Chapter 18
Monetary Policy:
Stabilizing the Domestic Economy
Conceptual and Analytical Problems
1. Explain how the Federal Reserve would implement a rise in the target range for the federal
funds rate? How does its action influence the market federal funds rate? (LO1)
Answer: The Federal Reserve would increase the interest rate on excess reserves (IOER), an
interest rate that it controls directly. This raises the minimum rate at which banks would be
therefore puts upward pressure on the market federal funds rate to bring it into the new
higher target range.
2. Using a graph of the market for bank reserves, show how, in the post-2008 environment, the
Federal Reserve can control independently both the price and quantity of aggregate bank
reserves. (LO1)
Answer: Figure 18.4 can be used to illustrate this point. The Fed can control the price of
aggregate reserves in the market for reserves by changing the interest rate it pays on excess
aggregate reserves. It is reflected in an upward shift in the flat portion of the reserve demand
curve.
Because there is an abundance of excess reserves in the banking system, banks’ demand for
without influencing their price.
3. Consider a scenario where, over the next 10 years, the supply of aggregate bank reserves
shrinks enough so that the reserve supply curve intersects the downward sloping part of the
Federal Reserve would bring about a reduction in the federal funds rate. In this scenario,
would it be possible to control independently both the price and quantity of reserves? (LO1)
Answer: This can be illustrated in a graph similar to Figure 18.2. If the reserve supply curve
intersects the downward sloping part of the reserve demand curve, shifting the reserve supply
the Fed would not be able to control independently the price and quantity of reserves: it had
to change the supply in order to hit the desired price.
4. Why might the market federal funds rate deviate from the interest rate on excess reserves?
(LO1)
Answer: The main reason that the market federal Funds rate might deviate from the interest
rate on excess reserves (IOER rate) is that some participants in the market for federal funds
lend those funds at a lower rate than the IOER rate in the federal funds market. Partly as a
result, the equilibrium federal funds rate is below the IOER rate.
5. * The overnight reverse repo rate (ON RRP) is a supplementary monetary policy tool of the
Federal Reserve. Explain how this tool can set a floor under the market federal funds rate.
(LO1)
Answer: Even if they are not eligible to earn the IOER rate, many nonbank participants in the
federal funds market, such as government-sponsored enterprises (GSEs), can engage in
will not be willing to lend in the federal funds in the market at a rate below the riskless ON
RRP rate.
6. Federal Reserve buying of mortgage-backed securities is an example of a targeted asset
purchase. Explain how the Fed’s actions are intended to work. (LO4)
Answer: The Fed wishes to stimulate the housing market. Housing prices and activity
collapsed in the 2007-2009 episode, serving as a key driver of the crisis. By purchasing
assets and had depleted their capital.
7. The strategy of inflation targeting, which seeks to keep inflation close to a numerical goal
over a reasonable horizon, has been referred to as a policy of “constrained discretion.” What
does this mean? (LO2)
Answer: Under inflation targeting, central banks conduct policy to attain the inflation goal.
policy credibility is diminished if central bank fails persistently to achieve the target.
8. The charge given by Congress to the Federal Reserve is to “promote effectively the goals of
whether the Taylor rule conforms to this mandate. (LO3)
Answer: The mandate given to the Federal Reserve by Congress is embedded in the Taylor
rule. First, if the inflation target π*, is low, the inflation gap term satisfies the “stable price”
inflation is low and near the target, then long-term interest rate should be “moderate.”
9. Use the following Taylor rule to calculate what would happen to the real interest rate if
inflation increased by 3 percentage points. (LO3)
Answer:
If actual inflation goes up by 3 percentage points, the target (nominal) federal funds rate goes
To calculate the impact on the real interest rate, we can use the Fisher equation
So, if the nominal rate increases by 4.5 percentage points and expected inflation increases by
10.*The Taylor rule in Problem 9 is thought to be a reasonably good description of policy
how would you amend the Taylor rule to better approximate policymaking behavior by the
ECB? (LO3)
Answer: The ECB has a hierarchical mandate where price stability is accorded greater
importance that other policy goals. Consequently, a weight on the inflation gap greater than
on the inflation gap should remain less than 1.
11. Go to the website of the Federal Reserve Board at www.federalreserve.gov and find the
section describing monetary policy tools. Which unconventional tools employed during
tools still remain in operation? (LO4)
Answer: On www.federalreserve.gov/monetarypolicy/expiredtools.htm the Fed reports that
the following policy tools have expired as of 2013: (1) the Money Market Investor Funding
Facility; (2) the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity
extensions in June 30,2010, and program 8 on December 31, 2012. Details on each are
available at the website noted above.
The order in which the facilities shut down reflects the sequence in which the problems they
were designed to fix were resolved. For example, liquidity-providing programs shut down
12.*Use your knowledge of the problems associated with asymmetric information to explain
below the target federal funds rate? (LO1)
Answer: Participants in the federal funds market do not have full information about each
fragility, borrowing banks were willing to pay higher interest rates for funds in the
marketplace.
13. Based on the liquidity premium theory of the term structure of interest rates, explain how
of forward guidance depend on its time consistency? (LO4)
Answer: The liquidity premium theory expresses the long-term interest rate as the sum of
average expected future short-term rates and a liquidity risk premium:
int=i1t+i1, t+1
e+…+i1, t+n−1
e
n+rpn
When credible, forward guidance influences expectations about future short-term rates. For
example, if policymakers credibly express intent to keep interest rates low for several years,
bank to renege on the policy commitment to keep rates low and steady in the future.
14. With the policy interest rate at the effective lower bound, how might a central bank counter
unwanted deflation? (LO4)
Answer: Several unconventional policy options exist, including forward guidance,
quantitative easing and targeted asset purchases. These can be used individually or in
hoping to lower the expected real interest rate.
15. *Outline and compare the ways in which the Federal Reserve and the ECB added to or
subsequent financial crisis in the euro area. (LO1)
Answer: The Federal Reserve set up a host of lending facilities such as the Term Auction
Facility, the Primary Dealer Credit Facility and the Commercial Paper Funding Facility (see
specifies a target range for the Federal Funds rate, with the interest on excess reserves
forming that range’s upper limit. Reserves are so abundant that small open market operations
would have little to no effect on the federal funds rate, resulting in the IOER rate replacing
OMOs as the principle tool in tightening monetary policy.
In both crises, the ECB used dollar liquidity swaps from the Fed to provide dollar funding to
euro-area banks. In the latter part of 2008, the ECB switched from using variable rate tenders
to fixed rate tenders for its main refinancing operations. Over time, it widened markedly the
The ECB also narrowed the spreads between its main refinancing rate and the marginal
lending facility rate (its counterpart to the discount rate) to 25 basis points (at the start of
2016). It also allowed the market overnight rate to sink well below the official target rate. In
reserves are plentiful and the auctions of repos are less effective.
Unlike the Fed, the ECB generally has not provided forward guidance regarding the future
level of the policy rate.
16. How might the Federal Reserve exit from the unconventional policies it employed during
the financial crisis of 2007–2009 without causing inflationary problems? (LO4)
Answer: The Fed could tighten monetary policy without selling assets by raising the deposit