10
MONETARY POLICY
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CHAPTER OUTLINE
Goals, Tools, and a Model of Monetary Policy
Central Bank Independence
Modern Monetary Policy
Summary
LEARNING OBJECTIVES
LO1: Describe the role of the Federal Reserve of the United States.
LO2: Define macroeconomic stability as the Fed’s primary goal while noting that controlling inflation has
typically been the means by which it has measured its success.
LO3: Integrate an understanding of the tools of monetary policy with their application utilizing an aggregate
supply-aggregate demand model.
LO4: Describe the recent history of monetary policy and Federal Reserve’s role in the 2007-2009 recession.
KEY TERMS
Federal funds rate- The rate at which banks borrow from one another to meet reserve requirements.
M2- M1 + savings accounts + small CDs.
Monetary aggregate- A measure of the quantity of money in the economy.
M1- Cash + coin + checking accounts.
Inflation targeting- A policy whereby a central bank publishes a desired range of a specified inflationary
measure and then using the tools of monetary policy to bring that measure of inflation into that desired
range.
Open-market operations- The buying and selling of bonds, which, respectively, increases or decreases the
money supply, thereby influencing interest rates.
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Primary credit rate or discount rate- The rate at which banks with excellent credit can borrow from the
Federal Reserve.
Reserve ratio- The percentage of every dollar deposited in a checking account that a bank must maintain at
a Federal Reserve branch.
Monetary transmission- The process by which the use of a monetary policy tool impacts the overall
economy.
Liquidity trap- A situation where zero or near zero interest rates do not stimulate borrowing.
Corporate paper- Short-term debt offered by large corporations.
Quantitative easing- The process by which the Federal Reserve buys long-term securities in order to
decrease long-term interest rates to directly stimulate business investment and housing markets.
Mortgage-backed security- Financial asset that is the aggregation of mortgages where the holder of the
security is paid from the combined mortgage payments of homeowners.
DISCUSSION QUESTIONS
1. What has been the Federal Reserve’s goal in the last 30 years or so? How does it measure its success?
2. How have the Fed’s mechanisms of controlling business cycles (booms and busts) changed from its early
days to the present?
3. Define a Fed’s “target.” What types of targets has the Fed used during the last 25 years?
4. How do the Fed’s tools and targets work together to influence the macroeconomy?
5. What are the Fed’s tools? Be sure to indicate how each tool ultimately increases or decreases the money
supply.
6. Use the process of money creation to illustrate how an initial deposit of $10,000 can lead to an increase in the
money supply of $50,000, if the reserve ratio is 20%.
7. Why do many economists consider monetary policy impotent in the long run?
8. How does monetary policy influence the economy?
9. Why does the United States allow the Fed to be so independent?
10. Consider the three possible “targets” of the Fed. Which one do you think would be best for the Fed to target.
Defend your answer.
11. Why is deflation a concern?
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THE WEB-BASED QUESTION
The Federal Reserve is responsible for monetary policy. The following website site discusses the Federal Reserve
in action and how it implements monetary policy.
www.frbsf.org/us-monetary-policy-introduction/tools/
Also visit the websites, www.econedlink.org/lessons/economic-lesson-search.php, and
www.federalreserve.gov/boarddocs/press/monetary/2005/20051213/default.htm
The first article is a case study of the Federal Reserve System and Monetary Policy, December 2005. It discusses
the decision of the Federal Reserve (Federal Open Market Committee) to raise its target for the federal funds rate.
The article discusses the Fed’s goals, tools, the Beige Book, and how it came to this policy decision. The second
article is a Federal Reserve Press Release that discusses the Fed’s action on December 13, 2005 to raise its target
federal funds rate by 25 basis points to 4-1/2 percent. This was the twelfth increase since June 2004.
Part I.
What are the Federal Reserve current observations and concerns?
Part II.
What tool will the Federal Reserve use to accomplish its goals?
Part III.
If the Federal Reserve were to become concerned about a slowing of the economic expansion, what is it likely
to do with its open market operations and the federal funds rate?
Part IV.
How do changes in monetary policy affect your family’s spending and business spending in the economy?
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ANSWERS TO STUDY QUESTIONS
SUGGESTED ANSWERS TO THE DISCUSSION QUESTIONS
1. The main goal of the Federal Reserve is macroeconomic stability, which means preventing boom and bust
cycles, by regulating banks and other financial institutions. The Fed measures its success by its ability to
control inflation.
2. The Fed began in 1913 as a response to the boom and bust nature of the financial world of the late nineteenth
and early twentieth century. It is still concerned with dampening the boom and bust cycle, but its mechanism
of doing so has changed from simply insuring the financial soundness of institutions to directly manipulating
interest rates to change the borrowing habits of banks, businesses, and consumers.
3. A target of the Federal Reserve can be either a key interest rate (usually the federal funds rate) or a monetary
aggregate (a measure of the quantity of money in the economy).
In the 1970s, the target was the federal funds rate (the rate at which banks borrow from one another to meet
reserve requirements). Targeting the federal funds rate required constant increases in the money supply. As
inflation heated up in the 1970s, the use of this target caused greater inflation and higher interest rates because
there was too much money chasing a limited amount of goods.
In October 1979, as the rate of inflation continued, the Fed changed its target to the monetary aggregate, M2
(the sum of all bills and coin and check-accessible accounts, plus the amount in small short-term certificates
of deposit). By the summer of 1982, inflation had subsided just as M2 became unstable and too difficult to
target. The Fed then reverted back to targeting the federal funds rate, and it has used this target since the
summer of 1982.
4. The Fed uses its tools (open market operations, the discount rate, and the reserve ratio) to keep the target
within the range it sets. The target is then designed to measure whether the Fed is meeting its goal of using
either the interest rate or the money supply to influence the macroeconomy.
5. An open market operation is the tool that the Fed uses to keep day-to-day tabs on its target. The Fed sells a
portion of its reserve of U.S. government bonds, when it wants to reduce the money in the system. (The
money supply is reduced when the buyers have to pay the Fed.) When it wants to add to the money in
circulation, the Fed buys bonds. (The Fed increases the money in circulation, when it pays the seller for the
bonds.)
The discount rate is the rate that the Fed charges when it lends money to banks. If it wants to reduce the
amount of money that the banks have to lend out, the Fed raises the discount rate, and thereby reduces the
amount of bank borrowing from the Fed. To increase the amount of loans that banks take out from the Fed,
the Fed lowers the discount rate.
Since 2003, the Fed has adopted the Lombard System where the discount rate is set above the federal funds
rate. In this way, banks with sufficient creditworthiness, can borrow unlimited amounts from the Fed at the
primary credit rate. Banks with lesser credit ratings face higher interest rates.
The reserve ratio is the percentage of every dollar deposited in a checking account that a bank must maintain
as reserves in either vault cash or as a deposit at a Federal Reserve branch. If the ratio is raised, the bank has
less money to lend. The reverse occurs if the reserve ratio is lowered.
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6. The process of money creation can be illustrated using the following series of steps.
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Assume that there are several individuals in the economy, A, B, C, D, E, and so on, and several
banks, 1st City, 2nd City, 3rd City, etc.

The banking system creates money through a series of loans.

Suppose individual A makes an initial cash deposit of $10,000 into 1st City bank.

With a reserve ratio of 20%, 1st City can only lend $8,000 to person B. (It has to keep 20% or
$2,000 as part of the required reserve.)

Suppose that person B uses the loan to buy something from C, who puts $8,000 in the 2nd City
bank.

If D now borrows money from the 2nd City, the maximum loan that 2nd City can make will be
$6,400. (It has to keep 20% or $1,600 on reserve.)

D uses the loan to make purchases from E, who puts $6,400 into 4th City bank.

4th City bank can now lend a maximum of $5,120, since it must keep $1,280 (or 20%) on reserve.

The process continues, and in the end, the deposits total $50,000 ($10,000 + $8,000 + $6.400 +
$5,120 + …) as a result of A’s initial cash deposit of $10,000.

The final amount of the deposits is equal to the initial deposit of $10,000  5 = $50,000, where 5 is
the “money multiplier,” which is equal to 1/ required reserve ratio.
7. Many economists consider that the Fed is unable to increase output through sustained increases in the money
supply over the long run. This is because they feel that investors anticipate substantial inflation as a result of
the increases in the money supply. In Figure 10.1 in your text, the AD shifts more and more to the right. As
inflation worsens, the money invested in the economy loses its value, the interest rates increase, higher
interest rates make investments more expensive, and RGDP can ultimately decrease.
8. When the Fed buys bonds, it increases the amount of money (loanable funds) that banks and other financial
institutions can lend. The increase in the supply of loanable funds decreases the interest rate. (See the left
panel of Figure 10.1.)
Investors tend to borrow more to buy plant and equipment when interest rates are lower. Consumers also are
more willing to buy expensive durable goods like cars and home furnishings. Those purchasing items for cash
sacrifice smaller amounts of interest income when they take money out of savings to buy anything. The
increase in investment and interest-sensitive consumption shift the aggregate demand curve to the right (see
the right panel of Figure 10.1.) The opposite happens when the Fed sells bonds, it decreases the amount of
money (loanable funds) as shown in the left panel of Figure 10.2. Since banks have less to lend, interest rates
rise and as investment and interest-sensitive consumption fall, it causes aggregate demand to fall. (See the
right panel of Figure 10.2).
9. Economists for the most part agree that the Fed must be free from political control in order to take the
necessary action to fight inflation, and that it should be able to do what it thinks is best without fear of being
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contradicted by the President and the Congress. Furthermore, the Fed does not protect the interests of either
political party.
Long-run economic growth requires that the financial markets have faith that money invested in a country
will not lose value as a result of excessive inflation. When people are concerned about inflation, interest rates
increase. Higher interest rates make investments more expensive. Since growth occurs only when investments
for the future take place, long-term growth depends on the existence of a believable monetary authority.
When we examine the experience of other countries, those countries with a history of independent monetary
authorities have experienced lower inflation rates and higher real growth rates than countries without that
history of independence. The United States, Germany, Switzerland, Japan, Canada, and the Netherlands are
examples of countries with such independence, whereas Spain and Italy, which are examples of countries
without such independence, experienced higher inflation rates. Because of economic stability, the United
States is willing to accept the risk of having an independent monetary authority.
10. Arguments can be advanced for the Fed to adopt any of the three targets, depending upon the goals of the Fed
and how well the Fed can manage its influence on the economy. The Fed should adopt the rate of inflation as
its target, if it is highly concerned with controlling inflation. The Fed should adopt a rate of interest as its
target, if it is highly concerned with interest rates being too low or too high. Finally, the Fed should adopt a
monetary aggregate, such as M1 or M2, if it is highly concerned with maintaining orderly economic growth.
Some argue, such as Milton Friedman, that the Fed is not able to hit its target, no matter what target it selects,
implying that the Fed should simply attempt to hold M1 constant.
11. Deflation is a concern because it can generate a self-reinforcing, downward spiral in the economy. At first,
deflation discourages people from buying now, because if they wait, the price will go down. Then, sales
decline and businesses cut prices further, profits and incomes decline, and unemployment increases. The
lower prices convince consumers to delay purchases again and again.
SUGGESTED ANSWER TO THE WEB-BASED QUESTION
Part I.
The Federal Reserve believes that the economy is growing without significant inflationary pressure. Its goal is
to remove the stimulative pressure created by low interest rates. It signaled that it will continue the gradual
increases in the target of the federal funds rate.
Part II.
The Federal Reserve can buy or sell U.S. Treasury bonds, which in turn will lower or increase the federal
funds rate. To reduce the stimulative effects of recent policy, the FOMC is increasing the target for the federal
funds rate. That means that the Federal Reserve is selling bonds. (Or it means that the Federal Reserve is
slowing the growth of the money supply by purchasing fewer bonds.)
Part III.
The Federal Reserve would do the opposite of its action in December. It would purchase bonds to expand the
reserves and the money supply, and lower the target federal funds rate.
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Part IV.
If the Federal Reserve is purchasing bonds, banks will have larger reserves due to increased deposits. With the
increased reserves, they can increase the number and size of loans. The increase in loans and the resulting
lower interest rates encourage business (and consumer) borrowing and spending. The increased spending in
the economy should result in increased business production and employment as aggregate demand increases.
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