: Response to Open Market
Operation or Change in Discount Rate
1.
2.
Open
market
purchase,
Rs shifts to
right and iff

id , DL ,
Rs shifts to
right and iff

6
Figure 7-3: Response to Change
in Required Reserves
1.
RR , Rd
shifts to
right, iff 
7
Tools of Monetary Policy

Open Market Operations
1.
2.

Dynamic: Meant to change Reserves
Defensive: Meant to offset other factors
affecting Reserves, typically uses repos
Advantages of Open Market Operations
1.
2.
3.
4.
Fed has complete control
Flexible and precise
Easily reversed
Implemented quickly
Information about the FOMC
http://www.federalreserve.gov/fomc
8
Discount Loans

3 Types
1.
2.
3.

Lender of Last Resort Function
1.
2.

Adjustment Credit
Seasonal Credit
Extended Credit
To prevent banking panics FDIC fund not big enough
Examples: Continental Illinois and Franklin National
Banks
To prevent nonbank financial panics
Example: 1987 stock market crash
Announcement Effect
1.
Problem: false signals
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Reserve Requirements

Advantages
1.

Powerful effect
Disadvantages
1.
Small changes have very large effect on Ms
2.
Raising causes liquidity problems for banks
3.
Frequent changes cause uncertainty for banks
4.
Tax on banks
FOMC calendar and meeting minutes
http://www.federalreserve.gov/fomc/#calendars
10
Goals of Monetary Policy

Goals
1.
2.
3.
4.
5.
6.

High employment
Economic growth
Price stability
Interest rate stability
Financial market stability
Foreign exchange market stability
Goals often in conflict
11
Figure 7-4: Central Bank Strategy
12
Money Supply Target
1.
Md
fluctuates
between
Md' and Md''
2.
With Mtarget at M*,
i fluctuates
between
i' and i''
Figure 7-5: Result of Targeting on the Money Supply
13
Interest Rate Target
Figure 7-6: Result of Targeting on the Interest Rate
1.
Md
fluctuates
between
Md' and Md''
2.
To set itarget at i*,
Ms
fluctuates
between
M' and M''
14
Criteria for Choosing Targets

Criteria for Intermediate Targets
1.
2.
3.
Measurability
Controllability
Ability to predictably affect goals


Interest rates aren't clearly better than Ms on criteria
1 and 2 because hard to measure and control real
interest rates
Criteria for Operating Targets
1.
Same criteria as above

Reserve aggregates and interest rates about equal
on
criteria 1 and 2, but for 3 if intermediate target is Ms
then reserve aggregate is better
15
History of Fed Policy Procedures

Early Years: Discounting as Primary Tool
1.
2.

Discovery of Open Market Operations
1.

Real bills doctrine
Rise in discount rates in 1920: recession 1920–
1921
Made discovery when purchased bonds to get
income
in 1920s
Great Depression
1.
2.
Failure to prevent bank failures
Result: sharp drop in Ms
16
History of Fed Policy Procedures

Pegging of Interest Rates: 1942–1951
1.
2.

To help finance war, T-bill at 3/8%, T-bond at
21/2%
Fed-Treasury Accord in March 1951
Money Market Conditions: 1950s and 1960s
1.
2.
Free reserves = ER  DL
Interest rates
17
History of Fed Policy Procedures

Targeting Monetary Aggregates: 1970s
1.
2.

New Operating Procedures: 1979–1982
1.
2.
3.

Federal funds rate as operating target with
narrow band
Procyclical Ms
Deemphasis on federal funds rate
Nonborrowed reserves operating target
The Fed still using interest rates to affect
economy
and inflation
Deemphasis of Monetary Aggregates:
1982–Early 1990s
18
History of Fed Policy Procedures

Fed Funds Targeting Again
1.

Federal funds target now announced
International Considerations
1.
2.
M  in 1985 to lower exchange rate, M  in
1987
to raise it
International policy coordination
19
Figure 7-7:
Federal
Funds Rate
and Money
Growth
Before and
After
October
1979
Monetary Targeting Abroad

United Kingdom
1.
2.

Canada
1.
2.

Targets M3 and later M0
Problems of M as monetary indicator
Targets M1 till 1982, then abandons it
1988: declining π targets, M2 as guide
Germany
1.
2.
3.
Targets central bank money, then M3 in 1988
Allows growth outside target for 2–3 years, but then
reverses overshoots
1990s: dilemma of restrain π, but keep exchange rate
in EMS
21
Monetary Targeting Abroad

Japan
1.
Forecasts M2 + CDs
2.
Innovation and deregulation makes less useful
as monetary indicator
3.
High money growth 1987–1989:
“bubble economy,” then tight money policy
22
Inflation Targeting

Lessons from Monetary Targeting
1.
2.
3.

Success requires correcting overshoots
Operating procedures not critical
Breakdown of relationship between M and
goals made
M-targeting untenable; led to inflation targeting
Inflation Targeting: New Zealand, U.K.,
Canada
1.
2.
3.
Announcement of numerical π goal
Commitment to price stability
Communication with “Inflation Report”
23
Inflation Targeting (cont.)

Lessons from Inflation Targeting
1.
2.
3.
Decline in π still led to output loss
Worked to keep π low
Kept π in public eye—reduced political
pressures
for inflationary policy
24
Using a Fed Watcher

Fed watcher predicts monetary tightening, i 
1.
2.

Acquire funds at current low i
Buy $ in FX market
Fed watcher predicts monetary loosening, i 
1.
2.
3.
Make loans now at high i
Buy bonds, price rise in future
Sell $ in FX market
25