Monetary Policy
Instruments, Targets, and Goals
The Federal Reserve System
• The Federal Reserve System was created in
1913. The Fed’s responsibilities include:
– Controlling the supply of money
– Monitoring & Regulating Commercial Banks
– Facilitate Checks Clearing
Who Owns the Federal Reserve
System
• The Federal Reserve System is a joint
enterprise between the government and the
private sector
– The Fed’s operating budget is not part of the
Federal budget
– National banks are required by law to be
members of the federal reserve system
(membership is optional for state banks), but
are also “owners” of the Fed.
Leadership of the Federal
Reserve
• The Federal Reserve is divided into twelve districts. Each
district has a Regional Federal Reserve Bank
Federal Reserve Districts
Leadership of the Federal
Reserve
• The Federal Reserve is divided into twelve districts. Each
district has a Regional Federal Reserve Bank
• Regional bank presidents are elected by member banks,
local businesses, and the Board of Governors for 5 year
terms (renewable)
• The Board of Governors has seven members. Each is
appointed by the president and confirmed by the senate for
a 14 year non-renewable term
• A member of the board is appointed chairman for a 4 year
(renewable) term.
The Federal Open Market
Committee
• The FOMC meets in New York City
approximately 8 times per year to formulate
monetary policy
• The FOMC consists of:
• The Board of Governors (7)
• President of the New York Fed
• Four Additional Regional Presidents (revolving)
• Policy is decided by a majority vote
Monetary Policy
• Monetary policy is characterized by four criterion:
– Goals: The desired result of monetary policy
– Instruments: The methods used to influence the
supply of money
– Targets: Attempts to quantify the size of a
policy decision
– Discretion: The degree of flexibility in
monetary policy
Monetary Policy Goals
• What are central banks trying to accomplish
through monetary policy?
– Low, stable rates of inflation (long run)
– Full employment (short run)
• Are these goals compatible with each other?
(Phillips curve)
• Internal objectives vs. external objectives
Monetary Policy Instruments
• How does the Federal Reserve “control” the
supply of money?
– Open Market Operations (M0 & M1)
– Discount Rate (M0 & M1)
– Reserve Requirement ( M1)
The Fed’s Balance Sheet
Assets
Liabilities
US Treasuries: $500B
Other Assets: $60B
Gold: $12B
Loans to Commercial Banks
(Discount Window): $.1B
Total: $572.1B
Currency
In Circulation: $500B
Vault Cash: $40B
Bank Deposits: $20B
Net Worth: $12.1B
Total: $572.1B
Open Market Operations
• Recall that M0 (Monetary Base) is defined
as liabilities of the central bank (currency
plus bank reserves)
• The Fed can control M0 through the
purchase or sale of assets
– Open Market Sale: Decreases M0
– Open Market Purchase: Increases M0
Example
• Suppose that the Fed wishes to increase the monetary base
by $10B. This could be accomplished through an open
market purchase of T-Bills
The Fed’s Balance Sheet
Assets
Liabilities
US Treasuries: $510B
Other Assets: $60B
Gold: $12B
Loans to Commercial Banks
(Discount Window): $.1B
Total: $582.1B
Currency
In Circulation: $500B
Vault Cash: $40B
Bank Deposits: $20B
Net Worth: $12.1B
Total: $572.1B
Example
• Suppose that the Fed wishes to increase the monetary base
by $10B. This could be accomplished through an open
market purchase of T-Bills
• The Fed pays for the securities by check which is
redeemable in cash or can be deposited
The Fed’s Balance Sheet
Assets
Liabilities
US Treasuries: $510B
Other Assets: $60B
Gold: $12B
Loans to Commercial Banks
(Discount Window): $.1B
Total: $582.1B
Currency
In Circulation: $500B
Vault Cash: $40B
Bank Deposits: $30B
Net Worth: $12.1B
Total: $582.1B
Example
• Suppose that the Fed wishes to increase the monetary base
by $10B. This could be accomplished through an open
market purchase of T-Bills
• The Fed pays for the securities by check which is
redeemable in cash or can be deposited
• Suppose the Fed wishes to lower M0 by $5– it could
accomplish this by selling some of its gold
The Fed’s Balance Sheet
Assets
Liabilities
US Treasuries: $510B
Other Assets: $60B
Gold: $7B
Loans to Commercial Banks
(Discount Window): $.1B
Total: $577.1B
Currency
In Circulation: $500B
Vault Cash: $40B
Bank Deposits: $30B
Net Worth: $12.1B
Total: $582.1B
Example
• Suppose that the Fed wishes to increase the monetary base
by $10B. This could be accomplished through an open
market purchase of T-Bills
• The Fed pays for the securities by check which is
redeemable in cash or can be deposited
• Suppose the Fed wishes to lower M0 by $5– it could
accomplish this by selling some of its gold
• The gold is paid for by check, which is drawn from either
the bank’s reserve cash or its account at the Fed
The Fed’s Balance Sheet
Assets
Liabilities
US Treasuries: $510B
Other Assets: $60B
Gold: $7B
Loans to Commercial Banks
(Discount Window): $.1B
Total: $577.1B
Currency
In Circulation: $500B
Vault Cash: $35B
Bank Deposits: $30B
Net Worth: $12.1B
Total: $577.1B
Commercial Banking and M1
• Recall that M1 is composed of Currency in
circulation and checking accounts. The Fed
can control currency directly, but checking
accounts are controlled by commercial
banks
Commercial Banking and M1
• Recall that M1 is composed of Currency in
circulation and checking accounts. The Fed
can control currency directly, but checking
accounts are controlled by commercial
banks
• The fed can influence the creation of
checking accounts through the reserve
requirement and the discount rate
Banks, like any other business, exist to
earn profits
• Banks accept deposits and then use those
funds to create loans
• Profit = Interest Collected on Loans –
Interest Paid to Deposits
Deposits represents a bank’s primary
liability
• When offering deposits a bank faces the
tradeoff between liquidity and cost
• Checkable deposits (included in M1)
typically pay little or no interest, but must
be paid on demand
• Time deposits (included in M2) pay interest,
but are less liquid
Banks use their collected funds to create
loans and buy securities
• By law, commercial banks are required to
keep a percentage of their deposits as vault
cash (Reserve Requirement) – the reserve
requirement is around 5% of checkable
deposits (Monetary Control Act of 1980)
• By law, commercial banks are restricted to
only buying US treasury securities and
some municipal bonds (Glass-Steagall Act)
Balance Sheet
Assets
Cash & Federal Reserve Deposits
(5%)
Marketable Securities (20%)
Loans (Consumer,
Commercial/Industrial, Real
Estate) (70%)
Liabilities
Transaction (Demand) Deposits
(11%)
Non-Transaction Deposits (52%)
Loans (Discount, Fed Funds)
(20%)
Example: A $10,000 Open
Market Purchase
• Suppose the fed purchases a $10,000 from a bond dealer
(M0 increases by $10,000). For simplicity, assume that the
Fed pays in cash.
Example: A $10,000 Open
Market Purchase
• Suppose the fed purchases a $10,000 from a bond dealer
(M0 increases by $10,000). For simplicity, assume that the
Fed pays in cash.
• The bond dealer deposits the $10,000 at his local bank.
Example: A $10,000 Open
Market Purchase
Assets
Cash: $10,000
Liabilities
Demand Deposits: $10,000
Example: A $10,000 Open
Market Purchase
• Suppose the fed purchases a $10,000 from a bond dealer
(M0 increases by $10,000). For simplicity, assume that the
Fed pays in cash.
• The bond dealer deposits the $10,000 at his local bank.
• The fed requires that 5% must remain in the bank’s vault
as reserves. However, the bank is free to loan out the rest
(assume it pays out the loan in cash)
Example: A $10,000 Open
Market Purchase
Assets
Cash: $500
Loans: $9,500
Liabilities
Demand Deposits: $10,000
Example: A $10,000 Open
Market Purchase
• Suppose the fed purchases a $10,000 from a bond dealer
(M0 increases by $10,000). For simplicity, assume that the
Fed pays in cash.
• The bond dealer deposits the $10,000 at his local bank.
• The fed requires that 5% must remain in the bank’s vault
as reserves. However, the bank is free to loan out the rest
(assume it pays out the loan in cash)
• Where does the $9,500 go?
Example: A $10,000 Open
Market Purchase
• Suppose the fed purchases a $10,000 from a bond dealer
(M0 increases by $10,000). For simplicity, assume that the
Fed pays in cash.
• The bond dealer deposits the $10,000 at his local bank.
• The fed requires that 5% must remain in the bank’s vault
as reserves. However, the bank is free to loan out the rest
(assume it pays out the loan in cash)
• Where does the $9,500 go?
• It ends up in another bank!
Example: A $10,000 Open
Market Purchase
Assets
Cash: $9,500
Liabilities
Demand Deposits: $9,500
Example: A $10,000 Open
Market Purchase
• Now the process is repeated. The bank that receives the
$9,500 keeps 5% ($475) and can loan out the remaining
$9,025.
Example: A $10,000 Open
Market Purchase
Assets
Cash: $475
Loans: $9,025
Liabilities
Demand Deposits: $9,500
Example: A $10,000 Open
Market Purchase
• Now the process is repeated. The bank that receives the
$9,500 keeps 5% ($475) and can loan out the remaining
$9,025.
• This $9,025 finds its way into another bank and the
process continues. What will the final impact on M1 be?
Example: A $10,000 Open
Market Purchase
• Now the process is repeated. The bank that receives the
$9,500 keeps 5% ($475) and can loan out the remaining
$9,025.
• This $9,025 finds its way into another bank and the
process continues. What will the final impact on M1 be?
• M1 = $10,000 + $9,500 + $9,025 + …… = $200,000
Example: A $10,000 Open
Market Purchase
• Now the process is repeated. The bank that receives the
$9,500 keeps 5% ($475) and can loan out the remaining
$9,025.
• This $9,025 finds its way into another bank and the
process continues. What will the final impact on M1 be?
• M1 = $10,000 + $9,500 + $9,025 + …… = $200,000
• (Change in M1)/(Change in M0) = money multiplier = 20
= 1/Reserve Requirement
Example: A $10,000 Open
Market Purchase
• Now the process is repeated. The bank that receives the
$9,500 keeps 5% ($475) and can loan out the remaining
$9,025.
• This $9,025 finds its way into another bank and the
process continues. What will the final impact on M1 be?
• M1 = $10,000 + $9,500 + $9,025 + …… = $200,000
• (Change in M1)/(Change in M0) = money multiplier = 20
= 1/Reserve Requirement (1/.05)
• Note that this scenario assumes that consumers never
withdraw any cash. Suppose that the average consumer
likes to keep 10% of their deposits as cash.
Example: A $10,000 Open
Market Purchase
• Of the initial $10,000 bond purchase, only $9,000
finds its way into a bank.
• The $9,000 deposit will generate $450 in reserves
and $8,550 in new loans.
• Of the $8,550 in loans, $7,695 is deposited, and so
on
• M1 = $9,000 + $8,550 + ….. = $73,000.
• M1/M0 = multiplier = 7.3 = (1+cd)/(cd + rr)
• cd (cash/deposits ratio) = .1 , rr (reserve req) = .05
The Money Multiplier
• The money multiplier is currently around 2.5 (a $1
increase in the monetary base increases M1 by $2.50)
• The size of the multiplier is influenced by
– Consumer behavior: If consumers hold onto more cash (cash to
deposits ratio increases) the multiplier falls.
– Commercial banks: Many banks choose to hold excess reserves
(reserves above the 5% requirement). As excess reserves increase,
the multiplier decreases.
– The Federal Reserve: The federal reserve can restrict loan creation
directly by raising the reserve requirement or indirectly by
increasing the discount rate (this raises the bank’s cost of capital)
Fed Instruments and Money
Supply
• If the federal reserve wishes to increase the
M1 money supply, it has three choices:
– An open market purchase of securities
– A decrease in the reserve requirement
– A decrease in the discount rate
The Discount Rate vs. the
Federal Funds Rate
• The discount rate is the interest rate charged by the Fed on loans to
commercial banks.
– The discount rate is a non-market rate. It is a policy instrument
determined by the Fed.
– Current policy states that the discount rate is chosen to be
approximately 100 basis points above the Federal Funds rate.
The Discount Rate vs. the
Federal Funds Rate
• The discount rate is the interest rate charged by the Fed on loans to
commercial banks.
– The discount rate is a non-market rate. It is a policy instrument
determined by the Fed.
– Current policy states that the discount rate is chosen to be
approximately 100 basis points above the Federal Funds rate.
• The federal funds rate is the interest charged by commercial banks for
very short term (usually overnight) loans to other commercial banks.
– The Fed Funds rate is a market rate of interest. Therefore, it is
determined by supply and demand, but is heavily influenced by the
Fed.
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Jan-00
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Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
Interest Rates
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12
10
8
6
Fed Funds
Discount
Prime
4
2
0
Intermediate Targets
• An intermediate target is a variable not controlled by the
fed, but heavily and predictably influenced by the Fed.
Targets are used to quantify fed policy decisions (by how
much will money supply be increased/decreased)
Intermediate Targets
• An intermediate target is a variable not controlled by the
fed, but heavily and predictably influenced by the Fed.
Targets are used to quantify fed policy decisions (by how
much will money supply be increased/decreased)
• We know that increasing the money supply lowers interest
rates. Therefore, an expansionary policy can be stated two
ways:
– (Money target) We will increase the M1 money supply by 5%.
– (Interest rate target) We will increase M1 by enough to lower the
federal funds rate by 50 basis points.
Price Targets
• Suppose that you can perfectly
control the supply of some
commodity. Your goal is to
maintain a constant price
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Price Targets
• Suppose that you can perfectly
control the supply of some
commodity. Your goal is to
maintain a constant price
• How would you respond to an
increase in demand?
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6
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0
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30
40
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Price Targets
• Suppose that you can perfectly
control the supply of some
commodity. Your goal is to
maintain a constant price
• How would you respond to an
increase in demand?
• By matching the rise in demand
with an equal increase in
supply, the interest rate remains
constant, but the quantity
change is exacerbated
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Quantity Targets
• Now, assume that instead,
you are targeting quantity
rather than price.
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Quantity Targets
• Now, assume that instead,
you are targeting quantity
rather than price.
• Rather than increasing
supply, you decrease
supply. This exacerbates
the price change.
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0
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Intermediate Targets
• In 1975, the Federal Reserve announced a change in Fed
policy. Rather than targeting interest rates, the Fed would
begin targeting growth rates of M1, M2, and M3.
Intermediate Targets
• In 1975, the Federal Reserve announced a change in Fed
policy. Rather than targeting interest rates, the Fed would
begin targeting growth rates of M1, M2, and M3.
• Due to significant financial innovation in the late 70’s,
money demand became very unstable and unpredictable.
Maintaining constant monetary aggregates created wildly
fluctuating interest rates.
Interest Rates: 1970 – 1985
25
20
Fed Funds
Discount
Prime
15
10
5
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Jan-82
Jan-80
Jan-78
Jan-76
Jan-74
Jan-72
Jan-70
0
Intermediate Targets
• In 1975, the Federal Reserve announced a change in Fed
policy. Rather than targeting interest rates, the Fed would
begin targeting growth rates of M1, M2, and M3.
• Due to significant financial innovation in the late 70’s,
money demand became very unstable and unpredictable.
Maintaining constant monetary aggregates created wildly
fluctuating interest rates.
• Money Targets were de-emphasized in 1982 and
eliminated completely by 1993.
• Currently, the Fed uses an interest rate target (Fed Funds)
Rules vs. Discretion
• A monetary policy rule is a system by which the
central bank’s actions are defined in advance.
– Simple (Non-Contingent) Rules
– Contingent Rules
Rules vs. Discretion
• A monetary policy rule is a system by which the
central bank’s actions are defined in advance.
– Simple (Non-Contingent) Rules
– Contingent Rules
• The Federal Reserve currently operates under a
discretionary system.
Rules vs. Discretion
Advantages of Rules
Disadvantages of Rules
Rules vs. Discretion
Advantages of Rules
• Less uncertainty
• Enhanced central bank
credibility (solves the
time inconsistency
problem)
Disadvantages of Rules
Rules vs. Discretion
Advantages of Rules
• Less uncertainty
• Enhanced central bank
credibility (solves the
time inconsistency
problem)
Disadvantages of Rules
• Less flexibility to deal
with new situations
• Rules can be subjected
to speculative attacks
Monetary Policy in the US
• Prior to 1971, the US followed a gold
standard.
Monetary Policy in the US
• Prior to 1971, the US followed a gold
standard.
• Under this system, the price of gold was set
at $20.67/oz (Roosevelt raised the price to
$35 in 1934)
• The US Government was required to buy or
sell gold from anyone at the official gold
price (convertibility)
The Gold Standard
• Recall, that currency is the main liability of the central
bank. Under the gold standard, the key asset is gold.
Assets
$300B: Gold
$100B: Treasuries
Liabilities
$400B: Currency in Circulation
• In the above example, the reserve ratio (the ratio of
currency to gold) would be 75%
The Gold Standard
• Recall, that currency is the main liability of the central
bank. Under the gold standard, the key asset is gold.
Assets
$300B: Gold
$100B: Treasuries
Liabilities
$400B: Currency in Circulation
• In the above example, the reserve ratio (the ratio of
currency to gold) would be 75%
• To maintain the gold standard, the reserve ratio must stay
“sufficiently high”
The Gold Standard
• The gold standard restricts the supply of
money to be tied to the supply of gold. This
promotes a stable long run price level.
The Gold Standard
• The gold standard restricts the supply of
money to be tied to the supply of gold. This
promotes a stable long run price level.
• However, in the short run, the gold standard
created significant instability by tying
monetary policy to fluctuations in the gold
market.
Example: A rise in the supply of
gold
• Suppose that a new gold
deposit was discovered.
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50
40
30
20
10
0
10
20
30
40
50
Example: A rise in the supply of
gold
• Suppose that a new gold
deposit was discovered.
• The increase in supply
puts downward pressure
on gold prices
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50
40
30
20
10
0
10
20
30
40
50
Example: A rise in the supply of
gold
• Suppose that a new gold
deposit was discovered.
• The increase in supply
puts downward pressure
on gold prices
• As people buy gold in
private markets and sell to
the central bank, the
money supply expands
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50
40
30
20
10
0
10
20
30
40
50
Example: A rise in the demand
for gold
• Suppose that demand for
gold increases. Rising
gold prices cause people
to buy gold from the
central bank.
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50
40
30
20
10
0
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20
30
40
50
Example: A rise in the demand
for gold
• Suppose that demand for
gold increases. Rising
gold prices cause people
to buy gold from the
central bank.
• This forces a contraction
in the money supply.
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50
40
30
20
10
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20
30
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Current Monetary Policy
• Currently, the Federal Reserve follows a
discretionary monetary policy
Current Monetary Policy
• Currently, the Federal Reserve follows a
discretionary monetary policy
– Interest Rate (Fed Funds) Targets
– Primary Goal: Maintain a full employment, low
inflation economy
Current Monetary Policy
• Currently, the Federal Reserve follows a
discretionary monetary policy
– Interest Rate (Fed Funds) Targets
– Primary Goal: Maintain a full employment, low
inflation economy
• This type of monetary policy can be
summarized by a Taylor rule
The Taylor Rule
• The Taylor rule explicitly models the two fed goals:
FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation – 2%)
The Taylor Rule
• The Taylor rule explicitly models the two fed goals:
FF = 2% + (Inflation) + .5(Output Gap) + .5(Inflation – 2%)
An economy with full employment and a 2% annual inflation rate (the
fed’s goal) would have a Fed Funds rate equal to 4%.
Using Okun’s law, we can write the Taylor rule in terms of unemployment
(1% cyclical unemployment = 2.5% output gap)
FF = 2% + (Inflation) + 1.25(Unemployment – 5%) + .5(Inflation – 2%)
The Taylor Rule
• The Taylor rule explicitly models the two fed goals:
FF = 2% + (Inflation) - 1.25(Unemployment – 5%) + .5(Inflation – 2%)
Ex) Currently, Unemployment is 6% and core inflation is 1%.
Target FF = 2% + 1% - 1.25(1.0) - .5(1.0) = 1.25%
Interest Rate Targeting
• To Target the interest rate, the central bank
must correctly identify the nature of market
disturbances and then act accordingly
Interest Rate Targeting
• To Target the interest rate, the central bank
must correctly identify the nature of market
disturbances and then act accordingly
– Capital Market (IS)
– Labor Market (FE)
– Money Market (LM)
Example: Anticipated
Productivity Growth
• During the 90’s expected
productivity created
dramatic increases in
investment. How will ISLM-FE be affected?
Example: Anticipated
Productivity Growth
• During the 90’s expected
productivity created
dramatic increases in
investment. How will ISLM-FE be affected?
• Under an interest rate
target, what should the
Fed do?
Example: Anticipated
Productivity Growth
• During the 90’s expected
productivity created
dramatic increases in
investment. How will ISLM-FE be affected?
• Under an interest rate
target, what should the
Fed do?
• The fed increases the
money supply to maintain
the target.
Example: Anticipated
Productivity Growth
• Remember, actual fed
policy is a type of Taylor
rule. An IS increase
would result in an increase
in the target FF rate.
Example: Anticipated
Productivity Growth
• Remember, actual fed
policy is a type of Taylor
rule. An IS increase
would result in an increase
in the target FF rate.
• A higher Federal Funds
rate results in a monetary
contraction
• The economy is returned
to full employment and
inflation is controlled
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Monetary Policy: 1995 - 2000
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6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
Fed Funds
Discount
Example: A Liquidity Shock
• Following the burst of the
stock market bubble, bank
reserves dramatically rose
US Bank Reserves
Example: A Liquidity Shock
• Following the burst of the
stock market bubble, bank
reserves dramatically rose
• A rise in reserves lowers
the multiplier which, in
turn lowers M1
• An increase in the money
supply is required to
prevent a recession and
deflation.
Oct-02
Jul-02
Apr-02
Jan-02
Oct-01
Jul-01
Apr-01
Jan-01
Oct-00
Jul-00
Apr-00
Jan-00
Monetary Policy: 2000 - 2003
7
6
5
4
3
Fed Funds
Discount Rate
2
1
0
Problems
• Obviously, we can’t observe IS, LM, FE
curves. Instead, we have to look at the data
and guess at the underlying cause.
• The outside lag (the amount of time for a
policy to impact the economy) is “long and
variable”