Monetary Policy

Abstract

We look first at the aims of monetary policy in terms of balancing the control of inflation with limiting excessive unemployment. The next consideration is the interaction between the money supply and economic activity. Turning to the actual mechanics of monetary policy, we address the issue of how the money supply is measured, including the various definitions of money. The specific tools discussed include not merely the traditional emphasis on open-market operations, but also the emergency measures and quantitative easing that have turned out to be important in the post-2007 era. The appendix provides an example of an open-market operation.

Appendix: An Open-Market Operation

Let’s actually start not with an open-market operation, but just with a regular private transaction. Alice is a depositor at Bank A, so her savings is a part of the line labeled “Deposits” on Bank A’s balance sheet (I’ve simplified the balance sheet to focus on just the parts that are important for this example). Similarly, Bob is a depositor at Bank B.

Table 1

Let’s say Alice has a Treasury bond that she’d like to sell; either she wants to spend the money on some goods or services, or she wants to buy some other asset (a different bond, or some stocks) that she thinks better suits her current needs. Alice and Bob agree on a price of $40.

Bob writes Alice a check for $40 and she sends him the bond (or some valid electronic documentation of ownership). We don’t have to worry about the bond anymore, because it wasn’t on either bank’s balance sheet (it was wealth that Alice had, but not wealth that was stored in a bank account). But we can track what happens to the check.

When Alice gets the check, she’ll take it to Bank A and deposit it. That will increase “Deposits” at Bank A by $40. Then Bank A will bring the check to Bank B and say, “Your customer Bob wrote this to our customer Alice, so give us $40.” Bank B will transfer $40 worth of reserves to Bank A, and it will reduce Bob’s account (and thus its total of “Deposits”) by $40.

Once the transaction is completed, the new balance sheets will look like this:

Table 2

Bank A does indeed have more reserves, but Bank B has fewer, and so the quantity of reserves in the banking system as a whole is unchanged.

In an open-market operation, one side of the transaction is not a private individual like Alice or Bob, nor is it a regular bank; it’s the Federal Reserve. Say Alice decides to sell another bond, but this time to the Fed, which is carrying out an open-market transaction. Alice gets another $40 check and deposits it. Bank A’s “Deposits” line goes up by another $40. But now it takes the check to the Federal Reserve instead of to Bank B. The Fed honors the check by increasing Bank A’s reserves, and it doesn’t have to decrease reserves at Bank B or anywhere else.

The balance sheets below show the situation after this second transaction; comparing to the previous table, you can see the increase in total reserves of the two banks together. If the Fed were to sell a bond rather than buying it, the process would operate in reverse: the money received by the Fed for the sale would end up coming out of the total reserves of the banking system.

Table 3

Problems

Problem 12.1 Figure 12.6 shows the effective Federal Funds rate for 1954 through 1984, with the shaded bars indicating U.S. recessions; Fig. 12.7 shows the same thing for 1985 into 2015.

Fig. 12.6

The effective Federal Funds rate, in percent, 1954–1984; from Federal Reserve Board of Governors (Shaded areas show U.S. recessions)

Fig. 12.7

The effective Federal Funds rate, in percent, 1985–2015; from Federal Reserve Board of Governors (Shaded areas show U.S. recessions)

Compare the two figures. What has changed in the relationship between the Federal Funds rate and the onset of recession?

Problem 12.2 Figures 12.8 and 12.9 show excess reserves as a share of potential GDP, for two different time spans.

Fig. 12.8

Excess reserves of depository institutions, as portion of potential GDP, 1985.I – 2008.II (Data from Federal Reserve Bank of St. Louis (reserves) and Congressional Budget Office (potential GDP))

Fig. 12.9

Excess reserves of depository institutions, as portion of potential GDP, 2000.I – 2015.I (Data from Federal Reserve Bank of St. Louis (reserves) and Congressional Budget Office (potential GDP))

• (a) In Fig. 12.8, the sharp spike in the chart is during September, 2001. What happened at that time that might have caused that phenomenon and why might it have been a good idea for the Federal Reserve to provide banks with a large quantity of additional reserves, suddenly and for only a short time?

• (b) The first eight-and-a-half years shown in Fig. 12.8 are the same as the last eight-and-a-half years of the span covered in Fig. 12.9, yet that span (January, 2000 through July, 2008) look very different in Fig. 12.9 than in Fig. 12.8. Why is that?

• (c) Comparing the two charts, what is the approximate ratio between excess reserves in 2015 and excess reserves during the mid-2000’s, when both are expressed as shares of potential GDP?

• (d) What does your answer to (c) suggest about where the money for quantitative-easing purchases has been going?

Problem 12.3 Assume your central bank is operating under a modified Taylor Rule: your assumed long-run neutral interest rate is 1.8%, your inflation target is 2.5%, and you put equal weight on the output gap and inflation.

• (a) Your average recent inflation is 2.8% and your estimated output gap [(Y − Y ^∗)∕Y ^∗] is 0.4%. What interest rate would you choose based on this version of the Taylor Rule?

• (b) Is your answer in (a) a rate that is likely to hold back growth or spur it higher? Explain.

• (c) Recalculate the Taylor-Rule interest rate with recent inflation of 2.2% and an output gap of − 0. 5%.

• (d) Is your answer in (c) a rate that is likely to hold back growth or spur it higher? Explain.

• (e) Calculate once more, with an output gap of − 1% and recent inflation of 3.2%.

• (f) How does your real interest rate in (e) compare to the assumed neutral rate? Explain why that is.