CENTRAL BANKING AND THE CONDUCT OF MONETARY
POLICY
U.S. Monetary policy & “The Fed”
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Federal Reserve System was founded by
Congress in 1913.
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Bank of Canada in 1935.
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The oldest is Sweden's Riksbank – 1668.
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Bank of England – 1694.
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Bank of France – 1800.
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ECB (European Central Bank) – 1998.
Federal Reserve's Core Functions
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As a central bank its function is to manage the
expansion and cost of money and credit, as a
means of achieving the predetermined goals.
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Conducting Monetary Policy.
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Maintaining the stability of the financial system.
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Performing banking supervision and regulation.
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Providing financial services.
Structure of The FRS
12 Federal
Reserve
Banks
Board of Governors
Washington D.C.
FOMC
(federal open market
committee)
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instrument independence - the ability of the central bank
to set monetary policy instruments
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goal independence - the ability of the central bank to set
the goals of monetary policy.
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BoC has less goal independence.
BoC is not fully isolated from other branches of government.
Ultimate responsibility for monetary policy goes to the
government.
BoC is less instrument independent.
This independence story is important because independent
Central Banks are able to achieve their goals (such as inflation
reduction) better.
Monetary Policy Objectives
“ ...maintain long run growth of the monetary and
credit aggregates commensurate with the economy's
long run potential to increase production, so as to
promote effectively the goals of maximum
employment, stable prices, and moderate long-term
interest rates.”
i.e. to balance growth in M with growth in Y
(see quantity theory of money equation)
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Cost of Unemployment (from too little money growth)
 lost opportunities from idle resources, emotional pain
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Cost of Inflation (from too much money growth)
 destruction of savings, losses to creditors, shoeleather costs,
menu costs, risk of entrenching inflation in people’s expectations.
 deflation also poses risks, primarily the risk that people postpone
purchases and investments.
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What number should FOMC shoot for?
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Remember: objective is price stability.  so inflation should be 0% right?
 If you aim for 0% you might accidentally undershoot and achieve deflation.
 little inflation “greases the wheels” , motivates people to look for higher-paying
jobs and find a better fit for their skills.
 economists have decided that inflation of 2% does little harm, so better to shoot
for that and avoid risk of deflation, unemployment.
“The Synthesis”
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The prevalent and core view among the central
bankers about how growth and inflation interact
emerged as a result of:
Great Depression (1930s)  Keynesians, short
run Keynesians believe that in the short run, when demand is depressed, increasing the money supply
and stimulating demand will not lead to inflation
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Great Inflation (1970s) New Classicalists,
long run New Classicalists, like Austrians, believe that in the long run, money is neutral in its
effects on the economy, because prices will adjust to balance money with output. Growth in output and
employment must come from improved productivity.
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Governors have to understand and accept both.
In the short run, for a given level of expected inflation, and for a given supply curve,
monetary policy moves the AD curve up and down the supply curve. Therefore there
is a tradeoff between unemployment and inflation, as shown in the Phillips curve.
If inflation gets too high i.e. the Central Bank stimulates AD too much, people will begin
to expect higher inflation. The Aggregate Supply curve will shift towards the origin as
people demand higher wages and higher rentals, leases, etc.
NAIRU Paradigm
Model of Growth and Inflation
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NAIRU stands for non-accelerating inflation rate of
unemployment. It is the lowest you can push
unemployment/the most you can stimulate aggregate demand
without causing inflation.
NAIRU is achieved at Yn, the “full-employment” level of GDP
that we have used in our diagrams of AD/AS equilibrium.
FOMC watches for NAIRU since it is the limit where a rise in the
inflation rate will show up.
More on NAIRU
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Very difficult to pin-point an exact number – it changed over the years.
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Controversial. Where is it? - 6% prior to 1995. Around 4.5% late 1990s
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Recent estimates by many put it at 4.5% to 5.0%.
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Really, you should think of it as concept not an exact number. It is a
balancing point. A rough measure but a key one.
The NAIRU is a moving target, estimated imprecisely, and with a lag
that may be long enough to make it an uncertain guide for policy.
“Point of heated” debate in the Fed meetings. Hawks vs. doves.
Politicians do not like it the idea of cooling the economy (thereby raising
unemployment) when the unemployment rate falls below NAIRU.
NAIRU has decreased over the years due to:
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Ease of internet job search
Aging population
Rising prison population
Decline in power of minimum wage
Decline in power of unions.
How fast can the economy grow?
POTENTIAL OUTPUT GROWTH (POG) is about 2.5-3% in the US.
OKUN’s Law is a rule-of-thumb that predicts by what percentage unemployment
will rise for every percentage point that output growth is below POG. In the
US, the Okun coefficient seems to be about 0.4.
SUMMARY
• Traditional way of operating  if U rate falls below NAIRU, economy
overheats and rate of inflation increases, so reduce money supply.
• Mid 1990s “temporary bliss”  U rate fell well below NAIRU (3.8%) but
inflation kept falling as well due to increases in productivity and competition
from international trade. There seemed to be no need to reduce the money
supply.
• In the 2000s the Fed kept the interest rate low to help the economy recover
from the dot-com bubble, and then the 9/11 scare.
• House prices and stock prices bubbled.
• The Fed felt it was better to live with a bubble than to pop it as Japan did in the
late 80s. Inflation was feared less than deflation.
The Conduct of the Monetary policy
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The role of policy is to move the economy to some preferred state.
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Decisions are made at the FOMC meeting.
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They can use:
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Reserve Requirements – seldom changed
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Discount Window – amount charged/paid to chartered banks for their
loans/deposits.
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Federal Funds Rate (i.e. overnight lending rate to chartered
banks)– most often used tool. The announced rate is backed up by
open market operations which work in the same direction. Once the
FFR has been reduced to near zero, the Fed must find another tool if
it wants to stimulate the economy any further.
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Big changes in the monetary base. This is called quantitative
easing/tightening.
Federal Funds Rate
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Is the interest rate charged on overnight loans from the Central Bank to
commerical banks or from one commercial bank to another.
Determined in the market for federal reserve balances (market for reserves)
FED influences the price at which this lending/borrowing is being done
through Open Market Operations
Open Market Operations
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buying and selling of U.S. gov. bonds – affects the federal funds rate
and interest rates generally
Most of it done in US Treasury securities  most liquid market
Buying bonds increases currency in circulation and selling bonds
decreases it.
Taylor Rule
• How should the target FFR be chosen?
• The Fed wants to decrease unemployment AND decrease inflation, if
possible, but in the short run there is a tradeoff between these two goals.
• Fed funds rate target = inflation rate + equilibrium real fed funds
rate + 1/2 (inflation gap) +1/2 (output gap)
• Simple policy rules like the Taylor rule are only rules of thumb, and
reasonable people can disagree about important details of the
construction of such rules. Moreover, simple rules necessarily leave out
many factors that may be relevant to the making of effective policy in a
given episode.
• The next graph shows that the Fed has behaved in a way consistent with
the Taylor Rule.
Channels
• How do changes in the Fed Funds Rate work their way to the
economy?
• Raising or lowering the FFR influences 4 major channels linked to
aggregate demand:
1. Higher (lower) interest rates discourage (encourage) business and
consumer spending
2. Weaken (raise) the value of the stock and housing market (mortgage rates)
 wealth effect
3. Appreciate (depreciate) the value of the currency, decreasing (increasing)
net exports.
4. Credit channel: Discourages (encourages) banks from lending, since the
value of collateral has fallen (risen). (See point 2.)
Credit Channel
• Wealth effect from houses and stocks not the whole story
• homes and stocks are used as collateral for loans
• tighter monetary policy decreases the value of homes and stocks 
lower collateral for borrowing
• tighter monetary policy  weaker economic outlook (incomes &
profits)
• Result: tougher standards for lending by banks in the credit market 
can harm economic growth
• Financial Accelerator is reduced when firms lack access to credit. The
financial accelerator describes how firms increase their investment in
response to improved sales.