Lesson 15: Monetary Policy Tools

Upon completion of this lesson, you should be able to do the following:

  • Describe the benefits in using open market operations as a monetary policy tool.
  • Descibe the costs and benefits in using discount policy as a monetary policy tool.
  • Describe the costs and benefits in using reserve requirements as a monetary policy tool.
  • Explain why the Fed can only concentrate either on the money supply or short-term interest rates, but not both at the same time.
  • Explain why financial analysts and the public scrutinize the federal funds market.


Many people especially in the financial markets scrutinize the Fed's actions in order to determine monetary policy. The people are trying to determine how interest rates will change, which in turn affect the prices in the financial markets. The process of watching the Fed in order to determine monetary policy is called Fed watching. This lesson introduces the Federal Reserve's three most important tools for conducting monetary policy: Open Market Operations, Discount Policy, and Reserve Requirements.

Open Market Operations

Open Market Operations is the most important tool of the Fed, which is the Fed's purchase and sale of U.S. government securities. The Fed can purchase any financial securities, and the impact is identical as if the Fed bought U.S. government securities. However, the Fed traditionally buys and sells highly liquid U.S. government securities. Open market operations will have an impact on the money supply and interest rates.

The Fed can use two monetary policies.

  1. Expansionary monetary policy - results in a larger money supply and lower short-term interest rates.

  2. Contractionary monetary policy - results in a smaller money supply and higher short-term interest rates.

Please review Lesson 5, because this lesson uses the demand and supply curves for the bond market. The Fed wants to increase the money supply, which is expansionary monetary policy.

  1. The Fed buys T-bills, causing Fed's assets to increase.

  2. When you look that T-bill market, the Fed increases its purchases of T-bills, causing the demand for T-bills to increase and shift right.

  3. The market price of T-bills increases. Using the present value formula, the market interest rate for T-bills decreases.

  4. The Fed pays for a T-bills with its check. When the check is deposited into banking system, bank reserves increase, causing the monetary base to increase.

  5. When bank reserves increase, the money supply increases.

T-bill Market
The Fed buys T-bills

The important thing to notice is open market operations affect the interest rate. The T-bill is a short-term credit instrument. When the Fed conducts open-market operations for T-bills, it affects the price of T-bills and the T-bill's interest rates. This causes changes in other short-term interest rates, such as the federal funds rate and the interest rates on commercial paper and banker's acceptances. Therefore, short-term interest rates of all short-term credit instruments will rise and fall together.

The contractionary monetary policy works the same way as expansionary monetary policy. The process is listed below:

  1. The Fed sells T-bills, causing Fed's assets to decrease.

  2. The supply of T-bills increases in the T-bill market. The supply curve for T-bills shifts right.

  3. The market price of T-bills decreases. The market interest rate for T-bills increases, when the present value formula is used.

  4. All other short-term interest rates increase, such a the federal funds rate.

  5. Bank reserves decrease, which causes the monetary base and money supply to decrease.

T-bill Market
The Fed sells T-bills

The Fed can only control the growth rate of the money supply or short-term interest rates. It cannot control them both at the same time. For example,

  • Suppose the Fed wants to increase the M1 money supply by 3%. The Fed keeps buying T-bills until the M1 money supply increases by 3%. However, short-term interest rates become lower. The Fed cannot prevent the lower interest rates, because it is focusing on the money supply.

  • Suppose the Fed wants to influence short-term interest rates. Suppose the interest rate is 4%, but the Fed wants a 6% short-term interest rate. In this case, the Fed sells T-bills, causing the market price of T-bills to decrease and interest rates to increase. The Fed keeps selling T-bills until the interest rate is 6%. However, this transaction causes bank reserves, monetary base, and the money supply to decrease. The Fed has no control over the money supply, because it is focusing on the interest rates.

Therefore, the Fed can control short-term interest rates or the money supply, but not both at the same time.

The Federal Open Market Committee meets 8 times a year and issues a general directive. A general directive states the objective for the monetary aggregates and interest rates. The Federal Reserve Bank of New York is given the responsibility of carrying out the general directive. The Fed Bank of New York deals with about 40 dealers who specialize in U.S. government securities (i.e. secondary market). The New York Fed is electronically connected to the dealers and when the Fed is ready to buy or sell government securities, the Fed will ask these dealers to make an offer. The Fed buys or sells to the dealers with the best offer. The department at the Fed that buys and sells government securities is referred to as the Open Market Trading Desk.

The Fed uses two types of methods to buy and sell U.S. government securities.

  • Outright purchases and sales - When the Fed sells or buys a security, the transaction is permanent. The dealer who bought the security has no obligation in the future to sell the security back to the Fed or vice-versa.

  • Federal Reserve repurchase agreement (REPO) - The Fed buys securities from a dealer and the dealer agrees to repurchase the securities for a specific price and on a specific date in the future. This is very similar to a bank repurchase agreement. Usually, the dealer buys the government security back within 15 days. The REPO provides temporary reserves in the banking system. For example, at Christmas time, there are enormous currency drains from the financial institutions as people withdraw money to buy presents. The Fed then uses the REPO to inject reserves in the banking system to offset the currency drain. When Christmas is over and the currency returns to the financial institutions, the REPO expires, and the temporary reserves are removed from the banking system, when the dealer buys back REPO.

The Fed can also do the opposite of a REPO, which is called the Reverse REPO (matched sale-purchase transactions). The Fed sells securities to the dealers and the dealers sells them back to the Fed for a specific price and on a specific data in the future. The reserve REPO temporarily lowers excess reserves in the banking system, such as offsetting an increase in the Federal Reserve float.

When the trading desk at the Fed conducts monetary action, it uses two types of transactions.

  • Dynamic transactions - This type of transaction is intended to carry out monetary policy as specified in the general directive.

  • Defensive transaction - The Fed uses open market operations to offset fluctuations in bank reserves. Defensive transactions are used more than dynamic transactions. For example, bank reserves decrease when people withdraw money from their accounts to buy presents at Christmas or when people pay their taxes in April. Also natural disasters and employee strikes can delay the delivery of the mail. Thus, slowing down the Fed's check clearing process. The float increases, causing bank reserves to increase. The Fed uses defensive transaction to offset temporary fluctuations in bank reserves.

The open market operations is the most popular tool the Fed uses.

  • The Fed can completely control how many securities that it wants to buy or sell.

  • Open market operations are very flexible. The Fed can influence bank reserves by a little amount by buying a small amount of U.S. government securities, or by a large amount by buying lots of securities.

  • If the FED made a mistake by buying too many U.S. government securities, then it can turn around and sell them to counteract this.

  • Open market operations can be implemented quickly.

Many people who watch the Fed read the directives issued to the open market trading desk. However, these directives are vague and are not precise. The reason is the principal-agent problem. If the directives are vague, then the outcome does not matter. Any outcome can be deemed a success, making the Fed unaccountable for errors. Many European central banks including the European Central Bank uses open market operations very similar to the United States. Some countries have a small market for government securities, such as Japan. The Japanese central bank relies on interest rate controls to control the money supply.

Discount Policy

The second monetary tool the Fed uses is discount policy. The Fed can make loans to financial institutions. For example, a bank is experiencing financial problems and needs reserves. The bank sells a $10,000 T-bill to the Fed. The Fed increases bank's reserves by $9,000. The difference is called the discount. The T-bill acts as the collateral of the loan. Eventually the bank buys the T-bill back from the Fed for $10,000. The $1,000 difference reflects the interest rate the Fed charges for the loan, called the discount rate. Traditionally, the Fed will only lend money to banks that were members of the Federal Reserve System. Now days, any bank in the U.S. can borrow from the Fed and the Fed may not require any collateral for the loan.

Each Fed district bank provides loans, known as the "discount window." The Fed can use discount policy to influence the money supply and interest rates. This model will examine the interest rate in the federal funds market.

The public and financial analysts scrutinize the federal funds market to predict monetary policy. The federal funds market is banks' deposits held at the Fed. One bank can lend some of its excess reserves to other banks. The deposits are electronically transferred through the Fedwire. When the Fed implements monetary policy, it has an immediate impact on the federal funds rate. When the public and financial analysts see the federal funds interest rate decrease, they infer that the Fed is using expansionary policy. If the federal funds rate increases, the public believes the Fed is using contractionary monetary policy. As you know from this lesson, the Fed cannot control the federal funds rate, but can only influence it.

The demand curve is the banks' demand for federal funds. These banks borrow funds to ensure they are holding enough reserves to meet depositors withdrawals or satisfy the Fed's reserve requirements. The demand curve is downward sloping, because banks will want to borrow more funds, if the interest rate decreases. The supply curve is the banks' supply of federal funds to the market, because these banks are holding excess reserves. These banks temporarily lend out excess reserves, so they can earn interest income. The supply curve is upward sloping, because banks will lend more funds, if the interest rate is higher. The point where the demand and supply curves intersect is the equilibrium interest rate ( i* ) and amount of reserves ( R* ) changing hands in this market.

The Fed decides to use expansionary monetary policy by using the discount rate.

  1. The Fed will decrease the discount rate.

  2. Banks can borrow more cheaply from the Fed, causing the amount of discount loans to increase. The discount loans are injecting more reserves into the banking system.

  3. Banks have more reserves, so the supply curve in the federal funds market shifts to the right and increases.

  4. The interest rate for federal funds decreases and both the monetary base and money supply increase.

Federal Funds Market
The Fed increases the amount of Federal Funds

The contractionary monetary policy works the same way as expansionary monetary policy. The process is listed below:

  1. The Fed raises the discount rate.

  2. Banks borrow less from the Fed, because loans have higher interest rates. Less reserves are injected into the banking system.

  3. Banks have less reserves. The supply decreases in the federal funds market and shifts left.

  4. The interest rate increases in the federal funds market.

  5. Bank reserves decrease, which causes the monetary base and money supply to decrease.

Federal Funds Market
The Fed decreases the amount of Federal Funds

The Fed makes three types of loans.

  1. Adjustment credit - these are short-term loans to help banks that are having short-term liquidity problems.

  2. Seasonal credit - these loans help small banks that are located in areas where agriculture or tourism is important.

  3. Extended credit - a large bank is on the verge of bankruptcy and has severe liquidity problems. The Fed will loan to this bank, preventing this bank from failing. The Fed along with FDIC will help restore the financial health of the bank.

    For example, Continental Illinois Bank failed during the 1970s. This bank was the 8th largest bank and failed because of too many bad loans. The FDIC purchased 80% of the bank's stock and elected new management. In essence, the U.S. government nationalized the bank, because it was too big to fail. The Fed provided loans around $3.5 billion to FDIC.

The discount window has a potential for abuse. For example, a bank could borrow funds from the Fed at 5% and loan these funds out at 6%, earning 1% interest on these loans. The Fed counters this problem by investigating and auditing the bank more, making sure the bank is complying with regulations. The Fed can also impose fines or publicly criticize the bank. A bank borrowing from the Fed may indicate financial weakness. Finally, the Fed may stop lending to the bank, because borrowing from the Fed is a privilege and not a right! Many economists argue that the Fed should set the discount rate higher than short-term interest rates. That way, borrowing from the Fed is always a penalty, because the interest rate is higher than the market rate.

The use of discount policy has many benefits.

  1. "Lender of the last resort" - if a bank has trouble with liquidity or needs reserves, the Fed is the last place to go (if the bank could not find no other lender).

  2. Announcement effect - when the Fed unexpectedly changes the discount rate, this change provides information to the financial markets, because monetary policy is conducted secretly. For example, the Fed causes the discount rate to rise. The press, politicians, and financial analyst think the Fed is following a tight monetary policy, i.e. contracting the money supply.

  3. Moral suasion - the Fed uses its power to persuade depository institutions to do what the Fed wants. Remember, to borrow from the Fed is a privilege, and not a right. If a bank needs a loan from the Fed and the bank did not do what the Fed wanted, then the bank might not get the loan!

  4. Prevention of financial crisis - the Fed lends to large banks, preventing them from bankrupting and even extended credit to financial institutions during the stock market crash in 1987.

Discount policy is not a good tool to control the money supply. If the Fed wants to increase the money supply, the Fed has to grant more discount loans to banks. What if the banks do not want these loans? In this case, discount policy fails to increase the money supply.

Reserve Requirements

The last monetary tool the Fed uses is reserve requirements. The reserve requirements can be satisfied by vault cash and/or deposits at the Fed. The Fed has the power to set reserve requirements for banks within the limits set by Congress. The Fed rarely changes the reserve requirements, because changes in the reserve requirements have a significant and disruptive impact on the banking system. Currently, the reserve requirements for checking accounts is 3% for the first $47.8 million. Banks are subjected to a reserve requirement of 10% for checking accounts exceeding $47.8 million. There are no reserve requirements for Eurodollar accounts and nonpersonal time deposits.

The Fed can use reserve requirements to alter the money supply. Let's look at how this might happen:

  1. If the Fed believes banks are holding too much excess reserves, then this may cause too much inflation in the future. When banks start lending their excess reserves out as loans, these loans come back as deposits, which increases the money supply and you have the multiple deposit expansion. The Fed can increase the reserve requirement ratio, which causes some excess reserves to be switched to required reserves.

  2. When the Fed changes the reserve requirement, it is changing the money multiplier (1 / rr ).

    • Let the required reserve ratio be 10%. If the Fed buys a $10,000 T-bill using a Fed check, the money supply can potentially increase by $100,000 ( = $10,000 / 0.10).

    • What if the Fed lowered the required reserve ratio to 5%? If the Fed buys a $10,000 T-bill, the money supply can potentially increase to $200,000 ( = $10,000 / 0.05).

Therefore, the Fed rarely changes the reserve requirement ratios, because this tool is too powerful! A small changes in the reserve requirement could have enormous impact on the banking system and the money supply.

Economists and policymakers debate reserve requirements as an effective monetary policy tool, because this tool may be too powerful and required reserves are a cost to the banks. Banks are not able to lend these reserves to borrowers, and therefore, do not earn interest income on required reserves. Instead, the reserves sit in a vault as cash or as a deposit at the Fed. There are two reasons why the Fed wants to retain reserve requirement as a monetary tool.

  1. The original purpose of reserve requirements was to make deposits more safe and have a more stable banking system. The problem with this logic is the reserve requirements are low. If the majority of the depositors came to their bank to withdraw their deposits, the bank would still fail. The bank is holding less than 10% of the deposits as vault cash and/or deposits at the Fed. Reserve requirements will not prevent bank runs and will not stabilize the banking system. Only deposit insurance prevents bank runs.

  2. The Fed believes it can have better control over the money supply, if the Fed controlled the reserve requirement ratios. The reserve requirement ratios are components of the money multiplier. The money multiplier and reserve requirements need to be stable for the Fed to effective control the money supply. There is no empirical evidence that reserve requirements improve the stability of the money multiplier. Also, if there were no reserve requirements, banks would still hold reserves in order to meet depositors' withdrawals.

Milton Friedman, a Nobel laureate, suggested that banks should have a 100% reserve requirement. The banks would hold all deposits as deposits at the Fed and/or vault cash. There would be no multiple deposit expansion and the money multiplier would be one. For example, if the Fed bought a $10,000 T-bill, the monetary base and the money supply would both increase by exactly $10,000. A 100% reserve requirement would give the Fed better control of the money supply. Banks would hold all deposits as reserves, so they could meet depositor's withdrawals. Federal deposit insurance could be eliminated. Also the Fed and Congress could substantially reduce bank regulations. This idea has one problem. Banks could not grant loans under this system, causing the financial intermediation process to break down. Banks link savers to the investors. The whole economy would need restructuring.