Chapter 8
Conduct of
Monetary Policy:
Tools, Goals,
and Targets
Chapter Preview
• 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
– Tools of Monetary Policy
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-2
Chapter Preview (cont.)
– Goals of Monetary Policy
– Central Bank Strategy: Use of Targets
– Choosing the Targets
– Fed Policy Procedures: Historical Perspective
– International Considerations
– Monetary Targeting in Other Countries
– The New International Trend in Monetary Strategy:
Inflation Targeting
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-3
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.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-4
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.
– Reserves: 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.
Since the Fed does not pay interest on reserves,
excess reserves are usually kept to a minimum.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-5
The Federal Reserve’s Balance
Sheet: Assets
• The monetary assets of the Fed include:
– Government Securities: 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.
– Discount Loans: These are loans made to
member banks at the current discount rate.
Again, an increase in discount loans will also
increase the money supply.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-6
The Federal Reserve’s Balance
Sheet: Impact of Open Market
Operations
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 reserving these transactions.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-7
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
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
Result R  $100, MB $100
8-8
The Federal Reserve Balance Sheet
• Discount Lending
Banking System
Assets
Reserves
Liabilities
Discount loans
+$100
+$100
The Fed
Assets
Liabilities
Discount loans Reserves
+$100
+$100
Result R  $100, MB $100
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-9
Market for Reserves
and the Fed Funds Rate
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.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-10
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 = Rs
Figure 8.1 Equilibrium in the Market for Reserves
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-11
Market for Reserves
and the Fed Funds Rate
1. Open market
purchase, Rs
shifts to right
and iff 
2. id , DL , Rs
shifts to right
and iff 
Figure 8.2 Response to an Open Market Operation
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-12
Market for Reserves
and the Fed Funds Rate
1. The Fed lowers id,
but does not cross
the demand curve
2. Rs shifts down but
no impact on the
fed funds rates
Figure 8.3, panel (a)
Response to a Change in the Discount Rate
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-13
Market for Reserves
and the Fed Funds Rate
1. The Fed lowers id,
and does cross the
demand curve
2. Rs shifts down
and iff 
Figure 8.3, panel (b)
Response to a Change in the Discount Rate
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-14
Market for Reserves
and the Fed Funds Rate
1. RR , Rd shifts
to right, iff 
Figure 8.4
Response to a Change in Required Reserves
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-15
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.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-16
Tools of Monetary Policy:
Open Market Operations
• Open Market Operations
1. Dynamic: Meant to change Reserves
2. Defensive: Meant to offset other factors affecting
Reserves, typically uses repos
• Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
Information about the FOMC
http://www.federalreserve.gov/fomc
8-17
Tools of Monetary Policy: Open Market
Operations at the Trading Desk
• The staff reviews the activities of the prior day and issue
forecasts of factors affecting the supply and demand
for reserves.
• This information is used to determine reserve changes
needed to obtain a desired fed funds rate.
• Government securities dealers are contacted to better
determine the condition of the market.
• Projections are compared with the Monetary Affairs
Division of the BOG, and a course of action is determined.
• Once the plan is approved, the desk carries out the
required trades, via the TRAPS system.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-18
Tools of Monetary Policy:
Discount Loans
• The Fed’s discount loans are primarily of
three types:
– Primary Credit: Policy whereby healthy banks
are permitted to borrow as they wish from the
primary credit facility.
– Secondary Credit: Given to troubled banks
experiencing liquidity problems.
– Seasonal Credit: Designed for small, regional
banks that have seasonal patterns of deposits.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-19
Tools of Monetary Policy:
Discount Loans
1. The Fed stands
ready to lend.
2. As demand
increases, Rs
shifts, limiting
the impact on iff.
Figure 8.5 How the Primary Credit Facility
Puts a Ceiling on the Federal Funds Rate
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-20
Tools of Monetary Policy:
Discount Loans
• Lender of Last Resort Function
1.To prevent banking panics FDIC fund not big enough
Examples: Continental Illinois and Franklin
National Banks
2.To prevent nonbank financial panics
Example: 1987 stock market crash
• Announcement Effect
1.Problem: false signals
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-21
Tools of Monetary Policy:
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
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
FOMC calendar and meeting minutes
http://www.federalreserve.gov/fomc/#calendars
8-22
Tools of Monetary Policy: Advantages of
Open Market Operations
• Open market operations are initiated by the Fed,
so the volume of these transactions is entirely
under the control of the Board of Governors.
• The operations are flexible and concise,
useful for both small and large changes in the
monetary base.
• Unanticipated effects are easily reversed,
if needed.
• Once the course of action is approved,
the policy is implements quickly, avoiding
administrative delays.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-23
Goals of Monetary Policy
• Goals
1. High employment
2. Economic growth
3. Price stability
4. Interest rate stability
5. Financial market stability
6. Foreign exchange market stability
• Goals often in conflict
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-24
Central Bank Strategy:
Use of Targets
• Generally, the Fed wishes to achieve certain
goals, but the tools at its disposal only allow for
indirect influence.
• All central banks, then, are limited to aiming at
variables that lie between their tools and the
achievement of the desired goals.
• The central bank identifies intermediate targets
which it aims to affect via its operating targets.
• The following diagram help explain
these concepts.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-25
Central Bank Strategy:
Use of Targets
Figure 8.6 Central Bank Strategy
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-26
Central Bank Strategy:
Choosing the Targets
• As shown in the previous figure, the Fed
can use two different target variables:
interest rates and aggregates.
• Unfortunately, the Fed can only choose one
of the two variables. The demand and
supply analysis that follows will show why
this is the case. Any action which affects
one of the targets will have some impact on
the other target.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-27
Central Bank Strategy:
Nonborrowed Reserves Target
1. The Fed targets
nonborrowed
reserves, shifting
to either Rd' or Rd''
2. The federal funds
rate will then
fluctuate to either
i' or i''
Figure 8-7
Result of Targeting on Nonborrowed Reserves
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-28
Central Bank Strategy:
Federal Funds Rate Target
• The Fed targets
the federal funds
rate, shifting to
either i' or i'‘
• The nonborrowed
reserves shift to
either Rd' or Rd''
Figure 8-8
Result of Targeting on the Federal Funds Rate
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-29
Central Bank Strategy:
Criteria for Choosing Targets
• Criteria for Intermediate Targets
1. Measurability
2. Controllability
3. Predictably effect on 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
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-30
Fed Policy Procedures:
Historical Perspective
• Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 1920–1921
• Discovery of Open Market Operations
1. Made discovery when purchased bonds to get income
in 1920s
• Great Depression
1. Failure to prevent bank failures
2. Result: sharp drop in Ms
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-31
Fed Policy Procedures:
Historical Perspective
• War Finance and the Pegging of Interest Rates:
1942–1951
1. To help finance war, T-bill at 3/8%, T-bond at 21/2%
2. Fed-Treasury Accord in March 1951
• Targeting Money Market Conditions: 1950s
and 1960s
1. Free reserves = ER  DL
2. Interest rates
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-32
Fed Policy Procedures:
Historical Perspective
• Targeting Monetary Aggregates: 1970s
1. Federal funds rate as operating target with narrow band
2. Procyclical Ms
• New Fed Operating Procedures: 1979–1982
1. De-emphasis on federal funds rate
2. Nonborrowed reserves operating target
3. The Fed still using interest rates to affect economy and inflation
• De-emphasis of Monetary Aggregates: 1982–Early 1990s
1. Targeted 3% for the fed funds rate from late 1992–February of 1994.
2. Raised the rate to 6% by early 1995.
3. Lowered the rate in the face of a slowing economy and LTCM crisis.
4. Continued this trend in 2001, when the economy faced a recession.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-33
International Considerations
The international marketplace and demand for
U.S. goods have significant impact on our
economy. Although not a primary focus, Fed
policy has been influenced by the notion of
international policy coordination. This represents
agreements among countries to enact
policies cooperatively.
For more information on this, see the “Global”
box on page 206 of your text.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-34
Monetary Targeting
in Other Countries
• United Kingdom
1. Targets M3 and later M0
2. Problems of M as monetary indicator
• Canada
1. Targets M1 till 1982, then abandons it
2. 1988: declining π targets, M2 as guide
• Germany
1. Targets central bank money, then M3 in 1988
2. Allows growth outside target for 2–3 years, but then
reverses overshoots
3. 1990s: dilemma of restrain π, but keep exchange rate in EMS
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-35
Monetary Targeting
in Other Countries
• 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
• Lessons from Monetary Targeting
1. Success requires correcting overshoots
2. Operating procedures not critical
3. Breakdown of relationship between M and goals made
M-targeting untenable; led to inflation targeting
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-36
The New International Trend in Monetary
Policy Strategy: Inflation Targeting
• New Zealand
– Passed the Reserve Bank of New Zealand act (1990)
– Policy target agreement set an annual inflation target in the range
of 0% to 2%
– Target has adjusted based on current economic conditions
• Canada
– Established formal inflation targets, starting in 1991
– Targets have also been adjusted as needed
• United Kingdom
– Established formal inflation targets, starting in 1992
– Targets have also been adjusted as needed
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-37
The New International Trend in Monetary
Policy Strategy: Inflation Targeting
• Lessons from Inflation Targeting
– Decline in inflation still led to output loss
– Worked to keep inflation low
– Kept inflation in public eye—reduced
political pressures for inflationary policy
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-38
Using a Fed Watcher
• Fed watcher predicts monetary tightening, i 
1. Acquire funds at current low i
2. Buy $ in FX market
• Fed watcher predicts monetary loosening, i 
1. Make loans now at high i
2. Buy bonds, price rise in future
3. Sell $ in FX market
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-39
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.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-40
Chapter Summary (cont.)
• Goals of Monetary Policy: the six primary goals of
monetary policy were discussed.
• Central Bank Strategy: Use of Targets: by
focusing on intermediate and operating targets,
the Fed can quickly adjust policy as needed
• Choosing the Targets: the Fed must choose
between interest rate and monetary targets.
Changes in one were shown to affect the other.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-41
Chapter Summary (cont.)
• Fed Policy Procedures: Historical Perspective: the Fed
has switched its monetary targets several times, with a
current focus on the Fed funds rate.
• International Considerations: policy coordination
among the leading industrial countries is part of Fed
decision-making.
• Monetary Targeting in Other Countries: the goals and
history of some of the leading industries societies reveals
commonalities and differences in strategies.
• The New International Trend in Monetary Strategy:
Inflation Targeting: New Zealand, Canada, and the U.K.
now specifically target inflationary growth ranges.
Copyright © 2006 Pearson Addison-Wesley. All rights reserved.
8-42