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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.
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.
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.
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.
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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
B. High Employment
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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.
Chapter 15 Monetary Policy 186
High employment, or a low rate of unemployment, is another key monetary policy goal.
C. Economic Growth
Economic growth provides the only source of sustained real increases in household incomes.
D. Stability of Financial Markets and Institutions
The stability of financial markets and institutions makes possible the efficient matching of
E. Interest Rate Stability
Like fluctuations in price levels, fluctuations in interest rates make planning difficult for
F. Foreign-Exchange Market Stability
G. The Fed’s Dual Mandate
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
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.
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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
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.
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Chapter 15 Monetary Policy 188
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.
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,
C. The Taylor Rule: A Summary of Fed Policy
Actual Fed deliberations are complex and incorporate many factors about the economy. John
D. Inflation Targeting
In 2012, the Fed joined many other central banks by setting an inflation target. With inflation
Arguments in favor of the Fed using an explicit inflation target focus on four points:
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189 Hubbard & O’Brien • Money, Banking, and the Financial System, Second Edition
1. Announcing explicit targets for inflation draws the public’s attention to what the Fed can
actually achieve in practice.
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.
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
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Solutions to the End-of-Chapter Questions and Problems
15.1 The Goals of Monetary Policy
Learning objective: Describe the goals of monetary policy.
Review Questions
1.1 Monetary policy aims to advance the economic well-being of the country’s citizens. Economic
well-being is typically determined by the quantity and quality of goods and services that
1.2 The Fed seeks to reduce cyclical unemployment. The Fed does not seek to reduce the
1.3 Interest rates represent the cost of borrowing by firms and households. Fluctuating interest rates
1.4 Excess fluctuations in the foreign exchange value of the dollar would make it difficult to know
Problems and Applications
1.5 Deflation, just like inflation, complicates the ability to distinguish overall price changes from
1.6 a. Extraordinary easing measures mean expansionary monetary policy of low interest rates and
b. The expansionary policy of low interest rates would stimulate spending, putting upward
pressure on prices. Deflation would be potentially highly damaging as it causes consumers to
c. Answers will vary. When deflation or high inflation is caused by a demand shock (too
little or too much aggregate spending), then the columnist is correct that the single mandate of
However, when the deflation or inflation is caused by a negative supply shock, such as an
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1.7 For its goal of high employment, the Fed seeks an unemployment rate equal to the natural rate of
1.8 The Fisher effect, which was discussed in Chapter 4, indicates that nominal interest rates
1.9 If the exchange rate between the Japanese yen and the U.S. dollar changes from ¥85 $1 to ¥95 $1,
15.2 Monetary Policy Tools and the Federal Funds Rate
Learning objective: Understand how the Fed uses monetary policy tools to influence the federal
funds rate.
Review Questions
2.2 The federal funds rate is the interest rate that banks charge each other on very short-term loans,
2.3 As the federal funds rate increases, the opportunity cost to banks of holding excess reserves
increases because the return they could earn from lending out those reserves goes up. The
2.4 The supply of reserves is determined by the Fed supplying nonborrowed reserves through open
market operations and borrowed reserves in the form of discount loans. The discount rate sets a
Problems and Applications
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Chapter 15 Monetary Policy 194
2.6 The graph on the left below shows that to lower its target for the federal funds rate from
iff 1
¿
to
iff 2
¿
, the Fed can conduct an open market purchase of securities. In the graph, the open
The graph on the right below shows that to raise its target for the federal funds rate from
iff 1
¿
¿
2.7 a. To raise the federal funds rate, the Fed would sell securities, which shifts the supply curve for
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b. Banks’ increased demand for reserves shifts the demand curve to the right from D1 to D2. To offset the effect
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Chapter 15 Monetary Policy 196
c. An increase in the required reserve ratio would increase the demand for reserves. To
2.8 An open market sale of Treasury securities by the Fed decreases the supply of reserves, causing
the supply curve for reserves to shift to the left from S1 to S2. As shown, the shift in the supply
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2.9 a. To raise the target for the federal funds rate, the Fed conducted an open market sale of securities.
As shown on the graph below, the sale shifted the supply curve for reserves to the left from S1 to
2.10 a. To lower the target for the federal funds rate, the Fed conducted an open market purchase of
Treasury securities. As shown on the graph below, the purchase shifted the supply curve for
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15.3 More on the Fed’s Monetary Policy Tools
Learning objective: Trace how the importance of different monetary policy tools has changed over
time.
Review Questions
3.1 An open market sale of Treasury securities decreases the price of Treasury securities, thereby
3.2 Open market operations have the advantages over other policy tools of control, flexibility, and
ease of implementation. The Fed initiates open market operations and completely controls the
3.3 To stimulate the economy, the Fed had already pushed the federal funds rate to near zero by
December 2008. But the economy continued to struggle and the Fed wanted to put further
3.4 Before 1980, only member banks of the Federal Reserve System could receive discount loans.
After 1980, all depository institutions could receive discount loans. During the financial crisis of
Problems and Applications
3.5 To hit the target federal funds rate, the account manager adjusts the supply of reserves by using
3.6 a. The Fed’s policy rate is the federal funds rate. “Policy rate” is a general term used to refer to the
c. The author means that additional monetary easing will not stimulate the economy.
Additional monetary easing will have no more effect than pushing on a string. Economists
d. Answers can vary. Additional quantitative easing will have limited effects in lowering
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Chapter 15 Monetary Policy 200
3.7 a. Bernanke uses the term monetary accommodation to mean the near zero federal funds rate,
c. Fed Chairman Bernanke’s letter to Congress mentions three channels the Fed used to ease
financial conditions:
1. Reducing the cost of capital to businesses by reducing interest rates, reducing credit
2. Boosting the aggregate wealth of U.S. households by supporting the housing market
3. Improving the competitiveness of U.S. businesses by allowing businesses to access
3.8 By increasing the interest rate it pays on bank reserves, the Fed can increase the level of reserves
Additionally, the Fed could use the other new policy tool of the term deposit facility to restrain
3.9 You should disagree. The Fed does not set the federal funds rate. The federal funds rate is
3.10 a. The implications of some financial institutions being able to borrow and lend in the federal funds
b. If only banks could borrow and lend in the federal funds market, then the actual federal
funds rate could not drop below the interest rate the Fed pays on reserve deposits because banks
3.11 The Primary Dealer Credit Facility was designed to help primary dealers—the financial firms
The Term Securities Lending Facility was designed to help financial firms by providing loans of
Treasury securities in exchange for mortgage-backed securities.
The Commercial Paper Funding Facility was designed to help nonfinancial corporations that
The Term Asset-Backed Securities Loan Facility was designed to help firms that raised funds
15.4 Monetary Targeting and Monetary Policy
Learning objective: 15.4: Explain the role of monetary targeting in monetary policy.
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Review Questions
4.1 The Fed often faces the key tradeoff between price stability and maximum employment. For
4.2 The two timing difficulties the Fed faces in using its monetary policy tools are the information
4.3 The following is a list of targets, or variables, that the Fed can influence directly. The targets are
listed from the most influence to the least influence:
Policy tools (Fed has most influence),
4.4 The Taylor rule is a monetary policy guideline economist John Taylor developed to help analyze
how the Fed chooses the target for the federal funds rate. The Taylor rule serves as a summary
4.5 The Bank of Canada uses inflation targeting and a focus on the exchange value of the Canadian
dollar. The Bank of England uses inflation targeting. The Bank of Japan has not adopted a
Problems and Applications
4.6
a. M2 is an intermediate target.
b. The monetary base is an intermediate target.
4.7 If the Fed uses the federal funds rate as a policy instrument, then increases in the demand for
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Chapter 15 Monetary Policy 202
4.8 The following legislative changes and financial innovations occurred after 1979:
1. Congress authorized NOW (negotiable order of withdrawal) accounts on which banks can pay
interest
2. Banks introduced two innovations:
(a) Automated transfer of saving accounts, which move checkable deposit balances into
(b) Sweep accounts, which move checkable deposits of businesses into money market
4.9 a. Increases in the Fed’s balance sheet increase the monetary base and typically increase the money
supply, subsequently causing increased inflation. Inflationary expectations were not unsettled
b. Bernanke’s “open-ended round of quantitative easing” refers to a third round of
quantitative easing (QE3), where the Fed pledged to continue purchases of mortgage-backed
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4.10 You should agree. The Fed cannot target—which would appear to be what the authors mean by
“manage”—both the level of reserves and the federal funds rate. If the Fed targets the federal
4.11 Using the equation found on page 474 of the text, the Taylor rule federal funds rate target 2%
4.12 a. The Federal Open Market Committee (FOMC) kept the federal funds rate at levels well below
b. Low interest rates encouraged subprime borrowers (borrowers with flawed credit
histories) and Alt-A borrowers (borrowers who did not document their incomes) to acquire
Data Exercises
D15.1 The answers below apply to the Federal Open Market Committee (FOMC) press release of
January 30, 2013.
a. The FOMC did not change the target for the federal funds rate. It kept the target range for
the federal funds rate at 0 to 0.25%.
d. The Fed announced that it would continue purchasing agency mortgage-backed securities at
a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion
D15.2
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Chapter 15 Monetary Policy 204
D15.3 The Bank of England’s total assets increased from almost $100 million at the end of 2007 to
nearly $300 million on October 22, 2008 after the Lehmann Brothers bankruptcy on September
D15.4
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Before the financial-crisis, discount loans were generally below $1 billion. Based only on the
data for the
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