CHAPTER 10

Conduct of
Monetary
Policy: Tools,
Goals, Strategy,
and Tactics
 Chapter Preview
Monetary policy refers to the management of the money
supply. Monetary policy is the process by which the
government, central bank, or monetary authority of a country
controls (i) the supply of money, (ii) availability of money,
and (iii) cost of money or rate of interest to attain a set of
objectives oriented towards the growth and stability of the
economy.
Although the idea is simple enough, the theories guiding the
Federal Reserve are complex and often controversial. But,
we are affected by this policy, and a basic understanding of
how it works is, therefore, important.

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 Chapter Preview
We examine how the conduct of monetary policy
affects the money supply and interest rates. We
focus primarily on the tools and the goals of the
U.S. Federal Reserve System, and examine its
historical success. Topics include:
The Federal Reserves Balance Sheet
The Market for Reserves and the Federal Funds
Rate

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 Chapter Preview (cont.)
Tools of Monetary Policy
Discount Policy
Reserve Requirements
Monetary Policy Tools of the ECB
The Price Stability Goal and the Nominal Anchor
Other Goals of Monetary Policy

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 Chapter Preview (cont.)
Should Price Stability be the Primary Goal of
Monetary Policy?
Inflation Targeting
Central Banks Responses to Asset-Price
Bubbles: Lessons from the 20072009
Financial Crisis
Tactics: Choosing the Policy Instrument

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 Monetary Policy
Monetary policy is the process by which the monetary authority of a country
controls the supply of money, often targeting a rate of interest for the purpose of
promoting economic growth and stability. The official goals usually include
relatively stable prices and low unemployment.
Monetary policy is referred to as either being expansionary or contractionary,
where an expansionary policy increases the total supply of money in the
economy more rapidly than usual, and contractionary policy expands the money
supply more slowly than usual or even shrinks it. Expansionary policy is
traditionally used to try to combat unemployment in a recession by lowering
interest rates in the hope that easy credit will entice businesses into expanding.
Contractionary policy is intended to slow inflation in order to avoid the resulting
distortions and deterioration of asset values.
Monetary policy differs from fiscal policy, which refers to taxation, government
spending and associated borrowing.

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 Monetary Policy
Therefore, monetary decisions today take into account a wider range of factors,
such as:
short term interest rates;
long term interest rates;
velocity of money through the economy;
Exchange Rate
Credit Quality;
Bonds and Equities (corporate ownership and debt);
government versus private sector spending/savings;
international capital flows of money on large scales;
financial derivatives such as options, swaps, future contracts, etc

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 Monetary Policy
Monetary Policy: Target Market Variable: Long Term Objective:
Interest rate on overnight A given rate of change in
Inflation Targeting
debt the CPI
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money A given rate of change in
Monetary Aggregates
supply the CPI
The spot price of the The spot price of the
Fixed Exchange Rate
currency currency
Low inflation as measured
Gold Standard The spot price of gold
by the gold price
Usually unemployment +
Mixed Policy Usually interest rates
CPI change

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 The Federal Reserves
Balance Sheet
The conduct of monetary policy by the Federal
Reserve involves actions that affect its balance sheet.
This is a simplified version of its balance sheet, which
we will use to illustrate the effects of Fed actions.

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 The Federal Reserves
Balance Sheet: Liabilities
The monetary liabilities of the Fed include:
Currency in circulation: the physical currency in the hands of the
public, which is accepted as a medium of exchange worldwide.
Currency in circulation can be thought of as "currency in hand",
meaning that it is used to buy goods and services. Central banks
pay attention to the amount of physical currency in circulation
because it is present in the most liquid asset class. The more
money that comes out of circulation and into longer-term
investments, the less money is available to fund shorter-term
consumption - a major component of GDP.

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 The Federal Reserves
Balance Sheet: Liabilities
The monetary liabilities of the Fed include:
Reserves: In Financial Accounting, the term reserve is most commonly used to
describe any part of shareholders equity, except for basic share capital. In nonprofit
accounting, an "operating reserve" is commonly used to refer to unrestricted cash on
hand availabto sustain an organization, and nonprofit boards usually specify a target of
maintaining several months of operating cash or a percentage of their annual income,
called an Operating Reserve Ratio.
Sometimes, reserve is used in the sense of the term provision; such a use, however, is
inconsistent with the terminology suggested by International Accounting Standard. For
more information about provisions, see provision .All banks maintain deposits with the
Fed, known as reserves. The required reserve ratio, set by the Fed, determines the
required reserves that a bank must maintain with the Fed. Any reserves deposited with
the Fed beyond this amount are excess reserves. The Fed does not pay interest on
reserves, but that may change because of legislative changes for 2011.

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 The Federal Reserves
Balance Sheet: Liabilities
The monetary liabilities of the Fed include:
Reserves: There are different types of reserves used in financial accounting like capital
reserves, revenue reserves, statutory reserves, realized reserves, unrealized reserves.
Equity reserves are created from several possible sources:
Reserves created from shareholders' contributions, the most common examples of which are:
legal reserve fund - it is required in many legislations and it must be paid as a percentage of share capital
Share Premium- amount paid by shareholders for shares in excess of their nominal value
Reserves created from profit, especially retained earnings, i.e. accumulated accounting profits, or in the case of nonprofits,
operating surpluses. However, profits may be distributed also to other types of reserves, for example:
legal reserve fund from profit - many legislations require creation of the fund as a percentage of profits
remuneration reserve - will be used later to pay bonuses to employees or management.
translation reserve - arises during consolidation of entities with different reporting currencies
Reserve is the profit achieved by a company where a certain amount of it is put back into the business which can help the
business in their rainy days.

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 The Federal Reserves
Balance Sheet: Liabilities
The monetary liabilities of the Fed include:
Reserves: 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
company. An increase in reserves lead to increase in level of deposits and hence in
money supply.
Total Reserves can be divided into two categories:
Required Reserves: That FED requires bank to hold
Excess Reserves: Any Additional Reserves the bank choose to hold
Required Reserve Ratio: FED require that for every dollar of deposits at a depository
institution, a certain fraction must be held as reserves and this is known as required
reserve ratio.

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 The Federal Reserves
Balance Sheet: Assets
The monetary assets of the Fed include:
Government Securities: Government securities promise
repayment of principal upon maturity as well as coupon or interest
payments periodically. Examples of government securities include
savings bonds, treasury bills and notes. Government securities are
usually used to raise funds that pay for the government's various
expenses, including those related to infrastructure development projects.
Because they are low risk, the return on the securities is generally low.
These are the U.S. Treasury bills and bonds that the Federal Reserve
has purchased in the open market. As we will show, purchasing Treasury
securities increases the money supply.

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 The Federal Reserves
Balance Sheet: Assets
The monetary assets of the Fed include:
Discount Loans: A discount loan is a loan arrangement where the
interest and any other related charges are calculated at the time the loan
is granted. At the same time, the total of the interest and other charges
are subtracted from the face amount of the discounted loan. Instead of
receiving the face value of the loan, the borrower receives the reduced
amount, but is still responsible for repaying the full face value of the loan.
These are loans made to member banks at the current discount rate.
Again, an increase in discount loans will also increase the money supply.
Discount loans are normally written as short-term loans. The idea is that
the borrower needs resources quickly to cover expenses in the near
future, and will be able to repay the face value of the loan within a period
of anywhere between three months to one calendar year.

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 Open Market Operations
The central bank's purchase or sale of bonds in the open market are the most
important monetary policy tool because they are the primary determinant
changes in reserves in the banking system and interest rate.
open market operation (also known as OMO) is an activity by a central bank
to buy or sell government bonds on the open market. A central bank uses
them as the primary means of implementing monetary policy. The usual aim of
open market operations is to manipulate the short term interest rate and the
supply of base money in an economy, and thus indirectly control the total
money supply, in effect expanding money or contracting the money supply.
This involves meeting the demand of base money at the target interest rate by
buying and selling government securities, or other financial instruments.
Monetary targets, such as inflation, interest rates, or exchange rates, are used
to guide this implementation

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 Open Market Operations
Open market operations, or OMOs, are the Federal Reserve's most
flexible and frequently used means of implementing U.S. monetary
policy.
Since most money now exists in the form of electronic records rather than in the form of
paper, open market operations are conducted simply by electronically increasing or
decreasing (crediting or debiting) the amount of base money that a bank has in its
reserve account at the central bank. Thus, the process does not literally require new
currency. However, this will increase the central bank's requirement to print currency
when the member bank demands banknotes, in exchange for a decrease in its
electronic balance.
The process works because the central bank has the authority to bring money in and
out of existence. They are the only point in the whole system with the unlimited ability to
produce money. Another organization may be able to influence the open market for a
period time, but the central bank will always be able to overpower their influence with an
infinite supply of money

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 Open Market Operations
In the next two slides, we will examine the impact
of open market operation on the Feds balance
sheet and on the money supply. As suggested in
the last slide, we will show the following:
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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 The Federal Reserve
Balance Sheet
Open Market Purchase from Public

Result R $100, MB $100

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 The Federal Reserve
Balance Sheet
Discount Lending
Banking System The Fed
Assets Liabilities Assets Liabilities
Reserves Discount loans Discount loans Reserves
+$100 +$100 +$100 +$100

Result R $100, MB $100

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 Discount Lending
Discount Lending:
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. When a bank repays its discount loan and so reduces the total amount of
discount lending, the amount of reserves decreases along with the monetary
base and the money supply.

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 Open Market Operations
An open market purchase leads to an expansion of reserves and deposits in the
banking system and hence to an expansion of the monetary base and the money
supply.
When a central bank conducts an open market sale, the public pays for the
bonds by writing a check that causes deposits and reserves in the banking
system to fall.
An open market sale leads to a contraction of reserves and deposits in the
banking system and hence to a decline in the monetary base and the money
supply.

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 Supply and Demand in the
Market for Reserves
We now have some understanding of the effect of
open market operations and discount lending on
the Feds balance sheet and available reserves.
Next, we will examine how this change in reserves
affects the federal funds rate, the rate banks charge
each other for overnight loans. Further, we will
examine a third tool available to the Fedthe ability
to set the required reserve ratio for deposits held by
banks.

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 Demand and Supply in the
Market for Reserves
The analysis of the market for reserves proceeds in a similar fashion to
the analysis of the bond market.
A demand and supply curve for reserves is derived, then the market
equilibrium in which the quantity of reserves demanded equals the
quantity of reserves supplied determines the federal fund rate the
interest rate charged on the loans of these reserves.

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 Demand and Supply in the
Market for Reserves
Demand Curve:
To derive the demand curve for reserves, it is required to know the
quantity of reserves demanded, holding everything else constant as the
federal funds rate changes.
Reserves can be split into two components:
Required Reserves: which equals the required reserve ratio times the
amount of deposits on which reserves are required.
Excess Reserves: The additional reserves banks choose to hold.
The quantity of reserves demanded equals required reserves plus the
quantity of excess reserves demanded.

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 Supply and Demand in the
Market for Reserves
1. Demand curve
slopes down
because iff ,
ER and Rd
up
2. Supply curve
slopes down
because iff ,
DL , Rs
3. Equilibrium iff
where Rs = Rd

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As the federal funds rate begins to rise above the discount rate, the
banks would want to keep borrowing more and more at interest rate and
the lending out the proceeds in the federal fund market at the higher rate
and as the result the supply curve becomes flat (infinitely elastic).

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 Response to Open Market Operations:
Case 1downward sloping demand

1. Open market
purchase shifts
supply curve to the
right (NBR1 to
NBR2).
2. Rs shifts down, fed
funds rate falls.
3. Reverse for sale.

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 Response to Open Market
Operations: Case 2flat demand
1. Open market
purchase shifts
supply curve to the
right (NBR1 to
NBR2).
2. Rs parallel, fed
funds rate
unchanged.
3. Reverse for sale.

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The effect of an open market operations depends on whether the supply
curve initially intersects the demand curve in its downward sloped
section versus its flat section.
An open market purchases leads to a greater quantity of reserves
supplied, this is true at any given federal funds rate because of higher
amount of nonborrowed reserves.
The conclusion is that an open market purchase causes the federal
funds rate to fall, whereas an open market sale causes the federla fund
to rise.
In case if supply curve initially intersects the demand curve on its flat
section, open market operations have no effect on the federal funds rate.

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 Response to Change in Discount
Rate: Case 1no intersection
1. The Fed lowers id,
and does not cross
the demand curve
2. Rs shifts down
3. iff is unchanged

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 Response to Change in Discount
Rate: Case 2demand intersected
1. The Fed lowers id,
and does cross the
demand curve
2. Rs shifts down
3. iff falls

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 Supply and Demand in the
Market for Reserves
RR , Rd
shifts to
right, iff

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 Market Equilibrium

Market equilibrium occurs where the quantity of reserves

demanded equals the quantity supplied, Rs=Rd. Equilibrium
therefore occurs at the intersection of the demand curve Rd
and the supply curve Rs at point 1 with an equilibrium
federal fund rate. When the federal fund rate is above the
equilibrium rate, there are more reserves supplied than
demanded (excess supply).
When the federal funds rate is below the equilibrium rate
there are more reserves demanded than supplied (excess
demand)

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 How Changes in the Tools of Monetary
Policy Affect the Federal Funds Rate

How changes in the three tools of monetary policy_open

market operations, discount lending and reserve
requirements affect the market for reserves and the
equilibrium federal fund rate. The first two tools open market
operations and discount lending affect the federal funds rate
by changing the supply of reserves while the third tool
reserve requirements affects the federal fund rate by
changing the demand for reserves.

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 CASE: How Operating Procedures
Limit Fluctuations in Fed Funds Rate

An advantage of current operating

procedures. Any changes in the demand for
reserves will not affect the fend funds rate
because borrowed reserves will increase to
match the demand increase. This is true
whether the demand increases, or decreased,
as seen in Figure 10.5 (next slide).

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 CASE: How Operating Procedures
Limit Fluctuations in Fed Funds Rate

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 Tools of Monetary Policy

Now that we have seen and understand the

tools of monetary policy, we will further
examine each of the tools in turn to see how
the Fed uses them in practice and how
useful each tools is.

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 Tools of Monetary Policy:
Open Market Operations
Open Market Operations
1. Dynamic: Strategies in open market operations that are
implemented to increase or decrease the level of funds available
in the economy
Meant to change Reserves
2. Defensive: Strategies used in open market operations in order to
offset other anticipated market conditions that would probably
affect the level of funds in the economy. For example, if a foreign
country is expected to sell its US treasury securities holding in
exchange for US dollars, the Federal Reserve may decide to buy
treasury securities in advance in order to maintain the same level
of US dollars.

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 Tools of Monetary Policy:
Open Market Operations
Advantages of Open Market Operations
1. Fed has complete control
2. Flexible and precise
3. Easily reversed
4. Implemented quickly

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 Disadvantages of OMO
This method is adopted by the central bank to expand or contrast credit money in the
market. Under this method the bank either sells or purchases government securities to
control credit. When it wants to expand credit it starts purchasing government securities
with the result that more money is pumped into the market. This money in return, is
deposited with the commercial banks which become more competent to grant a greater
amount of loans thereby expanding credit in the market.

On the other hand when the central bank wants to contrast credit it starts selling the
government securities owing to which market money goes to the central bank with the
result that money in the market is reduced. The deposits of commercial banks go down,
weakening their power to lend.

This method will work when the following conditions are fulfilled.
1. The method should affect the reserves of commercial banks. They should contract or
expand as a result of Open Market Operations (OMO). The method would fail if the bank
reserves remain unaffected.

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 Disadvantages of OMO
2. Demand for bank loans should increase or decrease in line with the increase or
decrease in the bank cash reserves and rate of interest.

3. Circulation of bank credit should remain unchanged.

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 Chapter Summary
The Federal Reserves Balance Sheet: the Feds
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.
Tools of Monetary Policy: the Fed can use open
market operations, discount loans, and reserve
ratios to enact Fed directives.

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 Chapter Summary
In conclusion, even though the Fed has three tools of monetary policy, the one
that is used the most is open market operations. The other tools are only used
on very rare occasions. The role of the Fed in the banking system and in our
economy is a very important one. They formulate and execute monetary
policy, supervise depository institutions, provide an elastic currency, assist the
federal governments finance operations, and serve as the banker of the
United States government. They remain to this day independent of our
nation's government which makes them less susceptible to bribery. All in all,
they form an excellent system that protects our nation's economy and banks.
They do most of this by using open market operations which is the tool that
works the fastest. It will remain the most important tool until a more efficient
way one is discovered.

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