MIFA Chap 8

Chap8OpenMarketDesk/FINMAC2018 July 2008/2013/Oct2015/TwkSep20 Pg 1
CHAPTER 8: CENTRAL BANKS, POLICY RATES AND BANK RESERVES

There have been three great inventions since the beginning of time: fire, the wheel and central
banking Will Rogers
Section 8.1 Various Interest Rates
The interest rate is a very important variable in macroeconomics, and the most important variable in
financial macroeconomics. It is also at the root of controversies between different approaches and
theories. In macroeconomics we talk about “the interest rate”, but at an operational level we should first
distinguish between different sets of interest rates. Below are listed important categories of interest rates.
(1) Short and long rates. Much of finance theory deals with the term structure of interest rates: explaining
the difference between rates at different maturities i.e. the yield curve.
(2) Policy rates, set by the central bank, and market determined interest rates.
(3) Deposit and lending rates of banks and other financial intermediaries.
(4) Government versus private bond yields.
Much of financial economics analyzes the connections between these different rates. This is done in the
next and some subsequent Chapters (11 to 14 MIFA). At a broad macroeconomic level, all these rates tend
broadly to move together. This can be seen in the table that lists Various Interest Rates for USA and India
Table for 2003 and 2007 for both countries on the next two pages. Of the 23 listed rates for USA, only four
have declined over this period, and mostly by small amounts. Over half of them rose between 3.0-4.5
percentage points, and a few rose close to 3.0 percent. Of the 22 listed for India, again over half of them
rose between 2.0-4.0 percent. (Tables on next 2 pages). Hence it is not only convenient but somewhat
legitimate, for many purposes, to analyze at a macro level, movements in “the interest rate (r)”. Since
2008, US interest rates have been zero, and so the interest rates trends are difficult to assess.
From a macro perspective, we mainly need to distinguish between (i) the real and the nominal rate of
interest and (ii) the policy rate and the market rate. Before getting to central bank policy, it is useful to go
over the link between bond prices and interest rates.
TABLE 8.1.A VARIOUS U.S. INTEREST RATES

Description of rate Sept 2003 Sept 2007 Change in rates
Federal funds (effective) Key Policy Rate 1.01 4.94 3.93
Non-financial Commercial Paper

1-month 1.02 4.94 3.92
3-month 1.04 4.92 3.82
CDs (secondary market)

3-month 1.08 5.46 4.38
6-month 1.13 5.33 4.20
Eurodollar deposits (London)

3-month 1.08 5.53 4.45
6-month 1.12 5.38 4.26
Bank Prime Loan 4.00 8.03 4.03
Discount Rate 2.00 5.53 3.53
US GSecs Treasury Bills (Secondary Market)

3-month 0.94 3.89 2.95
6-month 1.01 4.05 3.04
Treasury constant maturities

3-month 0.96 3.99 3.03
1-year 1.24 4.14 2.90
2-year 1.71 4.01 2.30
5-year 3.18 4.20 1.02
10-year 4.27 4.52 0.25
Inflation-indexed
10-year 2.19 2.26 0.07

Inflation-indexed long-term average 2.67 2.29 -0.38
Interest rate swaps

1-year 1.34 4.91 3.57
5-year 3.61 4.86 1.25
30-year 5.49 5.41 -0.08
Corporate bonds ( Moody’s seasoned)

Aaa 5.72 5.74 0.02
Baa 6.79 6.59 -0.20
State and local bonds 4.92 4.51 -0.41
Conventional mortgages 6.15 6.38 0.23
Source : U.S. Federal Reserve, Series G.15 etc.
TABLE 8.1.B INDIAN INTEREST RATES

Description of rate Sept. 2003 Set. 2007 Change in rates
Repo rate (key policy rate) 7.00 7.75 0.75
MONEY MARKET
a) Call Rate (Average) 4.50 6.41 1.91
b) Commercial Paper
Weighted average Deposit rate (61-90 days) 5.26 8.25 2.99
Weighted average Deposit Rate (91-180 days) 4.89 8.21 3.32
c) Certificates of Deposit
Range 4.25 - 6.00 6.82 - 10.00 3.28
Typical 3 months rate 5.00 8.13 3.13
Typical 12 months rate 5.31 8.94 3.63
d) Treasury Bills
91 days 4.57 7.10 2.53
364 days 4.59 7.50 2.91
DEBT MARKET
a) Govt Securities Market
Five Year 4.79 7.78 2.99
Ten Year 5.13 7.93 2.80
b) AAA rated Corporate Bonds
One year 5.05 -
Five Year 5.54 -
(TERM) DEPOSIT AND LENDING RATES

a) Public Sector Banks
Upto 1 year 3.75 - 5.50 7.75 - 8.50 3.50
Over 3 years 5.25 – 6.25 8.00 – 9.50 3.00
b) Private Sector Banks
Upto 1 year 3.00 - 7.00 2.50 – 9.25 0.875
Over 3 years 3.75 – 8.00 2.00 – 9.50 -0.125
c) Foreign Banks
Upto 1 year 3.00 – 7.75 2.00 – 9.00 0.125
Over 3 years 3.75 – 8.00 2.00 – 9.50 -0.125
PRIME LENDING RATES

Public Sector Banks 9.00 – 12.25 12.50 – 13.50 2.375
Private Sector banks 8.00 – 15.50 13.00 – 16.50 3.00
Foreign Banks 5.05 – 17.50 10.00 – 15.50 1.475
Savings bank account deposit rate 3.50 3.50 ----

Note : Changes in rates for those figures where ranges are given (as for deposit and lending rates) are calculated by
considering the mid-points of the given ranges.
Source : Report on Trend and Progress of the Banking Sector 2007, RBI
Section 8.2 The Basics of Bond Pricing

The pricing of bonds is a huge topic with much quantitative detail. Bonds most often pay coupon interest
(usually twice a year) and the face value of the bond (principal invested) is repaid at maturity. However,
there are also some bonds without coupons, such as zero coupon bonds, that pay accrued interest along
with the principal at maturity. Bills which have a maturity of less than a year pay no coupon interest but
are issued at a discount relative to the face value paid at maturity, the difference being the accrued
interest. 1 However, the crucial economic feature of bonds and bills, unlike bank deposits that also pay
interest, is that they are traded in a secondary market.2
The price of a bond is determined by a Present value formula, as explained in any Finance textbook. The
market interest rate is what equates the price of the bond (PB) to the Present Value of the entire stream of
the remaining interest payments on the bond and the principal. From a macro viewpoint, the two
important properties of bond pricing are: (i) Bond prices are inversely linked to bond yields and (ii) The
longer the maturity, the more sensitive is its change in price to a change in the interest rate, R.
A numerical example using a perpetuity or a Consol can be used to explain bond pricing. 3 A Consol is a
bond that never pays any prinicipal but pays a fixed coupon [C] forever, hence the term perpetuity. The
price of the Consol P(Consol) = C/R, where R is the current rate on the Consol. Start with a Consol issued
when R is 10% with a coupon of Rs. 10. Using the formula P(Bond) = 1/R, where R is the current yield, P(B)
= 10/0.1 = Rs. 100, which is its face value. When r = 11%, then P(Consol) = 10/0.11 = Rs 90.90 and when R =
9%, then P(Consol) = Rs. 111.11. By contrast, for a three month Treasury bill, when the interest rate drops
from 10% to 9%, the price goes up from Rs. 97.56 to Rs. 97.80, a small change.
Section 8.3 The Policy Rate and Open market Operations

For starters, the interest rate is announced and ‘set’ by the central bank. However, the word ‘set’ above
has been placed within inverted commas because there are underlying economic forces that influence the
rate which the central bank can and does decide upon. These will be analyzed later in this text. In the USA,
the Federal Reserve sets the federal funds rate. Similarly the ECB (European Central Bank), the Bank of
Canada, the Bank of England and other major central banks in developed and many developing countries
all set their short-term policy interest rate. A few are listed below.
Country/Region Key Policy Rate Policy Rates Change (Since 2005)
As of Aug 17, 2006 (in basis Points)
Developed economies:
1
Details of bond pricing and types of binds are available in any Finance text such as Principles of Corporate Finance by
Brealey and Myers. Those who have covered this topic in a Finance course can skip this section.
2
The primary market refers to the market for newly issued instruments, while the secondary market refers to the
market where existing instruments are traded. Primary and secondary markets exist for equities and other financial
instruments.
3
Consols are bonds that were first issued in Britain in 1722. They paid interest of 3% in perpetuity but no principal,
and traded actively for over two hundred years.
Euro Area Rate on Main refinancing 3.00 100 50

Operations (ECB)
Japan Uncollateralised Overnight Call Rate 0.25 25 25
UK Official bank rate 4.75 zero 25
USA Federal funds rate 5.25 250 50
Developing Economies:
Brazil Selic rate 14.75 (-) 450 (-) 175
India Reverse repo rate 6.00 125 50
Indonesia BI Rate 11.75 325 (-) 100
Thailand 14-day repo rate 5.00 275 50
Source: RBI Publication Macroeconomic and Monetary Developments in 2006-07 (Check?).
Monetary policy involves many other decisions in various realms. In this context, the other two major tools
of policy part from the key policy rate above, are reserve requirements and the discount rate. The
importance of reserve requirements versus the key policy rate varies across economies.
This Section describes and explains some aspects of how the central bank sets the interest rate in the
United States. The Federal Reserve (the Fed, to use the widespread abbreviation) is the most important
central bank in the world, and its policy greatly influences the world economy. Chart 8.1 (on page 7) plots
the federal funds rate from 1990 to 2005, a fifteen year period. The Fed normally announces the fed funds
rate decisions, and changes (if any), after the Federal Open Market Committee (FOMC) meetings.
However, changes on unscheduled dates, based on sudden or critical developments, are also made. For
instance, just after September 11th 2001, the fed funds rate was lowered from 3.5% to 3.0% and again from
3.0% to 2.5% in early October, a huge 100 bps drop in under a month. 4
The federal funds rate is the rate on overnight transactions in the federal funds market. In this market,
banks and other depository institutions trade their non-interest bearing reserve balances with each other.
Most trades are overnight.5 What needs to be understood is how this market determined federal funds
rate (i.e. via private inter bank transactions) is set by the central bank. The Fed manages to do so because
it is the most influential participant and a large transactor in this market. This inter bank market for
reserves largely exists, because commercial banks, under the jurisdiction of the central bank, are legally
required to hold some reserves.6 However, banks also hold small amounts of what are called excess
reserves (2% of total reserves in USA as of 1995) on their own. Total reserves equal required reserves plus
excess reserves. Due largely to these reserve requirements, there is an adequately large demand for
reserves from commercial banks and hence the Fed is able to control or set the fed funds rate.
For all practical purposes the Fed can be said to set or determine the funds rate. This can be seen in Chart
8.2 by comparing the effective funds rate with the target rate that the Fed announces. The (daily) effective
Fed funds rate is the weighted average rate of all banks, based on their actual transactions. The daily gap
between the two is normally so small that, averaging over longer periods, when conditions in the money
market are normal, the discrepancy can be ignored. For instance, during April-October 2001, the average
daily discrepancy between the two (target minus effective) was 3 basis points (bps) while the range was
181 bps to - 36 bps. 7
4
Further information on the structure and content of Fed decision making is provided in Chapter 17.
5
The other participants in the fed funds market are savings banks, savings and loan associations, credit unions, etc.
For convenience, participants in the fed funds market may be referred to here as banks, ignoring the others.
6
As of October 2007, banks etc under the Federal Reserve System were required to hold 3% as reserves on (demand)
deposits between $8.5 million and $ 45.8 million and 10% on deposits more than $ 45.8 million
7
Even this 3 bps average gap was due to the steep drop in the effective rate to almost 1% when the target was 3% just
after the 9/11 attack.
Fig 8.1 Federal Funds Target Rate
Fig 8.2 Federal Funds Target and Effective Rate
The Fed (or any other central bank that sets the interest rate) keeps the actual funds rate (or equivalent) as
close to the target rate as possible by open market operations. In general, when we say the funds rate,
the default reference is to the target, not the effective rate. The target rate is typically changed by a
quarter percentage point or more, and other central banks, such as the RBI, are now following this practice.
Section 8.3.1 The Mechanics and Economics of Open Market Operations
The market interest rate is determined by the central bank’s money supply operations. Both the public and
the central bank hold bonds. In this context, the term public refers to all economic entities other than the
central bank and the government (Finance Ministry). The public comprises banks, financial institutions, life
insurance companies, pension funds, and also individual retail investors holding bonds.
When the central bank changes the interest rate (or keeps it at the target rate) it does so through open
market operations. To lower the interest rate it buys bonds from the public and gives them money in
exchange. The money given to the public by the central bank is either currency or bank reserves, which are
an accounting entry in the banking system (cf. Chapter 15 ). The increase in the demand for bonds from
the central bank pushes up the price of ‘bonds’ and thus lowers the interest rate. The rise in the price of
bonds induces holders of these bonds to sell them in return for money. Vice versa for an increase in the
interest rate and a corresponding decrease in money supply – work it out yourself. The mechanics of
monetary policy varies across countries, but the macroeconomic nature and impact of money supply
changes are the same, and are shown in the schematic below.
SCHEMATIC TO DEPICT OPEN MARKET OPERATIONS
Sells bonds to ↓ In Money Supply R ↑
Central Bank Takes
Sellsmoney
bonds from
to Public*
↑In supply of bonds PB↓
↑ In Money Supply R ↓
Central Bank Gives money Public*
to institutions,
*The Public comprises of Buys bonds
banks, from
financial life insurance companies,
↓ In supplypension funds
of bonds PB ↑and
retail investors (individuals).
Alternatively, this process could be described by looking at the demand and supply of reserves, part of the
nitty gritty of banking. The opportunity cost of holding money for the public (banks) is the interest
foregone on holding bonds. The quest for profits will make the banks want to hold less reserves i.e lend
them out to earn more interest when the rate is higher. But they have to trade this off interest earned
against the penalty interest rate charged for having reserve deficiencies at the end of the reporting period,
and their own economic benefits, or convenience, from holding reserves. Hence the demand curve for
reserves slopes downwards, while the supply is set by the central bank. The impact of the increase in
money supply upon the interest rate, and corresponding change in bond prices, is depicted below:
Fig 8.3.1 Open Market Operations: Increase in Money Supply
8.4.1 Targeting Interest Rate versus Targeting Reserves

The above diagram is useful as a starting point in understanding how the central bank in its money market
operations targets the interest rate versus its other option – targeting (some measure of) reserves. In the
inter-bank market, while one bank can and does meet its demand for money by borrowing from another
bank, for all banks as a whole, if the demand for reserves exceeds the supply, then the interest rate (here
the price of reserves) will have to rise to bring the two back into balance or equilibrium. A higher interest
rate reduces the quantity of reserves demanded by individual banks, until total quantity demanded
reduces to equal available supply. This would be the case if the Fed targets reserves (left diagram Fig 8.4).
However, if the Fed adds reserves at the going interest rate to meet the Fed funds target, as is the current
practice, then equilibrium is restored without the interest rate changing (right diagram Fig 8.4). 8
After 2009 when the federal funds rate and short term rates fell to zero or close to zero, the mechanics of
monetary policy has changed, with the practice of quantitative easing. The description in this whole
8
An analogy from microeconomics can help clarify this choice. A monopolist can either fix the price and let the
quantity be determined by buyers, or can fix the quantity and let the market clear at that corresponding price.
section is meant for situations with (healthily) positive interest rates say above 1%. This has been the case
for most of the post war period in US and other economies.
Fig 8.3.2 The Alternatives: Bank Reserves or Interest Rate Target?
% S S’
R Reserves Target
%
R
R’
D
Reserves ($) D’
R Target
D’
D
Reserves ($)
Reversible versus Outright Transactions

When it comes to the nuts and bolts of open market operations, it is essential to distinguish between
reversible and outright transactions. The purchase of bonds described above is an outright transaction.
However, many reversible transactions are undertaken to meet temporary fluctuations in the demand for
reserves, within the (typically) fourteen day reserve requirements reporting period. 9 These temporary
operations are conducted through repo and reverse repo instruments. A repo operation involves a
temporary increase (or injection) of money, while a reverse repo involves a temporary decrease (or
absorption or withdrawal). In effect, the central bank buys securities from a dealer who agrees to
repurchase them at a specific price on a specific date – hence the term repo, short for repurchase, and vice
versa for a reverse repo. Banks borrow from and lend to the central bank via these instruments. These
operations enable the central bank to inject and withdraw large amounts on a temporary basis. They help
smooth the pattern of reserves for the maintenance period (usually two weeks) by meeting the needs of
banks on a particular day. The maturity of repos varies from one to fourteen days.
By contrast, outright transactions or conventional open market operations are undertaken a limited
number of times each year, mostly to meet long term reserve needs. Over time currency demand from
customers tends to be the largest factor requiring injections. Outright transactions are done through
purchase and sale of Treasury bills (up to a year maturity) or longer term Treasury coupon securities of
differing maturities along the yield curve. These are done in the secondary or open market (hence the
origin of the term open market operations).
Most prevailing textbook discussion of open market operations (OMOs), including this one, refers to buying
and selling of bonds, as in the first part of this section. However, in practice most OMOs are reversible
transactions involving repos and reverse repos. Even many of the outright OMOs are usually conducted
with short-term Treasury bills, and very rarely with actual bonds which have much longer maturity.
Section 8.3.2 A Description of Actual Open market Operations:
To understand more about the open market process for USA, the following two identities are needed:
Total Reserves = Required Reserves + Excess Reserves = Borrowed reserves + Non Borrowed Reserves.
Borrowed Reserves is the amount member banks have borrowed from the discount window at the
Discount Rate i.e. an administered rate. (The term discount rate is usually applied to interest rate on direct
credit available from the Fed and the term “discount window” to the mechanism of such credit. When the
9
In the US and most other countries including India, banks are required to hold an average amount of reserves over a
two week reserve maintenance period, rather than a specific amount each day.
fed funds rate is higher than the discount rate and/or is rising, banks try to borrow more from the discount
window at the lower Discount rate to meet their reserve needs. However, access to the discount window
is rationed, otherwise banks would borrow as much as possible from the Fed instead of other banks, due
to the rate differential. Also, banks are reluctant to borrow from the discount window since this may signal
to others in the financial system that the bank is in trouble, since the discount window is meant for
emergencies. Non Borrowed Reserves (NBR) refers to reserves that banks borrow from each other i.e.
they do not borrow it from the Fed, hence the name Non Borrowed.
The preceding discussion has drawn heavily from a Federal Reserve Bank of New York publication
‘Understanding Open Market Operations’. The following excerpt from this publication describing the
situation in the inter-bank market on Monday, April 17, 1995 is meant to provide a feel of the process:
“On that Monday, the monetary system faced large projected reserve deficiencies for the day and for several days (Fig
5-2)….On Monday morning, excess reserves for the period were running negative, and banks had significant
cumulative reserve deficiencies, in part because the Treasury balance had turned out to be higher than expected over
the weekend. …Confronted with large reserve deficiencies for the day, banks had bid up the federal funds rate to the
6 1/8 – 6 3/16 ranges that Monday morning, somewhat above the FOMC’s intended 6 percent level Other short-term
interest rates also experienced modest upward pressures. The firmness in the money market likely reduced the
reserve pressures stemming from federal tax payment flows….Against this background, the Desk supplied about $ 7.7
billion in reserves by arranging three day System RPs on that Monday: as explained above, System RPs offer a very
convenient mechanism for injecting large amounts of temporary reserves….In the absence of such a large temporary
reserve injection, the funds rate would most likely have come under additional upward pressures, moving further
above The Committee’s level as banks would have struggled to keep on track toward meeting their reserve
requirements and avoid ending the day with reserve shortages.” (M.A. Akhtar, 1997, from pg. 38-40)
*Note: NBR Path (4) = (1) + (2) − (3) and that Open Market Operation to Hit path (6) = (4) − (5)
Section 8.4 The Policy Rates in India

The call rate in India is the inter bank determined market rate, the equivalent of the fed funds rate.
However, compared to developed countries central banks, the RBI’s control over the money markets in
India is limited, and so it was not able to keep the call rate at a certain level. Instead it operates with a
band. The reverse repo rate is the lower limit and the repo rate is the upper limit of the band. The RBI’s
policy is to keep the call rate within this band or corridor, but not always very successfully. 10 This can be
seen in the Charts below. (Its control over the repo rate has been increasing a lot in recent years). The
RBI’s ability to predict and respond to liquidity changes that occur in the banking system for various
reasons is improving.
The RBI also exercises control also via reserve requirements: the CRR (Cash Reserve Ratio). Very briefly
suppose the CRR is lowered from 5% to 4%, and banks have Rs 10,000 crores as deposits. The 1% drop in
CRR means they have to now keep only Rs 4,000 crs as Reserves against deposits, and can start lending out
more. That is equivalent to an increase in reserve money of 1,000crs. that could have been instead put in
via open market operations. To understand how reserve requirements operate requires a detailed analysis
of money supply data, not possible here.
Monetary Policy in China: The PBoC which relies heavily on reserve requirements and its Required Reserve
Ratio (RRR) is also increasingly moving to open market operations.
“In previous years money market rates in China almost always jumped before the New Year holiday as
companies rushed to pay cash bonuses to workers and individuals drew down their savings to buy gifts. But
the central bank this year has so far succeeded in preventing such a spike. Its injection on Tuesday of Rmb
450 bn via 14 day reserve repurchase agreements was the most ever on a single day. The central bank added
another tool to its arsenal in January when it announced it would start using short term liquidity operations
as a supplement to its regular open market operations, which previously were restricted to Tuesday and
Thursdays”…. (Simon Rabinovitch, Financial Times 2013)
10
For instance, it was reported for 19th March 2007, that “Intra-day call rate touches 9-year high: Hits 60% before
closing at 17% as banks see outflows of Rs 40000 crores towards tax payments. (Business Standard, 20 th March 2007)
Indian’s Policy Interest Rates and Corresponding Changes in Reserves
Repo Rate
Reverse Repo Rate
LAF:- A tool used in monetary policy that allows banks to borrow money through repurchases agreements.
This arrangement allows banks to respond to liquidity pressures and is used by governments to assure
basic stability in the financial markets.
Liquidity adjustments facility are used to aid banks in resolving any short term cash shortages during
periods of economic stability or from any other form of stress caused by forces beyond their control.
Various banks will use eligible securities as collateral through a repo agreement and will use the funds to
alleviate their short term requirements, thus remaining stable. Data Appendix for this Sec 8.4 after Part B..
Chapter 8: PART B Critiques of IS/LM

Section 8.B.1 : Basic Critique: FAQs on IS/LM (For those who have not taken a full macro course).
ONE: What is IS/LM?
A model developed by Hicks (1937) to clean up and formalize Keynes General Theory (1936),
during the Depression when short rates were close to zero i.e.
abnormal circumstances, as after 2008 crisis.
IS/LM is used to explain how R and y are determined normally.
TWO: What is terribly wrong with IS/LM? (many things are
wrong with it).
From Figure 8.3, we know there are two alternative monetary
policy operating procedures:
(A) Fix BKR, let R vary as the D curve for BKR (Bank Reserves) in
inter-bank market shifts.
(B) Fix R, let BKR (appropriate measure of Bank Reserves) vary
as D curve for BKR shifts.
Even many AAA people (aam aadmi and aurats) know that central banks generally follow
procedure B, although main textbooks and Ivy League economists state otherwise.
THREE: Are these two procedures (they are not just views) equivalent as Mankiw (6 th edn) claims?
Answer: If the D curve for BKR does not shift and (ii) RBI knows exactly where D curve lies, then
the two are equivalent. Equivalent means leading to same economic outcome. But if this is the
case, as the leading text by Mankiw claims, why not just spell out what the target rate is?
In diagram, the 25 bps rate cut is equivalent to say Rs 50 crs injection.
But in reality RBI does not know where exactly D curve for BKR is, and further
The D curve is subject to huge random shocks. So with Rs 50 crs injection, we can end up with an
R of say 7.55% (not the intended 7.75% target) if demand curve has shifted down. Or R could rise
to above 8% despite a Rs 50 crs. injection if demand curve for BKR has shifted up hugely above D.
Economic outcomes of two procedures are different and more so as the same procedure
continues over time and its impact cumulates across economy.
Section 8.B.2 Detailed Critique: Why IS/LM is Irrelevant and Wrong (economicsperiscope.com Feb 2015)
What is IS/LM? The General Theory of Employment, Interest and Money that Keynes wrote in 1936 had
some analytically loose ends. In his 1937 article “Mr Keynes and the Classics: A Suggested Interpretation”
Nobel laureate economist Sir John Hicks developed a precise model to tie up these loose ends. He
expanded and converted Keynes framework i.e. Keynes multiplier equations etc into the IS/LM model. In
Hicks’ model, the IS curve plots the equilibrium of Investment (I) and Savings (S) while LM plots the
equilibrium between money demand or Liquidity (L) and Money supply (M). Hence the terms IS and LM.
[Hicks called the second the LL curve, but it is generally called the LM curve].
The IS/LM model is the central component of most macroeconomics texts. 11 The intersection of the IS and
LM curves are supposed to simultaneously determine the interest rate (R) and real output (y) as shown in
the graph below. Just as intersecting supply and demand curves determine Price and Quantity in micro,
the intersecting IS and LM curves as supposed to determine R and real output y .
What is wrong with it? Very many things. We can classify the problems with IS/LM as Level one, Level
two etc. depending on whether the problems are basic or advanced, and on how wrong they are, starting
from very wrong (level zero) to lesser mistakes and problems.
Level Zero Critique: To begin with, income is a flow (say GDP per quarter) while money is a stock, so the
time dimension on the x axis is not clear. To make sense, two
intersecting curves e.g supply and demand curves for apples should be
over the same period e.g day or month etc. Same for IS/LM.
Level Zero critique: IS/LM fundamentally misrepresents how
monetary policy is conducted under normal circumstances. By
normal circumstances I mean when interest rates are positive i.e.
before the 2008 financial crisis. Note that in 1936 & 1937, when
Keynes and Hicks wrote, short rates were about 50 and 15 basis points
in UK and USA respectively i.e. close to zero. (A 100 basis points is one
percent).
Close to zero rates reflect abnormal circumstances, which may
nevertheless continue for long, just as in Japan since late 1990s and
USA etc since late 2008. In this situation, monetary policy cannot
lower the policy rate. The central bank can only increase the quantity of reserves, which hence becomes
the policy variable. This broadly corresponds to what is now called ‘quantitative easing’. The limited
relevance of IS/LM for such abnormal circumstances calls for separate analysis.
The discussion in Chapter 8 of my book MIFA and here pertains to normal circumstances. As drawn in
MIFA Chart 8.3.2 The Alternatives: Bank Reserves or Interest Rate Target” the central bank has two
alternative options. It can fix R and let Bank Reserves vary endogenously. This is what is normally done.
The other option is that it can fix the relevant measure of Bank Reserves (let us call it BKR) and let R vary
endogenously in response to shifts in D i.e. the demand curve for Bank Reserves (BKR).
Monetary policy changes: In the first case below the central bank decides the policy rate change e.g. Jan
15th 2015 when the Reserve Bank of India (RBI) lowered the repo rate from 8% to 7.75% (attachment). The
central bank then supplies whatever extra BKR are required to clear the market at the new rate. BKR is
thus endogenous. However, suppose RBI announces increase in say Rs 50 crs of BKR. This is similar to a
downward shift in the LM curve. (The difference is that here we look at demand and supply just of bank
reserves BKR in determining R, but the LM curve looks at total demand and money supply in the whole
economy, which is misleading.) When BKR goes up by 50 crs, R will fall endogenously to some new rate R’
shown below, depending on the slope of the demand curve for BKR.
Policy Change in the Real World Policy Change in the IS/LM approach
11
There are textbooks that do not use IS/LM. John Taylor and Akila Weerapana and Bernanke and Frank develop an
alternate model with a policy rate, similar to my Chapter 9. Many economists teaching macroeconomics reject the
IS/LM framework for different reasons. Those who believe that Keynes analysis was about disequilibrium reject this
equilibrium model. John Hicks himself renounced IS/LM in an article in 1980, but not for the reasons discussed here.
According to the IS/LM model policy is conducted the second way. 12 This is factually wrong. Ordinary
persons who watch TV or read the newspaper know that monetary policy is about interest rate changes.
Fortunately, some macro economists are also aware of this level zero problem with IS/LM! The noted
Berkeley macroeconomist Brad de Long in an article “A Macroeconomics Textbook Manifesto” as long back
as 2000 wrote down on his blog what he considered should be seven features of a good text. 13 Here I cite
and comment on the relevant feature five of his article,
Point 5 from Brad de Long’s textbook Manifesto “Downplay the LM curve”…
You can see the contortions that people get themselves into... convince students of the applicability of the IS-LM
framework for understanding macroeconomic events. Smart students notice this incongruity. They wonder what is
going on. Other students don't wonder, but then they have a very hard time understanding the newspaper: "why," they
ask, "does the newspaper talk about interest rate changes instead of shifts in the LM curve?" Brad de Long. (My
comment on this: I wish more students would ask this question, and more so other professors teaching macro!)
[The approach taken here, is based on such an operational critique. This critique may or may not be
consistent with many other academic and metholodogical critiques of IS/LM, perhaps discussed here.]
Below is the flawed justification provided by Mankiw for IS/LM, then my comments in red font.
“Sec 11.1: What is the Fed’s Policy Instrument – The money supply or the interest rate?
Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by
controlling the money supply i.e. shifts in the LM curve. By contrast, when the media report on changes in
Fed policy, they often just say that the Fed has raised or lowered interest rates. Which is right? Even
though these two views may seem different, both are correct, and it is important to understand why….. In
recent years, the Fed has used the federal funds rate—as its short-term policy instrument.” Mankiw 6th
ed.pg 313.
(Note: Later edition 2012 his defence of IS/LM is milder. VM)
Mankiw is wrong, first analytically and second factually regarding the validity of IS/LM.
Analytically: First and foremost, targeting the interest rate versus bank reserves are not views, but
operating procedures in the inter bank market. Just as you cannot simultaneously drive a car and
two wheeler, you cannot simultaneously target the interest rate and the money supply. There can
be only one vehicle or operating procedure. One can have a view as to which procedure is better,
but that is an entirely subsequent matter.
More specifically, if BKR is exogenous, R is endogenous, and vice versa, just as for Price and
Quantity in microeconomics. Mankiw is trying to justify the use of IS/LM by saying that, if both
procedures lead to the same result, are they not equivalent? Is not fixing BKR the same thing as
indirectly fixing R? Let us discuss this.
12
In the IS/LM model the variable is not the demand for bank reserves as here but something broader i.e the total
demand for money by the public, a complicated issue since there is no clear definition of what is the money supply. In
my Chap 8 there is a clear variable: BKR. We can ignore this Level one issue right now.
13
I have written a fuller Comment/Response to de Long, posted on my website, or available upon request . Coincidentally, an
alternative to IS/LM with the interest rate as the policy variable, I first developed in a study for RBI in June 2000.
Algebraically, suppose the demand curve for Bank Reserves is BKR = α – β*RATE. Then R or RATE
is just a linear transformation of above. In the RBI case discussed, the equivalence implies that
when the central bank increases BKR by say Rs. 50 crs, the equivalent fall in the repo rate is say 25
bps, depending on the values of α and β. For it to achieve this target of 25 bps cut, the central
bank should know the α and β of the demand curve for BKR. But it does not. And if it does know,
why not state the target R directly, which is what banks and individuals are concerned about?
Further, the demand curve for bank reserves is stochastic, not deterministic, a crucial fact.
i.e. BKR = α - β*RATE + Error. Now errors or shifts in BKR at any given R will occur due to say
quarterly tax payment outflows on a certain day. Hence the demand curve for BKR shifts
randomly and hugely most of the time. Then the rate R corresponding to a Rs 50 crs increase in
BKR might end up at say 7.55% or 7.95% and not 8%. At the open market desk, the economic
outcomes of the two procedures are different, and much more so as the effects of the alternative
procedures cumulate across the wider economy.
Second factually: Let us evaluate the following passage from Mankiw:
Sec 18.1: Financial Innovation, Near Money and the Demise of the Monetary Aggregates.
“In Feb 1993, Fed Chairman Alan Greenspan announced that the Fed would pay less attention to the
monetary aggregates that it had in the past… Since then, the Fed has conducted policy by setting a target
for the federal funds rate….. It adjusts the target interest rate in response to changing economic
conditions.” Mankiw 6th edition pg 525
Mankiw suggests that after 1993 Fed moved to interest rate procedure: As a purely factual matter,
except during October 1979 to August 1982, the Fed Funds rate has generally been the instrument
or operating target from 1950 onwards. However, from Feb 1994 onwards, the Fed disclosed its
fed funds target rate. The disclosure was new, not the target rate. In late 1990s the Federal
Reserve Board in Washington D.C. even stopped publishing money supply data! Besides there are
several money supply measures, but just one policy rate. All Central Banks use the policy rate as
the operating target, pointing to the global invalidity of IS/LM. At quarterly or annual frequency
some money supply measure can and has been used as an intermediate target, but very rarely as
the overnight money market operating target.
To understand this issue further, look at the Chart below. It plots the fed funds rate under
different operating procedures. The only period when the Fed used Bank Reserves as its operating
target (Non Borrowed Reserves to be precise) during October 1979-August 1982 (as part of an
overall package to control inflation) the fed funds rate gyrated wildly – just as implied by our
preceding analysis of the result of huge shifts in the demand for bank reserves. The economy
could not function smoothly, and the Fed quickly abandoned it and slowly went back to an
interest rate target. (Borrowed Reserves targeting between 1983 to 1989 was a procedure in-
between strict reserves versus interest rate targeting). By 1990 Fed had effectively returned to
interest rate targeting, the procedure for most of its history, and other central banks did so too.
There are many more problems with the IS/LM framework, some we will discuss in Ch 9. Ohers
require going into financial economics. For the purposes of basic macro, all you need to know is
that the short-term interest rate is chosen by central bank, and so it cannot be determined by the
intersection of hypothetical IS & LM curves. Second the central bank changes this policy rate in
response to inflation etc as we shall see in Chap 9.
Various pitfalls of IS/LM are also dealt with in subsequent chapters 9, 11 and 17 of MIFA.
Chart from The Money Market by Marcia Stigum 3rd edn. Ch 9 The Most Watched Player: The Fed,
Short Rate, Long Rate and IS/LM: The puzzled and perceptive reader may ask if the IS/LM policy of QE
applies when the interest rate is zero, why does the IS/LM diagram show the two curves intersecting at a
positive rate? The answer to this question involves the short rate in the money market and the long rate in
the bond market, which we will explicitly deal with in Chap 13 MIFA, but not in basic macroeconomics.
The IS/LM model was meant to determine the long rate when the short rate is close to zero or zero. It has
been mistakenly applied in the postwar period to determine the short rate when it is adequately positive,
as in Mankiw’s discussion that we critiqued, and in other leading textbooks too. These books are oblivious
to the short rate long rate distinction and do not clearly specify as to whether the curves determine the
short rate or the long rate. A classic paper by Poole(1970) as to whether the money supply or interest rate
is a better instrument also does not make this distinction. When the short rate is zero, the distinction is
crucial. Although the IS/LM assumption that money supply is the instrument in this situation, it does not
properly explain what drives long rates. When the short rate is healthily positive, we can ignore the short -
llong rate distinction and work with one rate for basic macroeconomics. However the short rate is the
instrument when rates are healthily positive and so IS/LM assumption of money supply instrument doe s
not hold. This issue is also discussed in Chapter 13 Part B, MIFA linking growth to short and long rates.
Post Script: As a Federal Reserve policy maker, I must live in the real world. ..I can vote for changes in the
Federal Reserve System holding of government securities…As a President of a Federal Reserve Bank, can
recommend to our Board of Directors they should submit a change in our Bank’s discount rate. I cannot
recommend to the FOMC that the LM curve be shifted down. I can only recommend actions in terms of the
instruments at hand” Darryl R Francis, President, Federal Reserve Bank of St. Louis, 1972
Data Appendix for Section 8.4

Overall Liquidity Position (crores)
Outstanding as on Last Friday LAF MSS Centre’s Surplus@ Total
1 2 3 4 5=(2+3+4)
2010
January 88,290 7,737 54,111 1,50,138
February 47,430 7,737 33,834 89,001
March* 990 2,737 18,182 21,909
April 35,720 2,737 -28,868 9,589
May 6,215 317 -7,531 -999
June -74,795 317 76,431 1,953
July 1,775 0 16,688 18,463
August 11,815 0 20,054 31,869
September -30,250 0 65,477 35,227
October -1,17,660 0 86,459 -31,201
@ : Excludes minimum cash balances with the Reserve Bank in case of surplus.
* : Data pertain to March 31.
Note: 1. Negative sign in column 2 indicates injection of liquidity through LAF.
2. Negative sign in column 4 indicates WMA /OD availed by the central government.
Plus (+) denotes an injection via repo operations and minus ( − ) denotes a withdrawal via reverse
repo operations under the LAF or MSS schemes.
LAF refers to Liquidity Adjustment Facility. MSS refers to Market Stabilisation Scheme. WMA refers to
Ways and Means Advances. OD refers to overdraft facilities. The MSS is the scheme involving short term
securities introduced in April 2004 as an instrument of sterilization to partly offset impact forex operation
on total money supply. Under this scheme RBI issues bonds on behalf of the Government of India and the
money raised is impounded in a separate account with RBI i.e. money does not go to the Government.
Main Monetary Measures from RBI Official Statement (with effect from May 3rd 2011)
Main Changes Based on the Report of the Working Group on Operating Procedure of Monetary Policy
(i) The weighted average overnight call money rate will be the operating target of monetary policy.
(ii) There will henceforth be only one independently varying policy rate and that will be the repo rate. The
reverse repo rate will continue to be operative but it will be pegged at a fixed 100 basis points below the
repo rate. Hence, it will no longer be an independent rate.
(iv) A new Marginal Standing Facility (MSF) will be instituted from which banks can borrow overnight up to
one per cent of their respective NDTL. The MSF rate will be 100 basis points above the repo rate.
(v) As per the above scheme, the revised corridor will have a fixed width of 200 basis points. The repo rate
will be in the middle. The reverse repo rate will be 100 basis points below it and the MSF rate 100 basis
points above it.
Savings Bank Deposit Interest Rate
64. As indicated in the Second Quarter Review of Monetary Policy 2010-11, the discussion paper
delineating the pros and cons of deregulating the savings bank deposit interest rate was placed on the
Reserve Bank’s website on April 28, 2011 for feedback from the general public.
65. herefore, pending a final decision on the issue of deregulation of savings bank deposit interest rate, it
has been decided to : increase the savings bank deposit interest rate from the present 3.5 per cent to 4.0
per cent with immediate effect.
Fix Range LAF Rates
Effective Bank Repo Reverse Cash Marginal Statutory
Date Rate Reserve Standing Liquidity
Ratio Facility Ratio
22-05-2020 4.25 4.00 3.35 - 4.25 -
17-04-2020 - 4.40 3.75 - - -
11-04-2020 - - - - - 18.00
28-03-2020 - - - 3.00 - -
27-03-2020 4.65 4.40 4.00 - 4.65 -
04-01-2020 - - - - - 18.25
12-10-2019 - - - - - 18.50
04-10-2019 5.40 5.15 4.90 - 5.40 -
07-08-2019 5.65 5.40 5.15 - 5.65 -
06-07-2019 - - - - - 18.75
06-06-2019 6.00 5.75 5.50 - 6.00 -
13-04-2019 - - - - - 19.00
04-04-2019 6.25 6.00 5.75 - 6.25 -
07-02-2019 6.50 6.25 6.00 - 6.5 -
05-01-2019 - - - - - 19.25
01-08-2018 6.75 6.50 6.25 - 6.75 -
06-06-2018 6.50 6.25 6.00 - 6.50 -
14-10-2017 - - - - - 19.5
02-08-2017 6.25 6.00 5.75 - 6.25 -
24-06-2017 - - - - - 20.00
06-04-2017 6.50 - 6.00 - 6.50 -
07-01-2017 - - - - - 20.50
04-10-2016 6.75 6.25 5.75 - 6.75 -
01-10-2016 - - - - - 20.75
09-07-2016 - - - - - 21.00
05-04-2016 7.00 6.50 6.00 - 7.00 -
02-04-2016 - - - - - 21.25
29-09-2015 7.75 6.75 5.75 - 7.75 -
27-06-2015 - - - 4.00 - -
02-06-2015 8.25 7.25 6.25 - 8.25 -
04-03-2015 8.50 7.50 6.50 - 8.50 -
07-02-2015 - - - - - 21.50
15-01-2015 8.75 7.75 6.75 - 8.75 -
09-08-2014 - - - - - 22.00
14-06-2014 - - - - - 22.50
28-01-2014 9.00 8.00 7.00 - 9.00 -
29-10-2013 8.75 7.75 6.75 - 8.75 -
07-10-2013 9.00 - - - 9.00 -
20-09-2013 9.50 7.50 6.50 - 9.50 -
15-07-2013 10.25 - - - 10.25 -
03-05-2013 8.25 7.25 6.25 - 8.25 -
19-03-2013 8.50 7.50 6.50 - 8.50 -
09-02-2013 - - - 4.00 - -
29-01-2013 8.75 7.75 6.75 - 8.75 -
03-11-2012 - - - 4.25 - -
22-09-2012 - - - 4.50 - -
11-08-2012 - - - - - 23.00
17-04-2012 9.00 8.00 7.00 - 9.00 -
10-03-2012 - - - 4.75 - -
13-02-2012 9.50 - - - - -
28-01-2012 - - - 5.50 - -
25-10-2011 - 8.50 7.50 - 9.50 -
16-09-2011 - 8.25 7.25 - 9.25 -
26-07-2011 - 8.00 7.00 - 9.00 -
16-06-2011 - 7.50 6.50 - 8.50 -
03-05-2011 - 7.25 6.25 - 8.25 -
17-03-2011 - 6.75 5.75 - - -
25-01-2011 - 6.50 5.50 - - -
18-12-2010 - - - - - 24.00

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Chap8OpenMarketDesk/FINMAC2018 July 2008/2013/Oct2015/TwkSep20 Pg 1

CHAPTER 8: CENTRAL BANKS, POLICY RATES AND BANK RESERVES

TABLE 8.1.A VARIOUS U.S. INTEREST RATES

Federal funds (effective) Key Policy Rate 1.01 4.94 3.93

Non-financial Commercial Paper

CDs (secondary market)

Eurodollar deposits (London)

Bank Prime Loan 4.00 8.03 4.03

Discount Rate 2.00 5.53 3.53

US GSecs Treasury Bills (Secondary Market)

Treasury constant maturities

10-year 2.19 2.26 0.07

Interest rate swaps

Corporate bonds ( Moody’s seasoned)

State and local bonds 4.92 4.51 -0.41

Conventional mortgages 6.15 6.38 0.23

Source : U.S. Federal Reserve, Series G.15 etc.

TABLE 8.1.B INDIAN INTEREST RATES

Repo rate (key policy rate) 7.00 7.75 0.75

(TERM) DEPOSIT AND LENDING RATES

PRIME LENDING RATES

Savings bank account deposit rate 3.50 3.50 ----

Section 8.2 The Basics of Bond Pricing

Section 8.3 The Policy Rate and Open market Operations

Euro Area Rate on Main refinancing 3.00 100 50

Fig 8.1 Federal Funds Target Rate

Fig 8.2 Federal Funds Target and Effective Rate

8.4.1 Targeting Interest Rate versus Targeting Reserves

Fig 8.3.2 The Alternatives: Bank Reserves or Interest Rate Target?

Reversible versus Outright Transactions

Section 8.4 The Policy Rates in India

Indian’s Policy Interest Rates and Corresponding Changes in Reserves

Reverse Repo Rate

Chapter 8: PART B Critiques of IS/LM

Data Appendix for Section 8.4

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