Chapter 10
Conduct of Monetary Policy: Tools,
Goals, Strategy, and Tactics
The Federal Reserve’s Balance Sheet
Liabilities
Assets
Open Market Operations
Discount Lending
The Market for Reserves and the Federal Funds Rate
Demand and Supply in the Market for Reserves
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate
Case: How the Federal Reserve’s Operating Procedures Limit Fluctuations in the Federal Funds
Rate
Conventional Monetary Policy Tools
Open Market Operations
Inside the Fed Box: A Day at the Trading Desk
Discount Policy and the Lender of Last Resort
Reserve Requirements
Interest on Reserves
Nonconventional Monetary Policy Tools and Quantitative Easing
Liquidity Provision
Inside the Fed Box: Fed Lending Facilities During the Global Financial Crisis
Asset Purchases
Quantitative Easing Versus Credit Easing
Management of Expectations: Commitment to Future Policy Actions
Monetary Policy Tools of the European Central Bank
Open Market Operations
Lending to Banks
Reserve Requirements
Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 49
The Price Stability Goal and the Nominal Anchor
The Role of a Nominal Anchor
The Time-Inconsistency Problem
Other Goals of Monetary Policy
High Employment
Economic Growth
Stability of Financial Markets
Interest-Rate Stability
Stability in Foreign Exchange Markets
Should Price Stability Be the Primary Goal of Monetary Policy?
Hierarchical vs. Dual Mandates
Price Stability as the Primary, Long-Run Goal of Monetary Policy
Inflation Targeting
Advantages of Inflation Targeting
Disadvantages of Inflation Targeting
Global Box: The European Central Bank’s Monetary Policy Strategy
Inside the Fed Box: Chairman Bernanke and Inflation Targeting
Should Central Banks Respond to Asset-Price Bubbles? Lessons from the Global Financial Crisis
Two Types of Asset-Price Bubbles
The Debate Over Whether Central Banks Try to Pop Bubbles
Tactics: Choosing the Policy Instrument
Criteria for Choosing the Policy Instrument
The Practicing Manager: Using a Fed Watcher
◼ Overview and Teaching Tips
Chapter 10 outlines the tools, goals, strategy, and tactics of central bank policymaking. The chapter starts
by looking at the Fed balance sheet and then, by analyzing the market for reserves, shows how monetary
policy affects the federal funds rate. It then analyzes how the Fed uses its tools in theory and in practice.
The next part of the chapter starts by laying out modern theories of central banking. It first discusses the
price stability goal and the role of a nominal anchor in solving the time-inconsistency problem. It then
discusses the other goals of monetary policy and why price stability is now viewed as the primary goal of
monetary policy.
The time-inconsistency problem is one of the most important ideas in monetary theory in the last twenty
years. I illustrate the time-inconsistency problem by using the example of how many people cannot stick to
a diet even though they know this is the right thing for them to do in the long run. Many other examples
can bring this idea home to the student. Another good example is the fact that it is optimal not to give in to
children when they are behaving badly, but parents still have a tendency to renege on this optimal plan. A
third example is that governments usually provide funds to rebuild in coastal areas after a hurricane, even
though it is not optimal to build in areas that are likely to be ravaged by hurricanes. You might ask the
students to think of other examples in order to hammer home this important concept.
With the theoretical perspective developed in the first part of the chapter, instructors can now go on to
discuss the most common strategy employed by central banks to pursue the price-stability goal: inflation
50 Mishkin/Eakins • Financial Markets and Institutions, Eighth Edition
targeting. In discussing this strategy, I have found that having a debate about the pros and cons of inflation
targeting piques students’ interest.
The recent financial crisis has generated much new thinking on how monetary policy should be conducted.
Given the role of asset-price bubbles in the recent financial crisis, one of the most hotly debated topics in
central banking circles right now is how central banks should respond to asset-price bubbles. The material
on this subject in the chapter can be used to stage a student debate in class on whether central banks should
respond to asset price bubbles. This will help them appreciate the change in thinking that has occurred in
central banking in the aftermath of the global financial crisis. The chapter then moves on to discuss
monetary policy tactics: in particular, what policy instrument should be choosen to conduct monetary
policy. Figures 6 and 7 illustrate why targeting on a monetary aggregate like nonborrowed reserves
implies a loss of control of interest rates like the fed funds rate, while targeting on the fed funds rate
implies a loss of control of monetary aggregates. Indeed, covering this topic is an excellent way of
providing students with another application to give them practice with the supply and demand analysis for
the market for reserves.
The chapter ends with a Practicing Manager application on using a Fed Watcher. This illustrates to the
student that an understanding of how the Fed conducts monetary policy can be used to increase the
profitability of a financial institution. This application helps business students see the relevance of
studying the Federal Reserve and the conduct of monetary policy.
◼ Answers to End-of-Chapter Questions
1. Disagree. Some unemployment is beneficial to the economy because the availability of vacant jobs
2. The goal of price stability often conflicts with the goal of high economic growth and employment
and interest-rate stability. When the economy is expanding along with employment, inflation may
3. True. In such a world, hitting a nonborrowed reserves target would mean that the Fed would also hit
4. a. The three-month Treasury bill rate can be thought of as either an operating target or an intermediate
target. It can be an operating target because it is a variable that can be affected directly by the
5. The Fed can control the interest rate on three-month Treasury bills by buying and selling them on the
open market. When the bill rate rises above the target level, the Fed would buy bills, which would bid
Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 51
Copyright © 2015 Pearson Education, Inc.
market operations would of course affect the money supply and cause it to change. The Fed would be
giving up control of the money supply to pursue an interest-rate target.
6. The increase in the demand for reserves which shifts the reserves demand curve to the right would
7. Disagree. Although nominal interest rates are measured more accurately and more quickly than the
money supply, the interest rate variable that is of more concern to policymakers is the real interest
8. The monetary base is more controllable than M2 because it is more directly influenced by the tools of
the Fed. It is measured more accurately and quickly than M2 because the Fed can calculate the base
10. Because of the large amount of liquidity in banks and the financial system, this could eventually lead
to substantial inflation problems as liquidity in the form of excess reserves leaves the banking system
11. It proved to be more widely used because the interest rate on these loans was set through a
competitive process, and that interest rate was less (in some cases much less) than the discount rate.
12. Since short-term interest rates cannot be lowered below the zero bound in this environment,
conventional monetary policy would be ineffective. Thus, the main advantage of quantitative easing
13. By purchasing particular types of securities, the Fed can impact interest rates and liquidity in
particular sectors of credit and financial markets, thereby providing a more surgical provision of
Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics 53
Copyright © 2015 Pearson Education, Inc.
to use monetary policy as a stabilization tool in a low inflation environment. In this context, it is
argued that a higher inflation target may be appropriate to give policymakers more flexibility. The
downside of this of course is that in general higher inflation rates can be costly to society, posing a
tradeoff for monetary policymakers in terms of flexibility versus efficiency of monetary policy.
25. There are several reasons why monetary policy may not be effective in eliminating asset price
bubbles. The main reason is that asset price bubbles are extremely difficult to identify in real time; in
many cases, by the time there is a consensus among policymakers and the public that a bubble exists,
26. In general, the question of appropriate policy response is one of minimizing loss. Credit-driven
bubbles (such as the housing bubble experience that resulted in the global financial crisis) can be far
more devastating to the economy if a crash occurs, than if policymakers acted to reduce the size of
27. Because a stock market bubble may be hard to identify (at least through consensus) and policy could
cause more damage than necessary, in general Greenspan would advocate not acting directly on the
◼ Quantitative Problems
1. Consider a bank policy to maintain 12% of deposits as reserves. The bank currently has $10 million
in deposits and holds $400,000 excess reserves. What is the required reserve on a new deposit of
$50,000?
