Conduct of monetary policy: Tools, Goals and Targets

Understanding conduct of monetary policy is important because it not

only effect money supply and interest rate but also level of economic
activity. To analyse this, balance sheet of Federal Reserves is seen and
how tools of monetary policy effect money supply and interest rate. Follow
is view of balance sheet of Fed:
1) Liabilities
Two liabilities on Balance sheet, an increase in 1)currency in circulation or
2) reserves (termed as monetary liabilities of Fed) will lead to increase in
money supply. While sum of Feds monetary liabilities (currency in
circulation + reserves) and US treasurys monetary liabilities (treasury
currency in circulation, primarily coins) is called monetary base.
However, more emphasize is put on monetary liabilities of Fed because
monetary liability of treasury account for less than 10 %.
a) Currency in circulation: Fed issue currency. Currency in
circulation is amount of currency in hands of public an important
component of money supply.
b) Reserves: all banks have an account at Fed in which they hold
deposits. Reserves consist of deposits at fed plus currency that is
physically held by banks (called vault cash because it is stored in
bank vaults). Reserves are assets for banks but liabilities for Fed
because the banks can demand payment on them at any time and
Fed is obliged to satisfy its obligations by paying Federal Reserve
notes.
an increase in reserves leads to an increase in the level of deposits
and hence in money supply.
Categories of reserves: Total reserves can be divided into two
categories:

reserves

that

Fed

requires

banks

to

hold

(Required

reserves) and any additional reserves the bank choose to hold (excess
reserves). For example, Fed might require that for every dollar of deposit

at depository institution, a certain fraction (say 10 cents) must be held as

reserves. This fraction is called required reserve ratio.
2) Assets: two assets on Feds balance sheet are important for two
reasons. First changes in asset items lead to changes in reserves and
consequently changes in money supply. Second because these assets
(govt securities and discount loans) earn interest while liabilities
(currency in circulation and reserves) do not, the Fed makes billions of
dollars every year- its assets earn income and its liabilities cost
nothing.
1. Government securities: this category of assets cover the Feds
holdings of securities issued by US Treasury. Fed provide reserves to
banking system by purchasing securities, thereby increasing its
holdings of these assets. An increase in government securities held
by Fed leads to an increase in the money supply.
2. Discount loans: the Fed can provide reserves to the banking
system by making discount loans to banks. An increase in discount
loans can be source of an increase in the money supply. The interest
rate charged banks for these loans is called discount rate.
Open market operations:
The central banks purchase or sale of bonds in the open market, are most
important monetary policy tool because they are primary determinant of
changes in reserves in banking system and interest rate. A purchase of
bond by Fed is called open market purchase, and a sale of bond by fed is
called open market sale. An open market purchase lead to an expansion of
reserves and deposits in banking system and hence to an expansion of
monetary base and the money supply. Similarly, when cental bank
conduct open market sale, public pays for bonds by writing a check that
causes deposit and reserves in banking system to fall. This an open
market sale leads to contraction of reserves and deposits in the banking
system and hence to a decline in monetary base and Ms.
Discount lending

Open market operation arent only way the Fed effect amount of reserves.
Reserves are also changed when Fed makes a discount loan to a bank. For
example if Fed makes a 100$ discount loan to national bank. Fed then
credits 100$ to bank reserve account. It will lead to increase monetary
liabilities of Fed by 100$, and increase in monetary base as well. A
discount loan leads to an expansion of reserves, which can be lent out a
deposits, thereby leading to an expansion of the monetary base and
money supply.

Tools of Monetary policy

1. Open market operations: there are two types of open market
operation:
Dynamic open market operations: these are intended to

change level of reserves

Defensive open market operations: these are intended to
offset movement in other factors that affect reserve such as

changes in treasury deposits with Fed.

2. Discount policy: the Federal Reserve facility at which discount
loans are made to bank is called discount window. It is used as a
tool to influence reserves in banking system and money supply.
Discounting is important in preventing financial panics. When Fed
was created its most important purpose was to be as lender of last
resort; it was to provide reserves to banks when no one else would
in order to prevent bank failure from spinning out of control, thereby
preventing bank and financial panic. Discounting is particularly
effective way to provide reserves to the banking system during a
banking crisis because reserves are immediately channelled to
banks that need them most.
3. Reserve requirements: changes in reserve requirements effect
demand for reserves. Rise in reserve requirement means that bank
must hold more reserves vice versa. These are rarely used as
monetary policy tool because raising them cause immediate
liquidity problems for banks with low excess reserves. Continually
fluctuating reserve requirement would also create more uncertainty
for banks and make their liquidity management more difficult.
Advantage of Open market operation over other tools:
Fed primary tool out of three tools of monetary policy is OMO,
because of its advantages.
1) Open market operation occur at initiative of fed which has
complete control over their volume. This control isnt found in
discount operations, in which Fed can encourage or discourage
banks to take out discount loan by altering the discount rate but
cant directly control volume of discount loans.

2) These are flexible and precise, they can be used to any extent.
No matter how small a change in reserves is desired, open
market operations can achieve it with small purchase or sale of
securities. Conversely, if desired result or change in reserves or
monetary base is very large, OMO can achieve it by large
3)

purchase or sale of securities.

OMO operations are easily reversed. If a mistake is made in
conducting OMO, Fed can immediately reverse it. If Fed decide
that federal funds rate is too low because it has made too many
OM purchases, it can immediately make a correction by

conducting open market sale.

4) OMO can be implemented quickly; they involve no administrative
delays. When Fed decided that it want to change reserves, it just
places orders with securities dealers, and traders are executed
immediately.

Goal of monetary policy

Six basic goals are continually mentioned by Fed and other Central banks
when they discuss objective of monetary policy
1) High

employment:

the

employment

act

of

1946

and

full

employment and balanced growth act of 1978 commits US govt to

promote high employment consistent with stable price level.
Although high employment is desirable, how high it should be? It
might seem that full employment is point at which no worker is out
of job, which is when unemployment is zero. However it ignores the
definition that some employment called frictional unemployment is
beneficial for economy.
Frictional unemployment involve searches by workers and firms to find
suitable matchups
For example, a worker who decide to look for a better job might be
unemployed for a while during the job search. Workers often decide to
leave work temporarily to pursue other activities, and when they decide to
re-enter the job market, it may take some time for them to find the right
`

job. The benefit of having some unemployment is similar to benefit of

having a non-zero vacancy rate in market for rental apartments.
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 requirement and skill or availability of local
workers. Clearly, this kind of unemployment is undesirable.
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 labour equal the supply of
labour. This level is called natural rate of unemployment. In addition
govt policies such as provision of better information about job vacancies
or

job

training

programs

might

decrease

the

natural

rate

of

unemployment.
2) Economic Growth: goal of steady economic growth is closely
related to 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 doesnt pay for a firm to invest in
additional plants and equipment. Although 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
it is stated purpose of so called supply side economics policies
which are intended to spur economic growth by providing tax
incentive for businesses to invest in factories and equipment and for
tax payers to save more.
3) Price stability: Instability hurts consumers and firms Inflation slows
growth (Stanley Fisher)

Price stability is desirable because rising price level (inflation)

creates uncertainty in economy, and that may hamper economic
growth. For example, information conveyed by prices of goods and
services is harder to interpret when overall level of prices is
changing, which complicate decision making for consumer, business
`

and government. Not only do public opinion survey indicate that

public is very hostile to inflation, but also growing body of evidence
suggest that inflation leads to lower economic growth. Most extreme
example of unstable price is hyperinflation such as Argentina, Brazil
etc. inflation make it hard to plan for future. For example it is more
difficult to decide how much funds should be put aside to provide for
childs college education in an inflationary environment. Further,
inflation may strain a countrys social fabric.
4) Interest rate stability: is desirable because fluctuation in interest
rate can create uncertainty in economy and make it harder to plan
for future. Fluctuations in interest rate that effect 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.
5) Stability of Financial markets: financial crisis can interfere with
ability of financial market to channel funds to people with productive
investment opportunities, thereby leading to a sharp contraction in
economic activity. Promotion of a more stable financial system in
which financial crisis are avoided is than an important goal for
central bank.

Stability of financial markets is also fostered by

interest rate stability because fluctuations in interest rates creates

great uncertainty for financial institutions.
6) Stability in foreign exchange market:

with

increasing

importance of international trade to US economy, the value of dollar

relative to other currencies has become major consideration for Fed.
A rise in value of dollar makes American industries less competitive
with those abroad, and decline in value of dollar stimulate inflation
in US. In addition. Preventing large changes in value of dollar makes
it easier for firms and individuals purchasing or selling goods abroad
to plan ahead. Stabilizing extreme movements in the vsalue of
dollar in foreign exchange markets is thus viewed as worthy goal of
monetary policy. In other countries, which are even more dependent
on foreign trade, stability in foreign exchange markets takes on
even greater importance.

Conflicts among Goals

Although many of goals are consistent with each other-high
employment with economic growth, interest rate stability with
financial market stability but this isnt always the case. The goal of
price stability often conflict with goals of interest rate stability and
high employment in short run. For example, when economy is
expanding and unemployment is falling, both inflation and interest
rates may start to rise. If central bank tries to prevent a rise in
interest rates, this may cause economy to overheat and stimulate
inflation. But if a central bank raises interest rates to prevent
inflation, in the short run unemployment may rise. The conflict
among goals may thus present central banks like Federal Reserve
with some hard choices.

Central bank strategy: use of targets

The central banks problem is that it wishes to achieve certain goal,
such as price stability with high employment, but it does not directly
influence the goals.it has set of tools to employ (OMO, changes in
discount rate and changes in reserve requirements) that can affect
the goals indirectly after a period of time typically more than a year.
If central bank waits to see what price level and employment will be
in one year, then any correction to such policy if mistaken will be
irreversible.
All central banks consequently pursue a different strategy for
conducting monetary policy by aiming at variables that lie between
their tools and achievements of their goals. The strategy is as
follow:
After deciding goals for employment and price level, the central
bank chooses a set of variable to aim for, called intermediate
targets, such as monetary aggregates (various measure of money
supply denoted as M1, M2 or M3) or interest rate (short or long
term) which have a direct effect on employment and price level.
However, even these intermediate targets are not directly affected
by central banks policy tools. Therefore, it chooses another set of
variables to aim for, called operating targets, or alternatively

called instruments such as reserve aggregates or interest rate,

which are more responsive to its policy tools.
Central bank pursue this strategy because it is easier to hit a goal
by aiming at targets than by aiming at goal directly. Specifically, by
using intermediate and operating targets, it can more quickly judge
whether its policies are on the right track, rather than waiting until it
sees final outcome of its policies on employment and price level.

Tools of central

Open market
operations
Discount
policy
Reserve
requirement

Operating
instruments
Reserve
aggregates
(reserves, nonborrowed reserves,
monetary base,
non-borrowed
base), interest
rates (short term
such as federal
fund rate)

Intermediate
Targets
Monetary
Aggregates (M1,
M2, M3)
Interest rates
(short term and
long term)

Goals
High employment,
Price Stability
Financial Markets
stability
And so on.

Choosing the Targets:

So basically there are two target variables: interest rates and aggregates. Let
central bank choose a 3% growth rate of non-borrowed reserves to achieve a 5%
rate of growth for nominal GDP. Alternatively, it could set federal funds rate at
2% to achieve same goal. Can central bank choose to pursue both of these
targets at the same time? The answer is no.
Lets first see why an aggregate target involves losing control of interest rate. Fig
A contain a supply and demand diagram for market for reserves. Although
central bank expects the demand curve for reserves to be at Rd, it fluctuates
between Rd* and Rd because of unexpected fluctuations in deposits or changes
in banks desire to hold excess reserves. If central bank has non-borrowed
reserves target of Rn*, it expects that federal funds rate will be i o. However, as
fig indicates, fluctuations in reserves demand curve between Rd* and Rd will
result in a fluctuation in federal fund rate between i1 and i2. Pursuing an
aggregate target implies that interest rate will fluctuate.

Rn

I1
io

Rd*
i2

Rd

Rd

quantity of reserves,

R
Fig A Result of Targeting on non-borrowed Reserves
Targeting on non-borrowed reserves of Rn* will lead to fluctuations in the federal
funds rate between i1 and i2 because of fluctuation in demand for reserves
between Rd* and Rd.

The supply and demand in fig B show consequences of an interest rate target set
at io, again central bank expect the reserve demand curve to be at Rd but it
fluctuates between Rd* and Rd due to unexpected changes in deposits or banks
desire to hold excess reserves.
If demand curve rises to Rd*,
the federal rate will begin to rise above i0 and central bank will engage in open
market purchases of bonds until it raises the supply of non-borrowed reserves to
Rn*, at which point the equilibrium federal funds rate is again at io. Conversely, if
demand curve falls to Rd and lowers the federal fund rate, the central bank
would keep making open market sales until non-borrowed reserves fall to Rn and
federal rate is io. The central banks adherence to the interest rate target thus
leads to a fluctuating quantity of non-borrowed reserves and money supply.
The conclusion from the supply and demand analysis is that interest rate and
reserve aggregate targets are incompatible. A central bank can hit one or the
other, but not both. Because a choice between them has to be made, we need to
examine what criteria should be used to decide on the target variables.

Criteria for Choosing Intermediate Targets:

The rationale behind a central banks strategy of using targets suggests three
criteria for choosing an intermediate target:
1) it must be measurable,
2) it must be controllable by central bank and
3) it must have a predictable effect on goal.
Measurability: quick and accurate measurement of an intermediate target
variable is necessary because the intermediate target will be useful only if it
signals when policy is off track more rapidly than the goal. Let if central bank
plan to hit 4% growth rate for M2, what should it do if it has no way of quickly
measuring M2? Data on monetary aggregates is available after a two week
delay, and interest rate data are available almost immediately. Data on variable
like GDP that serves as a goal, are compiled quarterly and are made available
with a months delay. In addition the GDP data is less accurate than data on
monetary aggregates of interest rate. So focusing on interest rate or monetary
aggregates as intermediate targets rather than on goal like GDP can provide
clearer signals about status of central banks policy.
Although, interest rate seem to be more measurable than monetary aggregates
and hence more useful as intermediate targets, because of quick availability of
data. But interest rate data is rarely revised in contrast to monetary aggregates,
which are subject to a fair amount of revision. However, real interest rate
adjusted for expected inflation is more accurate tool but its hard to measure
because we have no direct way to measure expected inflation. Since both
interest rate and monetary aggregates have measurability problems, so decision
to take which one as intermediate target becomes hard.
Controllability: a central bank must be able to exercise effective control over a
variable if it is to function as a useful target. If central bank cant control
intermediate target, knowing that it is off track does little good because the bank
has no way of getting back on track. Some economist have suggested that
nominal GDP should be used as an intermediate target, but sine the central bank

has little direct control over nominal GDP, it will not provide much guidance.
However, central bank has good control over monetary aggregates and interest
rates.
Central bank does have ability to exercise a powerful effect on money supply,
although its control isnt perfect. OMO can be used to set interest rate by directly
effecting the price of bonds. Because a central bank can set interest rate directly
whereas it cant completely control the money supply, it might appear that
interest rate dominate the monetary aggregates on controllability criterion.
However a central bank cant set real interest rate because it does not have
control over expectations of inflation. So again, a clear cut case cant be made
that interest rates are preferable to monetary aggregates as an intermediate
target or vice versa.

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. If a central bank can accurate and quickly measure the price of
tea in china and can completely control its price, what good will it do? The
central bank cant use the price of tea in china to effect goals is so critical to the
usefulness of an intermediate target variable, the linkage of monetary supply
and interest rate with the goals---output, employment and price level is matter of
such debate.

Criteria for choosing operating targets:

the choice of an
operating target can be based on the same criteria used to evaluate
intermediate targets. Both the federal funds rate and reserve aggregates are
measured accurately and are available daily with almost no delay; both are
easily controllable using the policy tools that are discussed earlier. When we look
at third criterion, we can think of intermediate target as the goal for operating
target. An operating target that has a more predictable impact on the most
desirable intermediate target is preferred. If the desired intermediate target is an
interest rate, the preferred operating target will be an interest rate variable like
the federal funds rate because interest rates are closely tied to each other.
However if the desired intermediate target is a monetary aggregate, a reserve
aggregate operating target such as monetary base will be preferred. Because
there does not seem to be much reason to choose an interest rate over a reserve
aggregate on the basis of measurability or controllability, the choice of which
operating target is better rests on choice the intermediate target (the goal of
operating target).