Monetary policy

Table of The Federal Reserve’s Balance Sheet

contents Open Market Operations

Discount lending

Equilibrium in the market for reserves

ECB

Should Price Stability be the Primary Goal?

Taylor Rule
•

•
Structure of
the Federal
Reserve
System
Credit Channel:
Impact on
Household
Consumption
and Corporate
investment
Monetary policy

“Monetary policy” refers to the management of the money supply.

Tools of Monetary Policy Discount Policy

The Price Stability Goal

Monetary Policy Tools of the Fed

Reserve Requirements

Other Goals of Monetary Policy

Monetary policy

• MS: Money Supply (Fed)

• MD: Demand of money (Households,
Banks, Firms…)
 • The conduct of monetary policy by the Federal
Reserve involves actions that affect its balance sheet.

The Federal • This is a simplified version of FEDs balance sheet:

Reserve’s
Balance
Sheet
Federal Reserve’s Assets and Liabilities

Source: The Fed - Monetary Policy: Monetary Policy Report (federalreserve.gov)

 The Federal Reserve’s Balance Sheet

The monetary liabilities of the Fed include:

• Currency in circulation: the physical currency in the hands of the
public, which is accepted as a medium of exchange worldwide:
Federal Reserve Note.
• Reserves: All banks maintain deposits with the Fed, known as
reserves.
 • All banks have an account at the Fed in which they
hold deposits.
• Reserves consist of deposits at the Fed plus currency
that is physically held by banks (called vault cash
because it is stored in bank vaults).
• Reserves are assets for the banks but liabilities for
the Fed because the banks can demand on them at
Reserves any time
• Total reserves can be divided into 2 categories:
➢ Reserves that the Fed requires banks to hold -
required reserves
➢ Any additional reserves the banks choose to hold -
excess reserves
 The required reserve ratio, set by the Fed, determines
the required reserves that a bank must maintain with
the Fed.

• Example:
The Fed might require that for every dollar of deposits at a
depository institutions, a certain fraction (say, 10 cents) must be
held as reserves. This fraction (10%) is called the required reserve
Reserves ratio.

Reserve requirements are imposed on "depository institutions"

Increasing the reserve ratio decreases the level of

deposits that can be supported by a given level of
reserves and, in the absence of other actions, reduces
the money supply.
 The Federal Reserve’s Balance Sheet

The monetary assets of the Fed include:

• Government Securities: These are the U.S. Treasury bills and bonds that the Federal
Reserve has purchased in the open market.
Purchasing Treasury securities increases the money supply.

• Discount Loans: These are loans made to member banks at the current discount rate.
An increase in discount loans will also increase the money supply.
12
Open Market Operations

• Fed injects reserves into the banking system through open market
operations or through discount loans and in the next slides we will show
the following:

➢Purchase of bonds increases the money supply

➢Making discount loans increases the money supply

• Fed can decrease the money supply by reversing these transactions.

Open Market Operations

• The central bank’s purchase or sale in the open market, is the most
important monetary policy tool - this is a primary determinant of changes
in reserves in the banking system and interest rates.
• Federal Reserve purchase and sale of bonds are always done with primary
dealers.
• Primary dealer is a bank or securities broker-dealer that is permitted to
trade directly with Fed.
• Let’s use T-accounts to examine what happens when the Fed conducts an
open market purchase in which $ 100 million of bonds are bought from
primary dealers.
Open Market Operations
When the primary dealer sells the $100 million of bonds to the Fed, the Fed adds $100 million to
the dealer’s deposit account at the Fed, so that reserves in the Banking system go up by $100
million.
Banking system The Fed
Assets Liabilities Assets Liabilities
Securities Securities Reserves
–$100 +$100 +$100
Reserves
+$100
(Deposits at the Fed)

➢ The effect on the Fed’s balance sheet is that it has gained $100 million of securities in its assets’
column, whereas reserves have increased by $100 million.
➢ The result of the Fed’s open market purchase is an expansion of reserves and deposits in the
banking system.
➢ Open market purchases of bonds expand reserves because the central bank pays for the bonds
with reserves.
Open Market Operations

• Because the monetary base equals currency plus reserves, we have

shown that an open market purchase increase the monetary base by an
equal amount.

• Because deposits are an important component of the money supply,

another result of the open market purchase is an increase in the money
supply. This leads to the following conclusion:
An open market purchase leads to an expansion of reserves and deposits in the
banking system and hence to an expansion of the monetary base and the
money supply.
Open Market Operations

• What happens if the Federal Reserve Bank conducts an open market

sale?

• Reserves in the banking system fall, because primary dealers pay for these
bonds with their deposits held at the Fed.

An open market sale leads to a contraction of reserves and deposits in the

banking system and hence to a decline of the monetary base and the money
supply.
Discount lending
Reserves are also changed when the Fed makes a discount loan to a bank.
▪ Example:
Suppose the Fed makes a $100 million discount loan to the First National
Bank. The Fed then credits $100 million discount loan to the First National
bank.
Banking System The Fed
Assets Liabilities Assets Liabilities
Discount loans Discount loans Reserves
(borrowing from +$100 +$100
Reserves the FED)
+$100 +$100

A discount loan leads to an expansion of reserves, which can be lent out,

thereby leading to an expansion of the monetary base and the money supply.
Discount lending

When a bank repays its discount loan and so reduces

the total amount of discount lending, the amount of
reserves decreases along with the monetary base and
the money supply.
 • An overnight loan is a loan between banks that lend each
other money for very short periods of time.

• The overnight rate is the interest rate at which a depository

institutions lend and borrow one-day (or “overnight”) funds
among themselves. (https://www.bankofcanada.ca/core-functions/monetary-
policy/key-interest-rate/)

Overnight • The overnight rate is the lowest available interest rate.

rate • In the U.S., the overnight rate is referred to as the federal

funds rate, while in Canada, it is known as the policy
interest rate.

Federal Fund rate is a rate at which banks in the US lend

reserves to each other overnight.
 The discount rate is the interest rate charged to
commercial banks and other depository institutions on
loans they receive from Fed's lending facility-the
discount window.

In the US, the discount rate, which acts as a reference

Discount rate for commercial banks' own lending rates, is one of
the two key rates manipulated by the Federal Reserve
rate to control money supply (the other being the Federal
funds rate).
The discount rate also refers to the interest rate used in
discounted cash flow (DCF) analysis to determine the
present value of future cash flows.
 • The market equilibrium occurs when the quantity of reserves
demanded equals the quantity of reserves supplied, determining
the federal funds rate, the interest rate charged on the loans of
these reserves.

𝑅𝑑 The demand curve for reserves:

Equilibrium The quantity of reserves demanded = required reserves + the
quantity of excess reserves.
in the
market for • Excess reserves are insurance reserves against deposit outflows
• The cost of holding these excess reserves is their opportunity
reserves cost - the interest rate that could have been earned on lending
these reserves out, minus the interest rate that is earned on
these reserves 𝒊𝒐𝒓 .
• Since 2008, the Federal Reserve has paid interest on reserves at a
level that is set at a fixed amount, below the federal funds target.
Demand curve
What happens to the quantity of reserves
demanded by banks, holding everything else
constant, as the federal funds rate changes?
• When the federal funds rate is above the rate
paid on excess reserves, ior, as the federal
funds rate decreases, the opportunity cost of
holding excess reserves falls, and the quantity
of reserves demanded rises. Consequently,
the demand curve for reserves 𝑅𝑑 slopes
downward when the federal funds rate is
above 𝑖𝑜𝑟 .
• However, if the federal funds rate begins to
fall below the interest rate paid on
reserves 𝑖𝑜𝑟 , banks would not lend in the
overnight market at a lower interest rate.
The result is that the demand curve for
reserves becomes flat at 𝑖𝑜𝑟 .
 𝑅 𝑠 The supply curve for reserves can be
broken into 2 components:
• the amount of reserves that are supplied
by the Fed’s open market operations,
nonborrowed reserves (NBR)
Equilibrium in the • the amount of reserves borrowed from the
Fed, called borrowed reserves (BR).
market for reserves

• The primary cost of borrowing from the Fed is

the interest rate the Fed charges on these loans
– discount rate 𝒊𝒅 .
Supply
Discount rate

• Because borrowing federal funds from

other banks is a substitute for
borrowing from the Fed, if the federal
funds rate 𝒊𝒇𝒇 is below the 𝒊𝒅 , then
banks will not borrow from the Fed and
borrowed reserves will be zero, because
borrowing in the federal funds market
is cheaper.
• As long as 𝒊𝒇𝒇 is below the 𝒊𝒅 , the
supply of reserves will just equal the
amount of nonborrowed reserves
supplied by the Fed (NBR) and so the
supply curve will be vertical.
Supply

• If the federal funds rate were to rise

even infinitesimally above the discount
rate, banks would want to keep
borrowing more and more at 𝑖𝑑 and the
lending out the proceeds in the federal
funds markets at the higher rate 𝑖𝑓𝑓 .

• The result is that the federal funds rate

can never rise above the discount rate
and the supply curve becomes flat at 𝑖𝑑 .
Equilibrium in the
market for reserves
• The market equilibrium in which the
quantity of reserves demanded equals the
quantity of reserves determines the federal
funds rate, the interest rate charged on the
loans of these reserves : 𝑅 𝑠 = 𝑅𝑑

When the federal funds rate is above the

2
equilibirum rate at 𝑖𝑓𝑓 , more reserves are
supplied than demanded (excess supply)
∗
and so the federal funds rate falls to 𝑖𝑓𝑓 .

When the federal funds rate is below the

1
equilibirum rate at 𝑖𝑓𝑓 , more reserves are
demanded than supplied (excess
demand) and so the federal funds rate
∗
rises to 𝑖𝑓𝑓 .
Response to Open Market
Operations:
Case 1—Supply curve initially intersects demand
curve in its downward sloping section
An open market purchase leads to a greater
quantity of reserves supplied.
• It is why at any given federal funds rate, there is
an increase on nonborrowed reserves, which
rises from NBR1 to NBR2.
• An open market purchase shifts the supply
curve to the right from 𝑅1𝑠 to 𝑅2𝑠 .
• The equilibrium move from point 1 to point 2,
1 2
lowering the federal funds rate from 𝑖𝑓𝑓 to 𝑖𝑓𝑓 .

Note that the same reasoning implied than an open market

sale decreases the quantity of nonborrowed reserves
supplied, shifts the supply curve to the left and causes the 𝒊𝒇𝒇
to rise.
Response to Open Market
Operations:
Case 2—Supply curve initially intersects demand
curve in its flat section
Open market purchase has no effect on the
federal funds rate.
• An open market purchase raises the quantity of
reserves supplied and shifts the supply curve
from 𝑅1𝑠 to 𝑅2𝑠 .
• The equilibrium move from point 1 to point 2
without decreasing 𝑖𝑓𝑓 because 𝑖𝑓𝑓 = 𝑖𝑜𝑟 and
banks will not lend at a rate below 𝑖𝑜𝑟 - interest
rate that is paid on excess reserves.
• 𝒊𝒐𝒓 sets a floor for the federal funds rate.
Response to Change in
Discount Rate:
Case 1— Intersection of supply and demand
curve is in the vertical part of supply curve

• If the intersection occurs in the vertical

section of the supply curve, so there is
no discount lending and borrowed
reserves BR = 0.

• The Fed lowers the discount rate from

𝑖𝑑1 to 𝑖𝑑2 , the horizontal section of the
supply falls from 𝑅1𝑠 to 𝑅2𝑠 , but
equilibrium stays at point 1, because 𝑅2𝑠
does not cross the demand curve 𝑅 𝑑 .

• The equilibrium federal fund rate 𝒊𝒇𝒇 is

unchanged.
Response to Change in
Discount Rate:
Case 2 — Intersection of supply and demand
curve is in the horizontal part of supply curve

• If the demand curve intersects the

supply curve on its flat section, so there
is some discount lending and borrowed
reserves. BR > 0.

• The
1
Fed
2
lowers the discount rate from
𝑖𝑑 to 𝑖𝑑 . So, the horizontal
𝑠 𝑠
section of
the supply falls from 𝑅1 to 𝑅2 .

• The equilibrium federal fund rate falls at

2
𝑖𝑓𝑓 (point 2).

• This time a change in the discount rate

has an impact of quantity of reserves.
 Supply and
Demand in the
Market for
Reserves: reserve
requirements

When the required reserve ratio

inscreases, required reserves increase =>
the quantity of reserves demanded
increases for any given interest rate.

A rise in the required reserve ration shifts

the demand curve to the right from 𝑅1𝑑 to When the Fed increases reserve requirements,
𝑅2𝑑 , move the equilibrium from point 1 to the federal funds rate rises.
point 2 and in turn raises the federal
1 2
funds rate from from 𝑖𝑓𝑓 to 𝑖𝑓𝑓 .
Supply and Demand in the Market for Reserves:
reserve requirements
• Conversely, a decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left and causes the federal funds rate to fall.

When the Fed decreases reserve requirements, the federal funds rate falls.

• When the federal funds rate is at the interest rate paid on excess reserves (𝑖𝑓𝑓 = 𝑖𝑜𝑟 ), a
rise in the interest rate on excess reserves 𝑖𝑜𝑟 raises the federal funds rate 𝑖𝑓𝑓 .
CASE: How
Operating
Procedures
Limit
Fluctuations
in Fed Funds
Rate
Fed’s procedures for operating discount window and paying
interest on reserves limit fluctuations in federal funds rate to
between 𝒊𝒐𝒓 and 𝒊𝒅 .
 Tools of Monetary Policy

Increase Money Decrease Money

Tools
supply supply
Reserve requirements ↘ ↗

Discount rate ↘ ↗

Open market operations Fed buys Fed sells

 Open Market Operations are of two types:

• Dynamic: intended to change the level of reserves

Tools of • Defensive: intended to offset other factors affecting

reserves, typically uses repos
Monetary Advantages of Open Market Operations
Policy • Fed has complete control over the volume of
transactions
• Flexible and precise
• Easily reversed
• Implemented quickly
Tools of Monetary Policy: Open Market Operations at
the Trading Desk

• Federal Reserve Bank of New York (FRBNY) is responsible for buying and selling
government bonds
• The staff reviews the activities of the previous day and with the update on the actual
amount of reserves in banking system, issue forecasts of factors affecting the supply and
demand for reserves.
• Manager of domestic OMOs determine nonborrowed reserve changes needed to obtain a
desired federal funds rate.
• Government securities dealers are contacted to better determine the condition of the
market.
• The FRBNY determines how much to buy or sell and places the appropriate order on the
Trading Room Automated Processing System (TRAPS) computer system that links all the
primary dealers.
 If Fed wants to implement dynamic strategy, the trading desk
will conduct outright transaction – buying or selling of
securities whose rights are permanently transferred to the
buyer (ex. sale or purchase of government bonds).
Tools of Monetary
Policy: Open If Fed wants to implement defensive strategy, the trading
Market desk will perform operations of buying or selling securities
whose rights are only temporarily transferred to the buyer.
Operations at the These transactions include:
Trading Desk • Repurchase agreements (often called repo): the seller of
securities agrees to buy back securities at some future date
and at specified price. In the case of central bank, this means
that funds are drained out of system only temporarily.
• Reverse repurchase agreement (often called reverse repo): the
buyer of securities agrees to sell back securities at some future
date and at specified price. With reverse repo the central bank
temporarily injects funds into the system.
Repo
transaction
• Federal Reserve describes its
own repo and reverse-repo
operations from its
counterparty’s viewpoint
rather than from its own
viewpoint.

•
Reverse-repo
transaction
• Federal Reserve describes its
own repo and reverse-repo
operations from its
counterparty’s viewpoint
rather than from its own
viewpoint.

•
 • The facility at which banks can borrow reserves from the
Federal Reserve is called the discount window.
• The Fed’s discount loans are primarily of three types:
• Primary Credit: is available to generally sound depository
institutions on a very short-term basis, typically overnight, but
at times for longer periods. It is the Federal Reserve’s main
discount window program and the term “discount rate” is often
Discount used to refer to the primary credit rate.
• Secondary Credit: available to depository institutions that are
Policy not eligible for primary credit. Given to troubled banks
experiencing liquidity problems. The interest rate on the
secondary credit is set at 0.5 percentage point above the
discount rate.
• Seasonal Credit: Designed for small, regional banks that have
seasonal patterns of deposits (in vacation and agricultural areas
for instance).
 • In the 2007–2009 Financial Crisis Fed acted as a lender of last resort.
• During this period, Fed provided liquidity to the banking system:

➢ Lowered the discount rate to 0.5% above the fed funds rate, and
then by March 2008, lowered that to just 0.25%.
➢ Discount loan maturity was extended from overnight loans to loans
maturity in 30 days, and then 90 days.

2007–2009 ➢ Set up the Term Auction Facility Rates in which it made loans at a
rate set by auction (rate was lower than the discount rate). Initially,
Financial Crisis the facility was funded with $20 billion. It increased to over $400
billion as the crisis worsened.
➢ In March 2008, it created the Term Securities Lending Facility to
provide Treasury securities to act as a collateral in credit markets.
Fed lent them to primary dealers to provide liquid collateral.
➢ New lending programs to help troubled institutions (AIG, J.P.
Morgan, Citigroup,…)
ECB

• To achieve its primary objective of price stability, the ECB aims to maintain a medium-term inflation
rate closely below 2%.

• The Governing Council of the ECB sets three key interest rates.
➢ main refinancing operations rate - the interest rate banks pay when they borrow money from
the ECB for one week (when they do this, they must provide collateral)
➢ the deposit facility rate - the interest rate banks receive for depositing money with the central
bank overnight (since June 2014, this rate has been negative)
➢ the marginal lending facility rate - is the interest rate banks pay when they borrow from the
ECB overnight
• Like the Fed, the ECB uses: open market operations, standing facilities and reserve requirements
to implement its monetary policy.
 Open market operations are in the form of:

• Main refinancing operations, or MROs - are regular liquidity-providing reverse

transactions conducted by the Eurosystem with a frequency and maturity of
normally one week. They are executed in a decentralized manner by the national
central banks (determine main refinancing rate).
• Longer-term refinancing operations, or LTROs - three-month liquidity-providing
reverse transactions.

ECB Standing facilities – used to provide or to absorb overnight liquidity

in the markets.
• Marginal lending facility (determines marginal lending facility rate, which is the
ceiling for overnight market interest rate)
• Deposit facility ( determines the deposit facility rate, which is the floor for overnight
market rate)

A minimum reserve requirement – minimum amount of reserves a

credit institution is required to hold with a central bank.
Should Price Stability be the Primary Goal?

The Fed, uses a dual mandate, where

The ECB uses a hierarchical
“maximizing employment, stable prices,
mandate, placing the goal of price
and moderate long-term interest rates”
stability above all other goals.
reduces to price stability and maximum
employment goals.
 Which is better?

• The dual mandate can lead to expansionary

Should Price policies that increase employment, output, but
also increases long-run inflation.
Stability be
• However, a hierarchical mandate can lead to
the Primary over-emphasis on inflation alone—even in the
Goal? short-run.

The answer? It depends.

• As long as, it helps the central bank focus on
long-run price stability, either is acceptable
 Taylor’s rule is a proposed guideline for
how central banks such as the Fed,
should alter interest rates in response to
changes in economic conditions.
• Most central banks currently conduct
monetary policy by setting a target for
short-term interest rates.
• How should this target be chosen?
Taylor
Rule This rule is based on 3 factors:
• where actual inflation is relative to the
targeted level that the Fed wishes to The Economist John Taylor of
achieve Stanford University
• how far economic activity is above or
below its “full employment” level
• what level of the short-term interest
rate is consistent with full
employment
 Taylor’s rule can be written as follows:
Interest rate target = equilibrium real interest rate + inflation
𝟏 𝟏
rate + (inflation gap) + (output gap)
𝟐 𝟐

The Taylor rule indicates that the policy interest rate should be set equal to
an « equilibrium » real policy interest rate (the real interest rate that is
Taylor Taylorconsistent
Rule with full employment in the long run) plus the inflation rate plus
a weighted average of 2 gaps: (1) an inflation gap, (2) an output gap, the
Rule percentage deviation of real GDP from an estimate of its potential full
employment level.

The Taylor rule can be written as follows:

𝑌𝑡 −𝑌𝑡∗
Interest rate target 𝑖𝑡𝑇 = 𝑟∗ + 𝜋𝑡 + 0.5 𝜋𝑡 − 𝜋𝑡∗ + 0.5
𝑌𝑡∗
 𝑻𝟗𝟑𝑨𝒅𝒋

Taylor 𝑹𝑻𝟗𝟑 𝑻𝑩𝑨

𝒕 , 𝑹𝒕 , 𝑹𝒕 , 𝑹𝑷𝑳 𝑻𝑭𝑫
𝒕 , 𝑹𝒕 nominal federal funds rate for quarter t by different approaches

𝜋𝑡 is four-quarter price inflation for quarter t and 𝑢𝑡 is the unemployment rate in

Rule quarter t.
𝒓𝑳𝑹
𝒕 is the level of the neutral real federal funds rate in the longer run that, on average,
is expected to be consistent with sustaining maximum employment and inflation at its 2
percent longer-run objective, 𝜋 𝐿𝑅 . 𝑢𝑡𝐿𝑅 is the rate of unemployment in the longer run. 𝑍𝑡
is the cumulative sum of past deviations of the federal funds rate from the prescriptions
of the Taylor (1993) rule when that rule prescribes setting the federal funds rate below
zero. 𝑃𝐿𝑔𝑎𝑝𝑡 is the percent deviation of the actual level of prices from a price level that
rises 2 percent per year from its level in a specified starting period.

Source: https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-part2.htm
Taylor Rule

Source: The Fed - Monetary Policy: Monetary Policy Report (federalreserve.gov)