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Chapter 15
Monetary Policy
Brief Chapter Summary and Chapter Objectives
15.1 The Goals of Monetary Policy (pages 448–451)
Describe the Goals of Monetary Policy.
The Fed has several goals for monetary policy, including price stability, high employment,
economic growth, stability of financial markets and institutions, interest rate stability, and
foreign exchange market stability.
15.2 Monetary Policy Tools and the Federal Funds Rate (pages 451–459)
Understand how the Fed uses monetary policy tools to influence the federal funds rate.
Although the Fed sets a target for the federal funds rate, the actual rate is determined by the
interaction of the demand and supply for bank reserves in the federal funds market.
To analyze the determinants of the federal funds rate, we need to examine the banking system’s
demand for and the Fed’s supply of reserves.
Although other tools are available, the Fed relies open market operations to hit its target for the
federal funds rate.
15.3 More on the Fed’s Monetary Policy Tools (pages 459–467)
Trace how the importance of different monetary policy tools has changed over time.
Open market operations have traditionally been the Fed’s preferred tool in conducting monetary policy.
Discount policy was used extensively in response to the financial crisis of 2007–2009.
Interest on reserves is a new tool introduced during the financial crisis.
15.4 Monetary Targeting and Monetary Policy (pages 468–480)
Explain the role of monetary targeting in monetary policy.
Traditionally, the Fed has relied on two types of targets:
1. Policy instruments, sometimes called operating targets
2. Intermediate targets
Targeting is no longer the Fed’s favored approach.
The Taylor rule summarizes the variables typically used in setting a target for the federal funds
rate.
Inflation targeting has become an increasingly popular approach to monetary policy, particularly
before the recent financial crisis.
Although there are institutional differences in the ways in which central banks conduct monetary
policy, most use short-term interest rates as a policy instrument to achieve an ultimate goal such
as low inflation.
Discount policy The policy tool of setting the
discount rate and the terms of discount lending.
Discount window The means by which the Fed
makes discount loans to banks, serving as the
channel for meeting the liquidity needs of banks.
Economic growth Increases in the economy’s
output of goods and services over time; a goal of
monetary policy.
Federal funds rate The interest rate that banks
charge each other on very short-term loans;
determined by the demand and supply for
reserves in the federal funds market.
Open market operations The Federal Reserve’s
purchases and sales of securities, usually U.S.
Treasury securities, in financial markets.
Primary credit Discount loans available to healthy
banks experiencing temporary liquidity problems.
Quantitative easing A central bank policy that
attempts to stimulate the economy by buying
long-term securities.
Reserve requirement The regulation requiring
banks to hold a fraction of checkable deposits as
vault cash or deposits with the Fed.
Seasonal credit Discount loans to smaller banks
in areas where agriculture or tourism is important.
Secondary credit Discount loans to banks that
are not eligible for primary credit.
Taylor rule A monetary policy guideline
developed by economist John Taylor for
determining the target for the federal funds rate.
Key Terms and Concepts
Chapter Outline
Teaching Tips
This chapter brings together a number of the topics covered in earlier chapters as part of an integrated
discussion of monetary policy. The chapter provides an overview of the Fed’s monetary policy tools,
including the Fed’s heavy use of discount lending during the financial crisis of 2007-2009. The
chapter uses a graph of the demand and supply for reserves in the federal funds market to illustrate
many key points (see Figure 15.1 on page 453 for the basic graph). The chapter includes a discussion
of the debate over the Fed’s choice of targets. Particularly useful here is the Making the Connection
that begins on page 470, which discusses the exchange during the 1980s between Milton Friedman
and Benjamin Friedman over the link between the growth of the money supply and the inflation rate.
The chapter concludes with a discussion of monetary policy in other high-income countries.
Bernanke’s Dilemma
During the financial crisis of 2007–2009, the Fed undertook extraordinary policy actions to keep the
financial system from imploding. Unfortunately, as Fed Chairman Ben Bernanke testified before
Congress in late July 2012, the economy was recovering at a slower rate than the Fed had hoped.
15.1 The Goals of Monetary Policy (pages 448–451)
Learning Objective: Describe the Goals of Monetary Policy.
The Fed has six monetary policy goals that are intended to promote a well-functioning economy.
A. Price Stability
Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and
as a unit of account. In a market economy, prices communicate information about costs and
about demand for goods and services to households and firms. Inflation therefore makes prices
less useful as signals for resource allocation. Severe inflation inflicts even greater economic
costs. As a result, price stability is a key monetary policy goal.
B. High Employment
High employment, or a low rate of unemployment, is another key monetary policy goal.
Unemployed workers and underused factories and machines reduce output. Unemployment
causes financial distress for workers who lack jobs. Although the Fed is committed to high
employment, it does not seek a zero percent rate of unemployment. Instead, the Fed attempts to
reduce levels of cyclical unemployment, which is unemployment associated with business
cycle recessions.
C. Economic Growth
Economic growth provides the only source of sustained real increases in household incomes.
Policymakers attempt to encourage stable economic growth over time because a stable business
environment allows firms and households to plan accurately and encourages the long-term
investment that is needed to sustain growth.
D. Stability of Financial Markets and Institutions
The stability of financial markets and institutions makes possible the efficient matching of
savers and borrowers. The financial crisis led to renewed debate over whether the Fed should
take action to forestall asset price bubbles such as those associated with the dot-com boom on
the U.S. stock market in the late 1990s and with the U.S. housing market in the 2000s.
E. Interest Rate Stability
Like fluctuations in price levels, fluctuations in interest rates make planning difficult for
households and firms. In addition, sharp interest rate fluctuations cause problems for banks and
other financial firms.
F. Foreign-Exchange Market Stability
A stable dollar simplifies planning for commercial and financial transactions. In addition,
fluctuations in the dollar’s value change the international competitiveness of U.S. industry.
G. The Fed’s Dual Mandate
Many economists refer to the Fed’s dual mandate as price stability and maximum employment.
An open question is whether this mandate is consistent with financial market stability.
15.2 Monetary Policy Tools and the Federal Funds Rate (pages 451–459)
Learning Objective: Understand how the Fed uses monetary policy tools to influence the federal
funds rate.
The Fed’s traditional policy tools include open market operations, discount policy, and reserve
requirements. During the financial crisis, the Fed added new tools including paying interest on
reserve balances and the term deposit facility.
A. The Federal Funds Market and the Fed’s Target Federal Funds Rate
Although the Fed sets a target for the federal funds rate, the actual rate is determined by the
interaction of demand and supply for bank reserves in the federal funds market. To analyze the
determinants of the federal funds rate, we need to examine the banking system’s demand for
and the Fed’s supply of reserves. Banks demand reserves both to meet their legal obligation to
hold required reserves and because they may wish to hold excess reserves to meet their
short-term liquidity needs. The Fed supplies borrowed reserves, in the form of discount loans,
and nonborrowed reserves, through open market operations.
Teaching Tips
It may prove helpful to spend a little extra time developing the graph of the federal funds market, Figure 15.1,
“Equilibrium in the Federal Funds Market,” on page 453. Students can easily gloss over it and treat it as a
standard supply and demand graph (that is, a graph with an upward sloping supply curve). You can help
students understand the graph by making it clear that the supply curve is vertical because the Fed controls the
volume of reserves, which makes the supply of reserves independent of the federal funds rate. Also, carefully
explain the reasoning behind the horizontal portions of each curve to help students gain a better
understanding of the unique shapes of the demand and supply for reserves.
B. Open Market Operations and the Fed’s Target for the Federal Funds Rate
The Fed uses open market operations to hit its target for the federal funds rate. An open market
purchase increases the supply of reserves, which decreases the federal funds rate.
C. The Effect of Changes in the Discount Rate and in Reserve Requirements
Typically, the Fed has raised or lowered the discount rate at the same time that it raises or
lowers the target for the federal funds rate. As a result, changes in the discount rate have no
independent effect on the federal funds rate. The Fed rarely changes the required reserve
ratio. If the other factors underlying the demand and supply curves for reserves are held
constant, an increase in the required reserve ratio increases the demand for reserves because
banks have to hold more reserves, resulting in a higher federal funds rate.
15.3 More on the Fed’s Monetary Policy Tools (pages 459-467)
Learning Objective: Trace how the importance of different monetary policy tools has changed over time.
A. Open Market Operations
When the Fed carries out an open market purchase of Treasury securities, the prices of these
securities increase, thereby decreasing their yields. Because the purchase will increase the monetary
base, the money supply will expand. At the end of each meeting, the FOMC issues a statement that
includes its target for the federal funds rate and its assessment of the economy, particularly with
respect to its policy goals of price stability and economic growth. In conducting the Fed’s open
market operations, the trading desk makes both dynamic, or permanent, open market operations and
defensive, or temporary, open market operations. Open market operations have several benefits that
other policy tools lack: control, flexibility, and ease of implementation. During the recent financial
crisis, with the federal funds rate already near zero, the Fed engaged in quantitative easing with the
intent of reducing long-term interest rates rather than the federal funds rate.
Teaching Tips
Though the first round of quantitative easing was generally supported by most economists, the second and
third rounds announced in November 2010 and September 2012, respectively, were more controversial.
Opponents of quantitative easing see it as a new approach to monetary policy with the risk of
significantly increasing inflation without effectively stimulating economic growth. Some of these
opponents see the policy as monetizing the national debt.
Supporters of quantitative easing argue that it is an extension of the traditional use of open market
operations that the Fed routinely uses to stimulate the economy when it is perceived to be too
weak.
The difference is that, typically, open market operations focus on the federal funds rate. In this case,
because the federal funds rate was already near zero, the Fed focused on reducing long-term interest rates.
A potentially worthwhile classroom exercise is to have a brief—10 to 15 minute—debate between two
groups of students: One group is charged with defending quantitative easing, while the other group is
charged with presenting the opposing case.
B. Discount Policy
Since 1980, all depository institutions have had access to the Fed’s discount window. The Fed’s
discount loans to banks fall into three categories:
1. Primary credit, which is available to healthy banks with adequate capital and supervisory
ratings.
2. Secondary credit, which is intended for banks that are not eligible for primary credit because
they have inadequate capital or low supervisory ratings.
3. Seasonal credit, which consists of temporary, short-term loans to satisfy seasonal
requirements of smaller banks in geographic areas where agriculture or tourism are important.
During the financial crisis of 2007-2009, the Fed set up a variety of temporary lending
facilities.
C. Interest on Reserve Balances
Paying interest on reserve balances gives the Fed another monetary policy tool. By increasing
the interest rate, the Fed can increase the level of reserves banks are willing to hold, thereby
restraining bank lending and increases in the money supply.
15.4 Monetary Targeting and Monetary Policy (pages 468-480)
Learning Objective: Explain the role of monetary targeting in monetary policy.
The central bank’s objective in conducting monetary policy is to use its policy tools to achieve
monetary policy goals. But the Fed often faces trade-offs in attempting to reach its goals,
particularly the goals of high economic growth and low inflation. Although it hopes to encourage
economic growth and price stability, it has no direct control over real output or the price level. The
Fed also faces timing difficulties in using its monetary policy tools.
A. Using Targets to Meet Goals
Targets are variables that the Fed can influence directly and that help achieve monetary policy
goals. Traditionally, the Fed has relied on two types of targets:
1. Intermediate targets, which are typically either monetary aggregates or interest rates.
2. Policy instruments, or operating targets, such as he mortgage interest rate or M2, are
variables that the Fed controls only indirectly because private sector decisions also influence
these variables.
Using targets is no longer the Fed’s favored approach.
B. The Choice between Targeting Reserves and Targeting the Federal Funds Rate
Traditionally, the Fed has used three criteria—whether a variable is measurable, controllable,
and predictable—when evaluating variables that might be used as policy instruments. The Fed’s
main policy instruments have been reserve aggregates, such as total reserves or nonborrowed
reserves, and the federal funds rate. A key point to understand is that the Fed can choose a
reserve aggregate for its policy instrument, or it can choose the federal funds rate—but it
cannot choose both.
C. The Taylor Rule: A Summary of Fed Policy
Actual Fed deliberations are complex and incorporate many factors about the economy. John
Taylor of Stanford University has summarized these factors in the Taylor rule for federal funds
rate targeting:
Federal funds target Current inflation rate Equilibrium real federal funds rate
(1/2 Inflation gap) + (1/2 Output gap).
According to the Taylor rule, the Fed should raise the federal funds rate in response to a
positive inflation gap or positive output gap. The Taylor rule tracks the actual federal funds rate
fairly closely, which confirms the view that the Fed has been attempting to reach its policy
goals directly through manipulating the federal funds rate rather than indirectly through using
an intermediate target.
D. Inflation Targeting
In 2012, the Fed joined many other central banks by setting an inflation target. With inflation
targeting, a central bank publicly sets an explicit target for the inflation rate over a period of
time, and the government and the public then judge the performance of the central bank on the
basis of its success in hitting the target.
Arguments in favor of the Fed using an explicit inflation target focus on four points:
1. Announcing explicit targets for inflation draws the public’s attention to what the Fed can
actually achieve in practice.
2. The establishment of transparent inflation targets for the United States provides an anchor for
inflationary expectations.
3. Announced inflation targets help institutionalize effective U.S. monetary policy.
4. Inflation targets promote accountability for the Fed by providing a yardstick against which
its performance could be measured.
Opponents of inflation targets also make four points:
1. Rigid numerical targets for inflation diminish the flexibility of monetary policy to address
other policy goals.
2. Because monetary policy influences inflation with a lag, inflation targeting requires that the
Fed depend on forecasts of future inflation, which can be inaccurate.
3. Holding the Fed accountable only for a goal of low inflation may make it more difficult for
elected officials to monitor the Fed’s support for good economic policy overall.
4. Uncertainty about future levels of output and employment can impede economic decision
making in the presence of an inflation target.
E. International Comparisons of Monetary Policy
Although there are institutional differences in the ways in which central banks conduct monetary
policy, there are two important similarities in recent practices. First, most central banks in
industrial countries rely on short-term interest rates—similar to the federal funds rate in the
United States—as the policy instrument, or operating target, through which goals are pursued.
Second, many central banks are focusing more on ultimate goals such as low inflation than on
particular intermediate targets.
