Chapter 25: Monetary Policy

Role of the Central Bank, Monetary Policy Tools, Challenges in Using Monetary Policy

The Federal Reserve System

What is a Central Bank?

A bank responsible for the management of a nation’s money supply that typically serves as a regulator of the banking system. Its primary responsibility is to maintain a stable & effective monetary system. It also distributes currency, is responsible for the design and implementation of monetary policy, engages in bank supervisory activities, the setting of margin requirements for equity markets (limits on how much can be borrowed when purchasing stocks/bonds), and a variety of consumer protection efforts.

Federal Reserve Tools

What is Monetary Policy?

Policies of the Federal Reserve System that affect the supply of money & credit. It’s intended to change the growth of the nation’s money supply to foster full employment, stable prices & a sound financial system. The “Fed” has 4 tools to achieve these goals.

What are Open Market Operations?

The purchase & sale of Treasury bonds by the Federal Reserve in the “open market”.

Expanding Money Supply

To expand money supply, it buys Treasury bonds from businesses, banks & individuals who own them. People sell their bonds to the Fed in return for a check. These checks are deposited in banks. Banks deposits increase. Banks present those checks to the Federal Reserve. The Federal Reserve increases the banks’ reserves by equivalent amounts. Money supply increases by an amount equal to the purchase of bonds.

Contracting Money Supply

To contract money supply, it sells bonds. People give checks to the Federal Reserve in return for bonds. The Federal Reserve presents those checks to banks. The banks remove the money from the respective person’s account & the Federal Reserve removes an equal amount from the banks’ reserves. Money supply shrinks by more than the amount of the original sale of bonds.

What is the Federal Funds Rate?

Federal funds are the portion of reserve balances that are held by commercial banks at Federal Reserve Banks. Banks with excess reserves can lend their excess to banks who don’t meet reserve requirements. The interest rate that banks charge each other is called the federal funds rate.

The Fed communicates plans by announcing a target for the federal funds rate, which signals direction change in monetary policy. They achieve their target by buying or selling bonds, which indirectly changes interest rates by changing the money supply.

Bond Prices & Interest Rates

A bond’s price & the interest rate earned by that bond (sometimes referred to as the yield to maturity or simply “bond yields”) move in opposite directions. Because of this, a sale of bonds raises the effective interest rate on Treasury bonds it buys/sells.

Since Treasury bonds are close substitutes to other types of bonds, as the rate of return on Treasury bonds increases, owners of other types of bonds may sell their bonds & buy Treasury bonds. The increase in the supply of the other bonds lowers their prices & raises their interest rate.

How does the Fed selling bonds affect interest rates?

  1. By reducing the supply of money.
  2. By restricting excess reserves that banks have available to loan to each other (thus raising the federal funds rate).
  3. By lowering prices of bonds (thus raising the effective interest rate that bonds pay).

What is the Discount Rate?

The interest rate when banks borrow reserves from the Fed through the discount window. Normally kept 1% above target federal funds rate. The Fed lends reserves through the discount window. Institutions with deposit accounts subject to reserve requirements have access to the discount window.

The theory is that the higher the discount rate, the costlier it is to borrow reserves, and therefore the less likely it is that banks will be fully loaned out (hold no excess reserves). That is, it’s less likely that the money supply will have been expanded to its absolute maximum.

What is the Required Reserve Ratio?

The percentage of deposits that must be kept on reserve. Reserves may consist of currency in bank vaults or deposits a bank keeps with the Fed. Altering the required reserve ratio is the least frequently used tool, due to the opportunity cost it imposes on banks who could otherwise receive interest & because of how easy it is to make a mistake with it (since it’s incredibly sensitive).

How Does the Fed Use Interest Paid on Required/Excess Reserves?

The Fed now pays interest on required & excess reserves. An increase in the interest paid on excess reserves will encourage banks to hold more excess reserves & make fewer loans. A decrease will encourage banks to make more loans & reduce excess reserves.

Monetary Policy in Action

What is a Restrictive or Contractionary Monetary Policy Intended to Do?

To reduce the rate of growth of spending in the economy.

What is a Stimulative or Expansionary Monetary Policy Intended to Do?

To increase the rate of growth of spending in the economy.

Monetary Policy in a Supply Shock

In the case of a supply shock, the policy choices are not good. We face two problems – rising unemployment and rising inflation. We can solve either problem, but, in the process, we make the other problem even worse.

If we stimulate the economy, we decrease unemployment but increase inflation. If we slow the economy, we decrease inflation but unemployment goes up.

Challenges of Monetary Policy


The Fed can decide very quickly what policy to undertake. However, the policy will not begin to work until spending is affected. It takes time for spending to change since businesses go through a lengthy evaluating process to decide if they should increase spending.

It takes the Fed a period of multiple observations to discover a trend. So even though the Fed can act quickly, it takes some time for the data they receive to indicate that they ought to act.

When the Fed engages in open market operation, its actions affect spending ~9 months from now. If the forecasts of future economic conditions are wrong, then the Fed may end up making a future problem worse.

What is a Bubble?

A rapid rise in a price of a good or resource to a level that appears to be above the price justified by the cost of producing or the price of similar goods and services. Bubbles are almost always followed by a crash or a bursting bubble.

New Monetary Policy Tools

What is Quantitative Easing?

The Fed uses open market operations to buy long-term bonds to expand reserves & money supply. Because the federal funds rate is near zero, there is little expectation of a decrease in short-term interest rates. However, interest rates on longer-term loans & financial instruments should decrease.

Monetarists & the Quantity Theory of Money

One of the models used by Milton Friedman’s group of economists in the analyses of the importance of changes in the money supply:

(Money Supply) x (# of times each dollar is spent) = (Overall Price Level) x (Real GDP)

Total Spending on Final Products = Nominal GDP


  • V’ is also known as velocity, which is the inverse of the percent of income people hold as money.
  • Real GDP (Q) will tend toward the full-employment level of real GDP regardless of the amount of money that circulates in the economy.

The quantity theory says that if V and Q are fixed, changes in M will have a powerful & predictable effect in the long run. Specifically, changes in M will only affect price level.

If the money supply growth is faster than the long-run growth in potential real GDP & velocity is not changing, then we will experience inflation.

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