Chapter 18. Monetary Policy: Using Interest Rates to Stabilize the Domestic Economy

Now that we've studied the money supply process, we take a closer look at how the Fed impacts the domestic economy. The Fed has three tools at it's disposal to impact the money supply: (1) open market operations (the federal funds rate target), (2) discount lending, (3) the reserve requirement. In this chapter we see how each tool impacts the federal funds market and evaluate its usefulness.

The Market for Reserves and the Federal Funds Rate

Recall that the federal funds rate is the short term interest rate for the interbank lending market where banks lend reserves to each other. The Fed conducts monetary policy primarily through affecting this market, which in turn impacts other debt markets and the economy.

The figure below shows the market for reserves, which determines the equilibrium federal funds rate:

Note that the demand for reserves is downward sloping with respect to the federal funds rate. This is because the federal funds rate is the opportunity cost for a bank holding excess reserves, since the bank could lend out those reserves at the federal funds rate. So the higher the federal funds rate, the higher the opportunity cost of holding excess reserves, so the quantity of excess reserves (and reserves) will be lower.

The supply curve is upward sloping because as the federal funds rates rises, banks will provide more reserves for other banks to borrow.

How do the three tools of monetary policy impact this market?

  • We have seen in chapter 17 how an open market purchases increases reserves in the banking system. So an open market purchase increases the supply of reserves, causing the federal funds rate to fall. An open market sale causes the federal funds rate to rise.
  • We have seen in chapter 17 how increases in discount loans will increase reserves. So a lower discount rate will encourage bank borrowing, increasing the supply of reserves and decreasing the federal funds rate.
  • With an increase in the required reserve ratio, banks must hold more reserves. A higher reserve requirement increases the demand for reserves and causes the federal funds rate to rise.

Open Market Operations

Open market operations are the most important tool of monetary policy. An open market purchase increases the monetary base and the money supply, lowering short-term interest rates. In theory the Fed could conduct open market operations with any type of debt security. In reality it uses Treasury securities because this market is large and liquid, so it can absorb large transactions.

The FOMC votes on open market operations by voting on a federal funds rate target to be acheived through open market operations. The actual buying and selling is left to the Federal Reserve Bank of New York (which is why the FRBNY president always has a vote on the FOMC). Every trading day, the FRBNY open market operations staff surveys conditions in financial markets to determine what type and how much of open market operations are need. They then line up potential buyers and sellers of Treasury securities by getting price quotes from large dealers in securities known as primary dealers. There are about 30 primary dealers. (FYI: Cantor Fitzgerald, a bond trading firm that lost 658 people in the WTC attack in September, did almost 25% of the trading volume in Treasury securities. They have since recovered that market share.) Trades are executed throughout the day, while watching for the desired impact in the federal funds market.

Now the FOMC can set a target and the FRBNY buys and sells to keep the equilibrium federal funds rate as close to the target as possible. The difference between the target and actuall federal funds rate is shown in figure 18.2, page 464.

OMO are the primary tool of monetary policy.  They are flexible, so the Fed and change the federal funds rate by a little or a lot.  They are quick and precises, with same day impact on the interbank lending market, with other short-term interest rates following quickly.  They are reversible.  If the Fed buys too many securities, they can turn around and sell some of them.

Discount Lending

Discount loans increase the monetary base and money supply. Each Federal Reserve district bank has a discount window where loans are made. They affect the volume of discount loans by setting the discount rate and by deciding when to make loans.

Discount loans are made to banks for very short-term liqudity problems at the primary discount rate = federal funds rate + 100 basis points. They are also given to banks in regions with seasonal fluctuations in reserves (such as agricultural areas), and finally to banks in serious trouble at the secondary discount rate = federal funds rate + 50 basis points. However, banks have an incentive not to come to the discount window too often, since this would invite additional scutiny from regulators concerned about the bank's liquidity management.

Beyond their ability to affect the monetary base, discount loans get to the original purpose of the Fed: To be a lender of last resort to banks in trouble in order to prevent larger bank and financial panics. The Fed, frankly, messed up this role during the Great Depression, but have done well in the post-WWII period in its role as lender of last resort. Even with the FDIC to insure deposits, the Fed still needs to be willing to provide liquidity to protect large depositors and to keep the FDIC from going bankrupt in the case of too many bank failures.

Despite the importance of discount loans for financial market stability, they are not an ideal tool for changing the money supply:

  1. Changes in the discount rate may be taken as a signal of monetary policy (an announcement effect) when the Fed is only trying to keep up with market interest rates. The fluctuating spread between the federal funds rate and discount rate will cause the volume of discount loans and the money supply to fluctuate, actually making it harder to control the money supply.
  2. Discount loans are not completely under Fed control. They depend on bank behavior as well.
  3. Discount rate changes are not easily reversible, since the rates on previous loans cannot be changed.

Reserve Requirements

The Federal Reserve Board of Governors sets the reserve requirements for depository institutions. Higher reserve requirements reduce the money multiplier and the money supply, causing short-term interest rates to rise. Required reserves on checkable deposits are 3% up to $44.3 million and 10% on the amount over $44.3 million.

Changing the reserve requirement is certainly effective. In fact it is a very powerful tool. This is actually a disadvantage. The Fed usually wants to make small adjustments to the money supply, and that is not possible with the reserve requirment. As one of my economics professors once said, "it's like using a nuclear warhead when just a fly swatter will do."

Also, practically speaking, the reserve requirement is expensive to change: Banks must change all types of liquidity and asset management strategies. Frequent changes in the reserve requirement would force banks to hold a large cushion of excess reserves to deal with the resulting uncertainty, cutting into their profits.

While reserves were originally required to ensure the soundness of the banking system in meeting depositor withdrawals, today the reserves deposited at the Fed help the Fed maintain the federal funds rate target.

The Goals of Monetary Policy

There are 4 basic goals of monetary policy , which are really desirable goals we want to see for the economy:

  • High Employment (Low unemployment). The federal government is required under laws passed in 1946 and 1978 to promote high employment consistent with price stability. It is clear why high unemployment would be bad: unused resources mean lost output and there are huge personal/social costs as well. But what level of unemployment is acceptable? As we learned in Principles of Macroeconomics the goal for unemployment is NOT zero. There will always be frictional and structural unemployment. The goal for unemployment is the natural rate of unemployment, estimated to be somewhere between 4 and 5%. The current unemployment rate is around 5.1%.  FYI:  The unemployment rate for the Syracuse area is currently at 4%, lower than the NYS 4.6%.
  • Economic Growth. This goal is closely related to the goal of high employment since strong economic growth leads to job creation and high employment while stagnant or falling economic growth means layoffs. Economic growth (the % change in real GDP) in the U.S. averages about 3%, although the averages for growth in the 1970s and 1980s were lower, but have rebounded in the 1990s. In 2006 real GDP rose about 2.7%.
  • Price Stability (Low inflation). Today this is view as the most important goal of monetary policy, not only by the Fed but by the European central banks as well. At high levels, inflation creates uncertainty, lower investments, and lower economic growth. How high is too high? In the U.S. currently, the Fed wants an inflation rate of about 2%, with higher than 4% being unacceptable. Inflation is a concern in 2007, given rising energy and food prices. In 2006 prices rose about 2.5% as measured by the CPI.
  • Financial Market Stability. This category includes the stability of financial institutions, interest rates, and foreign exchange rates. Interest rate stability creates a more favorable investment climate and promotes economic growth. Stepping in to avoid financial crises also avoids the extreme recessions that can follow such crises. A stable exchange rate promotes international trade. This last goal often requires international cooperation with many central banks around the world.

Linking Tools to Objectives

To function as an effective instrument a tool must be

  • easily observable by all
  • controllable by the Fed
  • predictably related to the objectives of monetary policy such as economic growth, low inflation, low unemployment, etc.

These criteria rule out discount lending and reserve requirement, and leave open market operations. Why?

  1. The Fed has complete control over open market operations. Not true with discount loans, where the banks decide to borrow or not.
  2. Open market operations are flexible. They can do a little or a lot, depending on the size of the change desired.
  3. Open market operations are easily reversible. If the initial purchase is too large, then the Fed just has to sell some.
  4. Open market operations are quick. Trades and their impact appear almost immediately during the trading day.

To summarize, all 3 tools at the Fed's disposal are capable of changing the money supply and interest rates, but only one tool, open market operations, is of practical use for conducting monetary policy. We will see how this tool is used to achieve economic goals

The Fed has these ultimate goals, but they only have direct control over a open market operations. Unfortunately it can take over a year for the tools to eventually impact the economic goals. How does the Fed gauge its progress? Through the use of targets. These targets are other variables related to both the tools and the goals of monetary policy. By looking at these variables, the Fed knows if it is on the right track.

The process looks like this:

First, the operating targets are variables closely related to the tools, and respond immediately to changes in the tools. Possible operating targets include reserves, the federal funds rate, or a Tbill rate. Currently the FOMC targets the federal funds rate.

The intermediate targets are variables affected by the operating target, but are closely associated with the goals. Possibilities includes the money aggregates (M1, M2, M3) or other short-term and long-term interest rates in the economy. Given the breakdown between monetary targets and the economy is recent decades, intermediate targets are not as important as they used to be.

So for example, the Fed may want a 5% growth rate for nominal GDP. To do this, they believe they need 4% growth in M2, which will be accomplished with 3% growth in the monetary base. Then, the Fed conducts open market purchases to increase the monetary base by 3% (the operating target), which is measures fairly quickly. Over the next few months it follows changes in M2 to hit a growth rate of 4%. If M2 growth is too low, the Fed will conduct more open market purchases. If the growth rate is too high the Fed will reverse and conduct open market sales.

However, the FOMC MUST make a choice between monetary and interest rates targets: they cannot simultaneously target both! Let's see why.

Suppose the Fed wants to target the money supply M*. As money demand fluctuates, the equilibrium interest rate will change. This is because the Fed is committed to M* as a target so it does not shift the MS curve when MD shifts. The result is an interest rates that fluctuates with money demand:

Suppose instead the Fed wants to target an interest rate i*. As money demand fluctuates, the equilibrium interest rate will rise above or fall below i*, the target. To prevent this, the Fed must increase or decrease the money supply to compensate, keep the equilibrium interest rate at i*. The result is that the money supply fluctuates when money demand fluctuates as the Fed pursues its interest rate target.

If the Fed targets the money supply, then it loses control of interest rates. If the Fed targets interest rates, then it loses control of the money supply.

The Taylor Rule

The federal funds rate is clearly a popular target for monetary policy. How should this target be chosen?

The Taylor Ruleis currently a popular policy rule created by John Taylor of Stanford University. The Taylor rule is an equation the says the target federal funds rate should be based on the current inflation rate, the real federal funds rate (a long-run equilibrium rate), the gap between real GDP and full employment GDP, and the gap between actual inflation and the inflation target.

FF rate target = 2.5 + current inflation + (1/2)(current-target inflation) + (1/2)(current - potential GDP)

So when inflation rises above its target level, the federal funds rate target should rise. When output falls below its potential level then the federal funds rate target will be lower. So the rule responds to economic conditions, including both prices and output. This relationship makes the federal fund rate target based on concerns about both price stability and the business cycle.

Figure 18.6 plots the FOMC's actual federal funds rate target against the rate under the Taylor rule. There is a close correspondence between the two. While the rule is a helpful guide, keep in mind that discretion is also important for the unexpected, such as 9/11.

FYI: Related Links

Multiple Choice Quiz Chapter 18 An interactive quiz from the textbook website

Understanding Open Market Operations A primer from the New York Fed.

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