Chapter 17
Tools and Conduct of
Monetary Policy
The Market for Reserves
and the Fed Funds Rate
Demand Curve for Reserves
1. R = RR + ER
2. i opportunity cost of ER, ER 
3. Demand curve slopes down
Supply Curve for Reserves
1. If iff is below id, then discount borrowing, Rs = Rn
2. Supply curve flat (infinitely elastic) at id because as iff
starts to go above id, banks borrow more at id
Market Equilibrium
Rd = Rs at i*ff
Supply and Demand for Reserves
Response to Open Market Operations
Open Market Purchase
Nonborrowed reserves,
Rn,  and shifts
supply curve to
right Rs2: i  to i2ff
Response to a Change in the Discount Rate
(a) No discount lending Lower
Discount Rate
Horizontal to section  and supply
curve just shortens, iff stays same
(b) Some discount lending
Lower Discount Rate
Horizontal section , iff  to
i2ff = i2d
Response to Change in Required Reserves
Required reserve
Requirement 
Demand for reserves ,
Rs shifts right and iff 
to i2ff
Open Market Operations
2 Types
1. Dynamic:
Meant to change MB
2. Defensive:
Meant to offset other factors affecting MB, typically
uses repos
Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly
Discount Loans
3 Types
1. Primary Credit
2. Secondary Credit
3. Seasonal Credit
Lender of Last Resort Function
1. To prevent banking panics
FDIC fund not big enough
Example: Continental Illinois
2. To prevent nonbank financial panics
Examples: 1987 stock market crash and September 11
terrorist incident
How Primary Credit Facility Puts Ceiling on iff
Rightward shift of Rs to
Rs2 moves equilibrium to
point 2 where i2ff = id and
discount lending rises
from zero to DL2
Discount Policy
Advantages
1. Lender of Last Resort Role
Disadvantages
1. Confusion interpreting discount rate changes
2. Fluctuations in discount loans cause
unintended fluctuations in money supply
3. Not fully controlled by Fed
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
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
Central Bank Strategy
Money Supply Target
1. M d fluctuates between
M d' and M d''
2. With M-target at M*, i
fluctuates between i'
and i''
Interest Rate Target
1. M d fluctuates
between M d' and
M d''
2. To set i-target at i*
Ms fluctuates
between M' and M''
Criteria for Choosing Targets
Criteria for Intermediate Targets
1. Measurability
2. Controllability
3. Ability to predictably affect goals
Interest rates aren’t clearly better than Ms on criteria 1 and 2
because hard to measure and control real interest rates
Criteria for Operating Targets
Same criteria as above
Reserve aggregates and interest rates about equal on criteria 1
and 2. For 3, if intermediate target is Ms, then reserve
aggregate is better
History of Fed Policy Procedures
Early Years: Discounting as Primary Tool
1. Real bills doctrine
2. Rise in discount rates in 1920: recession 1920–21
Discovery of Open Market Operations
1. Made discovery when purchased bonds to get income in 1920s
Great Depression
1. Failure to prevent bank failures
s
2. Result: sharp drop in M
Reserve Requirements as Tool
1. Banking Act of 1935
2. Required reserves  in 1936, 1937 to reduce “idle” reserves:
s
Result: M  and severe recession in 1937–38
Pegging of Interest Rates: 1942-51
1. To help finance war, T-bill at 3/8%, T-bond at 2 1/2%
2. Fed-Treasury Accord in March 1951
Money Market Conditions: 1950s and 60s
1. Interest Rates
A. Procyclical M
Y   i   MB   M 
   e   i   MB   M 
Targeting Monetary Aggregates: 1970s
1. Fed funds rate as operating target with narrow band
2. Procyclical M
New Operating Procedures: 1979–82
1. Deemphasis on fed funds rate
2. Nonborrowed reserves operating target
3. Fed still using interest rates to affect economy and inflation
Deemphasis of Monetary Aggregates: 1982–Early 1990s
1. Borrowed reserves (DL) operating target
A. Procyclical M
Y   i   DL   MB   M 
Fed Funds Targeting Again: Early 1990s to the present
1. Fed funds target now announced
International Considerations
1. M  in 1985 to lower exchange rate, M  in 1987 to raise it
2. International policy coordination
Taylor Rule, NAIRU and the Phillips Curve
Taylor Rule
Fed funds rate target = inflation rate +
equilibrium real fed funds rate +
1/2 (inflation gap) +
1/2 (output gap)
Phillips Curve Theory
Change in inflation influenced by output relative to potential, and
other factors
When unemployment rate < NAIRU, inflation rises
NAIRU thought to be 6%, but inflation falls with unemployment rate
below 5%
Phillips curve theory highly controversial
Taylor Rule and Fed Funds Rate