R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

1. R. GLENNHUBBARDANTHONY PATRICKO’BRIEN Money,Banking, andthe Financial System

2. Monetary Policy 15 C H A P T E R LEARNING OBJECTIVES After studying this chapter, you should be able to: Describe the goals of monetary policy 15.1 Understand how the Fed uses monetary policy tools to influencethe federal funds rate 15.2 Trace how the importance of different monetary policy tools haschanged over time 15.3 Explain the role of monetary targeting in monetary policy 15.4

3. Monetary Policy 15 C H A P T E R • BERNANKE’S DILEMMA • During the financial crisis of 2007–2009, the Fed took extraordinary policy actions, including huge asset purchases that expanded bank reserves and the monetary base. • The Fed had hoped for a strong recovery, where it could begin its “exit strategy” of returning bank reserves and the monetary base to more normal levels. Unfortunately, as of July 2010, the economy was recovering more slowly than the Fed had hoped. • Since most macroeconomic policy consists of monetary policy, it was not surprising that Bernanke was the center of attention as the economy struggled through a slow recovery in 2010. • For a discussion of some of the policy options open to the Fed, read AN INSIDE LOOK AT POLICY on page 472.

4. Key Issue and Question Issue: During the financial crisis, the Federal Reserve employed a series of new policy tools in an attempt to stabilize the financial system. Question: Should price stability still be the most important policy goal of central banks?

5. 15.1 Learning Objective Describe the goals of monetary policy

6. The Goals of Monetary Policy The Fed has set six monetary policy goals that are intended to promote a well-functioning economy: 1. Price stability 2. High employment 3. Economic growth 4. Stability of financial markets and institutions 5. Interest rate stability 6. Foreign-exchange market stability

7. The Goals of Monetary Policy Price Stability Inflation, or persistently rising prices, erodes the value of money as a medium of exchange and as a unit of account. Most industrial economies have set price stability as a policy goal. Inflation makes prices less useful as signals for resource allocation. Uncertain future prices complicate decisions households and firms have to make. Inflation can also arbitrarily redistribute income. Rates of inflation in the hundreds or thousands of percent per year—known as hyperinflation—can severely damage an economy’s productive capacity. The range of problems caused by inflation—from uncertainty to economic devastation—make price stability a key monetary policy goal.

8. The Goals of Monetary Policy High Employment High employment, or a low rate of unemployment, is another key monetary policy goal. Unemployment reduces output and causes financial and personal distress. Congress and the president share responsibility for the goal of high employment. Even under the best economic conditions, some frictional and structural unemployment always remains. The tools of monetary policy are ineffective in reducing these types of unemployment. Instead, the Fed attempts to reduce levels of cyclical unemployment, which is unemployment associated with business cycle recessions. Most economists estimate that the natural rate of unemployment is between 5% and 6%.

9. The Goals of Monetary Policy Economic Growth Economic growth Increases in the economy’s output of goods and services over time; a goal of monetary policy. Economic growth provides the only source of sustained real increases in household incomes. Economic growth depends on high employment. With high unemployment, businesses have unused productive capacity and are much less likely to invest in capital improvements. Stable economic growth allows firms and households to plan accurately and encourages the long-term investment that is needed to sustain growth.

10. The Goals of Monetary Policy Stability of Financial Markets and Institutions When financial markets and institutions are not efficient in matching savers and borrowers, the economy loses resources. The stability of financial markets and institutions makes possible the efficient matching of savers and borrowers. The Fed responded vigorously to the financial crisis that began in 2007, but it initially underestimated its severity and was unable to head off the deep recession of 2007–2009. Some economists believe that actions to deflate asset bubbles may be counterproductive, but the severity of the 2007–2009 recession has made financial stability a more important Fed policy goal.

11. The Goals of Monetary Policy Interest Rate Stability Like fluctuations in price levels, fluctuations in interest rates make planning and investment decisions difficult for households and firms. The Fed’s goal of interest rate stability is motivated by political pressure as well as by a desire for a stable saving and investment environment. Sharp interest rate fluctuations cause problems for banks and other financial firms. So, stabilizing interest rates can help to stabilize the financial system.

12. The Goals of Monetary Policy Foreign-Exchange Market Stability In the global economy, foreign-exchange market stability, or limited fluctuations in the foreign-exchange value of the dollar, is an important monetary policy goal of the Fed. A stable dollar simplifies planning for commercial and financial transactions. Fluctuations in the dollar’s value change the international competitiveness of U.S. industry: A rising dollar makes U.S. goods more expensive abroad, reducing exports, and a falling dollar makes foreign goods more expensive in the United States. In practice, the U.S. Treasury often originates changes in foreign-exchange policy, although the Fed implements these policy changes.

13. 15.2 Learning Objective Understand how the Fed uses monetary policy tools to influence thefederal funds rate.

14. Monetary Policy Tools and the Federal Funds Rate The Fed’s three traditional policy tools are: 1.Open market operations. Open market operations The Federal Reserve’s purchases and sales of securities, usually U.S. Treasury securities, in financial markets. 2.Discount policy. 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. 3.Reserve requirements. Reserve requirement The regulation requiring banks to hold a fraction of checkable deposits as vault cash or deposits with the Fed.

15. Monetary Policy Tools and the Federal Funds Rate During the financial crisis, the Fed introduced two new policy tools connected with bank reserve accounts that were still active in the fall of 2010: 1.Interest on reserve balances. By raising the interest rate it pays, the Fed can increase banks’ holdings of reserves, potentially restraining banks’ ability to extend loans and increase the money supply. By reducing the interest rate, the Fed can have the opposite effect. 2.Term deposit facility. Similar to certificates of deposit, the Fed’s term deposits are offered to banks in periodic auctions. The interest rates are determined by the auctions and have been slightly above the interest rate the Fed offers on reserve balances. The more funds banks place in term deposits, the less they will have available to expand loans and the money supply.

16. Monetary Policy Tools and the Federal Funds Rate The Federal Funds Market and the Fed’s Target Federal Funds Rate 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. The target for the federal funds rate is set at meetings of the Federal Open Market Committee (FOMC). We use a graph of the banking system’s demand for and the Fed’s supply of reserves to see how the Fed uses its policy tools to influence the federal funds rate and the money supply. Demand for and Supply of Reserves The figure that follows shows both the demand and supply curves for reserves.

17. Monetary Policy Tools and the Federal Funds Rate Equilibrium in the Federal Funds Market Figure 15.1 Equilibrium in the Federal Funds Market Equilibrium in the federal funds market occurs at the intersection of the demand curve for reserves, D, and the supply curve for reserves, S. The Fed determines the level of reserves, R, the discount rate, id, and the interest rate on banks’ reserve balances at the Fed, irb. Equilibrium reserves are R*, and the equilibrium federal funds rate is i*ff.•

18. Monetary Policy Tools and the Federal Funds Rate Open Market Operations and the Fed’s Target for the Federal Funds Rate Figure 15.2 (1 of 2) Effects of Open Market Operations on the Federal Funds Market In panel (a), an open market purchase of securities by the Fed increases reserves in the banking system, shifting the supply curve to the right from S1 to S2. The equilibrium level of reserves increases from R*1 to R*2 while the equilibrium federal funds rate falls from 1.5% to 1%. The discount rate is also cut from 1.75% to 1.25%.

19. Monetary Policy Tools and the Federal Funds Rate Open Market Operations and the Fed’s Target for the Federal Funds Rate Figure 15.2 (2 of 2) Effects of Open Market Operations on the Federal Funds Market In panel (b), an open market sale of securities by the Fed reduces reserves, shifting the supply curve to the left from S1 to S2. The equilibrium level of reserves decreases from R*1 to R*2 while the equilibrium federal funds rate rises from 5% to 5.25%. The discount rate is also increased from 6% to 6.25%.•

20. Monetary Policy Tools and the Federal Funds Rate The Effect of Changes in the Discount Rate and in Reserve Requirements Changes in the Discount Rate Since 2003, the Fed has kept the discount rate higher than the target for the federal funds rate. This makes the discount rate a penalty rate, which means that banks pay a penalty by borrowing from the Fed rather than from other banks in the federal funds market. Changes in the Required Reserve Ratio The Fed rarely changes the required reserve ratio. Changing the required reserve ratio without also engaging in open market operations would cause a change in the equilibrium federal funds rate. If the Fed changes the required reserve ratio, it will likely carry out offsetting open market operations to keep the target for the federal funds rate unchanged (see figure 15-3).

21. Figure 15.3 The Effect of a Change in the Required Reserve Ratio on the Federal Funds Market In panel (a), the Fed increases the required reserve ratio, which shifts the demand curve for reserves from D1 to D2. The equilibrium federal funds rate rises from i*ff1 to i*ff2. In panel (b), the Fed increases the required reserve ratio, which shifts the demand curve from D1 to D2. The Fed offsets the effects of the increase in the required reserve ratio with an open market purchase, shifting the supply curve from S1 to S2. The level of reserves increases from to R*1 to R*2, while the target federal funds rate remains unchanged, at i*ff1.•

22. 15.2 Solved Problem Analyzing the Federal Funds Market Use demand and supply graphs for the federal funds market to analyze the following two situations. Be sure that your graphs clearly show changes in the equilibrium federal funds rate and equilibrium level of reserves, and also any shifts in the demand and supply curves. a. Suppose that banks decrease their demand for reserves. Show how the Fed can offset this change through open market operations in order to keep the equilibrium federal funds rate unchanged. b. Suppose that in equilibrium the federal funds rate is equal to the interest rate the Fed is paying on reserves. If the Fed carries out an open market purchase, show the effect on the equilibrium federal funds rate. Monetary Policy Tools and the Federal Funds Rate

23. 15.2 Solved Problem Solved Problem Analyzing the Federal Funds Market Solving the Problem Step 1Review the chapter material. Step 2 Answer part (a) by drawing the appropriate graph. Monetary Policy Tools and the Federal Funds Rate

24. 15.2 Solved Problem Solved Problem Analyzing the Federal Funds Market Solving the Problem Step 3Answer part (b) by drawing the appropriate graph. Monetary Policy Tools and the Federal Funds Rate

25. 15.3 Learning Objective Trace how the importance of different monetary policy tools has changed over time.

26. More on the Fed’s Monetary Policy Tools Open Market Operations In 1935, Congress established the FOMC to guide open market operations. An open market purchase of Treasury securities causes the prices to increase, thereby decreasing their yield. Because the purchase will increase the monetary base, the money supply will expand. An open market sale has the opposite effects. Because open market purchases reduce interest rates, they are considered an expansionary policy. Open market sales increase interest rates and are considered a contractionary policy.

27. More on the Fed’s Monetary Policy Tools Implementing Open Market Operations The FOMC issues a policy directive to the Federal Reserve System’s account manager, who is a vice president of the Federal Reserve Bank of New York and who has the responsibility of implementing open market operations and hitting the FOMC’s target for the federal funds rate. The Open Market Trading Desk is linked electronically through the Trading Room Automated Processing System (TRAPS) to about 18 primary dealers. Each morning, the trading desk notifies the primary dealers of the size of the open market purchase or sale being conducted and asks them to submit offers to buy or sell Treasury securities.

28. More on the Fed’s Monetary Policy Tools Dynamic open market operations are intended to change monetary policy as directed by the FOMC. Defensive open market operations are intended to offset temporary fluctuations in the demand or supply for reserves, not to carry out changes in monetary policy. Dynamic open market operations are likely to be conducted as outright purchases and sales of Treasury securities to primary dealers. Defensive open market operations are much more common, and are conducted through repurchase agreements.

29. Making the Connection A Morning’s Work at the Open Market Trading Desk 7:00 A.M. The account manager receives an estimate of the supply of reserves for that day and for the remaining days of the current maintenance period. 8:00 A.M.–9:00 A.M. The account manager begins to assess conditions in the government securities market, and estimates the demand for reserves and how the prices of government securities will change during the trading day. 9:10 A.M. The account manager studies the FOMC’s directive, or the level of the federal funds rate desired, and designs dynamic open market operations and defensive open market operations to offset temporary disturbances to reserves as predicted by the staff. 9:30 A.M. Traders notify primary dealers of the Fed’s desired transactions and request quotations for asked/bid prices. 9:40 A.M. The primary dealers submit their propositions to the trading desk. 9:41 A.M. The trading desk selects the lowest prices (for purchases) and highest prices (for sales) and returns the results to dealers. 10:30 A.M. By this time, the transactions have been completed. More on the Fed’s Monetary Policy Tools

30. Open Market Operations versus Other Policy Tools The benefits of open market operations include control, flexibility, and ease of implementation. Discount loans depend in part on the willingness of banks to request the loans and so are not as completely under the Fed’s control. The Fed can make both large and small open market operations. Often, dynamic operations require large purchases or sales whereas defensive operations call for small. Reversing open market operations is simple for the Fed. Discount loans and reserve requirement changes are more difficult to reverse quickly. This is a key reason that the Fed has left reserve requirements unchanged since 1992. The Fed can implement its open market operations rapidly, with no administrative delays. Changing the discount rate or reserve requirements requires lengthier deliberation. More on the Fed’s Monetary Policy Tools

31. “Quantitative Easing”: Fed Bond Purchases during the Financial Crisis of 2007–2009 Thepolicy of a central bank attempting to stimulate the economy by buying long-term securities is called quantitative easing. The Fed took the unusual step of buying more than $1.7 trillion in mortgage-backed securities and longer-term Treasury securities during 2009 and early 2010. In November 2010, the Fed announced a second round of quantitative easing (dubbed QE2). With QE2 the Fed would buy an additional $600 billion in long-term Treasury securities through June 2011. Some economists and policymakers worried that they would eventually lead to higher inflation. More on the Fed’s Monetary Policy Tools

32. Making the Connection Why Can’t the Fed Always Hit Its Federal Funds Target? The Fed can only set a target for the federal funds rate. The actual federal funds rate is determined by the demand and supply for reserves in the federal funds market. The New York Fed uses open market operations to try to keep the actual federal funds rate as close as possible to the target rate. Overall, the trading desk has done a good job of keeping the actual rate close to the target rate. More on the Fed’s Monetary Policy Tools

33. More on the Fed’s Monetary Policy Tools Discount Policy Since 1980, all depository institutions have had access to the discount window. Each Federal Reserve Bank maintains its own discount window, although all Reserve Banks charge the same discount rate. Categories of Discount Loans The Fed’s discount loans to banks fall into three categories: (1) primary credit, (2) secondary credit, and (3) seasonal credit. Primary credit Discount loans available to healthy banks experiencing temporary liquidity problems. Secondary credit Discount loans to banks that are not eligible for primary credit. Seasonal credit Discount loans to smaller banks in areas where agriculture or tourism is important.

34. More on the Fed’s Monetary Policy Tools Discount Lending during the Financial Crisis of 2007–2009 The initial stages of the financial crisis involved shadow banks rather than commercial banks. When the crisis began, the Fed was handicapped in its role as a lender of last resort because it had no recent tradition of lending to anyone but banks. The Fed did, however, use its authority to set up several temporary lending facilities: Primary Dealer Credit Facility. This facility was intended to allow the investment banks and large securities firms that are primary dealers to obtain emergency loans. Term Securities Lending Facility. This facility was intended to allow financial firms to borrow against illiquid assets, such as mortgage-backed securities. It was established in March 2008 and closed in February 2010.

35. More on the Fed’s Monetary Policy Tools Commercial Paper Funding Facility. Under this facility, the Fed purchased three-month commercial paper directly from corporations so they could continue normal operations. Term Asset-Backed Securities Loan Facility (TALF). Under this facility, the Federal Reserve Bank of New York extended three-year or five-year loans to help investors fund the purchase of asset-backed securities. Asset-backed securities are securitized consumer and business loans, apart from mortgages. The Fed also set up a new way for banks to receive discount loans under the Term Auction Facility. In this facility, the Fed for the first time began auctioning discount loans at an interest rate determined by banks’ demand for the funds. The Fed ended these innovative discount programs in 2010, with the financial system having recovered from the worst of the crisis.

36. More on the Fed’s Monetary Policy Tools Interest on Reserve Balances Banks had long complained that the Fed’s failure to pay interest on the banks’ reserve deposits amounted to a tax. 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. Lowering the interest rate would have the opposite effect.

37. 15.4 Learning Objective Explain the role of monetary targeting in monetary policy.

38. Monetary Targeting and Monetary Policy The Fed often faces trade-offs in attempting to reach its goals, particularly the goals of high economic growth and low inflation. In an attempt to spur economic growth, the Fed could lower the target for the federal funds rate and cause other market interest rates to fall through open market purchases, which increase the monetary base and money supply, potentially increasing the inflation rate in the longer run. With economic growth having slowed and the unemployment rate seemingly stuck well above 9%, the Fed contemplated taking further expansionary actions despite their consequences. Adding insult to injury, the Fed has no direct control over real output or the price level. The tools of monetary policy don’t permit the Fed to achieve its monetary policy goals directly.

39. Monetary Targeting and Monetary Policy The Fed also faces timing difficulties. The information lag refers to the Fed’s inability to observe instantaneously changes in GDP, inflation, or other economic variables. A second timing problem is the impact lag. This is the time that is required for monetary policy changes to affect output, employment, or inflation. The Fed’s actions may affect the economy at the wrong time, and the Fed might not be able to recognize its mistakes soon enough to correct them. One possible solution to the problems caused by the information lag and impact lag is for the Fed to use targets to meet its goals. Unfortunately, targets also have problems.

40. Monetary Targeting and Monetary Policy 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: policy instruments—sometimes called operating targets—and intermediate targets. Although using policy instruments and intermediate targets is no longer the favored approach at the Fed, reviewing how they work can provide some insight into the difficulties the Fed faces in executing monetary policy.

41. Monetary Targeting and Monetary Policy Intermediate Targets By using prospective intermediate targets, typically either monetary aggregates or interest rates, the Fed can try to achieve a goal outside of its direct control better than it would if it had focused solely on the goal. Using intermediate targets can also provide helpful feedback about the Fed’s policy actions. Policy Instruments, or Operating Targets Policy instruments, or operating targets, are variables that the Fed controls directly with its monetary policy tools and that are closely related to intermediate targets. Examples of policy instruments include the federal funds rate and nonborrowed reserves. Most major central banks use interest rates as policy instruments.

42. Figure 15.4 Achieving Monetary Policy Goals The Federal Reserve establishes goals for such economic variables as the rate of inflation and the rate of unemployment. The Fed directly controls only its policy tools. It can use targets—intermediate targets and policy instruments—which are variables that the Fed can influence, to help achieve monetary policy goals. In recent years, the Fed has deemphasized the use of targeting procedures of this type.•

43. Making the Connection What Happened to the Link between Money and Prices? In the United States, the money supply has grown more rapidly during decades when the inflation rate has been relatively high. Prior to 1980, there was significant evidence that the link between money and prices held up in the short run of a year or two. In fact, many economists were convinced that the acceleration in inflation during the late 1960s and 1970s was due to the Fed’s having allowed the growth rate of the money supply to sharply increase during those years. The economists who argued this point most forcefully were known as monetarists. The most prominent monetarist was Nobel laureate Milton Friedman of the University of Chicago. Under Paul Volcker, the Fed shifted its policy to emphasize nonborrowed reserves as a policy instrument, or operating target. This episode, referred to as “The Great Monetarist Experiment,” produced mixed results. Monetary Targeting and Monetary Policy

44. Making the Connection What Happened to the Link between Money and Prices? After 1980, the short-run link between the growth of the money supply and inflation broke down. The reason for the breakdown in the relationship between the growth of the money supply and inflation is that the nature of M1 and M2 had changed. As a result of changes and innovations in financial markets, a rapid increase in M1 need not translate directly into spending increases that would lead to higher inflation.

45. Monetary Targeting and Monetary Policy The Choice between Targeting Reserves and Targetingthe Federal Funds Rate Traditionally, the Fed has used three criteria when evaluating variables that might be used as policy instruments. The main policy instruments have been reserve aggregates and the federal funds rate. 1. Measurable. The variable must be measurable in a short time frame to overcome information lags. Both reserve aggregates and the federal funds rate are easily measurable. 2. Controllable. Open market operations can keep both variables close to whatever target the Fed selects. 3. Predictable. The complexity of the impact a change in either reserves or the federal funds rate has on goals such as economic growth or price stability compromises predictability. Thus, economists continue to discuss which policy instrument is best.

46. Figure 15.5 (1 of 2) Choosing between Policy Instruments The Fed chooses the level of reserves as its policy instrument by keeping reserves constant, at R*. With demand for reserves at D1, the equilibrium federal funds rate is i*ff1. If the demand for reserves shifts to the right from D1 to D2, the equilibrium federal funds rate increases from from i*ff1 to i*ff2. Similarly, if the demand for reserves shifts to the left from D1 to D3, the equilibrium federal funds rate decreases from i*ff1 to i*ff3. Monetary Targeting and Monetary Policy

47. Figure 15.5 (2 of 2) Choosing betweenPolicy Instruments In panel (b), the Fed chooses the federal funds rate as its policy instrument by keeping the rate constant, at R*. If the demand for reserves increases from D1 to D2, the Fed will have to increase the supply of reserves from S1 to S2 in order to maintain its target for the federal funds rate at i*ff. If the demand for reserves decreases from D1 to D3, the Fed will have to decrease the supply of reserves from S1 to S3 to maintain its target for the federal funds rate.• Monetary Targeting and Monetary Policy

48. Monetary Targeting and Monetary Policy The Fed faces a trade-off. It can choose a reserve aggregate for its policy instrument, or it can choose the federal funds rate, but it cannot choose both. Using reserves as the Fed’s policy instrument will cause the federal funds rate to fluctuate in response to changes in the demand for reserves. Using the federal funds rate as the policy instrument will cause the level of reserves to fluctuate in response to changes in the demand for reserves. By the 1980s, the Fed had concluded that the link between the federal funds rate and its policy goals was closer than the link between the level of reserves and its policy goals. So, for the past 30 years, the Fed has used the federal funds rate as its policy instrument.

49. Monetary Targeting and Monetary Policy The Taylor Rule: A Summary Measure of Fed Policy Actual Fed deliberations are complex and incorporate many factors about the economy. John Taylor of Stanford University has summarized these factors in the Taylor rule. Taylor rule A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate. The Taylor rule begins with an estimate of the value of the real federal funds rate, which is the federal funds rate—adjusted for inflation—that would be consistent with real GDP being equal to potential real GDP in the long run. With real GDP equal to potential real GDP, cyclical unemployment should be zero, and the Fed will have attained its policy goal of high employment.

50. Monetary Targeting and Monetary Policy