Chapter 8
Conduct of
Monetary Policy:
Tools, Goals,
Strategy,
and Tactics

Chapter Preview
“Monetary policy” refers to the management of the money supply.
Although the idea is simple enough, the theories guiding the Federal Reserve are complex and often controversial. But, we are affected by this policy, and a basic understanding of how it works is, therefore, important. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-2

Chapter Preview
• We examine how the conduct of monetary policy affects the money supply and interest rates. We focus primarily on the tools and the goals of the
U.S. Federal Reserve System, and examine its historical success. Topics include:
– The Federal Reserve’s Balance Sheet
– The Market for Reserves and the Federal Funds Rate
– Tools of Monetary Policy

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-3

Chapter Preview (cont.)
– Discount Policy
– Reserve Requirements
– Monetary Policy Tools of the ECB
– The Price Stability Goal and the Nominal
Anchor
– Other Goals of Monetary Policy

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-4

Chapter Preview (cont.)
– Should Price Stability be the Primary Goal of
Monetary Policy?
– Monetary Targeting
– Inflation Targeting
– Tactics: Choosing the Policy Instrument

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-5

The Federal Reserve’s Balance Sheet
The conduct of monetary policy by the Federal
Reserve involves actions that affect its balance sheet. This is a simplified version of its balance sheet, which we will use to illustrate the effects of
Fed actions.

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8-6

The Federal Reserve’s Balance Sheet:
Liabilities
• 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.
– Reserves: All banks maintain deposits with the Fed, known as reserves. The required reserve ratio, set by the Fed, determines the required reserves that a bank must maintain with the Fed. Any reserves deposited with the Fed beyond this amount are excess reserves.
The Fed does not pay interest on reserves, but that may change because of legislative changes for 2011.
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-7

The Federal Reserve’s Balance Sheet:
Assets
• 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.
As we will show, purchasing Treasury securities increases the money supply.
– Discount Loans: These are loans made to member banks at the current discount rate.
Again, an increase in discount loans will also increase the money supply.
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-8

Open Market Operations
In the next two slides, we will examine the impact of open market operation on the Fed’s balance sheet and on the money supply. As suggested in the last slide, we will show the following:
– Purchase of bonds increases the money supply
– Making discount loans increases the money supply

Naturally, the Fed can decrease the money supply by reversing these transactions.

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-9

The Federal Reserve Balance Sheet
• Open Market Purchase from Public
Public
Assets

The Fed
Liabilities

Securities
–$100
Deposits
+$100

Assets

Liabilities

Securities
Reserves
+$100
+$100

Banking System
Assets
Reserves

Liabilities
Deposits

+$100

+$100

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Result R  $100, MB $100
8-10

The Federal Reserve Balance Sheet
• Discount Lending
Banking System
Assets
Reserves

Liabilities

Discount loans
+$100
+$100

The Fed
Assets

Liabilities

Discount loans Reserves
+$100
+$100

Result R  $100, MB $100

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

8-11

Supply and Demand in the