The Conduct of
Monetary Policy
The specific “nuts and bolts” of
monetary policy, from beginning
(policy tools) to end (key
macroeconomic variables such as
the price level and real GDP).
How Monetary Policy
is Done -- A Diagram
Policy Tools  Operating Target
 Intermediate Target
 Final Targets
Important Terms
Policy Tools -- The Federal
Reserve’s policy instruments,
usually open market operations
(OMOs).
Final Targets -- Overall goal
variables for the economy, such as
real GDP (Y) or the price level (P).
Intermediate Targets
Intermediate Targets -- Variables which
are known to have a direct effect on
final targets.
Possible Candidates – an interest rate
(short-term and long-term), M1, M2,
other money supply measures.
Operating Targets
Operating Targets -- Variables which
are known to have a direct effect on
intermediate targets.
Possible Candidates -- the Federal
Funds rate (iFF), Reserves (R), the
Monetary Base (H), the Nonborrowed
Base (HNON), Nonborrowed Reserves
(RNON).
Criteria for Choosing
Intermediate Targets
Measurability -- The variable must
be accurately measured and
available on a frequent basis.
Controllability -- The Fed should
be able to hit the target with
reasonable accuracy on a
consistent basis.
Predictive Accuracy -- Given the
value of the intermediate target,
the Fed should be able to predict
with reasonable accuracy the final
targets.
The Money Supply -- not great at
controllability, stronger on
predictive accuracy.
Criteria for Choosing
Operating Targets
Same as choosing intermediate
targets.
Controllability more important.
Predictive ability -- applies to
intermediate target.
The Current Conduct
of US Monetary Policy
Policy Tools  Operating Target
 Intermediate Target
 Final Targets
Since 1988:
OMOs  iFF  M2  Y, P
Setting Monetary Policy -Expansionary
The FOMC lowers the target
Federal Funds Rate.
To achieve this target, the Open
Market Manager buys bonds,
supplying more reserves to the
system.
The Fed does this until the new
equilibrium iFF equals its newly set
target rate.
Setting Monetary Policy -Contractionary
The FOMC raises the target
Federal Funds Rate.
To achieve the FOMC’s new target,
the Open Market Manager sells
bonds, thereby removing reserves
from the system.
The Fed does this until the
equilibrium iFF equals its target.
Maintaining Monetary Policy
(Increased Loan Demand)
Income (Y) or Loan Demand
increases.
This change increases the
Demand for Reserves, shifting the
curve rightward, and threatening
to increase the equilibrium iFF.
The Open Market Manager
increases the Supply of Reserves
until the equilibrium iFF equals its
mandated target rate.
The Procyclical
Money Supply
Outcome of Federal Funds rate
targeting, due to policy
maintenance.
Money supply misses its target in
the direction of the business cycle
(e.g. too much during inflation).
Potentially destabilizing on
economy, money supply miss
aggravates the existing macro
problem.
Monetary Policy -- Current
Issues and Developments
M1 is becoming obsolete -- sweep
programs.
Less reliance on money supply for
short-term policy, used for longer-term
growth targets instead.
Greater reliance on iFF as an operating
target. Has it in fact become the
intermediate target?
More Developments
The end of stand-alone investment
banks? (merging with banks or
converting into banks)
The restructuring of Fannie Mae
and Freddie Mac
Another look at mortgages and
mortgage securitization
Developments -- Banking
Getting out of the mortgage foreclosure
problem and stabilizing the banking system.
Harsher bank regulations coming down (as
with FIRREA)?
More global cooperation and coordination of
banking and financial market regulations?
Continuous Financial innovation -- a given.