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Chapter 15

Tools of Monetary Policy

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Preview

This chapter examines the tools used by the Federal Reserve System to control the money supply and interest rates

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Learning Objectives

Illustrate the market for reserves and demonstrate how changes in monetary policy can affect the federal funds rate.

Summarize how conventional monetary policy tools are implemented and the advantages and limitations of each tool.

Explain the key monetary policy tools that are used when conventional policy is no longer effective.

Identify the distinctions and similarities between the monetary policy tools of the Federal Reserve and those of the European Central Bank.

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The Market For Reserves and the Federal Funds Rate

Demand and Supply in the Market for Reserves determines the federal funds rate.

Interest rate on overnight loans of reserves from one bank to another)

What happens to the quantity of reserves demanded by banks, holding everything else constant, as the federal funds rate changes?

Total Reserve= Excess reserves + Required Reserve

Excess reserves are insurance against deposit outflows

The cost of holding these is the interest rate that could have been earned minus the interest rate that is paid on these reserves, ior

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Demand in the Market for Reserves

Since the fall of 2008 the Fed has paid interest on reserves at a level that is set at a fixed amount below the federal funds rate target.

When the federal funds rate is above the rate paid on excess reserves, ior, as the federal funds rate decreases, the opportunity cost of holding excess reserves falls and the quantity of reserves demanded rises.

Downward sloping demand curve that becomes flat (infinitely elastic) at ior

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Supply in the Market for Reserves

Supply in the Market for Reserves have two components: non-borrowed and borrowed reserves

Cost of borrowing from the Fed is the discount rate (id)

Borrowing from the Fed is a substitute for borrowing from other banks

If iff < id, then banks will not borrow from the Fed and borrowed reserves are zero

The supply curve will be vertical because total reserves equals non-borrowed reserves (NBR)

As iff rises above id, banks will borrow more and more at id, and re-lend at iff

The supply curve is horizontal (perfectly elastic) at id

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Figure 1 Equilibrium in the Market for Reserves

Federal

Funds Rate

Quantity of Reserves, R

NBR

With excess supply of reserves, the federal funds rate falls to

With excess demand for reserves, the federal funds rate rises to

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

Effects of open an market operation depends on whether the supply curve initially intersects the demand curve in its downward sloped section versus its flat section.

An open market purchase causes the federal funds rate to fall whereas an open market sale causes the federal funds rate to rise (when intersection occurs at the downward sloped section).

Open market operations have no effect on the federal funds rate when intersection occurs at the flat section of the demand curve.

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Figure 2 Response to an Open Market Operation

Step 1. An open market purchase shifts the

supply curve to the right …

Step 2. causing the federal funds rate to fall.

Step 1. An open market purchase shifts the supply curve to the right …

Step 2. but the federal funds rate cannot fall below the interest rate paid on reserves.

(a) Supply curve initially intersects demand

curve in its downward-sloping section

(b) Supply curve initially intersects

demand curve in its flat section

Federal

Funds Rate

Federal

Funds Rate

Quantity of

Reserve, R

NBR1

NBR2

NBR1

Quantity of

Reserves, R

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

If the intersection of supply and demand occurs on the vertical section of the supply curve, a change in the discount rate will have no effect on the federal funds rate.

If the intersection of supply and demand occurs on the horizontal section of the supply curve, a change in the discount rate shifts that portion of the supply curve and the federal funds rate may either rise or fall depending on the change in the discount rate.

When the Fed raises reserve requirement, the federal funds rate rises and when the Fed decreases reserve requirement, the federal funds rate falls.

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Figure 3 Response to a Change in the Discount Rate

(a) No discount lending (BR = 0)

(b) Some discount lending (BR > 0)

Step 2. but does not lower the federal funds rate.

Step 1. Lowering the discount rate shifts the supply curve down…

Step 2. and lowers the federal funds rate.

NBR

Quantity of Reserves, R

Federal Funds Rate

BR1

BR2

Quantity of Reserves, R

NBR

Federal Funds Rate

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Figure 4 Response to a Change in Required Reserves

NBR

Quantity of Reserves, R

Federal Funds Rate

ior

Step 1. Increasing the reserve requirement causes the demand curve to shift to the right . . .

Step 2. and the federal funds rate rises.

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Figure 5 Response to a Change in the Interest Rate on Reserves

NBR

Quantity of Reserves, R

NBR

Quantity of Reserves, R

Federal Funds Rate

Step 2. leaves the federal funds rate unchanged.

Step 1. A rise in the interest rate on reserves from to

Step 2. raises the federal funds rate to

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Figure 6 How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds Rate

Federal Funds Rate

Quantity of Reserves, R

NBR*

Step 1. A rightward shift of the demand curve raises the federal funds rate to a maximum of the discount rate.

Step 2. A leftward shift of the demand curve lowers the Fderal funds rate to a minimum of the interest rate on reserves.

Supply and demand analysis of the market for reserves illustrates how an important advantage of the Fed’s current procedures for operating the discount window and paying interest on reserves is that they limit fluctuations in the federal funds rate.

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Conventional Monetary Policy Tools

During normal times, the Federal Reserve uses three tools of monetary policy to control the money supply and interest rates, and these are referred to as conventional monetary policy tools

open market operations,

discount lending, and

reserve requirements

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Open Market Operations

Dynamic open market operations

Intended to change the level of reserves and the monetary base

Defensive open market operations

Intended to offset movements in other factors (treasury deposits and floats) that affect reserves and the monetary base

Open Market Operations are conducted by primary dealers-specific set of dealers in government securities

TRAPS (Trading Room Automated Processing System)

Defensive open market operations are of two types

Repurchase agreements (repo): Fed purchases securities with an agreement the seller will repurchase them in short period

Matched sale-purchase agreements: Fed sells securities and the buyer agrees to sell them back to the Fed in the near future

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Discount Policy and the Lender of Last Resort

Discount window

The facility at which banks can borrow reserves from the Federal Reserve

Backup source of liquidity for the federal funds market (market where banks borrow from each other)

Three types of discount loans

1. Primary credit: standing lending facility

Lombard facility

Healthy banks can borrow all they want at very short maturity

2.Secondary credit is given to banks in financial trouble and severe liquidity problems

3.Seasonal credit: seasonal borrowing

Lender of last resort to prevent financial panics

Creates moral hazard problem

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Reserve Requirements

Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same for all depository institutions.

3% of the first $48.3 million of checkable deposits; 10% of checkable deposits over $48.3 million

The Fed can vary the 10% requirement between 8% to 14%.

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Relative Advantages of the Different Monetary Policy Tools

Open market operations are the dominant policy tool of the Fed since it has complete control over the volume of transactions, these operations are flexible and precise, easily reversed and can be quickly implemented.

The discount rate is less well used since it is no longer binding for most banks, can cause liquidity problems, and increases uncertainty for banks. The discount window remains of tremendous value given its ability to allow the Fed to act as a lender of last resort.

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On the Failure of Conventional Monetary Policy Tools in a Financial Panic

When the economy experiences a full-scale financial crisis, conventional monetary policy tools cannot do the job, for two reasons.

First, the financial system seizes up to such an extent that it becomes unable to allocate capital to productive uses, and so investment spending and the economy collapse.

Second, the negative shock to the economy can lead to the zero-lower-bound problem

Central bank is unable to lower short-term interest rate further because they hit a floor of zero

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Nonconventional Monetary Policy Tools During the Global Financial Crisis

Liquidity provision: The Federal Reserve implemented unprecedented increases in its lending facilities to provide liquidity to the financial markets

Discount Window Expansion

Lowered discount rate to 0.50 basis point above the federal funds rate in 2007 and to 0. 25 in March 2008

Term Auction Facility

Temporary loans made at rate set by competitive auctions

New Lending Programs: providing loans to financial institutions outside banks

Example: Investment banks

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Nonconventional Monetary Policy Tools During the Global Financial Crisis

Large-scale asset purchases: During the crisis the Fed started three new asset purchase programs to lower interest rates for particular types of credit:

Government Sponsored Entities Purchase Program

QE2

QE3

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Figure 7 The Expansion of the Federal Balance Sheet, 2007-2014

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Monetary Policy Tools of the European Central Bank

Open market operations

Main refinancing operations

Weekly reverse transactions

Longer-term refinancing operations

Lending to banks

Marginal lending facility/marginal lending rate

Deposit facility

Reserve Requirements

2% of the total amount of checking deposits and other short-term deposits

Pays interest on those deposits so cost of complying is low

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Chapter 16

The Conduct of Monetary Policy: Strategy and Tactics

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Preview

This chapter examines the goals of monetary policy and then considers one of the most important strategies for the conduct of monetary policy, inflation targeting

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Learning Objectives

Identify the six potential goals that monetary policymakers may pursue.

Compare and contrast the advantages and disadvantages of inflation targeting.

Identify the key changes made over time to the Federal Reserve monetary policy strategy.

List the four lessons learned from the global financial crisis and discuss what they mean to inflation targeting.

Describe and assess the four criteria for choosing a policy instrument.

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The Price Stability Goal and the Nominal Anchor

Over the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy.

The role 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

The time-inconsistency problem

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Other Goals of Monetary Policy

Five other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy:

High employment and output stability

Economic growth

Stability of financial markets

Interest-rate stability

Stability in foreign exchange markets

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Should Price Stability Be the Primary Goal of Monetary Policy?

Hierarchical Versus Dual Mandates:

Hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued

Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability)

Price Stability as the Primary, Long-Run Goal of Monetary Policy

Either type of mandate is acceptable as long as it operates to make price stability the primary goal in the long run but not the short run.

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Inflation Targeting

Public announcement of medium-term numerical target for inflation

Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal

Information-inclusive approach in which many variables are used in making decisions

Increased transparency of the strategy

Increased accountability of the central bank

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New Zealand (effective in 1990)

Inflation was brought down and remained within the target most of the time.

Growth has generally been high and unemployment has come down significantly.

Canada (1991)

Inflation decreased since 1991; some costs in term of unemployment

United Kingdom (1992)

Inflation has been close to its target.

Growth has been strong and unemployment has been decreasing.

Inflation Targeting

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Figure 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2014

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Advantages:

Does not rely on one variable to achieve target

Easily understood

Reduces potential of falling in time-inconsistency trap

Stresses transparency and accountability

Disadvantages:

Delayed signaling

Too much rigidity

Potential for increased output fluctuations

Low economic growth during disinflation

Inflation Targeting

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The Evolution of the Federal Reserve’s Monetary Policy Strategy

The United States has achieved excellent macroeconomic performance (including low and stable inflation) until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation target.

History:

Fed began to announce publicly targets for money supply growth in 1975

Paul Volker (1979) focused more in nonborrowed reserves

Greenspan announced in July 1993 that the Fed would not use any monetary aggregates as a guide for conducting monetary policy

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The Evolution of the Federal Reserve’s Monetary Policy Strategy

There is no explicit nominal anchor in the form of an overriding concern for the Fed.

Forward looking behavior and periodic “preemptive strikes”

The goal is to prevent inflation from getting started.

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The Evolution of the Federal Reserve’s Monetary Policy Strategy

Advantages

Uses many sources of information

Demonstrated success

Disadvantages

Lack of accountability

Inconsistent with democratic principles

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The Fed’s “Just Do It” Monetary Policy Strategy

Advantages of the Fed’s “Just Do It” Approach:

forward-looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby ameliorating the time-inconsistency problem

Disadvantages of the Fed’s “Just Do It” Approach:

lack of transparency; strong dependence on the preferences, skills, and trustworthiness of the individuals in charge of the central bank

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Lessons for Monetary Policy Strategy from the Global Financial Crisis

Developments in the financial sector have a far greater impact on economic activity than was earlier realized.

The zero-lower-bound on interest rates can be a serious problem.

The cost of cleaning up after a financial crisis is very high.

Price and output stability do not ensure financial stability.

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Lessons for Monetary Policy Strategy from the Global Financial Crisis

How should Central banks respond to asset price bubbles?

Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst.

Types of asset-price bubbles

Credit-driven bubbles

Subprime financial crisis

Bubbles driven solely by irrational exuberance

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Should central banks respond to bubbles?

Strong argument for not responding to bubbles driven by irrational exuberance

Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time.

Monetary policy should not be used to prick bubbles.

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Macropudential policy: regulatory policy to affect what is happening in credit markets in the aggregate.

Monetary policy: Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction.

Should central banks respond to bubbles?

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Tactics: Choosing the Policy Instrument

Tools

Open market operation

Reserve requirements

Discount rate

Policy instrument (operating instrument)

Reserve aggregates

Interest rates

May be linked to an intermediate target

Interest-rate and aggregate targets are incompatible (must chose one or the other).

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Figure 2 Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets, and Goals of Monetary Policy

Open Market Operations

Discount Policy

Reserve Requirements

Interest on Reserves

Large-scale Asset

Purchases

Forward Guidance

Tools of the

Central Bank

Policy

Instruments

Intermediate

Targets

Goals

Monetary Aggregates

(M1, M2)

Interest rates

(short-term and

long-term)

Price Stability

High Employment

Economic Growth

Financial Market Stability

Interest-Rate Stability

Foreign Exchange Market

Stability

Reserve Aggregates

(reserves, nonborrowed

reserves, monetary base,

nonborrowed base)

Interest rates

(short-term such as

federal funds rates)

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Figure 3 Result of Targeting on Nonborrowed Reserves

Step 1. A rightward or leftward shift in the demand curve for reserves …

Quantity of

Reserves, R

Federal

Funds Rate

NBR*

Step 2. leads to fluctuations in the

federal funds rate between

Rd*

Rd′′

Rd′

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Figure 4 Result of Targeting on the Federal Funds Rate

Federal Funds Rates Target,

ier

Federal Funds Rate

Quantity of Reserves, R

Step 1. A rightward or leftward shift in the demand curve for reserves…

Step 2. lead the central bank to shift the supply curve of reserves so that the federal rate does not change…

Step 3. with the result that non-borrowed reserves fluctuate between NBR′ff and NBR′′ff.

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Criteria for Choosing the Policy Instrument

Observability and Measurability

Controllability

Predictable effect on Goals

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Tactics: The Taylor Rule

An inflation gap and an output gap

Stabilizing real output is an important concern

Output gap is an indicator of future inflation as shown by Phillips curve

NAIRU

Rate of unemployment at which there is no tendency for inflation to change

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Figure 5 The Taylor Rule for the Federal Funds Rate, 1970–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

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