1. Monetary Policy: Tools, Instruments, and Goals
Fundamentals of Finance – Lecture 7

2. Monetary Policy:
Tools and Instruments

3. Tools of Monetary Policy
Open market operations
Affect the quantity of reserves and the monetary base
Changes in borrowed reserves
Affect the monetary base
Changes in reserve requirements
Affect the money multiplier
Target of Monetary Policy: Interest Rate (Federal Funds Rate, or Interbank Money Rate)
- The interest rate on overnight loans of reserves from one bank to another.
Last time we talked about money supply process. We understood who the players are (the CB, commercial banks and the public) what kind of operation the CB performs and how that affects money supply. We also derived the deposit multiplier and the money multiplier. Knowing that the CB controls only the reserve money, we saw that through the process of deposit multiplication the CB can influence money supply. Now we continue with the analyzing monetary policy in detail by looking at central bank’s tools and instrument in the process of conducting monetary policy. Than we will clarify what are the goals of monetary policy and how can we prioritize them when they different goals appear to be in conflict.

4. The Demand for Bank Reserves
Why do banks demand reserves?
The CB requires banks to hold a certain percentage of reserves as deposits;
Banks may choose to hold excess reserves to ensure against increased deposit outflows.
Every unit held in reserve is not earning interest as a loan
The interest rate represents the interest that could have been earned;
As the interest rate falls, the opportunity cost of holding reserves falls.
Just to remind you that reserve money consists of bank reserves and cash. Given that when analyzing reserve money bank reserves are paramount, we start our today’s lecture with factors that affect demand and supply of bank reserves. We need to answer the question why banks demand reserves.

5. Demand for Reserves Interest Rate iff,2 iff,1 RD Reserves R2 R1
To derive the demand curve for reserves, we need to ask what happens to the quantity of reserves demanded, holding everything else constant, as the interest rate changes. Recall from the previous lecture that the amount of reserves can be split up into two components: (1) required reserves, which equal the required reserve ratio times the amount of deposits on which reserves are required, and (2) excess reserves, the additional reserves banks choose to hold. Therefore, the quantity of reserves demanded equals required reserves plus the quantity of excess reserves demanded. Excess reserves are insurance against deposit outflows, and the cost of holding these excess reserves is their opportunity cost, the interest rate that could have been earned on lending these reserves out, which is equivalent to the federal funds rate. Thus as the interest rate decreases, the opportunity cost of holding excess reserves falls and, holding everything else constant, including the quantity of required reserves, the quantity of reserves demanded rises. Consequently, the demand curve for reserves, Rd, slopes downward. RD
Reserves R2 R1

6. Supply of Reserve Interest Rate iff,3 RS id iff,2 iff,1 Reserves NBR
The supply of reserves, Rs, can be broken up into two components: the amount of reserves that are supplied by the CB’s open market operations, called non borrowed reserves (Rn), and the amount of reserves borrowed from the FCB , called discount loans (DL). The primary cost of borrowing discount loans from the CB is the interest rate the CB charges on these loans, the discount rate (id). Because borrowing from the interbank money market is a substitute for taking out discount loans from the CB, if the interest rate on the IBMM iff is below the discount rate id, then banks will not borrow from the CB and discount loans will be zero because borrowing in from the IBMM market is cheaper. Thus, as long as iff remains below id, the supply of reserves will just equal the amount of nonborrowed reserves supplied by the CB, Rn, and so the supply curve will be vertical as shown in Figure 1. However, as the federal funds rate begins to rise above the discount rate, banks would want to keep borrowing more and more at id and then lending out the proceeds in the federal funds market at the higher rate, iff. The result is that the supply curve becomes flat (infinitely elastic) at id, as shown in Figure 1
NBR
Reserves

7. Equilibrium in the Market for Reserves
Market equilibrium occurs where the quantity of reserves demanded equals the quantity supplied. When the interest rate (federal funds rate) is above the equilibrium rate at i2 ff , there are more reserves supplied than demanded (excess supply) and so the federal funds rate falls to i*ff as shown by the downward arrow. On the other hand, when the federal funds rate is below the equilibrium rate at i1 ff , there are more reserves demanded than supplied (excess demand) and so the federal funds rate rises as shown by the upward arrow. Now that we understand how the federal funds rate is determined, we can examine how changes in the three tools of monetary policy—open market operations, discount lending, and reserve requirements—affect the market for reserves and the equilibrium federal funds rate.

8. An Open Market Purchase
Interest Rate id
RS1
RS2
iff,1
iff,2
Suppose the CB decided to purchase bonds on the open market
This would lead to an increase in NBR since the CB is paying for bonds with money (that then gets classified as “non-borrowed bank reserves)
The increase in NBR causes the supply of reserves held by banks to shift right
There will be a decrease in the interest rate since banks will be more willing to lend to one another at lower rates. RD
NBR1
NBR2
Reserves

9. An Open Market Sale Interest Rate id iff,2 iff,1 RS2 RS1 RD NBR2 NBR1
Now suppose the CB sold bonds on the open market
There would be a decrease in NBR since the CB is replacing cash with bonds (not classified as reserves)
The supply of reserves will shift left as bank reserves fall
This forces the interest rate up
If the cut in NBR is large enough then the federal funds rate may go as high as the discount rate
It will not exceed the discount rate, since any ff rate above id will no longer be binding (banks will just borrow directly from the Fed at iff>id RD
NBR2
NBR1
Reserves

10. Lowering the Discount Rate (Non-Binding)
Interest Rate
Id,1
RS1
Id,2
RS2
iff,1
The effect of a discount rate change depends on whether the demand curve intersects the supply curve in its vertical section versus its flat section – i.e. binding or not binding.
Changing the discount rate will only affect reserves (and thus the money supply) and the interest rate if…
It is lowered below the federal funds rate
It was previously below iff, but is raised above iff.
The Figure shows what happens if the intersection occurs at the vertical section of the supply curve so there is no discount lending. In this case, when the discount rate is lowered by the CB from i1d to i2d , the vertical section of the supply curve where there is no discount lending just shortens, as in Rs 2, while the intersection of the supply and demand curve remains at the same point. Thus, in this case there is no change in the equilibrium interest rate, which remains at i1 ff. Because this is the typical situation—since the CB usually keeps the discount rate above its target for the federal funds rate—the conclusion is that most changes in the discount rate have no effect on the interest rate. RD
NBR1
Reserves

11. Lowering the Discount Rate (Binding)
Interest Rate
id,1
RS1
iff,2 = id,2
iff,1
id,2
RS2
However, if the demand curve intersects the supply curve on its flat section, so there is some discount lending, changes in the discount rate do affect the interest rate. In this case, initially discount lending is positive and the equilibrium interest rate equals the discount rate, i1 ff i1 d. When the discount rate is lowered by the CB from i1d to i2d , the horizontal section of the supply curve Rs2 falls, moving the equilibrium from point 1 to point 2, and the equilibrium federal funds rate falls from i1 ff to i2 ff (id2). RD
NBR1 R2
Reserves

12. The Central Bank as a Lender of Last Resort
One of the most important functions of the CB is its role as a lender of last resort to the banking system.
Banks in need of liquidity may borrow from the CB at the discount rate.
A large increase in the demand for reserves (demand for liquidity) by banks is tempered by the CB’s ability to step in and lend at the discount rate.
The interest rate is actually capped by the discount rate.
While this role has helped avert some bank panics, it may have created moral hazard costs
Banks know they will be bailed out by the CB if they fail
Encourages them to take on high-return/high-risk loans
If the loan comes in, they keep all the profits
If the loan fails, the Fed subsidizes the losses.

13. Raising the Reserve Requirement
Interest Rate
Id,1
RS1
iff,2
iff,1
When the CB requires a larger percentage of deposits to be held in reserve, bank’s demand a larger quantity of reserves
Increasing the reserve ratio shifts the demand for reserves to the right
Decreasing the reserve ratio shifts the demand for reserves left.
An increase in reserve demand pushes up the interest rate and lowers the money supply (lower multiplier)
In practice, the reserve requirement is not the most effective policy tool
Many banks hold excess reserves due to classification rules
An increase or decrease in the reserve requirement may not alter their behavior.
Raising RR directly influences bank profitability and can cause severe liquidity problems.
In fact, many countries have abandoned reserve requirements as a policy tool (Australia, Canada, New Zealand)
The question is will the CB be able to conduct monetary policy if there are no reserve requirements? Look at the next slide.
RD2
RD1
NBR1
Reserves

14. The Channel/Corridor System
Without reserve requirements, can a central bank still control interest rates?
If banks don’t hold reserves, then how can the CB induce changes in interest rates through changes in reserves?
One solution is the channel/corridor system
Banks set up one facility that stands ready to lend to banks at a guaranteed lending rate (il)
This facility will supply as many reserves to banks as they desire at this rate
Another facility is set up that accepts deposits from banks and pays them a guaranteed interest rate on these deposits (ir)
This facility will accept an unlimited amount of deposits.
These two interest rates present the lower and upper bound for the federal funds rate negotiated between banks.

15. The Channel System
If banks don’t hold reserves, then how can the CB induce changes in interest rates through changes in reserves?
One solution is the channel/corridor system
Banks set up one facility that stands ready to lend to banks at a guaranteed lending rate (il) This facility will supply as many reserves to banks as they desire at this rate
Another facility is set up that accepts deposits from banks and pays them a guaranteed interest rate on these deposits (ir). This facility will accept an unlimited amount of deposits.
These two interest rates present the lower and upper bound for the federal funds rate negotiated between banks.

16. Conventional Monetary Policy Tools
During normal times, the Central Bank uses three tools of monetary policy—open market operations, discount lending, and reserve requirements—to control the money supply and interest rates, and these are referred to as conventional monetary policy tools.

17. Open Market Operations
Dynamic open market operations
Defensive open market operations
Primary dealers
Repurchase agreements
There are two types of open market operations: Dynamic open market operations are intended to change the level of reserves and the monetary base, and defensive open market operations are intended to offset movements in other factors that affect reserves and the monetary base, such as changes in Treasury deposits. The CB conducts open market operations in government securities because the market for these securities is the most liquid and has the largest trading volume. It has the capacity to absorb the CB substantial volume of transactions without experiencing excessive price fluctuations that would disrupt the market.

18. Advantages of Open Market Operations
The CB has complete control over the volume
Compare this to discount lending, in which the CB sets the price of borrowing, but does not directly control how much banks actually borrow.
Flexible and precise
Can be used to enact both small and large changes in the monetary base.
Easily reversed
Mistakes can be quickly corrected in a way that would not have been possible with reserve requirements or discount lending.
Quickly implemented
There is no administrative delay to conducting open market operations.

19. Discount Policy and the Lender of Last Resort
Discount window
Primary credit: standing lending facility
Lombard facility
Secondary credit
Seasonal credit
Lender of last resort to prevent financial panics
Creates moral hazard problem
The CB’s discount loans to banks are of three types: primary credit, secondary credit, and seasonal credit. Primary credit is the discount lending that plays the most important role in monetary policy. Healthy banks are allowed to borrow all they want from the primary credit facility, and it is therefore referred to as a standing lending facility. The interest rate on these loans is the discount rate, and as we mentioned before, it is set higher than the federal funds rate target, usually by 100 basis points (one percentage point), and thus in most circumstances the amount of discount lending under the primary credit facility is very small. Then why does the CB have this facility? The answer is that the facility is intended to be a backup source of liquidity for sound banks so that the interest rate never rises too far above the target.
Secondary credit is given to banks that are in financial trouble and are experiencing severe liquidity problems. The interest rate on secondary credit is set at 50 basis points (0.5 percentage points) above the discount rate. This interest rate on these loans is set at a higher, penalty rate to reflect the less-sound condition of these borrowers.
Seasonal credit is given to meet the needs of a limited number of small banks in vacation and agricultural areas that have a seasonal pattern of deposits. The interest rate charged on seasonal credit is tied to the average of the federal funds rate and certificate of deposit rates. This, however, is an old tool

20. Advantages and Disadvantages of Discount Policy
Used to perform role of lender of last resort
Cannot be fully controlled by the CB; the decision maker is the bank
Discount facility is used as a backup facility to prevent the federal funds rate from rising too far above the target
Before moving to the next topic, lets say a few words about the currency board arrangement.

21. Monetary Policy: Goals
Now that we understand the tools that central banks use to conduct monetary policy, we can proceed to how monetary policy is actually conducted. Understanding the conduct of monetary policy is important, because it not only affects the money supply and interest rates but also has a major influence on the level of economic activity and hence on our well-being. To explore this subject, we look at the goals that the CB establishes for monetary policy and its strategies for attaining them.

22. The Price Stability Goal and the Nominal Anchor
Over the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy.
The role of a nominal anchor: a nominal variable such as the inflation rate or the money supply, which ties down the price level to achieve price stability.
Although it is clear that high employment is desirable, how high should it be? At what point can we say that the economy is at full employment? At first, it might seem that full employment is the point at which no worker is out of a job; that is, when unemployment is zero. But this definition ignores the fact that some unemployment, called frictional unemployment, which involves searches by workers and firms to find suitable matchups, is beneficial to the economy. Another reason that unemployment is not zero when the economy is at full employment is due to what is called structural unemployment, a mismatch between job requirements and the skills or availability of local workers. Clearly, this kind of unemployment is undesirable. Nonetheless, it is something that monetary policy can do little about. The goal for high employment should therefore not seek an unemployment level of zero but rather a level above zero consistent with full employment at which the demand for labor equals the supply of labor. This level is called the natural rate of unemployment.
The goal of steady economic growth is closely related to the high-employment goal because businesses are more likely to invest in capital equipment to increase productivity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it does not pay for a firm to invest in additional plants and equipment. Although the two goals are closely related, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest. In fact, this is the stated purpose of so-called supply-side economics policies, which are intended to spur economic growth by providing tax incentives for businesses to invest in facilities and equipment and for taxpayers to save more. There is also an active debate over what role monetary policy can play in boosting growth.

23. Other Goals of Monetary Policy
Five other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy:
(1) high employment and output stability
(2) economic growth
(3) stability of financial markets
(4) interest-rate stability
(5) stability in foreign exchange markets
Financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities, thereby leading to a sharp contraction in economic activity. The promotion of a more stable financial system in which financial crises are avoided is thus an important goal for a central bank.
Interest-rate stability is desirable because fluctuations in interest rates can create uncertainty in the economy and make it harder to plan for the future. Fluctuations in interest rates that affect consumers’ willingness to buy houses, for example, make it more difficult for consumers to decide when to purchase a house and for construction firms to plan how many houses to build. A central bank may also want to reduce upward movements in interest rates as they generate hostility toward central banks and lead to demands that their power be curtailed.
With the increasing importance of international trade, the exchange rate has become a major consideration for Central banks. A rise in the value of the national currency makes domestic industries less competitive compared to those abroad, and a decline in the value of the national currency stimulates inflation and exports. In addition, preventing large changes in the value of the ER makes it easier for firms and individuals purchasing or selling goods abroad to plan ahead. Stabilizing extreme movements in the value of the ER is thus viewed as a worthy goal of monetary policy.
Conflict among goals
Although many of the goals mentioned are consistent with each other—high employment with economic growth, interest-rate stability with financial market stability—this is not always the case. The goal of price stability often conflicts with the goals of interest-rate stability and high employment in the short run (but probably not in the long run). For example, when the economy is expanding and unemployment is falling, both inflation and interest rates may start to rise. If the central bank tries to prevent a rise in interest rates, this might cause the economy to overheat and stimulate inflation. But if a central bank raises interest rates to prevent inflation, in the short run unemployment could rise. The conflict among goals may thus present central banks with some hard choices.

24. Should Price Stability Be the Primary Goal of Monetary Policy?
Hierarchical Versus Dual Mandates:
hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued
dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability
Price Stability as the Primary, Long-Run Goal
of Monetary Policy
- Either type of mandate is acceptable as long as it operates to make price stability the primary goal in the long run, but not the short run

25. Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets, and Goals of Monetary Policy
The central bank’s problem is that it wishes to achieve certain goals, such as price stability with high employment, but it does not directly influence the goals. It has a set of tools to employ (open market operations, changes in the discount rate, and changes in reserve requirements) that can affect the goals indirectly after a period of time (typically more than a year). If the central bank waits to see what the price level and employment will be one year later, it will be too late to make any corrections to its policy—mistakes will be irreversible.
All central banks consequently pursue a different strategy for conducting monetary policy by aiming at variables that lie between its tools and the achievement of its goals. The strategy is as follows: After deciding on its goals, the central bank chooses a set of variables to aim for, called intermediate targets, such as the monetary aggregates (M1, M2, or M3) or interest rates (short- or long-term), which have a direct effect on employment and the price level. However, even these intermediate targets are not directly affected by the central bank’s policy tools. Therefore, it chooses another set of variables to aim for, called operating targets, or alternatively instrument targets, such as reserve aggregates (reserves, non-borrowed reserves, monetary base, or non-borrowed base) or interest rates (federal funds rate or Treasury bill rate), which are more responsive to its policy tools. (Recall that non-borrowed reserves are total reserves minus borrowed reserves, which are the amount of discount loans; the non-borrowed base is the monetary base minus borrowed reserves; and the federal funds rate is the interest rate on funds loaned overnight between banks.

26. Criteria for Choosing the Policy Instrument
Observability and Measurability
Controllability
Predictable effect on Goals
Measurability. Quick and accurate measurement of an intermediate-target variable is necessary, because the intermediate target will be useful only if it signals rapidly when policy is off track. What good does it do for the central bank to plan to hit a 4% growth rate for M2 if it has no way of quickly and accurately measuring M2? At first glance, interest rates seem to be more measurable than monetary aggregates and hence more useful as intermediate targets. Not only are the data on interest rates available more quickly than on monetary aggregates, but they are also measured more precisely and are rarely revised, in contrast to the monetary aggregates, which are subject to a fair amount of revision. However, the interest rate that is quickly and accurately measured, the nominal interest rate, is typically a poor measure of the real cost of borrowing, which indicates with more certainty what will happen to GDP. This real cost of borrowing is more accurately measured by the real interest rate—the interest rate adjusted for expected inflation. Unfortunately, the real interest rate is extremely hard to measure, because we have no direct way to measure expected inflation. Since both interest rate and monetary aggregates have measurability problems, it is not clear whether one should be preferred to the other as an intermediate target.
Controllability. A central bank must be able to exercise effective control over a variable if it is to function as a useful target. If the central bank cannot control an intermediate target, knowing that it is off track does little good, because the central bank has no way of getting the target back on track.
Predictable effect on goals. The most important characteristic a variable must have to be useful as an intermediate target is that it must have a predictable impact on a goal. Because the ability to affect goals is so critical to the usefulness of an intermediate-target variable, the linkage of the money supply and interest rates with the goals—output, employment, and the price level—is a matter of much debate and theoretical research.

27. Inflation Targeting
Public announcement of medium-term numerical target for inflation
Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal
Information-inclusive approach in which many variables are used in making decisions
Increased transparency of the strategy
Increased accountability of the central bank

28. Inflation Targeting (cont’d)
New Zealand (effective in 1990)
Inflation was brought down and remained within the target most of the time.
Growth has generally been high and unemployment has come down significantly
Canada (1991)
Inflation decreased since then, some costs in term of unemployment
United Kingdom (1992)
Inflation has been close to its target.
Growth has been strong and unemployment has been decreasing.

29. Inflation Targeting (cont’d)
Advantages
Does not rely on one variable to achieve target
Easily understood
Reduces potential of falling in time-inconsistency trap
Stresses transparency and accountability
Disadvantages
Delayed signaling
Too much rigidity
Potential for increased output fluctuations
Low economic growth during disinflation

30. Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2011

31. Lessons for Monetary Policy Strategy from the Global Financial Crisis
Developments in the financial sector have a far greater impact on economic activity than was earlier realized
The zero-lower-bound on interest rates can be a serious problem
The cost of cleaning up after a financial crisis is very high
Price and output stability do not ensure financial stability

32. Should central banks respond to bubbles?
Lessons for Monetary Policy Strategy from the Global Financial Crisis (cont’d)
Should central banks respond to bubbles?
Strong argument for not responding to bubbles driven by irrational exuberance
Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time.
Monetary policy should not be used to prick bubbles.

33. How should Central banks respond to asset price bubbles?
Lessons for Monetary Policy Strategy from the Global Financial Crisis (cont’d)
How should Central banks respond to asset price bubbles?
Asset-price bubble: pronounced increase in asset prices that depart from fundamental values, which eventually burst.
Types of asset-price bubbles
Credit-driven bubbles
Subprime financial crisis
Bubbles driven solely by irrational exuberance

34. Lessons for Monetary Policy Strategy from the Global Financial Crisis (cont’d)
Macropudential policy: regulatory policy to affect what is happening in credit markets in the aggregate.
Monetary policy: Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed without any reaction.