The Tools and Goals of Central Bank Monetary Policy

By Rose, P.S., Marquis, M.H.

Edited by Paul Ducham


The principal policy tool of the Federal Reserve (and many other central banks as well) is open market operations. By definition, open market operations in the United States consist of buying and selling U.S. government and other securities by the Federal Reserve System to affect the quantity and growth of legal reserves and, ultimately, general credit conditions. Open market operations are the most flexible policy tool available to the Fed, suitable for fine-tuning short-term interest rates and the availability of credit in the financial markets when this is necessary. Other central banks around the world may use different types of securities to buy or sell in conducting their open market operations, especially if they lack a “deep” market for their government’s debt. Among the more common financial instruments traded by many central banks today are bank deposits, derivative securities, and central bank debt. Open market operations are rapidly becoming the most popular tool of leading central banks around the globe. An important example is the new European Central Bank (ECB) that was granted the open market tool; it selects which financial instruments can be used and under what terms and conditions, but the ECB’s operations must be carried out through the central banks of its member countries.

Effects of Open Market Operations on Interest Rates The open market tool has two major effects on the banking system and credit conditions. First, it has an interest rate effect. For example, in the United States, the Fed typically buys or sells a large quantity (often exceeding a billion dollars worth) of government securities in the financial marketplace at any one time. If the Fed is purchasing securities, this adds additional demand for these securities in the market, which tends to increase their prices and lower their yields. In this case, interest rates decline. If the Federal Reserve is selling securities from its portfolio, this action increases the supply of securities available in the market, tending to depress their prices and raise their yields. In this case, interest rates tend to rise.

Effects of Open Market Operations on Reserves The principal day-today effect of central bank open market operations is to change the level and growth of legal reserves. For example, a Federal Reserve purchase of government securities increases the reserves of the banking system and expands its ability to make loans and create deposits, increasing the growth of money and credit. In contrast, a sale of securities by the Federal Reserve decreases the level and growth of reserves and ultimately reduces the growth of money and credit. The impact of Federal Reserve open market operations on the reserve positions of depository institutions with accounts in the United States is illustrated in Exhibit 13.1 .

Fed Purchases In the top portion of Exhibit 13.1 , we assume the Fed is making purchases of U.S. government securities in the open market from either depository institutions, which keep their reserve accounts at the Federal Reserve banks, or from other institutions and individuals. If purchases are made from depository institutions, the Federal Reserve System would record the acquisition of securities in the System’s asset account—U.S. securities—and pay for the securities acquired by increasing the reserve accounts of the selling institutions. Thus, reserves of depository institutions at the Fed rise, while institutional holdings of securities fall by the same amount. Note that both total and excess reserves rise in the wake of a Fed purchase, assuming that depository institutions have no reserve deficiencies to begin with. With these extra reserves, additional loans can be made and deposits created that will have an expansionary impact on the availability of credit in the economy.

An expansionary effect would also take place were the Federal Reserve to buy securities from an institution or individual other than a depository institution. Legal reserves would increase, but total deposits—a component of the money supply—would increase as well. Deposits would rise because the central bank would issue a check to pay for the securities it purchased and that check would be deposited in some financial institution, which would, in turn, present the check to the Federal Reserve for crediting to the institution’s legal reserve account. Excess reserves would then have risen, making possible an expansion of deposits and loans on the part of depository institutions. Note, however, that the rise in excess reserves is less in this case than would occur if the Fed bought securities only from depository institutions that maintain reserve accounts with the Federal Reserve banks. This is due to the fact that some of the new legal reserves created by the Fed purchase must be pledged as required reserves behind the newly created deposits. Therefore, Federal Reserve open market purchases of securities have less of an effect on total credit and deposit expansion if the Fed’s transaction involves only nondeposit financial institutions and individuals.

Fed Sales Central bank sales of securities reduce the growth of reserves, deposits, and loans. For example, as shown in the bottom half of Exhibit 13.1 , when the Federal Reserve sells U.S. government securities from its portfolio to a depository institution or to a dealer with an account at a depository institution, that institution must pay for those securities by letting the Fed deduct the amount of the purchase from its reserve account. Both total reserves and excess reserves fall. If depository institutions were fully loaned up with no excess reserves available, the open market sale would result in a reserve deficiency. Some institutions would be forced to sell loans and securities or borrow funds in order to bring in additional reserves, thereby reducing the availability of credit.

Suppose the central bank were to sell securities to an individual or a nondeposit institution. As Exhibit 13.1 reveals, in this instance, both reserves and deposits fall. Credit becomes less available and usually more expensive.

How Open Market Operations Are Conducted in the United States All trading in securities by the Federal Reserve System is carried out through the System’s Trading Desk, located at the Federal Reserve Bank of New York. The Trading Desk is supervised by the manager of the System Open Market Account (SOMA), a vice president of the New York Fed. The SOMA manager’s activities are, in turn, supervised and directed by the Federal Open Market Committee. In reality, the Fed does not trade with the public; rather all Fed security purchases and sales are made through a select list of primary U.S. government securities dealers who agree to buy or sell in amounts called for by the Trading Desk at the time the Fed wishes to trade. Many of these dealers are banks that have securities departments. The rest are exclusively dealers in U.S. government and selected private securities.

Federal Reserve purchases and sales of Treasury bills, repurchase agreements, and other financial instruments normally are huge in volume. For example, during the month of October 2006, Fed purchases of repurchase agreements (RPs) exceeded $175 billion and its rollover of reverse RPs were nearly $650 billion. By the end of that month the Fed held securities in its own portfolio amounting to more than $772 billion (at face value), of which more than $277 billion were U.S. Treasury bills and better than $495 billion were Treasury notes and bonds. It also held in custody on behalf of foreign governments and official institutions nearly $1.7 trillion in marketable securities. Most of its portfolio is short in maturity, rolling over within a year, keeping Fed traders in New York busy much of the time.

The Policy Directive How does the SOMA manager decide whether or not to buy or sell securities in the open market on a given day? The manager is guided, first of all, by a policy directive issued to the Federal Reserve Bank of New York following the conclusion of each meeting of the Federal Open Market Committee (FOMC). The SOMA manager attends each FOMC meeting and participates in its policy discussions. He or she listens to the views of each member of the Federal Reserve Board and the Reserve bank presidents, who describe economic conditions in their region of the country. The manager also receives the benefit of a presentation by staff economists of the Federal Reserve Board who analyze current economic and financial developments.

In recent years, with the issuance of a policy directive to the SOMA manager at the Fed’s Trading Desk in New York, the FOMC has been releasing to the public a Federal Open Market Committee Statement regarding its planned course of action after each committee meeting (normally by 2:15 pm. EST on the last day of an FOMC meeting). These policy statements reflect the central bank’s efforts to be more transparent (i.e., to make more public disclosures) and to be more accountable to the public for what it does. An example of a recent policy statement is shown in Exhibit 13.2 . This statement summarizes the Federal Reserve’s view of current economic developments, particularly those that pertain to the growth of output in the economy and to movements in prices and employment. The FOMC specifies a target level for a key money market interest rate—the effective federal funds rate.

We note that the FOMC policy statement is extremely general in nature and recognizes the need for flexibility as market conditions change. Many factors other than Federal Reserve operations affect interest rates and credit availability. Consequently, the Federal Open Market Committee must be flexible and trust the SOMA manager’s judgment in responding to daily conditions in the money market, which subsequently may be quite different from those anticipated when the FOMC held its last meeting.

The Conference Call As an added check on the decisions of the SOMA manager, a conference call between staff economists at the Federal Reserve Board, a member of the FOMC, and the SOMA manager is often held each day before trading occurs. The SOMA manager updates those sitting in on the conference call on current conditions in the money market and then makes a recommendation on the type and volume of securities to be bought or sold that day. At this point, the conference call participants may make alternative recommendations. Usually, however, the SOMA manager’s recommendation is taken and trading proceeds.

Types of Open Market Operations There are four basic types of Federal Reserve open market operations. (See Exhibit 13.3 .) The so-called straight, or outright, transaction refers to the sale or purchase of securities in which outright title passes to the buyer on a permanent basis. In this case, a permanent change occurs in the level of legal reserves, up or down. Thus, when the Federal Reserve wants to bring about a once-and-for-all change in reserves, it tends to use the straight or outright type of transaction—something that normally takes place only a few times during the year. One reason the Fed wishes to make occasional permanent additions to its portfolio of government securities is to account for the secular growth in the liquidity demands of a growing economy.

In contrast, when the Fed wishes to have a temporary effect on bank reserves, correcting temporary mismatches between the demand for and supply of reserves, it employs a repurchase agreement with a securities dealer. Under a repurchase agreement (RP)—today the most popular type of open-market operation—the Fed buys securities from dealers but agrees to sell them back within a short period of time, usually the following day. The result is a temporary increase in legal reserves that will be reversed when the Fed sells the securities back to the dealers. Such RPs frequently are used during holiday periods or when factors are at work that have resulted in a temporary shortfall in reserves.

A good example of how the RP can be used to deal with temporary emergencies appeared in September 2001 when, in the wake of a terror attack on the United States, the Fed injected about $80 billion in additional liquidity into the U.S. financial system using repurchase agreements with primary security dealers. A week later, as market conditions stabilized, the Fed withdrew most of these extra funds.

The Fed can also deal with a temporary excess quantity of reserves by using a matched-sale purchase (MSP) transaction, commonly called a reverse RP. In this instance, the Fed agrees to sell securities to dealers for a brief period and then to buy them back. Frequently, when deliveries are slowed by weather or strikes, the result is a sharp increase in the volume of uncollected checks (float), giving depository institutions millions of dollars in excess reserves until the unpaid items are cleared. The Fed can absorb these excess reserves using reverse RPs until the situation returns to normal. Incidentally, reverse RPs are used for the types of problems just described because the Fed is not allowed by law to use a simpler and less costly approach to the problem—borrowing from the public—in order to reduce the volume of reserves available to the banking system.

The third type of open market operation is the runoff. The Federal Reserve may deal directly with the U.S. Treasury in acquiring and redeeming securities. Suppose the Fed has some maturing U.S. Treasury securities and wishes to replace them with new securities currently being offered by the Treasury in its latest public auction. The amount of securities the Fed takes will not then be available to the public, reducing the quantity of securities sold in the marketplace. Other things being equal, this would tend to raise security prices and lower interest rates.

On the other hand, the Fed may decide not to acquire new securities from the Treasury to replace those that are maturing. This would mean the Treasury would be forced to sell an increased volume of securities in the open market to raise cash in order to pay off the Fed. At the same time, the Treasury would draw funds from its deposits held at private banks, reducing bank reserves, to redeem the Fed’s maturing securities. Other things equal, security prices would fall and interest rates rise. Credit market conditions would tighten up. Moreover, the Federal Reserve saves on transaction costs (in the form of dealer fees) by dealing directly with the Treasury and not conducting a regular open market transaction through private security dealers.

Finally, the Fed also conducts purchases and sales of securities on behalf of foreign central banks and other official agencies and institutions that hold accounts with the New York Federal Reserve Bank, known as agency operations. The Fed may buy or sell securities from its own portfolio to accommodate these foreign accounts or merely act as an intermediary between the foreign accounts and security dealers.

For example, suppose that the Federal Reserve Bank in New York has just received a request from the Bank of Japan to purchase U.S. government securities. That central bank has probably built up too much cash in its U.S. accounts and has decided to earn some interest on that cash by buying some U.S. Treasury bonds. To pay for the securities, the Bank of Japan transfers a portion of its deposit at a U.S. bank to its deposit account at the New York Fed. The Fed’s Trading Desk may contact private dealers and make the purchase on behalf of the Bank of Japan, crediting the dealers’ banks for the purchase price of the securities and reducing the Bank of Japan’s deposits at the Fed. In this case, total reserves of the U.S. banking system do not change, falling initially but then rising back to their original level.

However, the Fed may decide to sell the Bank of Japan securities from its own portfolio (that is “from System account”). In this case, bank reserves fall initially, as the Bank of Japan pays for its purchase, but do not rise again. The money received from this Fed sale is “locked up” within the Federal Reserve System and does not flow out to private banks. In general, sales of Federal Reserve-held securities to foreign accounts reduce U.S. bank reserves; purchases of securities from foreign accounts that go into the Fed’s own security account increase U.S. bank reserves.

Goals of Open Market Operations: Defensive and Dynamic In the use of any of its policy tools, the Federal Reserve, like other central banks, always has in mind the basic economic goals of maximum employment, a stable price level, and sustainable economic growth. However, only a portion of the Federal Reserve’s daily open market activity is directed toward those particular goals. The Fed is also responsible on a day-to-day basis for stabilizing the money and capital markets and keeping the financial markets functioning smoothly. These technical adjustments in market conditions are often referred to as defensive open market operations. Their basic purpose is to preserve the status quo and to keep the present pattern of interest rates and credit availability about where it is.

For example, suppose the Fed believes the current level of reserves held by the banking system—about $42 billion—is just right to hold interest rates and credit conditions where they are. However, due to changes in other factors affecting bank reserves (such as the public demanding more currency and coin from banks to spend over the holidays), total reserves in the system are expected to fall to $41 billion. The Fed is likely to buy about $1 billion in securities so that total reserves remain at $42 billion—a defensive operation.

In contrast, when the Federal Reserve is interested in the pursuit of broader economic goals, it engages in dynamic open market operations. These operations are designed to upset the status quo and to change interest rates and credit conditions to a level the Fed believes more consistent with its economic goals. For example, if the Fed believes the economy needs to grow faster to create more jobs, it may come to the conclusion that total reserves in the banking system must increase from $42 billion to $44 billion. In this case, the Fed’s Trading Desk is likely to launch an aggressive program of buying securities until reserve levels reach $44 billion. Open market operations have now become dynamic, not merely defensive.

The fact that open market operations are carried out for a wide variety of purposes makes it difficult to follow a central bank’s daily transactions in the marketplace and to draw firm conclusions about the direction of monetary policy. On any given day, the central bank may be buying or selling securities defensively merely to stabilize market conditions without any longer-term objectives in mind. The central bank is really a balance wheel in the financial system, supplying or subtracting reserves as needed to eliminate demand-supply mismatches on any given day. Although experienced central bank watchers find the daily pattern of open market operations meaningful, unless the investor possesses inside information on the motivation of central bank actions, it is exceedingly difficult to “read” daily open market operations. A longer-term view is usually needed, supplied in part by the FOMC’s policy statement, to see the direction in which the central bank is trying to move the financial system.





One of the oldest of all monetary policy tools is the discount rate —the interest rate the Federal Reserve banks (and many other central banks as well) charge on loans they grant to other institutions (principally banks and security dealers). In the United States, any depository institution that accepts transaction (payments) accounts or nonpersonal time deposits (mainly business CDs) and holds a legal reserve account at the Fed may request a loan from the discount window maintained by the Federal Reserve bank in its region. For the most part, these loans are regarded as temporary credit and a backup source of funds to the money market, where credit is usually cheaper and easier to find.

On January 9, 2003, the Federal Reserve redesigned the discount windows of the Federal Reserve banks in an effort to streamline the Fed lending process, reduce administrative costs, lower the historic reluctance of depository institutions to seek Federal Reserve credit, and stabilize conditions in the marketplace for reserves (principally the federal funds market). The Fed also created two new types of loans, labeled primary credit and secondary credit, to replace older loan categories that used to be called “adjustment” and “extended” credit. A third loan category—known as seasonal credit —was retained.

Primary credit today is extended only to sound depository institutions—that is, those with adequate capital and supervisory ratings in the top safety and soundness categories. A borrowing institution seeking primary credit no longer has to demonstrate, as it did in the past, that it has sought funds from other sources before coming to the Fed. These loans may be used for any lawful purpose, including the expansion of a depository institution’s assets and to help finance the sale of federal funds to other institutions.

Secondary credit, on the other hand, is intended for borrowing institutions that do not qualify for primary credit. Moreover, the secondary-credit borrower may not employ the money it receives to expand its assets. For example, a depository institution requesting secondary credit cannot arbitrage funds, borrowing from the Fed at a cheaper interest rate and lending those funds to another borrower at a higher interest rate.

Seasonal credit is usually available only to relatively small depositories that show a clear pattern of seasonal (intrayear) fluctuations in their deposits and loans. For example, farm banks experience their greatest need for liquidity around planting and harvesting times in their local communities, and are typically smaller banks with less ready access to the capital markets.

The Fed’s discount rate on the loans described above is expressed in annual percentage terms. The board of directors of each Federal Reserve bank decides whether the discount rate in their district needs to be changed. However, the Federal Reserve Board in Washington, D.C., must approve any discount rate change in any of the 12 Federal Reserve districts. This procedure serves to prevent the existence of different discount rates from region to region of the nation for lengthy periods of time.

The most significant policy change recently made by the Fed involved setting the discount rate on primary and secondary credit above the target interest rate on federal funds. For example, in 2007 the Fed’s Federal Open Market Committee (FOMC) set its target for the federal funds rate at 5 1/4 percent. Accordingly, the discount rate on primary credit was initially set at 1 percentage point (or 100 basis points) above the target federal funds rate and the rate on secondary credit was set at 1 1/2 percentage points (or 150 basis points) above the Fed funds rate target. Seasonal credit loan rates are usually much lower than either primary or secondary loan rates, however, and are usually based on prevailing market interest rates. (For a summary of recent discountwindow loan rates, see Exhibit 13.4 .)

In earlier times the discount rate was nearly always less than the federal funds rate, creating a great temptation for depository institutions to garner funds from the Reserve banks and relend those monies in the Fed funds market. To prevent this maneuver the Fed was forced to become a vigilant “watch dog.” However, its actions tended to discourage many institutions from seeking any form of Federal Reserve credit and borrowings at the discount window nearly ceased. With the changes instituted during 2003 the Fed hopes that depository institutions will be less reluctant to seek out discount-window loans, though borrowers will, in effect, be paying a penalty rate for the credit they receive. As illustrated in Exhibit 13.5 , discount-window borrowing still remains small in volume—usually less than 1 percent of total legal reserves in the banking system—and seasonal credit tends to be the largest loan type by dollar volume, followed by primary credit.

The Fed’s decision to create the new loan categories of primary and secondary credit and raise the discount rate above most other money market rates was motivated by several factors. One was the 9/11 terrorist crisis, during which time several leading banks and primary security dealers found themselves in desperate need of liquid funds and conventional funds sources dried up. The new discount-window policy ensures a “no hassle” supply of primary credit to sound depository institutions facing emergencies. Moreover, the fixed, positive spread between the discount rate and the federal funds rate target is expected to lower the volatility of the federal funds market rate, making it somewhat easier for the central bank to achieve its interest rate targets and reduce the interest rate risk for borrowers in the federal funds market. Indeed, under the newly revised policy, the primary credit rate is expected to serve as a cap for the prevailing market rate on federal funds because an attempt by the funds rate to rise above the discount rate would likely direct more borrowers to the Fed’s discount window.

Borrowing and Repaying Discount Window Loans Depository institutions that borrow regularly at the discount window keep a signed loan authorization form at the Federal Reserve bank in their district and keep U.S. government securities or other acceptable collateral on deposit there. When a loan is needed, the officer responsible for managing the borrowing institution’s legal reserve position contacts the district Federal Reserve bank and requests that the necessary funds be deposited in that institution’s reserve account.

In Exhibit 13.6 , we illustrate the borrowing process by supposing that a depository institution has requested a loan of $1 million and the Fed has agreed to make the loan. The borrowing bank receives an increase in its account, Reserves Held at Federal Reserve Bank, of $1 million. At the same time, the bank’s liability account, Bills Payable, increases by $1 million. On the Federal Reserve bank’s balance sheet, the loan is entered as an increase in Bank Reserves of $1 million—a liability of the Federal Reserve System—and also as an increase in a Fed asset account, Discounts and Advances. When the loan is repaid, the transaction is reversed.

Quite clearly, borrowings from the Fed’s discount window increase total reserves available to the banking system. Repayments of those borrowings cause total reserves to fall.

Effects of a Discount Rate Change Most observers today believe that at least three effects follow from a change in the lending rates of most central banks. One is the cost effect. An increase in the discount rate may mean it is more costly to borrow reserves from the central bank than to use some other source of funds. Other things being equal, loans from the discount window and the total volume of borrowed reserves may decline. Conversely, a lower discount rate may result in an acceleration of borrowing and more reserves flowing into the banking system. Of course, the strength of the cost effect depends on the prevailing spread between the discount rate and other money market interest rates.

A second consequence of changes in the discount rate is the substitution effect. A change in the discount rate may cause other interest rates to change as well. This is due to the fact that the central bank is one source of borrowed reserves, but certainly not the only source. An increase in the discount rate, for example, makes borrowing less attractive, but borrowing from other sources, such as the Eurodollar market, may become relatively more attractive. Borrowers may shift their attention to other markets, causing interest rates there to rise as well. A lowering of the central bank’s discount rate, on the other hand, may cause a downward movement in other interest rates.

The final possible effect of a discount rate change is the announcement effect. The discount rate may have a psychological impact on the financial markets because the central bank’s lending rate is widely regarded as an indicator of monetary policy. If, for example, the Federal Reserve raises its discount rate, some observers may regard this as a signal the Fed is pushing for tighter credit conditions. Market participants may respond by reducing their borrowings and curtailing their spending plans.

Unfortunately, the psychological impact of the discount rate may work against the central bank as well as for it. It is possible, for example, that if the Federal Reserve raises its discount rate, borrowers will respond by accelerating their borrowings in an effort to secure the credit they need before interest rates move even higher. Such an action would tend to thwart the Fed’s objective of slowing the growth of borrowing and spending.

Beginning in 1999, the Fed’s discount rate was set up to follow the federal funds interest rate. Each time the target federal funds rate—the Federal Reserve’s principal policy target today—was changed by the Federal Open Market Committee, the discount rate was moved in parallel fashion. As we noted earlier in this chapter, this policy was reinforced in 2003 when the spread between the discount rate on primary credit and the Fed’s current target for the Fed funds rate was set at one percentage point (100 basis points). The result of this new policy has been to turn the discount rate and the discount window into a relatively passive tool in the conduct of U.S. monetary policy. This new minimal role for the discount rate (plus the very small amount of borrowing actually taking place through the discount window) has led to proposals to eliminate this policy tool. Yet, as the terrorist attacks in September 2001 demonstrated, access to the discount window can help stabilize the economy in times of crisis and provide badly needed liquidity in a hurry. History teaches us that policy tools that may have little importance today can suddenly become important again.




Since the 1930s in the United States, the Federal Reserve Board has had the power to vary the amount of required legal reserves member banks must hold behind the deposits they receive from the public. With passage of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980, nonmember banks and other depository financial institutions (including credit unions and savings and loan associations) were required to conform to the deposit reserve requirements set by the Fed.

Early in the Fed’s history, it was believed that the primary purpose of reserve requirements was to safeguard the public’s deposits. Most recently, we have come to realize that their principal use is to give the central bank a powerful tool for affecting the supply of money and credit in the economy, particularly if emergency situations arise in the financial markets. Indeed, reserve requirements are probably the most potent policy tool the Federal Reserve System has at its disposal today. However, changes in reserve requirements are a little-used policy tool in the United States, and their role is likely to diminish in the future. In 2006 Congress passed legislation—scheduled to take effect on October 1, 2011—that (1) would authorize the Federal Reserve to pay interest on reserve balances member banks hold with the Federal Reserve (if the Federal Reserve so chooses), and (2) would allow the Federal Reserve to adjust reserve requirements downward, even to the point of eliminating them completely. (See the accompanying Financial Developments box.) In recent years, these actions have been taken by many other nations, including Canada, New Zealand, and the United Kingdom. In the meantime, reserve requirements will remain in force as a tool that the Federal Reserve may have recourse to utilize if it perceives that conditions in the financial markets and the macroeconomy require it.

Effects of a Change in Deposit Reserve Requirements A change in deposit reserve requirements—which acts like a “tax” on deposits—has at least three different effects on the financial system. First, it changes the deposit multiplier (or coefficient of expansion), which affects the amount of new deposits and loans the banking system can create for any given injection of new reserves. A change in reserve requirements also affects the size of the money multiplier, influencing the rate of increase in the money supply. If the Fed increases reserve requirements, the deposit multiplier and the money multiplier are reduced, slowing the growth of money, deposits, and loans. On the other hand, a decrease in reserve requirements increases the size of both the deposit multiplier and the money multiplier. In this instance, each dollar of additional reserves will lead to accelerated growth in money, deposits, and loans.

Second, a change in reserve requirements affects the mix between excess and required legal reserves. If reserve requirements are reduced, a portion of what were required reserves now becomes excess reserves. Depository institutions will soon convert all or a portion of these newly created excess reserves into loans and investments, expanding the money supply. Similarly, an increase in reserve requirements will mean that some depository institutions will be short required legal reserves. These institutions will be forced to sell securities, cut back on loans, and borrow reserves from other financial institutions to meet their reserve requirements. The money supply will grow more slowly and may even contract.

Third, interest rates also respond to a change in reserve requirements. A move by the central bank toward higher reserve requirements may soon lead to higher interest rates, particularly in the money market, as depository institutions scramble to cover any reserve deficiencies. Credit becomes less available and more costly. In contrast, a lowering of reserve requirements tends to bring interest rates down and increase investment spending and income.

An Illustration Exhibit 13.7 illustrates the effects of changes in reserve requirements. Suppose depository institutions are required to keep 10 percent of their deposits in legal reserves: $100 of legal reserves will then be needed to support each $1,000 in deposits. If there is sufficient demand for loanable funds, institutions will probably loan or invest the remaining $900. Suppose that the Federal Reserve increases reserve requirements from 10 percent to 15 percent. As a result, more legal reserves are necessary to support the same volume of deposits, and institutions have a $50 reserve deficit for each $1,000 of deposits. This deficit may be covered by selling financial assets, borrowing funds, or reducing deposits.

On the other hand, suppose required reserves are lowered from 10 percent to 8 percent. There are now $20 in excess reserves for each $1,000 in deposits, and that excess can be loaned or invested, creating new deposits. We should note that total legal reserves available to the banking system are not affected by changes in reserve requirements. A shift in reserve requirements affects only the mix of legal reserves between required and excess.

Current Levels of Reserve Requirements In the United States, reserve requirements are imposed by the Federal Reserve Board on all depository institutions eligible for federal deposit insurance. Three types of deposits are, potentially at least, subject to legal reserve requirements:

  1. Transaction accounts, which are deposits used to make payments by negotiable or transferable instruments and include regular checking accounts, NOW accounts, and any account subject to automatic transfer of funds.
  2. Nonpersonal time deposits, which are interest-bearing time deposits—including savings deposits and money market deposit accounts (MMDAs)—held by businesses and governmental units, but not by individuals.
  3. Eurocurrency liabilities, which are borrowings of deposits from banks and bank branches located outside the United States.

As shown in Exhibit 13.8 , the reserve requirements for 2006 transaction deposits— checkable or draftable accounts for making payments—are zero for banks holding total transaction deposits totaling $8.5 million or less (known as the reserve requirement exemption amount ) and 3 percent for depository institutions with transaction accounts exceeding $8.5 million and up to $45.8 million. Transaction deposits exceeding $45.8 million are assessed a 10 percent reserve requirement. Time and savings deposits and eurocurrency liabilities currently carry zero reserve requirements, although the Federal Reserve Board could impose new reserve requirements on these deposits at any time. Average reserve requirements usually are higher on transaction accounts than on time and savings accounts because transaction balances are considered to be less stable than time and savings deposits.

Clearly, the largest depository institutions carry the heaviest reserve requirements. This is due to the fact that larger financial institutions hold the deposits of thousands of smaller deposit intermediaries. The failure of a large depository institution can send shock waves through the entire financial system and threaten the economic viability of many other institutions as well.

Changes in reserve requirements can be used to carry out major shifts in government economic policy. The reserve requirement tool is exceedingly powerful, so that even a small change affects hundreds of millions of dollars in legal reserves. Moreover, it is an inflexible tool. Required reserve ratios cannot be changed frequently because this would disrupt the banking system. Not surprisingly, changes in reserve requirement ratios do not occur often, having averaged no more than once every three to five years since World War II. In fact, the Federal Reserve has not changed reserve requirement ratios since 1992.

Today in the United States, legal reserves apply only to checkable-type deposits and are gradually fading in their impact on the banking system. Depository institutions have found innovative new ways (such as “sweep accounts” that temporarily move customer funds out of a deposit account subject to reserve requirements) to lower their required reserve levels. Indeed, most depositories now meet their reserve requirements by holding vault cash rather than keeping large balances at the Federal Reserve banks. By way of comparison, the new European Central Bank (ECB) imposed a 2 percent reserve requirement on the short-term deposits and debt of financial institutions subject to its authority. Unlike the Federal Reserve, however, the ECB pays interest on required reserve balances.




A widely used selective policy tool is known as moral suasion. This refers to the use of “arm-twisting” or “jawboning” by central bank officials to encourage banks and other lending institutions to conform with the spirit of its policies. For example, if the Federal Reserve wishes to tighten credit controls and slow the growth of credit, Fed officials issue letters and public statements urging financial institutions operating in the United States to use more restraint in granting loans. These public statements may be supplemented by personal phone calls from top Federal Reserve officials to individual lending institutions, stressing the need for more conservative policies. Some central banks, such as the Bank of Japan, use the moral suasion tool as an important supplement to their other policy tools.


A selective credit control still under the exclusive control of the Federal Reserve Board is the use of margin requirements on the purchase and short sales of stocks and convertible bonds. Margin requirements were enacted into law with passage of the Securities Exchange Act of 1934. This federal law limited the amount of credit that could be used as collateral for a loan. Regulations G, T, and U of the Federal Reserve Board prescribe a maximum loan value for marginable stocks, convertible bonds, and short sales. That maximum loan value is expressed as a specified percentage of the market value of the securities at the time they are used as loan collateral. The margin requirement on a regulated security, then, is simply the difference between its market value (100 percent) and the maximum loan value of that security.

For example, as shown in Exhibit 13.9 , the current margin requirement on stock is 50 percent. This means that common and preferred stock can be purchased on credit with the stock itself used as collateral. However, the purchaser can borrow only up to a maximum of 50 percent of the stock’s current market value. He or she must put up the remainder of the stock’s purchase price in cash money.

As Exhibit 13.9 suggests, margin requirements are not often changed. In fact, the current U.S. margin requirements on stocks, convertible bonds, and short sales have remained unchanged since January 1974. Most observers of the financial markets believe the imposition of margin requirements was unnecessary. These requirements arose out of the turmoil of the Great Depression of the 1930s, when many believed speculative buying and selling of stocks had contributed to the U.S. economy’s sudden collapse. This was probably not the case, but margin requirements do ensure that a substantial amount of cash will be contributed by the buyer of securities, keeping borrowing against these securities within reasonable limits. One serious limitation of this selective tool is that it does not cover purchases of all types of stocks and bonds. For this reason, its future use as a tool of monetary policy is likely to remain very limited.



The money market indicator that usually feels the first impact from Federal Reserve policy moves is the effective federal funds rate. Beginning in 1989 the Fed adopted a federal funds interest rate targeting procedure — the monetary policy approach it uses today. When the Fed sells securities, the supply of reserves available to depository institutions is reduced and, other things held equal, the Fed funds rate—the interest rate charged on overnight borrowings of reserves in the banking system—tends to rise. On the other hand, a Federal Reserve purchase of securities increases available reserves to depository institutions, which tends to push the Fed funds rate down.

Beginning in 1994, the Federal Reserve adopted a new policy of “openness” or “transparency” when it comes to announcing its target for the federal funds interest rate, letting the public know right away what the current funds rate target is and explaining its reasoning to the public if it is moving the funds rate target. However, history has shown that when the Fed begins to adjust interest rates either upward or downward it does so incrementally and over an extended period of time that could extend for a year or more. This gradual process by which the funds rate target is adjusted in a series of 25 or 50 basis point moves all in the same direction (either up or down) has come to be known as policy inertia. This policy inertia is evident in Exhibit 13.10 , which displays how the federal funds rate target has changed in the recent past, and how closely the federal funds rate tracks the Fed’s chosen target.

As Exhibit 13.10 illustrates, once the Fed begins to raise or lower interest rates, the process could persist for months, and market participants have to gauge how long this process will last in order to gain perspective on how much the federal funds rate will ultimately be increased or decreased by the time the current round of rate adjustments is completed. In keeping with the Fed’s policy of increased transparency, announcements following the meetings of the FOMC that describe the new funds rate target have often included a hint—in a little more than a sentence—as to whether the FOMC believes it is more likely in the future to be raising, lowering, or leaving the target unchanged. This hint is referred to as the bias, and is often the most intensely scrutinized wording within the FOMC’s announcement.

How is the Federal Reserve’s Trading Desk able to maintain the federal funds rate so close to its announced rate target? Exhibit 13.11 provides us with an illustration of the process. Suppose the Fed has targeted a Fed funds rate of 5 percent and the funds rate currently sits at the 5 percent level, where the total demand for reserves by depository institutions (represented by schedule D in Exhibit 13.11 ) intersects the supply of total reserves (represented by schedule S ), achieving an equilibrium rate of interest at E.

We note that the supply of total reserves consists of the sum of borrowed and nonborrowed reserves:

Total reserves = Borrowed reserves + Nonborrowed reserves

Borrowed reserves (labeled BR in Exhibit 13.11 ) are loans made to depository institutions by the Federal Reserve banks. Nonborrowed reserves are legal reserves that belong to depository institutions (labeled SNBR in Exhibit 13.11 ). Through open market operations the central bank impacts primarily nonborrowed reserves which, in turn, affect total reserves available to the banking system.

Now, suppose that depository institutions increase their demand for total reserves to D . If the Federal Reserve does nothing to the supply of reserves, the Fed funds rate must rise above its current equilibrium 5 percent target level to accommodate the new higher level of demand for total reserves, perhaps rising to equilibrium level E' , well above the old 5 percent target for the Fed funds rate. If the Fed doesn’t want this to happen, it will increase the supply of nonborrowed reserves by using open market operations, sliding the old schedule SNBR over to a new schedule, SNBR' . This action moves the supply of total reserves, S, over to a new schedule S' . If the amount of borrowed reserves doesn’t change, we now have a new intersection of supply and demand for reserves, but the level of the Fed funds rate stays at the old equilibrium point E, and at the old 5 percent interest rate. Thus, the Federal Reserve can keep the Fed funds interest rate at or near its desired level so long as the central bank is willing to offset changes in the demand for total reserves and in the demand for borrowed reserves by making appropriate adjustments in the supply of nonborrowed reserves through open market operations.

Of course, the central bank cannot maintain the Fed funds rate exactly at its target level every hour of every day. This is because depository institutions are constantly changing their demands for reserves and their attitudes about borrowing reserves from the Federal Reserve banks. Moreover, interest rates are impacted by the public’s expectations regarding inflation and by the total demand for and supply of credit within the financial system. The Fed’s Trading Desk manager, acting on behalf of the FOMC, tries to project what the banking system’s demand for reserves is likely to be in order to supply enough reserves through open market operations to keep the federal funds rate at or close to its target level. Similarly, the Trading Desk manager must make further corrections through open market operations when his or her forecasts are off the mark.




Finally, one more important point about targeting the federal funds rate should be noted. Just because the Fed can manipulate the federal funds rate—a key money market interest rate—does not mean that long-term capital market interest rates will also respond in the same way to the Fed’s activities. For example, when the Federal Reserve nudged the Fed funds rate downward in November of 2002 in order to bolster the sagging U.S. economy, the 10-year U.S. Treasury bond rate—a key capital market interest rate—hardly moved at all for three months, while nine months later it actually moved substantially higher, not lower, relative to its position when the Fed funds rate was lowered. A similar phenomenon occurred when the Fed embarked on a series of interest rate increases in 2004 that are illustrated in Exhibit 13.10 . Long-term interest rates actually fell throughout most of the period when short-term interest rates were on the rise. Why do long-term interest rates sometimes move quite differently than the short-term federal funds rate?

One factor is inflation. When the central bank cuts short-term interest rates investors in the capital market may come to believe that prices will rise. Thus, easier monetary policy lowers short-term interest rates in the near term, but may lead longer-term investors to expect higher short-term interest rates in the future. Ultimately, higher inflationary expectations may push long-term interest rates upward as capital market investors seek compensation for their fear of greater inflation.

The key point to remember is that the central bank does not have direct control over longer-term interest rates. And, unfortunately, it is long-term interest rates that appear to have the greatest impact on investment spending in the economy and the creation of new jobs. The central bank must be patient. Short-term interest rates, like the Fed funds rate, react quickly to changes in central bank policy, but long-term interest rates may take months to respond to what the central bank is trying to do. Monetary policy often operates with long and variable time lags.


Inflation —a rise in the general price level of all goods and services produced in the economy—has been among the more serious economic problems of the world during the past half century, with many nations experiencing far higher annual rates of inflation than those currently prevailing in the United States. Moreover, inflation is not new; price levels have been generally rising since the beginning of the Industrial Revolution in Europe nearly 300 years ago. There is also evidence of outbreaks of rampant inflation during the Middle Ages and in both ancient and more recent times.

What are the causes of inflation? During the 1960s and 1970s, war and government spending were certainly contributing factors. Soaring energy and food costs, higher home mortgage rates, and rapid increases in labor and medical care costs also played key roles until the 1980s brought a turnaround, as Exhibit 13.12 reveals. Another contributing factor was the decline in the value of the U.S. dollar in international markets. The dollar’s weakness relative to other major currencies, such as the Japanese yen, raised the prices of imports into the United States and lessened the impact of foreign competition on domestic producers until the dollar strengthened significantly during the 1990s.

With the opening of the twenty-first century, inflationary pressures continued to be muted, owing principally to the continued resurgence of productivity growth in the United States that had begun during the 1990s. This greater productivity allowed businesses to increase the supply of goods and services without employing additional labor or capital in their production, thus keeping a lid on price increases. Later, when the economy dipped into recession in 2001, the demand for goods and services fell, and, for a brief period, the Fed switched its concern from inflation to deflation, which appeared to be a real threat for the first time since the Great Depression of the 1930s. However, once the economy regained its momentum, deflationary fears subsided and the Fed has once again become concerned about a resurgence of inflation. Nonetheless, this episode provided an important lesson for the Fed. It became aware that the conduct of monetary policy during deflationary times, when the economy is weak, may be very difficult, especially if the target federal funds rate has already been lowered close to zero.

Still another causal factor is inflationary expectations: the anticipation of continued inflation by businesses and households. Once underway, inflation may develop a momentum of its own, as consumers spend more and borrow more freely to stay ahead of rising prices, sending prices still higher. Businesses and labor unions begin to build inflation into their price and wage decisions, passing higher costs along in the form of higher prices for goods and services. This process may for a time result in a wageprice spiral in which each plateau of increased costs is used as a basis for justifying further price increases.

Inflation creates distortions in the allocation of scarce resources and hurts certain groups. For example, it tends to discourage saving and encourages consumption at a faster rate to stay ahead of rising prices. Moreover, the decline in the savings rate tends to discourage capital investment. Unfortunately, this means the economy’s growth in productivity (output per worker-hour) tends to slow, so the supply of new goods and services cannot keep pace with rising demands, putting further upward pressure on prices. At the same time, workers often seek cost-of-living adjustments in wages and salaries, leading to an increase in labor costs. Some workers represented by strong unions or in growth industries may be able to keep pace with inflation, but other groups, including retired persons and government employees, whose income is fixed or rises slowly, often experience a decline in their real standard of living when inflation is on the rise.

Central Bank Targeting of Inflation Beginning in the 1990s several central banks around the world began setting target inflation rates to shoot at with their policy weapons. New Zealand was the first nation to establish a formal inflationtargeting regime. Canada followed in 1991, Great Britain in 1992, and Australia and Sweden in 1993. Before they joined the European Community, Spain and Finland adopted an inflation-targeting approach and the European Central Bank (ECB) soon declared that price stability was its primary goal. Other prominent nations with inflation targets include Brazil, the Czech Republic, Hungary, Israel, South Korea, Poland, and Switzerland—overall at least 21 countries in total. In contrast, the United States (along with Japan) has set no explicit inflation rate target, though it seeks to drive inflation so low that it doesn’t affect business and consumer decisions. Inflation targets vary among the nations that have set them—some are point targets and others are inflation rate target ranges. For example, New Zealand’s central bank has expressed its determination to keep inflation within a 0 to 3 percent annual rate range. (The New Zealand central bank’s governor can be fired if he or she misses the target range!) Most other countries seek to hold inflation near 2 percent annually and the target inflation-rate range is normally somewhere close to 1 to 3 percent. The key inflation measure most widely used is usually some index of consumer prices, such as the Consumer Price Index (CPI). If the target or target range is missed, some nations give their central banks a specific time period to get the inflation rate back on track—for example, 18 months to two years.

The jury is still out on the success or failure of central bank inflation targeting. Certainly the central bank is the most likely institution to pursue inflation targets successfully. But some central bankers are hesitant to set specific numerical inflation-rate targets, fearing a loss of flexibility and possible adverse consequences if the public becomes aware the announced target has been missed. For example, might a missed inflation target lead to even greater inflation? More evidence is needed on the actual benefits and costs of inflation targeting.

Deflation Price stability can be disrupted by falling prices, or deflation, as well as by rising prices, or inflation. Deflation plagued Japan for more than a decade in the 1990s and early 2000s, during which time its economy—once the star performer among industrialized economies—experienced an average annual growth rate of close to zero percent! In an effort to reinvigorate its economy, the Bank of Japan took monetary policy to its limits by driving interest rates to zero and then continuing to inject reserves into the banking system at a rapid pace—a policy that came to be known as quantitative easing. This policy has met with only limited success. Because it represents one of the few experiences over the past century of developed economies attempting to grapple with deflation, it is not surprising that this policy has caught the attention of central bankers around the world who, for so long, have been struggling to reduce inflation rates down to the low single digits.

Hyperinflation At the other extreme of deflation is hyperinflation, when the inflation rate exceeds 100 percent per year. Inflation rates of this magnitude may seem too unusual to residents in the United States or Europe, for example, where inflation rates have never approached these figures since World War II more than half a century ago. However, many economies around the world have had bouts of hyperinflation relatively recently, some of which have lasted for decades—Brazil, Argentina, and Israel are three examples of these economies, where in some cases the inflation rate exceeded 1,000 percent per year! Living in such an environment can be difficult for businesses, consumers, and governments. Prices of goods and services may have to be changed daily! And currency may be losing value so rapidly that everyone has to go to extraordinary lengths to protect their wealth. Economies suffering from hyperinflation have generally performed poorly, and the measures taken by governments to rid their economies of hyperinflation have proven to be costly in terms of economic growth and employment in the short run. However, in the long run, eliminating hyperinflation has brought greater economic growth and more rapid job creation.



For the past half century, the Federal Reserve has also been committed to achieving the highest level of employment consistent with sustainable long-run economic growth. However, translating these lofty goals into practical policy objectives has proven difficult. To achieve these goals, the Fed has attempted to pursue policies that promote a smoothly functioning economy in which the economy’s resources of capital, labor, and entrepreneurial talent are efficiently deployed in the production of goods and services to provide for the greatest standard of living for the country’s citizens.

But how do policymakers know when the economy’s resources are efficiently deployed? What does this mean in terms of employment? Does full employment mean zero unemployment? If not, then what is the maximum sustainable level of employment, and to what level of unemployment does this correspond? Can they look only at the current level of economic growth without regard to the future? Shouldn’t the rate of investment in expanding the economy’s resources be an important criterion? These are difficult questions with which the policymakers must grapple and the answers they arrive at are subject to change over time, due to new technology, demographic shifts, changes in the economy’s international competitiveness, and other factors.

The Natural Rate of Unemployment Some unemployment is inevitable in a market-oriented economy, where the workforce is constantly changing in size and composition and where workers are free to change jobs and businesspeople are free to hire and fire workers. There is a minimum level of unemployment, which the government attempts to measure, referred to as frictional unemployment, which arises from the temporary unemployment of job seekers, who are either new to the workforce or who are in transition from one job to another, perhaps in search of higher pay or better working conditions. This frictional unemployment is often referred to as the full employment level of unemployment, or the natural rate of unemployment. The economy’s actual unemployment rate is measured as the percentage of the workforce actively seeking employment. When the unemployment rate equals the natural rate, then the economy’s labor resources are thought to be fully employed. But what is the natural rate of unemployment?

As Exhibit 13.13 illustrates, the average unemployment rate in the United States during the 1950s and 1960s suggested to economists the economy’s natural rate of unemployment was around 5 to 5 1/4 percent. However, during the 1970s and early 1980s, as the unemployment rate seemed to ratchet upward to higher levels with each succeeding recession and stubbornly refused to fall, economists began to raise their estimates of the natural rate of unemployment up to around 6 to 6 1/4 percent. Two key factors leading to this secular rise in unemployment were the post-World War II baby boom generation reaching working age and the rapid increase in the number of adult women seeking jobs. The upward surge in the participation rate of women in the workforce may have been due to a decline in fertility rates, more varied jobs available to women, and the erosion of family incomes due to inflation. Both the entries of baby boomers and more women into the workforce raised the supply of labor faster than the economy could create new jobs to absorb all of these new workers. Sometime during the 1980s, this trend began to reverse. After the unemployment rate peaked at more than 10 percent during the deep recession in the early 1980s— which was its highest level since the Great Depression—the unemployment rate began to ratchet down, with lower peaks in each recession preceding sustained declines during the historically long periods of economic expansion that followed. Today, economists believe the surges in the labor supply have been largely absorbed by the economy and the natural rate of unemployment is back down to its historic pattern of close to 5 percent.

These historical changes in the natural rate of unemployment are better understood today than they were at the time they were taking place. The Federal Reserve did not have the benefit of hindsight. Indeed, it not only had the problem of understanding what the current natural rate was, but had to project what the natural rate of unemployment would be in the future. Exhibit 13.13 suggests just how difficult this process has become. New questions are being posed today with which policymakers will have to concern themselves. As one example, technology has significantly altered the demands of the workplace with an increased emphasis on high-skilled workers. Just how well the economy’s system of education and technical training responds to these demands will have a significant impact on employment decisions of firms and consequently on the natural rate of unemployment.

The Output Gap The difficulties with identifying changes in the natural rate of unemployment have caused the Federal Reserve to focus on additional indicators of the economy’s long-run sustainable growth path. Using statistical methods, the Fed creates a measure of what the level of real GDP would be if the economy were fully utilizing its economic resources of capital, labor, and entrepreneurial talent in an efficient manner. This measure is called potential GDP. When real GDP is equal to potential GDP, the economy is thought to be on its long-run growth path, with the unemployment rate equal to the natural rate. To gauge how far away the economy is from this desired growth path, the Federal Reserve tracks a measure referred to as the GDP gap, which is the difference between actual GDP and potential GDP as a percentage of potential GDP. Exhibit 13.14 displays how this GDP gap has changed over time.

A negative GDP gap is a sign the economy is underperforming relative to its capability, producing less output in the form of goods and services, generating lower incomes, and creating fewer jobs. The Federal Reserve takes that condition as one signal that corrective policy action may be in order, whereby it would lower interest rates and stimulate investment and job growth. Conversely, the Fed interprets a positive GDP gap as a sign the economy may be in for a bout of higher inflation with the demand for goods and services outpacing the ability of the economy to increase production in the short run, thus resulting in higher prices. A positive GDP gap is one sign the Fed should raise interest rates to slow the demand for goods and services until the economy has increased its production capacity sufficiently to bring supply and demand back into balance without rapid increases in the inflation rate.