Chapter 29

Monetary
Policy

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 In this chapter you will learn to

1. Describe the long-term objectives of the Federal Reserve.

2. Explain why the Fed has chosen to express its short-term

monetary policy targets in terms of an interest rate rather
than the money supply.
3. Describe the market for commercial bank reserves.
4. Explain how the Fed uses open market operations to
achieve its short-term objectives in the federal funds
market.
5. Describe the recent track record of monetary policy and
some likely future challenges.
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Objectives of Monetary Policy

Long-Run Objectives of Monetary Policy

Like most central banks, the Fed pursues:

1. maximum employment
2. price stability
3. moderate long-term interest rates

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Short-Term Targets of Monetary
Policy
The Fed has targeted the money supply and the federal funds
rate:
• Money supply during the late 1970s and early 1980s
• Federal funds rate — the price of borrowing reserves
— for most of the period since 1970

Regardless of whether the Fed chooses either short-term

targets, both potential target variables will react to any change in
reserves.

• The question for the Fed is not which variable to influence

but rather which variable to watch

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Linking the Short-Run and Long-Run Goals:
The Transmission Process

Monetary policy affects the economy through the monetary

transmission mechanism:
• The Fed sets a target for the federal funds rate
• which influences other market interest rates
• which change desired aggregate expenditure
• which changes aggregate demand
• which affects the price level and the level of real GDP

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Figure 29.1 The Monetary
Transmission Mechanism

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Linking the Short-Run and Long-Run Goals

Policy Procedure
The Fed’s policy procedure is to link short-term targets for
monetary conditions and its long-term objectives.

To close an inflationary gap:

- raise the target federal funds rate

To close a recessionary gap:

- lower the target federal funds rate

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Figure 29.2 The Output Gap,
Inflation, and Monetary Policy

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Money Supply Targets versus Interest
Rate Targets

Long-Run Objectives of Monetary Policy

Monetary policy can be implemented either by pursuing a

target for the money supply or for the interest rate, but not
both. Why?

- For a given money demand curve, both

cannot be set independently.

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Figure 29.3 Two Approaches to the
Implementation of Monetary Policy

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Monetary Policy Target

Why the Fed does not use the money supply as a

target?

The Fed is unable to predict accurately the position of the

MD curve at any given time.

- largely due to innovations in the financial sector

Like the Fed, most central banks choose to influence the

interest rate directly.

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How the Fed Implements
Monetary Policy

Reserve Markets and the Federal Funds Rate

The market for reserves is similar to those for money supply
and money demand.

The Fed has the ability to shift the demand and supply
curves.
APPLYING ECONOMIC CONCEPTS 29.1
The Federal Funds Rate and the
Treasury Bill Rate

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Figure 29.4 The Federal
Funds Market

The Fed uses its

influence over the
supply of reserves to
keep the equilibrium
federal funds rate close
to its target level.

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The Fed’s Monetary Policy Tools
and the Market for Reserves

The three policy tools that the Fed uses to affect conditions
in the market for reserves:

1. open market operations

2. the discount rate

3. reserve requirements

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Table 29.1 Initial Balance Sheet
Changes Caused by an Open Market
Purchase from a Commercial Bank

The Fed can increase the reserves available to the

banking system by purchasing bonds on the open
market.
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 The Discount Window

The intention of the discount window was initially that the

Fed would help banks survive a panic by serving as a “bank
for bankers.”

The difference the amount lent and the amount repaid by

the bank is called a “discount.”

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 Reserve Requirements

The Fed has the authority to set the required levels of

reserves for banks and other depository institutions

If the Fed raises the required reserve ratio, banks would

lend a smaller fraction of their deposits, which would
decrease the money supply and increase the federal funds
rate.

If the Fed lowers the required reserve ratio, banks would

lend a larger fraction of their deposits, which would
increase the money supply and decrease the federal funds
rate.”
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Figure 29.5 The Fed’s Response to a
Shift in the Demand for Reserves

The Fed responds

to the shift in the
demand curve by
rising the supply of
reserves through
open market
purchase of bonds.

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 Achieving the Federal Funds Rate
Target

APPLYING ECONOMIC CONCEPTS 29.2

A Look at a Federal Open Market
Committee Meeting

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Monetary Policy in Action:
Challenges and Issues

The stagflation of the 1970s revealed the cost of allowing

elevated inflation expectations to emerge.

Since the early 1990s, inflation has been relatively low and
stable.

In 2006, Ben Bernanke replaced Alan Greenspan as

chairperson of the Federal Reserve.

Bernanke inherited an economy with a low inflation rate

and a level of real GDP close to its potential level.

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Figure 29.6 The Output Gap
and the Inflation Rate

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 Uncertainty about the Monetary
Policy Transmission Process

The Fed faces uncertainty regarding:

1. the magnitude of the policy response
− our analysis does not tell us how much the target for
the federal funds rate needs to change to close an
output gap

2. the timing of the policy response

− the federal funds rate only affects inflation through
a series of chain reactions, each of which can take
months to be complete

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 The Stock Market

Stock market performance does not equate the health of

the overall economy.

However, because developments in the stock market can

affect the rest of the economy, the Fed pays attention to the
stock market.

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 Deflation, Low Interest Rates,
and the Money Supply

Deflation: when the average price level is falling over time.

Because money wages fall much more slowly than they

rise, a recessionary gap that leads to deflation might last for
a long period of time.

 a prompt monetary policy response is needed

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 Inflation Targeting

A number of countries have adopted formal targets for

inflation.
Prior to joining the Fed, Ben Bernanke (the current Fed
Chairman) argued that central banks should announce
explicit targets for the inflation rate.
 speculation that the Fed will eventually adopt an
inflation rate target
Since price stability is achieved only when real GDP is
close to potential, the Fed’s current goals of price stability
and maximum employment is still compatible with an
inflation rate target.
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