Macroeconomics:
Monetary Policy
Explore These Useful Links at the FED
 Main Web Page: http://www.federalreserve.gov/default.htm
 Policy Statements:
http://www.federalreserve.gov/monetarypolicy/default.htm
 Descriptive Information:
http://www.federalreserve.gov/aboutthefed/default.htm
 Education:
http://www.federalreserve.gov/aboutthefed/educationaltools/default.htm
 Data:
http://research.stlouisfed.org/fred2/
The Legal Framework

The FEDERAL RESERVE ACT OF 1913 lays out the goals of monetary
policy. It specifies that, the Federal Reserve System and the Federal Open
Market Committee should seek “to promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.”

The 1979 HUMPHREY-HAWKINS ACT amended the FED's mission
requiring:

the Board of Governors of the Federal Reserve to apply monetary policy that
maintains long-run growth, minimizes inflation, and promotes price stability.

instructed the Board of Governors of the Federal Reserve to transmit an
Monetary Policy Report to the Congress twice a year outlining its policies.

required the President to set numerical goals for the economy of the next fiscal
year in the Economic Report of the President and to suggest policies that will
achieve these goals.

Finally, it required the Chairman of the Federal Reserve to coordinate the
monetary policy with the Presidential economic policy.
Structural Design
 The Federal Reserve System was created in 1913 under the
administration of Woodrow Wilson to safeguard the banking
system against the panics which had existed during much of the
19th century.
 The FED is charged with providing an elastic currency, not just
during financial panics, but generally. It serves as a lender of last
resort.
 THE FED IS DESIGNED TO BE INDEPENDENT. NOT
ONLY IS IT NEAR IMPOSSIBLE FOR A PRESIDENT OR
CONGRESS TO CONTROL THE COMPOSITION OF THE
BOARD, ITS BUDGET DOES NOT GO THROUGH EITHER
PRESIDENTIAL (OMB) OR CONGRESSIONAL
CHANNELS. THE FED IS FINANCED BY A FEE LEVIED
ON MEMBER BANKS.
 The Chairman of the Federal Reserve (currently Janet Yellen) is
selected by the president with the consent of Congress for a 4 year
term. Can be reappointed. For example, Paul Volker served as
chairman from 1979 through 1987. Alan Greenspan served as
chairman from 1987 through 2006. Ben Bernanke served as
chairman from 2006 through 2014. The chairman of the FED is
arguably one of the two most important economic actors in the
United States, along with the President.
 Board of Governors- 7 members appointed for 14 years by the
president and confirmed by the Senate. Staggered terms by 2
years. Difficult for a president or party to appoint a majority. The
Board is responsible for the overall operations of the Fed. It
determines broad monetary, credit, and operating policies for the
system and formulates the rules and regulations for carrying out
the purposes of the Federal Reserve Act. Its duties include
monitoring credit conditions, supervising the Federal Reserve
District Banks and member banks, and helping to implement
certain consumer credit protection laws.
 Federal Reserve Banks-There are twelve Reserve Banks in major
financial centers, including Boston, New York, Philadelphia, Cleveland,
Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City,
Dallas, and San Francisco. There are also twenty-five branch banks in
other important commercial centers. The twelve district reserve banks,
and their branch offices reflect regional interests.
 Each reserve bank has a nine member board of directors: three elected
by member banks, three elected by member banks and must be actively
involved in the economy, but can’t be officers of banks, and three
appointed by the Board of Governors. The president and vice-president
are appointed by the Board of Directors, but subject to the approval of
the Board of Governors.
 What do the Reserve banks do? Reserve banks receive local banks’
deposits. They can also lend or extend credit to both member and nonmember banks, but usually only just “overnight”. Reserve banks also
serve as a clearinghouse and collecting agent for depository institutions
in the handling of checks and other instruments.
 The banks also issue Federal Reserve notes, which make up most of the
money in circulation in the United States. They act as depositories and
fiscal agents of the U.S. government and help issue and redeem federal
securities.
 The Federal Advisory Council (FAC), which is composed of
twelve representatives of the banking industry, consults with and
advises the Board on all matters within the Board's jurisdiction.
The council ordinarily meets four times a year, the minimum
number of meetings required by the Federal Reserve Act. Each
year, each Reserve Bank chooses one person to represent its
District on the FAC, and members customarily serve three oneyear terms. The members elect their own officers.
 Federal Open Market Committee (FOMC)- This is the policy-
making arm of the Federal Reserve. This is the most important
part of the FED outside of the Chairman. The FOMC meets in
Washington 8 times per year to establish policies for sales and
purchase of securities, principally federal, in the open market.
These policies are executed by the Reserve Bank of New York.
They are designed to expand and contact the money supply. The
FOMC also directs the Reserve Bank of New York in transactions
involving foreign currencies in order to safeguard the value of the
dollar on international markets and facilitate liquidity in the
global economy.
Powers of the FED
 The powers of the FED are extensive.
 Broad regulatory power over member banks. The FED shares
regulatory authority over banks with the FDIC (insures deposits and
monitors bank health) and the Office of the Comptroller of the
Currency (charters, regulates, and supervises all national banks).
 Regulates disclosure of terms of credit.
 Regulates use of margin credit in purchase of stocks and securities.
 Sets the bank Reserve Requirements (the amount of reserves that a
bank must keep on hand).
 Sets, the Discount Rate (the interest rate that Federal Reserve Banks
charge depository institutions for short-term loans)
 Manipulates the Federal Funds Rate through open market operations
(the buying and selling of government securities). This is most
important tool of monetary policy.
 Setting the Reserve Requirement, the Discount Rate, and
manipulating the Federal Funds Rate through open market
operations are the FED's three main tools of monetary policy.
 There is a continual flow of reserves among banks, representing
the ever-changing supply and demand for these reserves at
individual banks. When the FED engages in open market
operations, it adds to or subtracts from the supply of reserves in
the monetary system. The effectiveness of the FED's actions
result from the reasonably predictable demand for reserves that is
created by reserve requirements.
Understanding Monetary Policy
 The beginning point to understanding monetary policy is understanding
that there is a market for money. Like in any market, there is supply and
demand which are determined by price (i.e, interest rates).
 Interest is what people pay to borrow money, and also determines the
willingness of creditors to lend money.
 Demand for money occurs when people want to be able to buy homes,
assume credit card debt, expand their businesses, expand their income,
or expand their purchasing power. It also comes from government
indebtedness to finance current spending through the issuance of bonds.
 Supply of money is also affected by interest rates. The institutions that
lend money include banks, saving and loans, private companies, and
perhaps most importantly, from the FED itself. Where does the money
come from? It comes from savings deposits in banks, inflows of capital
from other countries, and is also manipulated by the Federal Reserve in
manners that we shall see below.
 In the preceding graph, the price of money is what is called the interest
rate.
 If demand exceeds supply, then the interest rate increases to quell the
excess demand.
 If supply exceeds demand, then the interest rate decreases to attract
more demand.
 Given these relationships, the main role of the Federal Reserve is
on the supply side of these relations. It can increase the supply of
money in the system which decreases interest rates. It can also
remove money from the system which increases interest rates.
Through these means the FED is able to affect economic behavior
throughout the macroeconomic system.
 The initial link between monetary policy and the economy occurs
in the market for monetary reserves.
Definition of Monetary Reserves
 Monetary reserves are what is used to back up the national currency
and to provide a cushion for executing central banking functions like
adding to the money supply and settling foreign exchange contracts in
local currencies.
 When the United States was using the Bretton Woods inspired
monetary system after World War II, only gold was used as a monetary
reserve, a structural problem that most saw as a roadblock to future
economic growth. The supply of gold is limited, so it is difficult to
expand the money supply. Hence, after 1971 the U.S. went off the gold
standard.
 The U.S. dollar is now a fiat currency (not pegged to gold reserves. Fiat
money is money that has value only because of government regulation
or law.). Even though the Federal Reserve Banks keep a large amount of
reserves, most of what is held today is used for settling short-term
currency contracts and for liquidity activities for the domestic economy.
 The Federal Reserve’s policies are intended to influence the
demand for or supply of money reserves at banks and other
depository institutions, and through this market, the effects of
monetary policy are transmitted to the rest of the economy.
Therefore, to understand how monetary policy is related to the
economy, one must first understand what the reserves market is
and how it works.
 Here is a simplified graphical depiction of the reserve system.
 Reserves on deposit – deposit accounts at the central bank, owned by
banks.
 Vault cash – reserves held as cash in bank vaults rather than being on
deposit at the central bank.
 Borrowed reserves – bank reserves that were obtained by borrowing
from the central bank.
 Non-borrowed reserves – bank reserves that were not obtained by
borrowing from the central bank.
 Required reserves – the amount of reserves that banks are required to
hold, determined by the central bank as a function of a bank's deposit
liabilities.
 Excess reserves – bank reserves in excess of the reserve requirement. A
portion of excess reserves (or even all of them) may be desired reserves.
 Total reserves – all bank reserves: vault cash plus reserves on deposit at
the central bank, also borrowed plus non-borrowed, also required plus
excess.
The Demand Side
 The demand for reserves has two components: required reserves and
excess reserves. All depository institutions—commercial banks, saving
banks, savings and loan associations, and credit unions—must retain a
percentage of certain types of deposits to be held as reserves. These
include vault cash and required reserve balances held at one of the 12
Federal Reserve banks. Excess reserves are those held at Federal
Reserve Banks in excess of required reserves.
 The reserve requirements are set by the Federal Reserve under the
Depository Institutions Deregulation and Monetary Control Act of
1980. Since the early 1990s, reserve requirements have been applied
only to transaction deposits (basically, interest-bearing and non-interestbearing checking accounts). Required reserves are a fraction of such
deposits; the fraction—the required reserve ratio—is set by the Board of
Governors within limits prescribed by law.
 Thus, total required reserves expand or contract with the level of
transaction deposits and with the required reserve ratio set by the
Board; in practice, however, the required reserve ratio has been adjusted
only infrequently. (1968, 12.3%; 1978, 10.1%; 1988, 8.5%; 1998, 10.3%)
 Depository institutions hold required reserves in one of two forms:
vault cash (cash on hand at the bank) or, more important for monetary
policy, required reserve balances in accounts with the Reserve Bank for
their Federal Reserve District.
 Depositors use their accounts at Federal Reserve Banks not only to
satisfy their reserve requirements but also to clear many financial
transactions. Given the volume and unpredictability of transactions that
clear through their accounts every day, depositories need to maintain a
cushion of funds to protect themselves against debits that could leave
their accounts overdrawn at the end of the day and subject to penalty.
 Depositories that find their required reserve balances insufficient to
provide such protection may open supplemental accounts for required
clearing balances. These additional balances earn interest in the form of
credits that can be used to defray the cost of services, such as checkclearing and wire transfers of funds and securities that the Federal
Reserve provides.
 Excess Reserves: Some depository institutions choose to hold
reserves even beyond those needed to meet their reserve and
clearing requirements. These additional balances, which provide
extra protection against overdrafts and deficiencies in required
reserves, are called excess reserves; they are the second
component of the demand for reserves (a third component if
required clearing balances are included).
 In general, depositories hold few excess reserves because these
balances do not earn interest; nonetheless, the demand for these
reserves can fluctuate greatly over short periods, complicating the
Federal Reserve’s task of implementing monetary policy.
The Supply Side:
 The supply of monetary reserves to the banking system is dependent on
policy by the Federal Reserve. It uses two tools to manipulate the supply
of reserves in the system.
 The Discount Rate-Lending through the Federal Reserve discount
window.
 Open Market Operations-Buying and selling government securities.
 Borrowed Reserves - Reserves obtained through the discount window
are called borrowed reserves. The Federal Reserve supplies these
directly to depository institutions that are eligible to borrow through the
discount window. Access to such credit by banks and thrift institutions
is established by rules set by the Board of Governors, and loans are
made at a rate of interest—the discount rate—set by the Reserve Banks
and approved by the Board. The supply of borrowed reserves depends
on the initiative of depository institutions to borrow, although it is
influenced by the level of the discount rate and by the terms and
conditions for access to discount window credit.
 In general, banks are expected to come to the discount window to meet
liquidity needs only after drawing on all other reasonably available
sources of funds, which limits considerably the use of this source of
funds. Historically, many banks fear that their use of discount window
credit might become known to private market participants, even though
the Federal Reserve treats the identity of such borrowers in a highly
confidential manner, and that such borrowing might be viewed as a sign
of weakness. As a consequence, the amount of reserves supplied
through the discount window is generally a small portion of the total
supply of monetary reserves.
 However, recently the FED has been using the discount window more
liberally in the sense that it loaned money to banks to deal with the
financial crisis.
 Non-Borrowed Reserves - The other source of reserve supply from the
FED is nonborrowed reserves. Although the supply of nonborrowed
reserves depends on a variety of factors, many of them lie outside the
day-to-day control of the Federal Reserve, the System can exercise
control over this supply through open market operations—the purchase
or sale of securities by the Domestic Trading Desk at the Federal
Reserve Bank of New York.
 When the Federal Reserve buys securities in the open market, it
creates reserves to pay for them, and the supply of nonborrowed
reserves increases. Conversely, when it sells securities, it absorbs
reserves in exchange for the securities, and the supply of
nonborrowed reserves falls. In other words, the Federal Reserve
adjusts the supply of nonborrowed reserves by purchasing or
selling securities in the open market, and the purchases are
effectively paid for by additions to or subtractions from a
depository institution’s reserve balance at the Federal Reserve.
 Consider the following graphic of how this all works.
Tools of Monetary Policy
Summarized

Tool 1, Bank Reserve Requirements- Again, the FED requires banks to keep a
proportion of their deposits in reserve to satisfy liquidity concerns. The FED
sets this proportion. Affects the amount of money banks have available for
loans, and directly their profitability. Banks receive no interest on the money
kept in reserve. Therefore, they don’t place any more than is required by the
FED. Because banks receive no interest on money’s held in excess of the
reserve requirement, there is an incentive to minimize this amount. Banks sell
their excess reserves in the federal funds market.

Illustration: Reserve Requirements and Money Creation
Reserve requirements affect the potential of the banking system to create
transaction deposits. If the reserve requirement is 10%, for example, a bank
that receives a $100 deposit may lend out $90 of that deposit. If the borrower
then writes a check to someone who deposits the $90, the bank receiving that
deposit can lend out $81. As the process continues, the banking system can
expand the initial deposit of $100 into a maximum of $1,000 of money
($100+$90+81+$72.90+...=$1,000). In contrast, with a 20% reserve
requirement, the banking system would be able to expand the initial $100
deposit into a maximum of $500 ($100+$80+$64+$51.20+...=$500). Thus,
higher reserve requirements should result in reduced money creation and, in
turn, reduced economic activity.
 The FED changes reserve requirements for monetary policy purposes
only infrequently. Reserve requirements impose a cost on the banks
equal to the foregone interest on the amount by which required reserves
exceed the reserves that banks would voluntarily hold in order to
conduct their business, and the FED has been hesitant to make changes
that would increase that cost.
 Tool 2, the Discount Rate- The discount rate is the interest rate charged
by the Federal Reserve Banks to member banks at the discount window.
 Discount Window Lending-Through the discount window, Federal
Reserve lends funds to depository institutions. All depository
institutions that maintain transaction accounts or non-personal time
deposits subject to reserve requirements are entitled to borrow at the
discount window. This includes commercial banks, thrift institutions,
and United States branches and agencies of foreign banks. Before
passage of the Depository Institutions Deregulation and Monetary
Control Act of 1980, discount window borrowing had been restricted
to commercial banks that were members of the Federal Reserve System.
 Discount window loans have traditionally been granted only after
Reserve Banks are convinced that borrowers have fully used reasonably
available alternative sources of funds, such as the federal funds market
and loans from correspondents and other institutional sources.
Relatively few depository institutions borrow at the discount window in
any one week. Thus, such lending provides only a small fraction of the
banking system’s total reserves.
 During the 2008 financial crisis the FED deviated from normal policy
and loaned large amounts of money through the discount window to
“prop up” troubled financial institutions.
 The Discount Rate- During normal times the discount rate is used in
two ways: (1) it affects the cost of reserves borrowed by banks from the
Federal Reserve and (2) changes in the rate can be interpreted as a
signal of monetary policy. Increases in the discount rate generally
reflect the Federal Reserve’s concern over inflationary pressures, while
decreases often reflect a concern over economic weakness.
 By law, the discount rate is set every two weeks by the directors of each
Reserve Bank, subject to the approval of the Board of Governors.
 Until 2003 the discount rate was lower than the federal funds rate. After
this it was by policy made higher. Again, the FED has not historically
allowed banks to borrow at the discount window for profit. Thus, it
monitors discount window and federal funds activity to make sure that
banks are not borrowing from the FED in order to lend at a higher rate
in the private money markets.
 Tool 3, Open Market Operations and the Federal Funds Rate- The
federal funds market is the market in excess bank reserves on deposit
with the FED. Banks may borrow money in the federal funds market to
satisfy their reserve requirements, or they may satisfy the reserve
requirements by borrowing from other banks or the Eurodollar market.
The federal funds rate is targeted by the FED through open market
operations as the desired interest rate for money in the federal funds
market. It achieves this interest rate through open market operations.
 In order for a private institution to participate in the federal funds
market the institution must be licensed. Participants in the federal funds
market include commercial banks, thrift institutions, agencies and
branches of foreign banks in the United States, federal agencies, and
government securities dealers. Many relatively small institutions that
accumulate reserves in excess of their requirements lend reserves
overnight to money center and large regional banks, and to foreign
banks operating in the United States. Federal agencies also lend idle
funds in the federal funds market.
 Other financial institutions serve as intermediaries in the market by
borrowing and lending funds on the same day, usually channeling funds
from relatively small to large depository institutions. Several broker
firms that neither borrow nor lend funds arrange transactions between
lenders and borrowers in order to earn commissions.
Economics of Open Market
Operations
 The most liquid supply of money in the reserves system is
designated M1. M1 is a measure of the money supply that
includes all physical money, such as coins and currency, as well as
demand deposits, checking accounts and Negotiable Order of
Withdrawal (NOW) accounts. M1 measures the most liquid
components of the money supply, as it contains cash and assets
that can quickly be converted to currency. It does not contain
"near money" or "near, near money" as M2 and M3 do.
 M1 is the measure the FED targets in attempting to manipulate
the economy through open market operations.

Suppose the economy is doing poorly and the FED wants to use open market
operations to increase investment, GDP, and consumer demand.

The FED is in full control of the Federal Funds Rate through open market
operations. However, the Federal Funds Rate is a short-term interest rate, and
the FED is only one actor affecting interest rates throughout the system,
including long-term interest rates. What the FED really wants to do is affect
long-term interest rates, which in turn affect macroeconomic performance.

The effectiveness of FED policy depends on how well changing the Federal
Funds Rate transmits through to other interest rates in the system. Only if
longer-term interest rates adjust to changes in short-term interest rates will
business investment and consumer spending react to FED policy. And it is
through changes in investment and consumption that the FED will influence
the growth rate of GDP.

How effective the FED will be in determining the direction of long-term
interest rates depends on changes in the spread or gap between short-term and
long-term rates. The historical gap between the 3-month Treasury bill rate and
the long-term government Treasury bond is about 2%. The longer the maturity
of the debt, the higher is the associated interest rate. If the FED lowers shortterm interest rates by 0.5% (1/2 a basis point), the FED's goal is to maintain a
constant spread. In this case long-term rates will also fall by 0.5% and
investment and consumption activity will increase.
Suppose the FED wants to expand the economy. Note that the following
graph assumes the FED is in full control of M1 (an inaccurate simplifying
assumption). Then the supply curve for M1 will be vertical as in the
following graph.
 Then, lower interest rates lowers savings and increases investment and
GDP (by our earlier identity). People don’t hold on to their money.
 Higher GDP translates directly into aggregate demand. Instead of
saving, people spend their money. That is, they consume things.
 Similarly, when the FED seeks to slow an overheating economy, it
takes the opposite action of decreasing the money supply. This
translates directly into higher interest rates, which reduces
investment, GDP, and consumption.
 This, in turn, translates into reduced investment and lower GDP (by our
previous identity).
 Aggregate demand also declines, because income is lower and
prices are higher due to increased interest rates.
Specifics of Policy Implementation
 In formulating monetary policy, the Federal Open Market Committee
(FOMC) sets a target level for the federal funds rate, and the FED's
announcements of changes in monetary policy specify the changes in
the FED's target for that rate. Go to the FED and see the latest policy
statement. http://www.federalreserve.gov/monetarypolicy/default.htm
 Decisions about the purchase or sale of securities in the open market
are based on the FOMC’s directive, or set of instructions. This directive
indicates the approach to monetary policy that the FOMC considers
appropriate for the time period between its meetings -- which are held
approximately every six to eight weeks.
 The Manager of the System Open Market Account -- who, along with
the staff of the Trading Desk at the New York Fed, executes open
market operations on behalf of the entire Federal Reserve System -uses the directive from the FOMC as a guide in making decisions about
the day-to-day purchase or sale of securities.
 Implementation occurs with the cooperation of a set of Primary
Dealers
 When the Federal Reserve buys securities from a primary dealer -- a
government securities dealer who has an established trading
relationship with the Federal Reserve -- it pays for those securities by
sending funds to the dealer’s account at its clearing bank, simultaneous
with the delivery of the securities to the Fed. This action adds reserves
to the banking system. Conversely, when the Federal Reserve sells
securities to a primary dealer, the FED delivers the securities and the
account of the primary dealer is debited. This action drains reserves
from the banking system.
 http://www.newyorkfed.org/markets/pridealers_current.html
 Gathering Information, Preparing to Act each Day - At the New York
FED's Trading Desk, the staff starts each workday by gathering
information about the market’s activities from a number of sources. The
FED's traders discuss with the primary dealers how the day might
unfold in the securities market and how the dealers’ task of financing
their securities positions is progressing. The Trading Desk staff also
talks with the large money center banks about their reserve needs and
the banks’ plans for meeting them.
 Reserve forecasters at the New York FED and at the Board of
Governors in Washington, D.C., compile data on bank reserves for the
previous day and make projections of factors that could affect reserves
for future days. The staff also receives information from the Treasury
about its balance at the Federal Reserve and assists the Treasury in
managing this balance and Treasury accounts at commercial banks.
 Following the discussion with the Treasury, forecasts of reserves are
completed. Then, after reviewing all of the information gathered from
the various sources, the Trading Desk staff develops a plan of action for
the day.
 That plan is reviewed with a Reserve Bank president currently serving
as a voting member of the FOMC during a conference call held each
morning. Board staff sends a summary of this discussion to members
of the FOMC later in the day, allowing the FOMC to monitor closely
the Trading Desk’s implementation of the Committee’s directive.
Conditions in financial markets, including domestic securities and
money markets and foreign exchange markets, also are reviewed each
morning.
 When the conference call is complete, the Trading Desk is ready to
enter the market to execute any temporary (RP or MSP) open market
operations. The Desk initiates this process by sending an electronic
message to all of the primary dealers, asking them to submit bids or
offers within 10 to 15 minutes. The message states the term of the
operation, but does not specify its size. (The size of the operation is
announced later, after the operation is completed.) The dealers’
propositions are evaluated on a competitive best-price basis. Primary
dealers whose offers have been accepted, and those whose offers have
been turned down, are notified of the results, usually about five minutes
after the bids or offers were due.
 In contrast, outright operations are arranged at various times during the
day, following a similar procedure. Outright purchases of securities of
different maturities may be spread over several days or weeks.

Depending upon the level of reserves in the banking system, the Trading Desk
may take one of several approaches regarding the type of transaction executed.

Most often, the transactions the Trading Desk engages in are short-term
repurchase agreements (RPs), which are used in situations that call for
temporary additions to bank reserves. With RPs, the Trading Desk buys
securities from the dealers, who agree to repurchase them by a specified date at
a specified price. When the RPs mature, the added reserves are automatically
drained.

When there is a temporary need to drain reserves, matched sale-purchase
transactions (MSPs) with dealers are executed. These transactions involve a
contract for immediate sale of Treasury bills to, and a linked matching contract
for subsequent purchase from, each participating dealer.

On occasion, the Desk may engage in outright purchases or sales of securities.
In these transactions, dealers are requested to submit offers to sell or bids to
buy securities of the type and maturity that the Desk has selected. These
transactions effectively add or drain reserves on a permanent basis. They
address persistent needs to adjust the supply of reserves, as for example those
arising from the public’s demand for currency.
 Go to FRED to view the federal funds rate and discount rate (called the
primary credit rate since 2003) through time. Look at other interest
rates as well. http://research.stlouisfed.org/fred2/
 NOTE: The FED does not SET interest rates in the system. It is only
able to set the Federal Funds Rate, and their actions are constrained
with respect to setting M1.
 The FED is the most important actor, but other participants include
other depository institutions, including commercial banks, savings and
loans, depositors, and borrowers. Foreign actors may also affect these
relations.
The FED's Taylor Rule
 Some economists and political scientists have studied the manner in
which the FOMC manipulates interest rates with respect to inflation
and economic growth. For example, some have argued that the FOMC
uses the Taylor Rule, named after a former Chairman of the Council of
Economic Advisors. That rule is as follows:
 In this equation, it is the target short-term nominal interest rate (e.g. the
federal funds rate in the US), πt is the rate of inflation as measured by
the GDP deflator, is the desired rate of inflation, is the assumed
equilibrium real interest rate, yt is the logarithm of real GDP, and is the
logarithm of potential output, as determined by a linear trend (Taylor,
1993). According to the rule, both aπ and ay should be positive (as a
rough rule of thumb, Taylor's 1993 paper proposed setting aπ = ay =
0.5). That is, the rule "recommends" a relatively high interest rate (a
"tight" monetary policy) when inflation is above its target or when the
economy is above its full employment level, and a relatively low interest
rate ("easy" monetary policy) in the opposite situations.
Quantitative Easing
 Because interest rates were already near zero at the start of the Great
Recession, the FED used an unconventional method called quantitative
easing (QE) to stimulate the economy. Indeed, quantitative easing only
came to an end in 2014. See the FED's statement on October 29, 2014.
 If the nominal interest rate is at or very near zero, the central bank
cannot lower it further. Such a situation, called a liquidity trap, can
occur, for example, during deflation or when inflation is very low. In
such a situation, the central bank may perform quantitative easing by
purchasing a pre-determined amount of bonds or other assets from
financial institutions without reference to the interest rate. The goal of this
policy is to increase the money supply rather than to decrease the
interest rate, which cannot be decreased further. This is often considered
a "last resort" to stimulate the economy.
 The central bank implements quantitative easing by purchasing
financial assets from banks and other private sector businesses with new
electronically created money. This action increases the excess reserves
of the banks, and also raises the prices of the financial assets bought.
 Expansionary monetary policy typically involves the central bank
buying short-term government bonds in order to lower short-term
market interest rates (using a combination of standing lending facilities
and open market operations). However, when short-term interest rates
are either at, or close to, zero, normal monetary policy can no longer
lower interest rates.
 Quantitative easing may then be used by the central bank to further
stimulate the economy by purchasing assets of longer maturity than
only short term government bonds, and thereby lowering longer-term
interest rates.
Chronology of the Great Recession
 http://timeline.stlouisfed.org/index.cfm?p=timeline By 2008, it had
become clear that the U.S. mortgage market was in deep trouble
because of the actions of banks and very large financial institutions
having speculated in securities called Mortgage Backed Securities
(sound familiar; it should; it was a lot like the start of the Great
Depression).
 Their debt was insured by other very large companies through a
financial practice called a Credit Default Swap (CDS). A CDS is a
financial swap agreement whereby the seller of the CDS will
compensate the buyer (the creditor of the reference loan) in the event of
a loan default (by the debtor) or other credit event.
 Mortgage Backed Securities held by many major banks and financial
institutions had become virtually worthless by 2008, leaving the sellers
of CDS on the hook for literally tens of trillions of dollars in bad loans.
 On September 16, 2008, the Federal Reserve Bank of New York made
an extraordinary $85 billion loan to American International Group
(AIG). AIG, the largest insurance company in the world, was on the
verge of collapse due to having sold roughly $500 billion worth of CDS.
 On Sept. 8, 2008, the U.S. Treasury seized control of mortgage giants
Fannie Mae and Freddie Mac and pledged a $200 billion cash injection
to help the companies cope with mortgage default losses.
 About a week later the government bailed out American International
Group Inc., or AIG, with $85 billion.
 The FED refused to save Lehman Brothers and the company was
forced to file for bankruptcy. Some of the other largest financial
institutions were on the verge of collapse as the mortgage market
melted down (Bank of America, Citigroup, Chase, etc.). As the crisis hit
the global market, the credit freeze spread and financial markets
dropped precipitously.
 The Treasury and the Federal Reserve began working on a $700 billion
bailout plan for banks and large companies. President George W. Bush
signed the bank bailout plan into law Oct. 3, 2008.
 Just weeks later, on Oct. 29, 2008 the FED cut the key interest rate to 1
percent.
 Before the Great Recession, the US Federal Reserve held between $700
billion and $800 billion of Treasury notes on its balance sheet. In late
November 2008, the Federal Reserve started buying $600 billion in
mortgage-backed securities. By March 2009, it held $1.75 trillion of
bank debt, mortgage-backed securities, and Treasury notes; this amount
reached a peak of $2.1 trillion in June 2010. Further purchases were
halted as the economy started to improve, but resumed in August 2010
when the FED decided the economy was not growing robustly. After
the halt in June, holdings started falling naturally as debt matured and
were projected to fall to $1.7 trillion by 2012. The FED's revised goal
became to keep holdings at $2.054 trillion. To maintain that level, the
FED bought $30 billion in two- to ten-year Treasury notes every month.
 In the interim, on February 19, 2009 new President Barack Obama
signs the American Recovery and Reinvestment Act of 2009. The
approximate cost of the fiscal stimulus package was estimated at $787
billion at the time of passage, later revised to $831 billion between 2009
and 2019. The Act included direct spending in infrastructure, education,
health, and energy, federal tax incentives, and expansion of
unemployment benefits and other social welfare provisions.
 In November 2010, the FED announced a second round of quantitative
easing, buying $600 billion of Treasury securities by the end of the
second quarter of 2011. The expression “QE2” became a ubiquitous
nickname in 2010, used to refer to this second round of quantitative
easing by US central banks. Retrospectively, the round of quantitative
easing preceding QE2 was called “QE1”.
 A third round of quantitative easing, “QE3”, was announced on 13
September 2012. In an 11–1 vote, the Federal Reserve decided to launch
a new $40 billion per month, open-ended bond purchasing program of
agency mortgage-backed securities. Additionally, the Federal Open
Market Committee (FOMC) announced that it would likely maintain
the federal funds rate near zero “at least through 2015.” According to
NASDAQ.com, this is effectively a stimulus program that allows the
Federal Reserve to relieve $40 billion per month of commercial housing
market debt risk. On 12 December 2012, the FOMC announced an
increase in the amount of open-ended purchases from $40 billion to $85
billion per month.
 On 19 June 2013, Ben Bernanke announced a “tapering” of some of
the FED's QE policies contingent upon continued positive economic
data. Specifically, he said that the FED could scale back its bond
purchases from $85 billion to $65 billion a month during the upcoming
September 2013 policy meeting. He also suggested that the bond-buying
program could wrap up by mid-2014. While Bernanke did not
announce an interest rate hike, he suggested that if inflation followed a
2% target rate and unemployment decreased to 6.5%, the FED would
likely start raising rates.
 The stock markets dropped by approximately 4.3% over the three
trading days following Bernanke's announcement, with the Dow Jones
dropping 659 points between 19 and 24 June, closing at 14,660 at the
end of the day on 24 June. On 18 September 2013, the FED decided to
hold off on scaling back its bond-buying program. Purchases were
halted on October 29, 2014 after accumulating $4.5 trillion in assets.
Controversy over Whether to Use Fiscal or
Monetary Policy During Severe Economic
Downturn
 A major controversy has historically existed about how well monetary
policy can be used to fight a major economic downturn.
 Keynes argued that monetary policy is ineffective under this
circumstance, because money markets have already driven interest rates
very low, and there is also a psychological problem in that under
conditions of economic uncertainty, no one wants to lend money.
 In contrast, Milton Friedman argued that monetary policy can be very
important in a major economic downturn. That argument has been
settled with the quantitative easing that occurred starting in 2008. The
FED injected huge amounts of money into the system by lowering the
interest rate to zero. However, that policy was insufficient.
 Hence, a monetary policy tool that Keynes did not anticipate,
quantitative easing was useful. Attribute this innovation to Ben
Bernanke, who by the way, was the greatest living scholar on the causes
and consequences of the Great Depression at the time of the Great
Recession.
DOMESTIC EFFECTS OF MONETARY
POLICY ON THE ECONOMY
 As observed through the preceding discussion, monetary policy works
through the market for reserves and involves the Federal Funds Rate. A
change in the reserves market will trigger a chain of events that affect
other short-term interest rates, foreign exchange rates, long-term interest
rates, the amount of money and credit in the economy, and levels of
employment, output, and prices.
 A change in short-term interest rates will also translate into changes in
long-term rates on such financial instruments as home mortgages,
corporate bonds, and Treasury bonds, especially if the change in shortterm rates is expected to persist. Thus, a rise in short-term rates that is
expected to continue will lead to a rise (though typically a smaller one)
in long-term rates.
 Higher long-term interest rates will reduce the demand for items that
are most sensitive to interest cost, such as residential housing, business
investment, and durable consumer goods (for example, automobiles and
large household appliances).
 Higher mortgage interest rates depress the demand for housing. Higher
corporate bond rates increase the cost of borrowing for businesses and,
thus, restrain the demand for additions to plants and equipment; and
tighter supplies of bank credit may constrain the demand for investment
goods by those firms particularly dependent on bank loans.
 Furthermore, higher rates on loans for motor vehicles reduce
consumers’ demand for cars and light trucks. Beyond these effects,
consumption demand is lowered by a reduction in the value of
household assets—such as stocks, bonds, and land—that tends to result
from higher long-term interest rates.
Foreign Effects of Monetary Policy
 The implications of changes in interest rates extend beyond domestic
money and credit markets. When interest rates in the United States
move higher in relation to those abroad, holding assets (securities)
denominated in U.S. dollars becomes more appealing, and the demand
for dollars in foreign exchange markets increases. A result is upward
pressure on the exchange value of the dollar.
 As a consequence, demands for U.S. goods are reduced as Americans
are induced to substitute goods from abroad for those produced in the
United States and people abroad are induced to buy fewer American
goods. These effects point to the linkage between monetary policy and
the income flow model we looked at earlier on fiscal policy.
 Changes in the demand for goods and services get translated into
changes in total domestic production and prices. Lessened demand
resulting from higher interest rates and the stronger dollar tends to
reduce production
Advantages of Using Monetary Policy to
Affect the Economy
 Monetary policy is continuous, while fiscal policy changes
generally occur only once a year at the time of the budget or
legislation.
 Monetary policy can be more fine-tuned than fiscal policy. It is a
less coarse tool of control of the economy.
 Monetary policy is not as sensitive as fiscal policy to political
decisionmaking. There are no partisan fights over words like
“stimulus”, “deficits and debt”, etc. The FED is designed to be
independent.
Problems with Using Monetary Policy to
Affect the Economy
 Banker’s bias- It is often asserted that the FED is more interested in
controlling inflation than reacting to recession. This implies a
differential effect on participants in the economy.
 Proliferation of non-bank institutions (savings and loans, insurance
companies, retirement funds). These can have large effects on the
money supply. Widespread use of credit cards. Eurodollars are
unregulated.
 May need to be coordinated with fiscal policy to be fully effective. Yet it
is sometimes not.
 Forecasting problems.
 Pressure on the FED from political actors (e.g., GHW Bush pushed the
FED hard to stimulate the economy in 1992).