The Nuts and Bolts of Monetary Policy

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CHAPTER 13

THE NUTS AND BOLTS
OF MONETARY POLICY

OVERVIEW

This chapter discusses monetary policy and explores the monetary and financial systems in the U.S. in more detail. The chapter starts by illustrating some features of the Federal Reserve Bank (Fed). Then, it looks at the financial assets and liabilities of the financial system and the role of money in the economy. Details about the operations of the Fed and the conduct of monetary policy are also provided in this chapter.

The Fed is the central bank of the U.S. It consists of 12 regional Federal Reserve Banks. The central committee in the Fed is the Federal Open Market Committee (FOMC). This committee consists of 12 members; 7 board of governors, the president of the N.Y. Fed, and a rotating group of 5 regional bank presidents.

FOMC is the committee that decides on the future monetary policy, which changes money supply and, as a result, short-term interest rates. The three tools used to change money supply are the reserves requirements, the discount rate, and the open market operations. The reserve requirement rate is the percentage of new deposits that banks must keep at the Fed. By changing the rate, the Fed changes the monetary base (the sum of currency and reserves) and the money supply. The discount rate is the interest rate that banks pay the Fed for borrowing funds. Although banks do not like to borrow from the Fed, the latter changes the discount rate to indicate the direction of monetary policy. The Fed conducts open market operations when it sells or buys government securities. Selling bonds decreases money supply, while buying them increases money supply.

The impact of changes in money supply as a result of changes in the monetary base depends on the money multiplier. The simple money multiplier equals 1/r, where r is the reserve requirement ratio. This multiplier is built on three simplifying assumptions; there is only one bank, there are no excess reserves, and individuals do not hold cash. The more realistic money multiplier is (1+c)/(r+c+e), where c is the currency-deposit ratio, r is the reserve requirement ratio, and e is the excess reserve-deposit ratio.

There are many issues related to FOMC operations. First, there are three different books that staff from the board of governors and district banks prepare and bring to any scheduled meeting. The Beige Book contains information on economic conditions in various regions. The Green Book contains a summary of the 2-year outlook of the FOMC meeting. The Blue Book surveys the status of money supply, interest rates, and reserves. It proposes three different policy actions--increase, decrease, or do not change money supply.

When deciding on a policy action, the Fed evaluates operating targets. The two most popular ones are borrowed reserves and the federal funds rate, which is what banks pay each other for borrowing reserves overnight. The Fed uses these operating targets because they are measurable, controllable, and can predict their impact on intermediate target and, as a result, on ultimate targets. Operating targets, when changed, affect intermediate targets, which, in turn, affect ultimate targets, such as price stability, low unemployment, or produce potential output. Historically, the intermediate targets have been the interest rate and the money supply. In recent years, the Fed abandoned targeting the money supply due to the increasing instability of the velocity of money.

Monetary policy actions can take two forms--dynamic or defensive actions. Dynamic monetary policy involves changing an operational target, i.e., changing the federal funds rate. Defensive monetary policy aims to offset short-term deviations of operational targets. For example, if the federal funds rate during the day deviates from its targeted level, the Fed takes a defensive action to maintain the sought target.

Some economists advocate the use of rules to govern...
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