93. The Conduct of Monetary Policy

The Monetary Policy Instrument

A monetary policy instrument is a variable that the Fed can directly control or closely target.

• The Fed could fix the exchange rate as its policy instrument. But then it could not pursue an independent monetary policy, so for that reason the Fed does not fix the exchange rate.

• The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. Although the Fed can change the federal funds rate by any reasonable amount, it normally changes the federal funds rate one quarter of a percentage point at a time.

• The federal funds rate is determined in the market for reserves

• The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. So the higher the federal funds rate, the smaller the quantity of reserves demanded. As shown in the figure, the demand curve for reserves ix downward sloping.

• The Fed’s open market operations determine the supply of reserves. Because the Fed determines the quantity of reserves, the figure shows that the supply curve of reserves is vertical at this quantity.

• An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves. The supply of reserves increases.

• An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves. The supply of reserves decreases.

• The figure shows the market for reserves. In the figure the equilibrium federal funds rate is 5 percent.

• If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The quantity of reserves increases and the federal funds rate falls.

If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities. The quantity of reserves decreases and the federal funds rate rises

94. Extraordinary Monetary Stimulus

The Key Elements of the Crisis

The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression.

• Banks were put under stress from three sources:

• A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity.

• A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start.

• A Run on the Bank: One bank in the United Kingdom, Northern Rock, experienced a bank run. In the United States, massive withdrawals of deposits from money market mutual funds occurred. Banks’ desired reserves increased so banks increased their reserves by calling in loans.

• The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity.

• Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world.

• The drastic decrease in the supply of loanable funds started to affect the real economy.