In vague, but by decisions and actions, we
In exploring monetary policy in the United States, it is essential to define what is meant by monetary policy. Monetary policy can be defined as the policy decisions and actions by the Federal Reserve System (Fed) that affect the banking system and money supply.
This may seem vague, but by decisions and actions, we mean the goals, tools, and targets of the Fed.In the following paper, I will look at monetary policy, “under a microscope.” The Fed itself will be looked at, regarding the components of the unique system. Then, the goals of monetary policy will be explained, followed by the tools used to achieve these goals. Next, the instruments used to attain the goals and tools will be explored.
Finally, I will look at monetary policy in the United States since 1970, to see the pattern that the Fed has used.FEDERAL RESERVE SYSTEMFounded in 1913 by an act of Congress, the Fed is the central bank of the United States. The Fed is a complicated institution with many responsibilities, including the regulation and supervision of over 10,000 commercial banks.
The organization of the Fed is included in the Appendix to this paper.The Board of Governors is the most important group within the Fed. The Board consists of seven members, each appointed for 14 years by the President of the United States.
The chair of the Fed, also appointed by the President, has a term of 4 years, and is sometimes said to be the second most powerful man in the country. The Fed is an inde-pendent agency, and thus does not take orders from either the President or Congress.Page 2The US is divided into 12 Federal Reserve districts, each having its own Federal Reserve bank. (These districts can also be seen in the Appendix.) The district banks are like branch offices of the Fed, carrying out the rules, regulations, and functions of the Fed. The banks report to the Board of Governors on local economic conditions.
The US monetary policy is formally set by the Federal Open Market Committee (FOMC). The FOMC consists of the seven members of the Board of Governors, the president of the NY Federal Reserve Bank, and, on a rotating basis, four of the presidents of the other eleven banks. The FOMC sets goals regarding the money supply and interest rates, and it directs the Open Market Desk in the NY Federal Reserve Bank to buy or sell government securities. (These open market operations will be discussed at length, later on in the paper.) (2, page 268)As noted before, the Fed is the central bank of the US Central banks are known as “banker’s” banks, because only banks can do business with them. Although the Fed’s crucial role is to control the money supply; it also performs several important functions for banks. These functions include clearing interbank payments, regulating the entire banking system, and assisting banks that are in a difficult financial position.
The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves.Besides facilitating the transfer of funds between banks, the Fed performs several other important duties. It is responsible for many of the regulations governing banking practices and standards. For example, the Fed has the authority to control mergers be-tween banks.
The Fed is also responsible for examining banks to ensure that they are fi-nancially sound and that they conform to regulations. One of the most important respon-Page 3sibilities of the Fed is to act as a lender of last resort for the banking system. This is ideal for two reasons.
First, providing funds to a bank that is in dire straits is risky and not likely to be profitable, making it hard for private banks of institutions to perform this role. Second, the Fed has an essentially unlimited supply of funds with which to bail out banks in need. The reason, as you will see, is that the Fed can basically create money at will.
(2, pages 269-271)GOALS OF MONETARY POLICYMonetary policy shares some of the basic goals of macroeconomic policy: high employment, price stability, exchange rate stability, and a high rate of economic growth. There are, however, a few specialized goals of monetary policy. They are interest rate stability, and the prevention of large-scale bank failures and financial panics. Each of these goals will now be discussed at length.High EmploymentThis is one obvious goal. Everyone seems to prefer high employment to large-scale unemployment.
However, an employment goal does raise serious issues. One, is the definition of high employment. It obviously does not mean zero unemployment, as there will always be some frictional unemployment. This results from workers leaving jobs to find new ones, new entrants into the labor force, and from a geographical mis-match or occupational mismatch of workers and jobs. Even if an appropriate level of un-employment is determined, there is not a good statistical measure of unemployment. The unemployment data is polluted in several ways.
First, they understate the true extent of Page 4unemployment because they count only those looking for work, thus leaving out those who have ceased to look for a job. Second, part-time workers, who want full-time jobs, are not counted as partially unemployed. Third, workers who lose a job and then their spouse looks for work are counted as two people looking, although only one wants a job. Furthermore, welfare recipients in some states have to look for work, even though a large number of them are unemployable. (1, page 302)Thus, not only do we not know what the proper level of unemployment is; we also cannot measure current unemployment accurately. This means that sometimes it is diffi-cult to decide whether unemployment is too high or too low.
For practical purposes, many people believe that a civilian unemployment rate between 4% and 6% indicates an economy operating at or near a level of high employment. It is important to realize that high employment is one of the Fed’s goals because, in certain circumstances, the Fed’s policy can directly influence the level of employment. “Easy money” policies regarding the money supply can be used, and these tools will be explained later.
Price StabilityThe next goal, price stability may seem an obvious one, but it is far from obvious. In considering a fully anticipated inflation , only three types of losses are imposed. First, there is the bother and inconvenience of having to change price and catalog prices fre-quently, and furthermore, the buyer’s knowledge about what is a good price for a good is quickly outdated. Second, since prices cannot be changed continually, they will be out of equilibrium for the presumably short period between price changes.
Third, inflation cre-ates an incentive to hold too little currency, be-Page 5cause currency holdings lose their real value without having the compensation of the higher nominal interest rates that other assets have. (1, pages 302-303)However, the inflations that we actually experience are not fully anticipated, and our economy is not fully indexed. Thus, nominal rather than real interest income is taxed. In addition, depreciation that firms are allowed to deduct against taxable income is too low because it is based on original rather than replacement cost. This raises their tax liability, and for this reason, inflation lowers stock prices. (1, page 303)Since inflation affects the tax burdens faced by corporations to varying degrees, it also leads to a socially inefficient allocation of investment funds. This is because after-tax profits become a less reliable guide to the true productivity of capital in various in-dustries.
Another effect of unanticipated inflation is its impact on the distribution of wealth and income. Obviously, it hurts creditors, and benefits debtors. In addition, it may help or hurt wage earners depending on whether or not wages lag behind prices. The distribu-tion of income becomes less unequal.
Another loss from inflation is that is creates uncertainty and insecurity. House-holds can no longer plan confidently for the future, since they do not know what their fixed dollar assets will then be worth in real terms. This is likely to cause people to lose their faith in the government and in the equity and reasonableness of social conditions in general.Page 6Foreign Exchange Rate StabilityThe foreign exchange rate market has become so much more important in recent years, as the economies of the world have become more integrated, and foreign currency exchange rates have begun to affect even larger segments of the economy.
Because ex-change rates are clearly dependent in some ways on the monetary policies of the major countries, the Fed has accepted the goal of stabilizing foreign exchange rates.A chief disadvantage of unstable foreign currency exchange rates is that the volatility in the prices of currencies inhibits the international trade that offers a host of benefits to all participating countries. Furthermore, both high and low exchange rates are considered detrimental to the US economy. High exchange rates reduce demand for US goods abroad and stimulate the import of foreign goods; the result is a trade imbalance. A weak dollar contributes to inflation, and US buyers pay more for the many goods that they do import. For these reasons, the Fed’s goal of stability in the currency market often amounts to keeping the value of the dollar, in terms of major foreign currencies, within some range that is considered politically acceptable and helpful to international trading, especially exporting. (3, pages 107-108)Economic GrowthThere has been much concern that our rate of growth is low relative to its trend in the postwar period and relative to that in other countries.
This lower rate growth rate is due to many factors, must of which are beyond the Federal Reserve’s control. However, the Fed can control one important determinant of economic growth, investment. A higher rate of investment not only means more capital per worker, but it is also an imPage 7portant way in which new technological developments come about. Innovations are often embodied in new equipment. For example, the invention of a new machine does not in-crease productivity until it has been installed.One way of raising investment is to keep real interest rates fairly low.
This inher-ently expansionary policy would have to be accompanied by a restrictive fiscal policy, that is, by a large surplus or small deficit. This fiscal policy is obviously another factor out of the Fed’s control. Another way in which the Fed can raise investment is by con-trolling the rate of inflation since the uncertainty created by an unpredictable rate of in-flation lowers investment.
(2, page 304)Investment-Rate StabilityAlthough, since 1979, the Fed has allowed greater fluctuations of interest rates, interest-rate stability has traditionally been one of its goals. A reason for this is that fluctuating interest rates hurt those who, when rates rise, have to sell securities at a loss. Such losses are inequitable. Furthermore, with sharply fluctuating interest rates, firms that plan to borrow have to spend time and effort trying to predict the best time to do so, and financial institutions that borrow short and lend long, are in trouble.
In addition, in-terest-rate fluctuations generate fluctuations in exchange rates and thus are disruptive to foreign trade and investment, as we have already seen. Finally, we must keep in mind that the Fed’s goal is to stabilize interest rates, not to prevent changes, as these changes are inevitable. (2, page 304)Page 8Prevention of Widespread Bank FailuresThe prevention of widespread bank failures and panic is, in a way, not a separate goal, since the main loss from large-scale bank failures is likely to be a depression with massive unemployment and economic chaos. It is used as a goal, just as a reminder of the Fed’s lender of last resort role. The FDIC takes care of many smaller bank failures for the Fed. But if somehow, bank holdings, which were 5 to 10 percent of total bank deposits, were in danger of not being able to meet depositors’ withdrawals, then it would be the Fed’s job to step in and, through massive open-market operations, provide the banking system with enough reserves to meet depositors’ demands. (2, page 305)Conflict Among GoalsAs we can see, the Fed has many different goals, and its task is greatly compli-cated due to conflicts among these goals.
Therefore, the Fed has to estimate the trade-offs and has to decide the extent to pursue one goal in sacrificing another.First, I will look at the relationship of economic growth to price stability and high-employment goals. Since inflation that is not fully anticipated reduces economic growth, there exists no conflict between high economic growth and price stability in the long run. There may, however, be a conflict in the short run.
To eliminate or reduce ex-isting inflation, it generally requires that unemployment and excess capacity increase. The more excess capacity firms have, the less is the incentive to invest.The prevention of widespread bank failures does not clash with the employment goal, but can conflict with the price-stability goal, and thus with the economic growth goal. For example, in 1982, the Fed called a halt to the severely restrictive policy it had Page 9adopted to fight inflation because it was afraid that a financial panic might occur.
Ad-mittedly, this situation arises very rarely. Beyond this, bank regulations, by inhibiting financial innovations, also have some deleterious effects on economic growth.The relation between price stability and interest rate stability is very different in the short run and long run. In the long run, there is no conflict between the two; the lower the inflation rate, the lower is the nominal interest rate, and similarly, the more er-ratic the inflation rate, the more erratic is the nominal interest rate.
But in the short run, it is very different. Suppose the aggregate demand increases because investment has be-come more profitable. As firms try to invest more, the rate of interest rises. The only way that the Fed can postpone this rise is to allow the quantity of money to increase at a faster rate. This, however is obviously inflationary.
A similar short-run conflict arises if an inflation is already underway. To stop the inflation, the Fed had to cut the money growth, which results in temporarily higher interest rates. (2, pages 306-308)Interest-rate stability has some, but probably only a small effect on the economic growth rate. But, although as it changes the inflation rate and the capacity utilization rate, it does affect growth indirectly in the ways just discussed.
Interest-rate stability is helpful in preventing bank failures, since a bank can be seriously hurt by the fall in the market value of its security holding when interest rates rise.The final goal is minimizing the special burden that monetary policy imposes on particular sectors of the economy. Here too, one must distinguish between the short run and long run.
In the long run, it is an expansionary policy that, by generating inflation, creates special problems for particular sectors of the economy. This is because the health Page 10of many of our institutions is predicated more or less on price stability. The problem that thrift institutions face is mainly due to the inflation-induced rise in nominal interest rates. Thus, in the long run, the moderately restrictive monetary policy that is headed to curb inflation is consistent with minimizing distortions. But in the short run, such a restrictive policy raises interest rates, and thus hurts sectors like residential construction.
(3, pages 307-309) The Fed seems to be in a “Catch 22”, and has to sacrifice some goals for the sake of others. Now that the goals have been properly discussed, the next part is the tools that the Fed uses to accomplish these goals.TOOLS OF THE FEDThe Fed, in trying to achieve the goals, does so by controlling the money supply. The key to understanding how the Fed controls the money supply in the US economy is an appreciation of the role of reserves. Reserves are the deposits of depository institu-tions on the Fed’s balance sheet.
As we know, the required reserve ratio establishes a link between the reserves of the commercial banks and the deposits that commercial banks are allowed to create. The reserve requirement, in essence, determines how much a given bank is available to lend.The money supply is equal to the sum of deposits inside banks and the currency in circulation outside the banks. It is obvious then, that reserves provide the leverage that the Fed needs to control the money supply. The question then becomes, how does the Fed control the supply of reserves? There are three major tools available to the Fed for Page 11changing the money supply. These are (1) changing the required reserve ratio, (2) changing the discount rate and, (3) open market operations.
Required Reserve RatioThe simplest way for the Fed to alter the supply of money is to change the re-quired reserve ratio. An analysis of how this process works is included in the Appendix.If the Fed decides to change the required reserve ratio, the result is an immediate change in the reserve portion of the banks and other depository institutions. If the re-quired reserve ratio is lowered, banks will have more reserves than they need.
Banks, now having excess reserves, will convert those reserves into loans or will buy govern-ment bonds. Either way, bank credit has expanded, and the result is an increase in the money supply. The money supply is increased due to an increase in the money multi-plier.
(4, page 201)Conversely, when the required reserve ratio is raised, banks have insufficient re-serves, causing them to try to replace those reserves. They do so by reducing the amount of loans, since there is no increase in the monetary base, and the money supply falls. Changes in the reserve ratio are very rare. The Fed seldom changes the reserve ration in such a dramatic fashion. The fact that changing the reserve ratio expands or reduces credit in every bank in the country makes it a very powerful tool, however, when the Fed does use it. There are better tools to use, as we will see, such as open market operations.
The Discount RateBanks are allowed to borrow money from the Fed. The interest rate that the banks pay is known as the discount rate. When banks increase their borrowing, money supply Page 12increases.
Of course, banks have to pay these loans back, and when they do the money supply decreases by the amount it originally increased by.The higher the discount rate, the higher the cost of borrowing, and the less bor-rowing banks will want to do. If the Fed wants to curtail the money supply, it raises the discount rate, the thus restricts the growth of reserves in banks.The discount rate cannot be used to control the money supply with great preci-sion, because its effects on banks’ demand for reserves are uncertain.
In practice, the Fed does not use the discount rate very often to control the money supply. It does change the discount rate from time to time, but this is to keep in line with other interest rates, which are usually leading the discount rate anyway. (4, page 203)Changing the discount rate has several problems associated with it.
First, al-though raising the discount rate does discourage banks from borrowing, it is never clear exactly how much of an effect will be felt. Second, movements in other interest rates can largely offset changes in the discount rate. For example, if the discount rate is set at 10%, and the T-Bill rate at11%, banks will obviously not find it profitable to borrow from the Fed to purchase T-Bills.
If the T-Bill rate rose to 11% however, then the banks could profitably borrow from the Fed to purchase T-Bills.Open Market OperationsBy far, the most significant of the Fed’s tools for controlling the money supply is open market operations. Congress has authorized the Fed to buy and sell US government securities in the open market.
When the Fed purchases a security, it pays for it by writing a check, therefore expanding the quantity of reserves and thus the money supply. When Page 13the Fed sells a bond, the opposite occurs, and the money supply is decreased. We must keep in mind that the Treasury Department also sells securities, but only initially. The Fed sells pre-existing securities on the open market. Also, the Treasury cannot print money to finance the debt, this is why is sell securities. (1, page 276)Because the Fed owns some securities, the government actually owes some of what it owes to itself. Again, these securities are nothing more than bills and bonds ini-tially used by the Treasury to finance the deficit.
The Fed acquired them over time through direct open market purchases, made in order to expand the money supply.How exactly do open market operation work? With the help of the chart in the Appendix, the following explanation should clear things up. In Panel 1, the Fed initially has $100 billion of government securities. Its liabilities consist of $20 billion of deposits, and $80 billion of currency. With the RRR at 20%, the $20 billion of reserves can sup-port $100 billion of deposits in the banks. The banking system is thus, fully loaded up. Panel 1 also shows the financial position of a private citizen, Jane Q.
Jane has assets of $5 billion, and a net worth of $5 billion as well.Now, imagine that the Fed sells $5 billion in government securities to Jane. Jane pays by writing a check to the Fed, drawn on her bank.
The Fed then reduces the reserve account of the bank by $5 billion. The balance sheets of all participants are in Panel 2. Note that the money supply (currency plus deposits) has fallen from $180 billion to $175 billion.Page 14As a result of the Fed’s sale of securities, the amount of reserves has fallen from $20 billion to $15 billion, while deposits have fallen from $100 billion to $95 billion. With a RRR of 20%, banks must have $19 billion in reserves.
Banks are thus $4 billion under the requirement. In order to comply with regulations, banks must decrease their loans and deposits.The final equilibrium position is seen in Panel 3, where commercial banks have reduced their loans by $20 billion. Notice that the change in deposits from Panel 1 to Panel3 is $25 billion, which is five times the size of the change in reserves brought about by the Fed.
This is the money multiplier. The change in money is equal to the multiplier times the change in reserves. The opposite holds true for a purchase of securities by the Fed. The purchase will result in an increase in reserves and an increase in the money supply by an amount equal to the multiplier times the change in reserves. (1, pages 277-279)Open market operations are the Fed’s preferred means of controlling the money supply for several reasons. First, they can be used with some precision. If the Fed needs to make small changes in the money supply, it just sells or purchases a small amount of securities.
Second, open market operations are extremely flexible. If the Fed decides to reverse course, it can switch from buying to selling or vice versa. Finally, the operations have a fairly predictable effect on the supply of money. Since banks are obliged to meet their reserve requirements, the math is fairly simple and easily calculated.Next, in my discussion of monetary policy are the targets that the Fed implements its tools and, in effect its goals on.
Page 15FEDERAL RESERVE TARGETSA problem in the implementation of monetary policy is that the Fed has no direct control over the goals that are the final objective of its policies. Even with its monetary policy tools, the Fed cannot directly influence such complex economic variables as the prices of goods and services, the unemployment rate, and economic growth. We know the Fed can affect the rate of growth in the money supply only by means of its control of reserves. As we know, the Fed cannot fully determine the impact of their tools on the money supply.
It depends on a number of factors including preferences, actions, and ex-pectations of consumers, borrowers, and banks.The Fed uses a chain reaction to achieve its goals. The chain reactions follow the following chronology: the Fed first employs one or more of its tools to affecting operat-ing targets. These operating targets are monetary and financial variables whose changes tend to bring about changes in intermediate targets. Intermediate targets, which may be interest rates or monetary aggregates, are variables that have a reasonably reliable linkage with other variables, such as output or employment, which constitute the Fed’s ultimate goals. The Fed exerts a type of indirect control over these intermediate targets through controlling the operating targets. Thus, the Fed’s power over the variables that make up its goal is quite indirect and dependent upon the linkage among the various targets and goals.
(2, page113)There are a few chief characteristics of a suitable operating or intermediate target. The first characteristic is linkage. An operating target must have an expected connection with the intermediate target or it will not work. Second, we have observability. This Page16characteristic is important because both operating and intermediate targets must be read-ily and regularly observable economic variables, so the Fed can monitor them. Third, and finally, there is responsiveness. To function as an operating target, a variable must respond quickly and in an expected way to the Fed’s use of one or more of its tools. An appropriate intermediate target is one that reacts, in an anticipated way and short time, to changes in the operating target. (2, pages 113-114)Choosing the Operating TargetThe Fed’s monetary policy, in the past, has directly targeted either short-term in-terest rates or some measure of bank reserves. An important point about the operating target is that the Fed must choose either a short-term interest rate or a reserve level and cannot choose to target both variables. The Fed’s tools, whether the secondary ones of discount loans and management of required reserves, or the primary tool of open market operations, enable the Fed to change only the level of reserves in the banking system. A change in reserves naturally changes the short-term interest rates, but an inverse relation-ship exists.Due to an inverse relationship, one might think the Fed should set these at the same time and view each variable as a target. This, in fact, is impossible. The reason is that the Fed cannot know or predict the public’s demand for money. This demand de-pends upon many factors, especially preferences and anticipations about future income and prices, and unexpected changes in those factors that will shift the public’s demand. Without knowledge of what the rate will be for a given change in reserves, the Fed can-not simultaneously determine both the interest rate and level of reserves. In choosing a Page 17target, the Fed decides to let the other variable fluctuate in response to changes in demand for money. The Fed can change its target from time to time, but it remains a fact that the Fed cannot target both at the same time.Choosing the Intermediate TargetThe best known of the intermediate targets is the money supply. Over time, other intermediate targets have been specified, including foreign exchange rates, the level of national output, and inflation levels, but money supply has remained the top choice of the Fed. Even the array of interest rates were at one time or another used as intermediate tar-get variables. Some of these, which failed, have done so because they fail to meet the readily observable characteristic that is sought after. (2, page 115) In the US, it has been recently said that Fed chairman Alan Greenspan carefully monitors the price of gold among other commodities. Thus, the purchasing power of the domestic currency and the foreign exchange rate of the currency could both become far more typical intermediate targets.We now have the entire monetary policy “team”, and should be wondering how good the theories work. How has the US handled monetary policy in the past 30 years? Next, and finally, I will explore briefly a review of the Federal Reserve’s Monetary Pol-icy from 1970 to 1995.Page 18UNITED STATES MONETARY POLICY1970-1979During most of the 1970’s the Fed viewed the federal funds rate either largely or exclusively as its operating target. The rate on interbank loans is the fed funds rate, and it is a good indicator of the banking system’s supply of loanable funds. When banks have a lot of funds and lending capacity, the rate is low; the rate is high when the banking sys-tem has drawn its reserve close to the required level. The rate is also readily observable and continuously available because the market for fed funds is large and active. The Fed targets the fed funds rate by its open market operations. The Fed can therefore exert a great amount of control over this target. The rational