Fmi - Part 4 - Chap 10 - Conduct of Monetary Policy

Financial Markets and Institutions
Ninth Edition, Global Edition
Chapter 10
Conduct of Monetary Policy:
Tools, Goals, Strategy, and
Tactics
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Chapter Preview
“Monetary policy” refers to the management of the money
supply. The theories guiding the Federal Reserve are
complex and often controversial. We are affected by this
policy, and a basic understanding of how it works is,
therefore, important.

Chapter Preview
• How Fed Actions Affect Reserves in the Banking
System
• The Market for Reserves and the Federal Funds
Rate
• Conventional Monetary Policy Tools
• Other Goals of Monetary Policy
• Should Price Stability be the Primary Goal of
Monetary Policy?
• Inflation Targeting
The Primary Function of the Central Bank
• To control money supply
• The goal is to achieve price level stability (Inflation),
full employment & maximum sustainable long term
growth of the economy
• The three monetary policy tools are?????
(OMOs, DR & CRR)

Four Players
in the Money Supply Process
1. Central bank: the Fed
2. Banks
3. Depositors
4. Borrowers from banks

Key Components of the Central Bank’s Balance
Sheet (Assets side)
1. Securities: these are the Fed’s holding of treasury

securities traded in open market operations OMO.
2. Discount Loans: loans by Fed to banks.
3. Other Assets: includes deposits and bonds
denominated in foreign currencies. Also includes
physical fixed assets.

Key Components of the Central Bank’s Balance
Sheet (Liabilities side)
7
1. Fed notes outstanding: notes in the hands of the

public. These notes are IOUs from Fed to the bearer.
2. Reserves: all banks have an account at the Fed in
which they hold deposits. Reserves are assets for the
banks but liabilities for the Fed. They include required
reserves and excess reserves.
3. Treasury deposits: the bank treasury keeps deposits
at the Fed against which is conducts RTGS (Real Time
Gross Settlement).
4. Foreign deposits: deposits kept in Fed by foreign
companies/government.
LIABILITIES
• The two liabilities on the balance sheet, currency in
circulation and reserves, are often referred to as the
monetary liabilities of the Fed.
• They are an important part of the money supply story
because increases in either or both will lead to an
increase in the money supply (everything else being
constant).
• The sum of the Fed’s monetary liabilities (currency in
circulation and reserves) and the U.S. Treasury’s
monetary liabilities (Treasury currency in circulation,
primarily coins) is called the monetary base
The Fed’s Balance Sheet
Federal Reserve System
Assets Liabilities
Government securities Currency in circulation

Discount loans Reserves
Monetary Base, MB = C + R
15-9
The Key Economic Indicator-GDP
10
• Gross Domestic Product: The value of goods &

services actually produced using factors of
production owned by citizens of a country
GDP = C + I + G + X

MV = GDP
M: Money Supply
V: Velocity (average number of times per each unit currency
is used to buy goods/services)
M = $ 1,861 billion
GDP = $ 14,870 billion
V = GDP/M = 14,870 / 1,861 =
7.99/Year
Quantity Theory of Money
13
States that an increase in money supply will

cause a proportional increase in prices.
Equation of exchange
MV = PY
M - Money supply
V – Velocity (average number of times per each unit
currency is used to buy goods/services)
P - Price level
Y - Real Output
Effects of increase in money supply
• One or more of
– rise in real output
– rise in prices
– fall in velocity of circulation

Quantity theory of money
MV = PY
• Y fixed -- economy at full employment
• V fixed
• If Money Circulation (M) goes up, then Price level
(P) has to go up as well.

Portfolio effects
• Increase in money supply causes people to attempt
to invest in more stocks and bonds.
• This raises share prices and bond prices
• Firms are better able to raise money on stock
market and carry out new investment projects

How Fed Actions Affect Reserves
in the Banking System
• The monetary policy seeks to influence either the demand
for, or supply of, excess reserves at DI and in turn the
money supply and the level of interest rates.
• Specifically, a change in excess reserves resulting from the
implementation of monetary policy triggers a sequence of
events that affect such economic factors as
– short-term interest rates,
– long-term interest rates,
– foreign exchange rates,
– the amount of money and credit in the economy, and
– ultimately the levels of employment, output, and prices.
All banks have an account at the Fed in which they
hold deposits. Reserves consist of deposits at the
Fed plus currency that is physically held by banks.
Reserves are divided into two categories:
• Required reserves
• Excess reserves
• The Fed sets the required reserve ratio – the
portion of deposits banks must hold in cash. Any
reserves deposited with the Fed beyond this
amount are excess reserves.

• Depository institutions trade excess reserves held
at their local Federal Reserve Banks among
themselves.
• Banks with excess reserves—whose reserves
exceed their required reserves—have an incentive
to lend these funds (generally overnight) to banks
in need of reserves since excess reserves held in
the vault or on deposit at the Federal Reserve
earn little or no interest.
•The Fed injects reserves into the banking system
in two ways:
• Open market operations
• Loans to banks, referred to as discount loans.
Open Market Operations
• Open market operations are particularly important because
they are the primary determinant of changes in bank
excess reserves in the banking system and thus directly
impact the size of the money supply and/or the level of
interest rates (e.g., the fed funds rate)
• We will discuss:
– Purchase of bonds increases the money supply
– Making discount loans increases the money supply
• Naturally, the Fed can decrease the money supply by
reversing these transactions.

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Addison-Wesley.
All rights reserved
Control of the Monetary Base
Open Market Purchase from Bank
The Banking System The Fed
Assets Liabilities Assets Liabilities
Securities – $100 Securities + $100 Reserves + $100
Reserves + $100
Open Market Purchase from Public
Public The Fed
Securities – $100 Securities + $100 Reserves + $100
Deposits + $100
Banking System
Assets Liabilities
Reserves Checkable Deposits
+ $100 + $100
Result: R  $100, MB  $100
15-22
The Federal Reserve Balance Sheet (1 of 2)
• Open Market Purchase from Primary Dealer
Banking System Blank The Fed Blank

Securities Blank
–$100 m Blank Securities Reserves
Reserves Blank
+$100 m +$100 m
+$100 m Blank
• Result R ↑ $100, MB $100

The Federal Reserve Balance Sheet (2 of 2)
• DISCOUNT LENDING
Banking System The Fed
Blank Blank
Reserves Loans Discount loans Reserves

+$100 m +$100 m +$100 m +$100 m
• ResultR ↑ $100, MB $100

DISCOUNT LENDING
• ResultR ↑ $100, MB $100

• a discount loan leads to an expansion of reserves,
which can be lent out as deposits, thereby leading to
an expansion of the monetary base and the money
supply.
RESERVE REQUIREMENTS
• In addition, there is a third tool, reserve
requirements, the regulations making it obligatory
for depository institutions to keep a certain fraction
of their deposits as reserves with the Fed.
• We will also analyze how reserve requirements
affect the market for reserves and thereby affect
the federal funds rate.
• CRR and SLR

The Market for Reserves and the Federal
Funds Rate
•We will now examine how this change in reserves
affects the federal funds rate, the rate banks charge
each other for overnight loans.
•The federal funds rate is particularly important in

the conduct of monetary policy because it is the
interest rate that the Fed tries to influence directly.
Thus, it is indicative of the Fed’s stance on
monetary policy.

Demand and Supply in the Market
for Reserves
• Demand Curve To derive the demand curve for
reserves, we need to ask what happens to the quantity
of reserves demanded, holding everything else
constant, as the federal funds rate changes.
• Therefore, the Q of Rd equals RR + the Q of ERd.
Excess reserves are insurance against deposit outflows,
and the cost of holding these excess reserves is their
opportunity cost, the interest rate that could have been
earned on lending these reserves out, minus the interest
rate that is earned on these reserves, ier (if any)

Figure 10.1 Equilibrium in the Market for
Reserves

The supply of reserves
• Two components:
– the amount of reserves that are supplied by the Fed’s open market
operations, called nonborrowed reserves (NBR), and
– the amount of reserves borrowed from the Fed, called borrowed
reserves (BR).
• The primary cost of borrowing from the Fed is the interest
rate the Fed charges on these loans, the discount rate (id).
• Because borrowing federal funds from other banks is a
substitute for borrowing (taking out discount loans) from the
Fed, if the federal funds rate iff is below the discount rate id,
then banks will not borrow from the Fed and borrowed
reserves will be zero because borrowing in the federal funds
market is cheaper
Figure 10.1 Equilibrium in the Market for
Reserves

Figure 10.2 Response to Open Market Operations

Figure 10.3 Response to Change in Discount Rate

Figure 10.4 Response to Change in Required Reserves

Figure 10.5 Response to Change in Discount Rate

Figure 10.6 How Operating Procedures Limit Fluctuations in
Fed Funds Rate

Conventional Monetary Policy Tools
We further examine each of the tools in turn to see how the
Fed uses them in practice and how useful each tools is.

Tools of Monetary Policy: Open Market
Operations
• Open Market Operations
1. Dynamic: Change reserves and monetary base
2. Defensive: Offset factors affecting reserves
and the MB, typically uses repos
• The Fed conducts open market operations
in U.S. Treasury and government agency
securities, especially U.S. Treasury bills.
– market for these securities is the most liquid
– largest trading volume.
Advantages of Open Market Operations
1.Fed has complete control

2.Flexible and precise
3.Easily reversed
4.Implemented quickly

Inside the Fed
• The trading desk typically uses two types of transactions to
implement their strategy:
– Repurchase agreements: the Fed purchases
securities, but agrees to sell them back within about 15
days. So, the desired effect is reversed when the Fed
sells the securities back—good for taking defense
strategies that will reverse.
– Matched sale-purchase transaction: essentially a
reverse repo, where the Fed sells securities, but
agrees to buy them back.

Tools of Monetary Policy: Discount Rates
• The rate of interest Federal Reserve Banks charge on
loans to financial institutions in their district.
• The Fed can influence the level and price of reserves by
changing the discount rate it charges on these loans.
• Acts as a signal to the market/ economy that the Fed
would like to see higher/ lower rates in the economy.
• signal of the FOMC’s intentions regarding the tenor of
monetary policy. Eg., raising the discount rate signals that
the Fed would like to see a tightening of monetary
conditions and higher interest rates in general (and a
relatively lower amount of borrowing). Lowering the
discount rate signals a desire to see more expansionary
monetary conditions and lower interest rates in general.
Tools of Monetary Policy: Discount Policy
• The Fed’s discount loans, through the discount window,
are:
– Primary Credit: Healthy banks borrow as they wish
from the primary credit facility or standing lending
facility.
– Secondary Credit: Given to troubled banks
experiencing liquidity problems.
– Seasonal Credit: Designed for small, regional banks
that have seasonal patterns of deposits.

Tools of Monetary Policy: Reserve
Requirements
Reserve Requirements are requirements put on financial
institutions to hold liquid (vault) cash again checkable deposits.
• Rarely used as a tool
– Raising causes liquidity problems for banks
– Makes liquidity management unnecessarily difficult
• A decrease in the RR means that DI may hold fewer
reserves (vault cash plus reserve deposits at the Fed)
against their transaction accounts (deposits).
• Consequently, they are able to lend out a greater
percentage of their deposits, thus increasing credit
availability in the economy.
Tools of Monetary Policy: Reserve
Requirements
• As new loans finance consumption and investment
expenditures, some of these funds spent will return to depository
institutions as new deposits by those receiving them in return for
supplying consumer and investment goods to bank borrowers.
• In turn, these new deposits, after deducting the appropriate
reserve requirement, can be used by banks to create additional
loans, and so on.
• This process continues until the banks’ deposits have grown
sufficiently large such that banks willingly hold their current
reserve balances at the new lower reserve ratio. Thus, a
decrease in the reserve requirement results in a multiplier
increase in the supply of bank deposits and thus the money
supply
The multiplier effect can be written as
follows:
•Conversely, an increase in the reserve requirement ratio

means that DI must hold more reserves against the transaction
accounts (deposits) on their balance sheet. Consequently, they
are able to lend out a smaller percentage of their deposits than
before, thus decreasing credit availability and lending, and
eventually, leading to a multiple contraction in deposits and a
decrease in the money supply. Now the multiplier effect is
•written as:

Monetary Policy Tools of the European
Central Bank
ECB policy signals by
• setting a target financing rate,
• which establishes the overnight cash rate.
The EBC has tools to implement its intended policy:
(1) open market operations,
(2) lending to banks, and
(3) reserve requirements.

ECB Open Market Operations
• Like the Fed, open market operations are the
primary tool to implement the policy.
• The ECB primarily uses main refinancing
operations (like repos) via a bid system from its
credit institutions.
• Operations are decentralized—carried out by each
nation’s central bank.
• Also engage in long-term refinancing
operations, but not really to implement policy.

ECB Lending to Banks
• Like the Fed, the ECB lends to its member
banks via its marginal lending facility.
• Banks can borrow at the marginal lending
rate, which is 100 basis points above the
target lending rate.
• Also has the deposit facility. This provides
a floor for the overnight market interest rate.

ECB Interest on Reserves
• Like the Fed, ECB has a deposit facility,
where banks can store excess cash and
earn interest.
• Unlike the Federal Reserve, the European
Central Bank pays interest on reserves.
Consequently, the banks’ cost of complying
with reserve requirements is low.

Price Stability Goal & the Nominal Anchor
(1 of 3)
Policymakers have come to recognize the social

and economic costs of inflation.
• Price stability, therefore, has become a primary
focus.
• High inflation seems to create uncertainty,
hampering economic growth.
• Indeed, hyperinflation has proven damaging to
countries experiencing it.

(2 of 3)
• Because price stability is so crucial to the long-run

health of an economy, a central element in successful
monetary policy is the use of a nominal anchor,
– a nominal variable such as the inflation rate or the money
supply, which ties down the price level to achieve price
stability
• Policymakers must establish a nominal anchor which
defines price stability. For example, “maintaining an
inflation rate between 2% and 4%” might be an anchor.
• An anchor also helps avoid the time-inconsistency
problem.
(3 of 3)
• The time-inconsistency problem is the idea that

day-by-day policy decisions lead to poor long-run
outcomes.
– Policymakers are tempted in the short-run to
pursue expansionary policies to boost output.
However, just the opposite usually happens.
– Central banks will have better inflation control
by avoiding surprise expansionary policies.
– A nominal anchor acts like a behavior rule,
helps avoid short-run decisions.
Other Goals of Monetary Policy
• Goals
1. High employment
 Want demand = supply, or natural rate of
unemployment
2. Economic growth (natural rate of output)
3. Stability of financial markets
4. Interest-rate stability
5. Foreign exchange market stability
• Goals often in conflict

Should Price Stability be the Primary
Goal? (1 of 4)
• Price stability is not inconsistent with the
other goals in the long-run.
• However, there are short-run trade-offs.
• In the short run price stability often conflicts
with the goals of high employment and
interest-rate stability.
• An increase in interest rates will help
prevent inflation, but increases
unemployment in the short-run.
Goal? (2 of 4)
• The ECB uses a hierarchical mandate,
placing the goal of price stability above all
other goals.
• The Fed uses a dual mandate, where
“maximizing employment, stable prices, and
moderate long-term interest rates” are all
given equal importance.

Goal? (3 of 4)
Which is better?
• Both hierarchical and dual mandates achieve the natural
rate of unemployment. However, usually more complicated
in practice.
• Also, short-run inflation may be needed to maintain
economic output. So, long-run inflation control should be
the focus.

Goal? (4 of 4)
Which is better?
• Dual mandate can lead to increased employment and
output, but also increases long-run inflation.
• Hierarchical mandate can lead to over-emphasis on
inflation alone - even in the short-run.
• Answer? It depends. Both help the central bank focus on
long-run price stability.

Inflation Targeting (1 of 2)
Inflation targeting involves:
1. Announcing a medium-term inflation target
2. Commitment to monetary policy to achieve the target
3. Inclusion of many variables to make monetary policy
decisions
4. Increasing transparency through public communication of
objectives
5. Increasing accountability for missed targets

Inflation Targeting: Pros and Cons (1 of 3)
• Advantages
– Easily understood by the public
– Helps avoid the time-inconsistency problem since
public can hold central bank accountable to a clear
goal
– Forces policymakers to communicate goals and
discuss progress regularly
– Performance has been good!

• Disadvantages
– Signal of progress is delayed
 Affects of policy may not be realized for several
quarters.
– Policy tends to promote too much rigidity
 Limits policymakers ability to react to unforeseen
events
 Usually “flexible targeting” is implemented, focusing
on several key variables and targets modified as
needed

• Disadvantages
– Potential for increasing output fluctuations
 May lead to a tight policy to check inflation at the
expense of output, although policymakers usually
pay attention to output
– Usually accompanied by low economic growth
 Probably true when getting inflation under control
 However, economy rebounds

Chapter Summary (1 of 5)
• How Fed Actions Affect Reserves in the Banking System:
the Fed’s actions change both its balance sheet and the
money supply. Open market operations and discount loans
were examined.
• The Market for Reserves and the Federal Funds Rate:
supply and demand analysis shows how Fed actions affect
market rates.
• Conventional Monetary Policy Tools: the Fed can use open
market operations, discount loans, and reserve ratios to
enact Fed directives.

• Nonconventional Monetary Policy Tools and Quantitative
Easing: Tools the Fed used to battle the effects of the
global financial crisis.
• Monetary Policy Tools of the ECB: The ECB vs. the Fed on
monetary policy, tools, and targets.

• The Price Stability Goal and the Nominal Anchor: stable
inflation has become the primarily goal of central banks,
but this has pros and cons.
• Other Goals of Monetary Policy: such as employment,
growth, and stability, need to be considered along with
inflation.

• Should Price Stability be the Primary Goal of Monetary
Policy?: We outlined conditions when this goal is both
consistent and inconsistent with other monetary goals.
• Inflation Targeting: This policy has advantages: clear,
easily understood, and keeps central bankers accountable.
But is this at the cost of growth and employment?

• Should Central Banks Respond to Asset Price Bubbles? In
the case of credit-driven bubbles, the answer appears to
be yes! But the right tool is not obvious.

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Financial Markets and Institutions

Ninth Edition, Global Edition

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

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1. Securities: these are the Fed’s holding of treasury

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1. Fed notes outstanding: notes in the hands of the

Government securities Currency in circulation

• Gross Domestic Product: The value of goods &

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States that an increase in money supply will

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• Result R ↑ $100, MB $100

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Reserves Loans Discount loans Reserves

• ResultR ↑ $100, MB $100

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• ResultR ↑ $100, MB $100

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•The federal funds rate is particularly important in

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1.Fed has complete control

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•Conversely, an increase in the reserve requirement ratio

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Policymakers have come to recognize the social

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• Because price stability is so crucial to the long-run

• The time-inconsistency problem is the idea that

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