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Chapter15MonetaryPolicy157
Chapter15
MonetaryPolicy
.1
Brief Chapter Summary and Chapter Objectives
15.1 TheGoalsofMonetaryPolicy(pages443446)
DescribetheGoalsofMonetaryPolicy.
TheFedhasmanygoalsformonetarypolicy,includingpricestability,highemployment,
economicgrowth,stabilityoffinancialmarketsandinstitutions,interestratestability,andforeign
exchangemarketstability.
15.2 MonetaryPolicyToolsandtheFederalFundsRate(pages446452)
UnderstandhowtheFedusesmonetarypolicytoolstoinfluencethefederalfundsrate.
AlthoughtheFedsetsatargetforthefederalfundsrate,theactualrateisdeterminedbythe
interactionofdemandandsupplyforbankreservesinthefederalfundsmarket.
Toanalyzethedeterminantsofthefederalfundsrate,weneedtoexaminethebankingsystems
demandforandtheFedssupplyofreserves.
Thoughothertoolsareavailable,theFedusesopenmarketoperationstohititstargetforthe
federalfundsrate.
15.3 MoreontheFedsMonetaryPolicyTools(pages452458)
Tracehowtheimportanceofdifferentmonetarypolicytoolshavechangedovertime.
OpenmarketoperationshavetraditionallybeentheFedspreferredtoolinconductingmonetarypolicy.
DiscountpolicywasusedextensivelyinresponsetotheFinancialCrisisof20072009.
Interestonreservesisanewtoolintroducedduringtherecentfinancialcrisis.
15.4 MonetaryTargetingandMonetaryPolicy(pages459470)
Explaintheroleofmonetarytargetinginmonetarypolicy.
Traditionally,theFedhasreliedontwotypesoftargets:(1)policyinstruments,sometimescalled
operatingtargets,and(2)intermediatetargets;thisisnolongerthefavoredapproach.
TheTaylorrulesummarizesthefactorstypicallyusedinsettingatargetforthefederalfundsrate.
Inflationtargetinghasbecomeanincreasinglypopularapproachtomonetarypolicy,particularly
beforetherecentfinancialcrisis.
Althoughthereareinstitutionaldifferencesinthewaysinwhichcentralbanksconductmonetary
policy,mostuseshortterminterestratesasapolicyinstrumenttoachieveanultimategoalsuch
aslowinflation.
2012PearsonEducation,Inc.PublishingasPrenticeHall
158Hubbard&OBrienMoney,Banking,andtheFinancialSystem,FirstEdition
.2
Key Terms and Concepts
DiscountpolicyThepolicytoolofsettingthe
discountrateandthetermsofdiscountlending.
PrimarycreditDiscountloansavailabletohealthy
banksexperiencingtemporaryliquidityproblems.
DiscountwindowThemeansbywhichtheFed
makesdiscountloanstobanks,servingasthe
channelformeetingtheliquidityneedsofbanks.
QuantitativeeasingAcentralbankpolicythat
attemptstostimulatetheeconomybybuying
longtermsecurities.
EconomicgrowthIncreasesintheeconomys
outputofgoodsandservicesovertime;agoalof
monetarypolicy.
ReserverequirementTheregulationrequiring
bankstoholdafractionofcheckabledepositsas
vaultcashordepositswiththeFed.
FederalfundsrateTheinterestratethatbanks
chargeeachotheronveryshorttermloans;
determinedbythedemandandsupplyfor
reservesinthefederalfundsmarket.
SeasonalcreditDiscountloanstosmallerbanks
inareaswhereagricultureortourismisimportant.
OpenmarketoperationsTheFederalReserves
purchasesandsalesofsecurities,usuallyU.S.
Treasurysecurities,infinancialmarkets.
TaylorruleAmonetarypolicyguideline
developedbyeconomistJohnTaylorfor
determiningthetargetforthefederalfundsrate.
SecondarycreditDiscountloanstobanksthatare
noteligibleforprimarycredit.
.3
Chapter Outline
BernankesDilemma
Duringthefinancialcrisisof20072009,theFedundertookextraordinarypolicyactionstokeepthe
financialsystemfromimploding.Unfortunately,asBernanketestifiedbeforeCongressinlateJuly2010,
theeconomywasrecoveringataslowerratethantheFedhadhoped.
15.1 The Goals of Monetary Policy (pages 443446)
LearningObjective:DescribetheGoalsofMonetaryPolicy.
A. PriceStability
Inflation,orpersistentlyrisingprices,erodesthevalueofmoneyasamediumofexchangeand
asaunitofaccount. Inamarketeconomy,inwhichpricescommunicateinformationabout
costsandaboutdemandforgoodsandservicestohouseholdsandfirms,inflationmakesprices
lessusefulassignalsforresourceallocation. Severeinflationinflictsevengreatereconomic
costs.
B. HighEmployment
Highemployment,oralowrateofunemployment,isanotherkeymonetarypolicygoal.
Unemployedworkersandunderusedfactoriesandmachinesloweroutput.Unemployment
causesfinancialdistressforworkerswholackjobs. AlthoughtheFediscommittedtohigh
employment,itdoesnotseekazeropercentrateofunemployment. Instead,theFedattemptsto
reducelevelsofcyclicalunemployment,whichisunemploymentassociatedwithbusinesscycle
recessions.
C. EconomicGrowth
Policymakersseeksteadyeconomicgrowth,orincreasesintheeconomysoutputofgoodsand
servicesovertime.Economicgrowthprovidestheonlysourceofsustainedrealincreasesin
householdincomes. Policymakersattempttoencouragestableeconomicgrowthbecausea
stablebusinessenvironmentallowsfirmsandhouseholdstoplanaccuratelyandencouragesthe
longterminvestmentthatisneededtosustaingrowth.
D. StabilityofFinancialMarketsandInstitutions
Thestabilityoffinancialmarketsandinstitutionsmakespossibletheefficientmatchingof
saversandborrowers.ThefinancialcrisisledtoreneweddebateoverwhethertheFedshould
takeactiontoforestallassetpricebubblessuchasthoseassociatedwiththedotcomboomon
theU.S.stockmarketinthelate1990sandtheU.S.housingmarketinthe2000s.
E. InterestRateStability
Likefluctuationsinpricelevels,fluctuationsininterestratesmakeplanningandinvestment
decisionsdifficultforhouseholdsandfirms. Inaddition,sharpinterestratefluctuationscause
problemsforbanksandotherfinancialfirms.
F. ForeignExchangeMarketStability
Astabledollarsimplifiesplanningforcommercialandfinancialtransactions. Inaddition,
fluctuationsinthedollarsvaluechangetheinternationalcompetitivenessofU.S.industry.
15.2 Monetary Policy Tools and the Federal Funds Rate (pages 446452)
LearningObjective:UnderstandhowtheFedusesmonetarypolicytoolstoinfluencethefederal
fundsrate.
TheFedstraditionalpolicytoolsincludeopenmarketoperations,discountpolicy,andreserve
requirements.Duringthefinancialcrisis,theFedaddednewtoolsincludinginterestonreserve
balancesandtermdepositfacility.
A. TheFederalFundsMarketandtheFedsTargetFederalFundsRate
AlthoughtheFedsetsatargetforthefederalfundsrate,theactualrateisdeterminedbythe
interactionofdemandandsupplyforbankreservesinthefederalfundsmarket.Toanalyzethe
determinantsofthefederalfundsrate,weneedtoexaminethebankingsystemsdemandforand
theFedssupplyofreserves. Banksdemandreservesbothtomeettheirlegalobligationtohold
requiredreservesandbecausetheymaywishtoholdexcessreservestomeettheirshortterm
liquidityneeds.TheFedsuppliesborrowedreserves,intheformofdiscountloans,and
nonborrowedreserves,throughopenmarketoperations.
Teaching Tips
Itmayprovebeneficialtospendalittleextratimedevelopingthegraphofthefederalfundsmarket,Figure15.1
onpage447.Studentscaneasilyglossoveritandtreatitasaregularsupplyanddemandgraph(i.e.,upward
slopingsupplycurve).Makingitclearthatthesupplycurveisverticalduetothesupplyofreservesbeing
independentofthefederalfundsrateduetotheFedscontroloverreservesshouldhelpstudentsunderstandthe
concept.Also,carefulexplanationastothereasoningbehindthehorizontalportionsofeachcurvewillhelp
studentsgainabetterunderstandingoftheuniqueshapesofthesupplyanddemandforreserves
(comparedtothecurvesthattheyhaveseenbefore).
B. OpenMarketOperationsandtheFedsTargetfortheFederalFundsRate
TheFedusesopenmarketoperationstohititstargetforthefederalfundsrate.Anopenmarket
purchaseincreasesthesupplyofreserves,whichdecreasesthefederalfundsrate.
C. TheEffectofChangesintheDiscountRateandinReserveRequirements
Typically,theFedhasraisedorloweredthediscountrateatthesametimethatitraisesor
lowersthetargetforthefederalfundsrate.Asaresult,changesinthediscountratehaveno
independenteffectonthefederalfundsrate. TheFedrarelychangestherequiredreserveratio.
Iftheotherfactorsunderlyingthedemandandsupplycurvesforreservesareheldconstant,an
increaseintherequiredreserveratioincreasesthedemandforreservesbecausebankshaveto
holdmorereserves,resultinginahigherfederalfundsrate.
15.3 More on the Feds Monetary Policy Tools (pages 452-458)

LearningObjective:Tracehowtheimportanceofdifferentmonetarypolicytoolshavechangedovertime.
A. OpenMarketOperations
WhentheFedcarriesoutanopenmarketpurchaseofTreasurysecurities,thepricesofthese
securitiesincrease,therebydecreasingtheiryield.Becausethepurchasewillincreasethemonetary
base,themoneysupplywillexpand. Attheendofeachmeeting,theFOMCissuesastatement
thatincludesitstargetforthefederalfundsrateanditsassessmentoftheeconomy,particularly
withrespecttoitspolicygoalsofpricestabilityandeconomicgrowth.InconductingtheFeds
openmarketoperations,thetradingdeskmakesbothdynamic,orpermanent,openmarket
operationsanddefensive,ortemporary,openmarketoperations. Openmarketoperationshave
severalbenefitsthatotherpolicytoolslack:control,flexibility,andeaseofimplementation.
Duringtherecentfinancialcrisis,withthefederalfundsalreadynearzero,theFedengagedin
quantitativeeasingwiththeintentofreducinglongterminterestratesinsteadofthefederal
fundsrate.
Teaching Tips
Thoughthefirstroundofquantitativeeasingwasgenerallysupportedbymosteconomists,thesecond
roundannouncedinNovember2010wasmuchmorecontroversial.Opponentsseeitasanewapproachto
monetarypolicywiththeriskofsignificantlyhigherinflationwithouteffectivelystimulatingeconomic
growth.Manyseeitasmonetizingthenationaldebt.Supportersofthepolicybasicallystatethatitisan
extensionofthetraditionaluseofopenmarketoperationsinthattheFednormallyconductsopenmarket
purchasestostimulatetheeconomywhenitisperceivedtobetooweak.Thedifferenceisthatthiswas
typicallyevidencedbyadeclineinthefederalfundsrate.Inthiscase,sincethefederalfundsrateis
alreadynearzero,itisevidencedbyanincreaseintheFedsbalancesheetorthemonetarybase.Have
studentsevaluatethetwosidesofthedebatetobetterunderstandwhattherealitiesofquantitativeeasing
inthecontextoftheeconomyoflate2010.
B. DiscountPolicy
Since1980,alldepositoryinstitutionshavehadaccesstothediscountwindow.TheFeds
discountloanstobanksfallintothreecategories:primarycredit,secondarycredit,andseasonal
credit. Primarycreditisavailabletohealthybankswithadequatecapitalandsupervisory
ratings.Secondarycreditisintendedforbanksthatarenoteligibleforprimarycreditbecause
theyhaveinadequatecapitalorlowsupervisoryratings. Seasonalcreditconsistsoftemporary,
shorttermloanstosatisfyseasonalrequirementsofsmallerbanksingeographicareaswhere
agricultureortourismisimportant.Duringthefinancialcrisisof20072009,theFedsetupa
varietyoftemporarylendingfacilities.
C. InterestonReserveBalances
PayinginterestonreservebalancesgivestheFedanothermonetarypolicytool.Byincreasing
theinterestrate,theFedcanincreasethelevelofreservesbanksarewillingtohold,thereby
restrainingbanklendingandincreasesinthemoneysupply.
15.4 Monetary Targeting and Monetary Policy (pages 459-470)

LearningObjective:Explaintheroleofmonetarytargetinginmonetarypolicy.
Thecentralbanksobjectiveinconductingmonetarypolicyistouseitspolicytoolstoachieve
monetarypolicygoals. ButtheFedoftenfacestradeoffsinattemptingtoreachitsgoals,
particularlythegoalsofhigheconomicgrowthandlowinflation.Althoughithopestoencourage
economicgrowthandpricestability,ithasnodirectcontroloverrealoutputorthepricelevel. The
Fedalsofacestimingdifficultiesinusingitsmonetarypolicytools.
A. UsingTargetstoMeetGoals
TargetsarevariablesthattheFedcaninfluencedirectlyandthathelpachievemonetarypolicy
goals.Traditionally,theFedhasreliedontwotypesoftargets:policyinstrumentssometimes
calledoperatingtargets,andintermediatetargets;thisnolongerthefavoredapproach.TheFed
controlsintermediatetargetvariables,suchasthemortgageinterestrateorM2,onlyindirectly
becauseprivatesectordecisionsalsoinfluencethesevariables.TheFedwouldthereforeneeda
targetthatwasabetterlinkbetweenitspolicytoolandintermediatetargets.Policyinstruments,
oroperatingtargets,arevariablesthattheFedcontrolsdirectlywithitsmonetarypolicytools
andthatarecloselyrelatedtointermediatetargets.
B. TheChoicebetweenTargetingReservesandTargetingtheFederalFundsRate
Traditionally,theFedhasusedthreecriteria(measurable,controllable,andpredictable)when
evaluatingvariablesthatmightbeusedaspolicyinstruments.TheFedsmainpolicy
instrumentshavebeenreserveaggregates,suchastotalreservesornonborrowedreserves,and
thefederalfundsrate.AkeypointtounderstandisthattheFedcanchooseareserveaggregate
foritspolicyinstrument,oritcanchoosethefederalfundsrate,butitcannotchooseboth.
C. TheTaylorRule:ASummaryofFedPolicy
ActualFeddeliberationsarecomplexandincorporatemanyfactorsabouttheeconomy.John
TaylorofStanfordUniversityhassummarizedthesefactorsintheTaylorruleforfederalfunds
ratetargeting:
Federalfundstargetcurrentinflationrateequilibriumrealfederalfundsrate
0.5 inflationgap 0.5 outputgap

AccordingtotheTaylorrule,theFedshouldraisethefederalfundsinresponsetoapositive
inflationgaporpositiveoutputgap.TheTaylorruletrackstheactualfederalfundsratefairly
closely,whichconfirmstheviewthattheFedhasbeenattemptingtoreachitspolicygoals
directlythroughmanipulatingthefederalfundsrateratherthanindirectlythroughusingan
intermediatetarget.
D. InflationTargeting
Withinflationtargeting,acentralbankpublicallysetsanexplicittargetfortheinflationrate
overaperiodoftime,andthegovernmentandthepublicthenjudgetheperformanceofthe
centralbankonthebasisofitssuccessinhittingthetarget. ArgumentsinfavoroftheFedusing
anexplicitinflationtargetfocusonfourpoints:First,announcingexplicittargetsforinflation
woulddrawthepublicsattentiontowhattheFedcanactuallyachieveinpractice. Second,the
establishmentoftransparentinflationtargetsfortheUnitedStateswouldprovideananchorfor
inflationaryexpectations. Third,announcedinflationtargetswouldhelpinstitutionalizeeffective
U.S.monetarypolicy.Finally,inflationtargetswouldpromoteaccountabilityfortheFedby
providingayardstickagainstwhichitsperformancecouldbemeasured. Opponentsofinflation
targetsalsomakefourpoints:First,rigidnumericaltargetsforinflationdiminishtheflexibility
ofmonetarypolicytoaddressotherpolicygoals.Second,becausemonetarypolicyinfluences
inflationwithalag,inflationtargetingrequiresthattheFeddependonforecastsoffutureinflation,
uncertaintyaboutwhichcancreateproblemsfortheconductofpolicy.Third,holdingtheFed
accountableonlyforagoaloflowinflationmaymakeitmoredifficultforelectedofficialsto
monitortheFedssupportforgoodeconomicpolicyoverall.Finally,uncertaintyaboutfuture
levelsofoutputandemploymentcanimpedeeconomicdecisionmakinginthepresenceofan
inflationtarget.
E. InternationalComparisonsofMonetaryPolicy
Althoughthereareinstitutionaldifferencesinthewaysinwhichcentralbanksconductmonetary
policy,therearetwoimportantsimilaritiesinrecentpractices.First,mostcentralbanksinindustrial
countrieshaveincreasinglyusedshortterminterestratessimilartothefederalfundsratein
theUnitedStatesasthepolicyinstrument,oroperatingtarget,throughwhichgoalsarepursued.
Second,manycentralbanksarefocusingmoreonultimategoalssuchaslowinflationthanon
particularintermediatetargets.
.4
Solutions to the End-of-Chapter Questions and Problems
Answers to Thinking Critically Questions

1.
2.
TheFederalReservewouldbeunderlesspressuretobuyTreasurysecurities,whichwouldlessenthe
likelihoodofanincreaseintheinflationrateinthefuture.Anadditionalbenefitwouldresultiftheprivate
sectorrespondedtothisdevelopmentbyincreasinginvestmentandemployment.Butprojectionsoffuture
deficitsdifferfromactualdeficits.If,forexample,Congressandthepresidentreachedagreementona
budgetthatwasexpectedtoreducedeficitsbyraisingtaxesonbusinesses,thiswouldhaveanegative
impactoninvestmentandemployment.Theresultcouldbelowertaxrevenueandgreateractual
deficits.Cutsinspendingprograms,ratherthanhighertaxes,wouldlikelyhaveapositiveimpacton
businessspending,butpoliticaloppositionmakesspendingcutsdifficulttoachieve.
Thegraphshowsthattheinitialinterestrateonbankreservedeposits,irb1,israisedtoirb2.Thenew,
higherequilibriuminterestrateonfederalfunds,iff2,isequaltotheinterestrateonbankreserve
deposits.TheFedincreasesinterestrateswithoutchangingitstargetforbankreserves.
15.1 The Goals of Monetary Policy

Learningobjective:Describethegoalsofmonetarypolicy.
Review Questions
1.1
Monetarypolicyaimstoadvancetheeconomicwellbeingofthecountryscitizens.Economic
wellbeingistypicallydeterminedbythequantityandqualityofgoodsandservicesthat
individualscanenjoy.
1.2 a. Pricestabilitymeansastableoverallpricelevelthroughouttheeconomyandisofteninterpreted
aslowandsteadyinflation.
b. Highemploymentmeansalowrateofunemploymentequaltothenaturalrateofunemployment.
c. Economicgrowthmeansincreasesintheeconomysoutputofgoodsandservicesovertime.
d. Stabilityoffinancialmarketsandinstitutionsreferstofinancialmarketsandinstitutionsworking
tomatchsaversandborrowerswithoutpanicsandexcessiveclosures.
e. Interestratestabilitymeansstableinterestrates.
f. Foreignexchangemarketstabilitymeanslimitedfluctuationsintheforeignexchangevalueof
thedollar.
1.3
TheFedseekstoreducecyclicalunemployment.TheFeddoesnotseektoreducethe
unemploymentratetozerobecausethetoolsofmonetarypolicyareaimedataffectingeconomic
conditionsthroughouttheeconomyandareineffectiveinreducingthelevelsoffrictionaland
structuralunemployment.
1.4
Interestratesrepresentthecostofborrowingbyfirmsandhouseholds.Fluctuatinginterestrates
makeinvestmentdecisionsbyfirmsandhouseholdsmoredifficultbecausethecostofborrowing
becomesmoreuncertain.
1.5
Excessfluctuationsintheforeignexchangevalueofthedollarwouldmakeitdifficulttoknow
thecostofyourproductsabroad,thecostofimportedintermediategoods,anddollarvalueof
foreignassets.
1.6
Theseverityofthe20072009financialcrisisandresultingrecessionhasputthemonetary
policygoalofstabilityoffinancialmarketsandinstitutionsfrontandcenter.Untilrecently,most
economistsprobablyconsideredpricestabilitytobetheFedstoppriority.
Problems and Applications

1.7
Deflation,justlikeinflation,complicatestheabilitytodistinguishoverallpricechangesfrom
relativepricechanges,whichdetermineresourceallocation.Unanticipateddeflation
redistributesincomejustasunanticipatedinflationdoes,aswhenborrowerssufferlossesfrom
unanticipateddeflation.
1.8
Foritsgoalofhighemployment,theFedseeksanunemploymentrateequaltothenaturalrateof
unemploymentwithzerocyclicalunemployment.TheFedwouldneedtobeawareofchangesin
thenaturalrateofunemploymentinordertoknowifcyclicalunemploymentexistsornot.
1.9
Nominalinterestratesincludeaninflationpremium.Thenominalinterestrateequalsthereal
interestrateplustheexpectedinflationrate.Highandvariableinflationratesleadtohighand
variablenominalinterestrates.
1.10
Inthelongrunforeignexchangeratesdependuponinflationratedifferentialsacrosscountries.
TheforeignexchangevalueoftheU.S.dollarwilldeclineandfluctuateastheU.S.inflationrate
risesandfluctuates.
1.11
IftheexchangeratebetweentheJapaneseyenandtheU.S.dollarchangesfrom85$1to95$1,
theU.S.dollarwouldhaveappreciatedandU.S.industrieswillbelesscompetitiverelativetoJapanese
industries.TheappreciationofthedollarmakesU.S.exportsmoreexpensiveandJapanese
importstotheU.S.cheaper.
15.2 Monetary Policy Tools and the Federal Funds Rate

Learningobjective:UnderstandhowtheFedusesmonetarypolicytoolstoinfluencethefederal
fundsrate.
Review Questions
2.1
TheFedsthreetraditionalmonetarypolicytoolsareopenmarketoperations,discountpolicy,
andreserverequirements.Openmarketoperationsisthepurchaseorsaleofsecurities,typically
U.S.Treasurysecurities,infinancialmarkets.Discountpolicyissettingthediscountrateandthe
termsofdiscountlending.Thereserverequirementisregulationrequiringbankstoholda
fractionofcheckabledepositsasvaultcashordepositswiththeFed.Themostimportantofthe
threetoolsisopenmarketoperations.
2.2
ThetwonewpolicytoolsavailabletotheFedaretheinterestrateonreservebalancesandthe
termdepositfacility.
2.3
Thefinancialassettradedisbankreserves.Thefederalfundsrateistheinterestratethatbanks
chargeeachotheronveryshorttermloans,whereasthediscountrateistheinterestratethatthe
FederalReservechargesbanksonloans.
2.4
TheFOMCistheFederalOpenMarketCommitteeoftheFederalReserve.TheFOMC
determinesthetargetforthefederalfundsrateanddirectsthebuyingandsellingofsecuritiesin
ordertoreachthefederalfundsratetarget.
2.5
Banksdemandreservesbothtomeettheirlegalobligationtoholdrequiredreservesandtheir
desiretoholdexcessreservestomeettheirshorttermliquidityneeds.Anincreaseinthefederal
fundsratedecreasesthequantityofreservesdemanded.Asthefederalfundsrateincreases,the
opportunitycosttobanksofholdingexcessreservesincreasesbecausethereturntheycouldearn
fromlendingoutthosereservesgoesup.Thedemandcurveforreservesbecomesperfectly
elasticattheinterestratetheFedpaysonbanksreservebalances.
2.6
ThesupplyofreservesisdeterminedbytheFedsupplyingnonborrowedreserves,throughopen
marketoperations,andborrowedreservesintheformofdiscountloans.Thediscountratesetsa
ceilingonthefederalfundsrate,causingthesupplycurveforreservestobecomehorizontal.
Bankswouldnotpayahigherinterestratetoborrowfromotherbanksthanthediscountrate
theycanpaytoborrowfromtheFed.

2.7
IfthefederalfundsratewasbelowtheinterestratetheFedpaysonbankreserves,thenbanks
wouldborrowatthelowerfederalfundsrateanddepositthefundsintheirreservebalancesat
theFedandearnariskfreereturn.Competitionamongbankstoobtainthefundstocarryout
thisriskfreearbitragewouldforceupthefederalfundsratetotheratetheFedpaysonbanks
reservebalances.
2.8
a. Adecreaseintherequiredreserveratiowoulddecreasethedemandforreserves.
b. Adecreaseinthediscountratewouldlowertheinterestrateatwhichthesupplyforreserves
becomeshorizontal.
c. Adecreaseintheinterestratepaidonreserveswouldlowertheinterestrateatwhichthe
demandcurvebecomeshorizontal.
d. Anopenmarketsaleofgovernmentsecuritieswoulddecreasethesupplyofreserves.
2.9
Toloweritstargetforthefederalfundsrate,theFedcanconductanopenmarketpurchaseof
securitiesandtoraiseitstargetforthefederalfundsrate,theFedcanconductanopenmarket
saleofsecurities.Inthegraphsbelow,thediscountrateisalsoassumedtobeloweredandraised
alongwiththetargetforthefederalfundsrate.
2.10 a. Toraisethefederalfundsrate,theFedcouldsellsecurities.
b. Tooffsettheeffectonthefederalfundsrateofanincreaseinthedemandforreserves,theFed
couldbuysecurities.Inthegraphbelow,theFedalsolowersthediscountrate.
c. Tooffsettheeffectofanincreaseintherequiredreserveratiowhichwouldincreasethedemand
forreserves,theFedcouldbuysecurities.Thegraphisthesameasforpartb.above.
2.11
AnopenmarketsaleofTreasurysecuritiesbytheFeddecreasesthesupplyofreserves,raising
thefederalfundsrate,unlessthenewsupplycurveofreservesintersectsthedemandcurvefor
reservesonthehorizontalportionattheinterestratetheFedpaysonreserves.
2.12 a. Seethegraphbelow.
b. Seethegraphforparta.above.TheFedwouldsellTreasurysecurities.
2.13 a. Seethegraphbelow.
b. Seethegraphforparta.above.TheFedwouldbuyTreasurysecurities.
15.3 More on the Feds Monetary Policy Tools

Learningobjective:Tracehowtheimportanceofdifferentmonetarypolicytoolshaschangedover
time.
Review Questions
3.1
a. ThepolicydirectiveisthegeneraldirectiveaftereachFOMCmeetingtotheFederalReserve
SystemsaccountmanagerstatingtheFOMCsoverallobjectivesforinterestratesandopen
marketoperations.
b. TheaccountmanageristheFederalReserveSystemsaccountmanager,whoisavicepresident
oftheFederalReserveBankofNewYorkandwhohastheresponsibilityofimplementingopen
marketoperationsandhittingtheFOMCstargetforthefederalfundsrate.
c. ThetradingdeskistheOpenMarketTradingDeskattheFederalReserveBankofNewYork.
Thetradingdeskislinkedelectronicallytoabout18primarydealers.
d. AprimarydealerisaprivatesecuritiesfirmthattheFedhasselectedtoparticipateinopen
marketoperations.
3.2
AnopenmarketsaleofTreasurysecuritiesdecreasesthepriceofTreasurysecurities,thereby
increasingtheyieldonTreasurysecurities.ThesaleofTreasurysecuritiesdecreasesthe
monetarybaseandthemoneysupply.
3.3
Dynamicopenmarketoperationsareintendedtochangemonetarypolicyasdirectedbythe
FOMC.Defensiveopenmarketoperationsareintendedtooffsettemporaryfluctuationsinthe
demandorsupplyforreserves,nottochangemonetarypolicy.Dynamicopenmarketoperations
arelikelytobeconductedasoutrightpurchasesandsalesofTreasurysecurities,whereas
defensiveopenmarketoperationsareconductedthroughrepurchaseagreementsandreverse
repurchaseagreements.
3.4
Openmarketoperationshavetheadvantagesoverotherpolicytoolsofcontrol,flexibility,and
easeofimplementation.TheFedinitiatesopenmarketoperationsandcompletelycontrolsthe
volumeofopenmarketpurchasesandsales.Openmarketoperationsareflexiblebecausethe
Fedcanmakebothlargeandsmallopenmarketoperations,andtheFedcaneasilyimplement
openmarketoperationsbythetradingdeskplacingbuyorsellorderswiththeprimarydealers.
3.5
Quantitativeeasingisthecentralbankpolicythatattemptstostimulatetheeconomybybuying
longtermsecurities.TheFed,traditionally,purchasesshorttermTreasurysecurities,butwith
thefederalfundsratealreadynearzerobyDecember2008,theFedpurchasedmortgagebacked
securitiesand10yearTreasurysecuritiestoreducetheinterestratesonmortgagesandother
longtermrates.
3.6
Thethreecategoriesofdiscountloansareprimarycredit,secondarycredit,andseasonalcredit.
Primarycreditisdiscountloanstohealthybanksexperiencingtemporaryliquidityproblems.
Secondarycreditisdiscountloanstobanksthatarenoteligibleforprimarycreditbecausethey
haveinadequatecapitalorlowsupervisoryratings.Seasonalcreditisdiscountloanstosmaller
banksinareaswhereagricultureortourismisimportant.Wheneconomistsandpolicymakers
refertothediscountrate,theyarereferringtotheinterestrateonprimarycredit.
3.7
Before1980,onlymemberbanksoftheFederalReserveSystemcouldreceivediscountloans.
After1980,alldepositoryinstitutionscouldreceivediscountloans.Duringthefinancialcrisisof
20072009,theFedsdiscountlendingexpandedtoincludetemporarylendingfacilitiesthat
madeloanstoprimarydealers(investmentbanksandlargesecuritiesfirms),financialfirmswith
mortgagebackedsecurities,nonfinancialcorporationsthatissuecommercialpaper,and
investorsthatpurchaseassetbackedsecurities.

3.8
Tohitthetargetfederalfundsrate,theaccountmanageradjustthesupplyofreservesbyusing
openmarketpurchasesandsalesofTreasurysecurities.Onmostdays,thetradingdeskcarries
outdefensiveopenmarketoperationstooffsettemporaryfluctuationsinthedemandorsupply
forreserves.
3.9
Agree.TheFedcannotmanageboththelevelofreservesandthefederalfundsrate.Ifit
managesthefederalfundsrate,thenthelevelofreservesmustchangewhenthedemandfor
reserveschangesinordertomaintainthedesiredfederalfundsrate.Likewise,iftheFed
managesthelevelofreserves,thenthefederalfundsratewillchangewhenthedemandfor
reserveschanges.
3.10
TheFedtypicallypurchasesshorttermTreasurysecurities,butwithquantitativeeasingtheFed
purchaseslongtermsecuritiessuchasmortgagebackedsecuritiesand10yearTreasurybonds.
Duringthefinancialcrisis,theFedturnedtoquantitativeeasingbecausetheyhadalready
pushedthefederalfundsratetonearlyzerobuttheeconomycontinuedtolingerinrecession.
Thepolicyofquantitativeeasinghasraisedconcernsofhigherinflationratesinthefuture
becausethesebondpurchasesgreatlyexpandedthemonetarybase.
3.11
Byincreasingtheinterestrateitpaysonbankreserves,theFedcanincreasethelevelofreserves
banksarewillingtohold,therebyrestrainingbanklendingandincreasesinthemoneysupply.
Additionally,thetermdepositfacility,theFedsothernewpolicytool,couldtousedtorestrain
banksfromlendinglargeamountsofexcessreservesallatonce.Themorefundsbanksplacein
termdeposits,thelesstheywillhaveavailabletoexpandloansandthemoneysupply.
3.12
Disagree.ThetargetforthefederalfundsrateissetbytheFOMC,butnottheactualfederal
fundsrate,whichisdeterminedbythedemandandsupplyofreserves.
3.13
Ifonlybankscouldborrowandlendinthefederalfundsmarket,thentheactualfederalfunds
ratecouldnotdropbelowtheinterestratetheFedpaysonreservedepositsbecausebankscould
borrowinthefederalfundsmarketandturnaroundanddepositthefundsintheirreserve
balancesattheFedandearnariskfreereturn.Competitionamongbankstoobtainthefundson
thefederalfundsmarketwoulddrivethefederalfundsrateuptotheinterestratetheFedpays
onreserves.
3.14
ThePrimaryDealerCreditFacilitywasdesignedtohelpprimarydealersbyproviding
emergencyloanswithmortgagebackedsecuritiesascollateral.TheTermSecuritiesLending
FacilitywasdesignedtohelpfinancialfirmsbyprovidingloansofTreasurysecuritiesin
exchangeformortgagebackedsecurities.TheCommercialPaperFundingFacilitywasdesigned
tohelpnonfinancialcorporationsthatissuedcommercialpaperbytheFeddirectlypurchasing
newissuesofthreemonthcommercialpaper.TheTermAssetBackedSecuritiesLoanFacility
wasdesignedtohelpfirmsthatraisedfundsthroughassetbackedsecurities.TheFedextended
threeyearorfiveyearloanstohelpinvestorspurchaseassetbackedsecurities.
15.4 Monetary Targeting and Monetary Policy

Learningobjective:15.4:Explaintheroleofmonetarytargetinginmonetarypolicy.
Review Questions
4.1
Inattemptingtoreachhigheconomicgrowthorhighemployment,theFedwouldpursue
expansionarymonetarypolicy,butthissamepolicycouldcausehigherinflation.
4.2
ThetwotimingdifficultiestheFedfacesinusingitsmonetarypolicytoolsaretheinformation
lagandtheimpactlag?TheinformationlagistheFedsinabilitytoobserveinstantaneously
changesinGDP,inflationorothereconomicvariables,andtheimpactlagisthetimethatis
requiredformonetarypolicychangestoaffectoutput,employment,orinflation.
4.3
TheFedcanmoredirectlycontrolandcanmorequicklyobserveintermediateoroperating
targetsthanpolicygoals.
4.4
Fromthemostinfluencetotheleastinfluence:policytools,policyinstruments,intermediate
targets,andpolicygoals.
4.5
ThecriteriaofpredictableapredictableimpactofthepolicyinstrumentontheFedspolicygoals
leadtheFedtousethefederalfundsrateasitspolicyinstrumentinsteadofthelevelofreserves.
4.6
TheTaylorruleisamonetarypolicyguidelinedevelopedbyeconomistJohnTaylorfor
determiningthetargetforthefederalfundsrate.TheTaylorruleservesasasummarymeasure
ofFedpolicyandcanbecomparedtotheFedsactualtargetforthefederalfundsratetogeta
senseofwhetherFedpolicyistoorestrictiveortooaccommodative.
4.7
Inflationtargetingreferstotheconductingofmonetarypolicysoastocommitthecentralbank
toachievingapubliclyannouncedlevelofinflation.Withthefinancialcrisis,thepolicygoalof
stabilityoffinancialmarketsandinstitutionshasbecomemorepressingthanthegoalofstableprices.
4.8
TheBankofCanadausesinflationtargetingandafocusontheexchangevalueoftheCanadian
dollar.TheBankofEnglandusesinflationtargeting.TheBankofJapanhasnotadopteda
formalinflationtarget,butdoesemphasizepricestability.TheEuropeanCentralBankhasan
inflationtargetandattachesasignificantroletothemonetaryaggregateM3.

4.9
TheFedcouldmoreaggressivelyattempttoreducehighcyclicalunemploymentwhenthe
inflationrateislowbecausetheexpansionarymonetarypolicyusedtodecreasecyclical
unemploymentwouldincreaseinflation.Theincreaseininflationwouldbelessofaproblemif
theinflationrateislow.
4.10
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
Statewhethereachofthefollowingvariablesismostlikelytobeagoal,anintermediatetarget,
anoperatingtarget,oramonetarypolicytool.
M2wouldbeanintermediatetarget.
Monetarybasewouldbeanintermediatetarget.
Unemploymentratewouldbeapolicygoal.
Openmarketpurchaseswouldbeapolicytool.
Federalfundsratewouldbeanoperatingtarget.
Nonborrowedreserveswouldbeanoperatingtarget.
M1wouldbeanintermediatetarget.
RealGDPgrowthwouldbeapolicygoal.
Discountratewouldbeapolicytool.
Inflationratewouldbeapolicygoal.
4.11
IftheFedusesthefederalfundsrateasapolicyinstrument,thenincreasesinthedemandfor
reserveswillleadtoanincreaseinthelevelofreserves.Conversely,iftheFedusesthelevelof
reservesasapolicyinstrument,thenincreasesinthedemandforreserveswillleadtoanincrease
inthefederalfundsrate.
4.12
CongressauthorizedNOWaccountsonwhichbankscanpayinterestandbanksdeveloped
automatedtransferofsavingaccounts,whichmovecheckabledepositbalancesintohigher
interestCDseachnightandthenbackintocheckabledepositbalancesinthemorning,and
sweepaccounts,whichmovecheckabledepositsofbusinessesintomoneymarketdeposit
accountsattheendofeachweekandthenmovethefundsbackintocheckabledepositsat
thebeginningofthefollowingweek.WithM1becomingmoreofastoreofvaluethana
puremediumofexchangetheshortrunlinkbetweenM1andspendingandthereforeM1
andinflationwasbroken.
4.13 a. M2
b. Changesinthemoneysupplyarenolongerusefulforforecastinginflationintheshortterm,but
areusefulinforecastinginflationinthelongterm.
4.14
Agree.TheFedcannotmanageboththelevelofreservesandthefederalfundsrate.Ifit
managesthefederalfundsrate,thenthelevelofreservesmustchangewhenthedemandfor
reserveschangesinordertomaintainthedesiredfederalfundsrate.Likewise,iftheFed
managesthelevelofreserves,thenthefederalfundsratewillchangewhenthedemandfor
reserveschanges.
4.15
Taylorrulefederalfundsratetarget220.5(1.22)0.5(7)0.10.ThisTaylorrule
federalfundsratetargetfitswithintheFedsactualtargetrangeof0.00to0.25%.
4.16 a. Monetaryexcessesinthiscontextwouldreferprimarilytothefederalfundsratebeingtoo
low.
b. TheevidenceofmonetaryexcessesisthattheFOMCkeptthefederalfundsrateatlevelswell
belowthoseindicatedbytheTaylorrulefrom2002to2006.
Data Exercises
D15.1
ThemostrecentFOMCpressreleasewillchangeovertime.Theanswersbelowapplytothe
pressreleaseofNovember3,2010.
a. TheFOMCmaintainedtherangeforthetargetforthefederalfundsrateat0to1/4percent,
andindicatedthateconomicconditionsarelikelytowarrantexceptionallylowlevelsforthe
federalfundsrateforanextendedperiod.
b. TheFOMCismoreconcernedaboutsloweconomicgrowth.
c. Nomentionofthediscountrate?
d. NomentionoftheinterestratepaidonbankreservesortheTermDepositFacility.TheFed
announcedanotherroundofquantitativeeasing(Q.E.II)withthepurchaseof$600billionof
longertermsecuritiesbetweenNovember,2010andtheendofthesecondquarterof2010.
D15.2
a.
b.
AsoftheearlyDecember2010,theupperlimitofthetargetforthefederalfundsratehas
notchangedoverthelastyear,remainingat0.25%.
Theeffectivefederalfundsratefluctuatedconsiderablyvaryingfrom0.04to0.22%.

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Chapter15MonetaryPolicy157

Brief Chapter Summary and Chapter Objectives

Key Terms and Concepts

15.3 More on the Feds Monetary Policy Tools (pages 452-458)

15.4 Monetary Targeting and Monetary Policy (pages 459-470)

0.5 inflationgap 0.5 outputgap

Solutions to the End-of-Chapter Questions and Problems

Answers to Thinking Critically Questions

15.1 The Goals of Monetary Policy

Problems and Applications

15.2 Monetary Policy Tools and the Federal Funds Rate

Problems and Applications

15.3 More on the Feds Monetary Policy Tools

Problems and Applications

15.4 Monetary Targeting and Monetary Policy

Problems and Applications

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