The Fed’s Monetary Policy Tools

Now that we have examined how adding or reducing reserves in the banking system affects the money supply, let us consider the Fed’s role in changing the money supply. Given our discussion, it should come as no surprise that the Fed changes the money supply by altering the level of bank reserves.

Remember the definition of the monetary base and the determination of the money supply:

• the monetary base equals all reserves held by banks and all currency in circulation.
• Money supply = (Monetary base) x (Money multiplier)

and

• Change in the Money supply = (Change in the Monetary base) x (Money multiplier).

So let us focus our attention on how the Fed uses its policy tools. The Fed will alter the monetary base and thus change the money supply by a multiple of that amount.

The Fed uses monetary policy to influence economic activity. But the Fed does not have direct control over the pace of economic growth. Rather, it uses policy tools to accomplish this task. The chain of events that we will discuss in this section work as follows:

1. The Fed uses one (or more) of its policy tools:

1. Open market operations, which we will emphasize ,
2. Changes in the reserve requirement, and
3. Changes in the discount rate.

Open Market Operations

The Fed’s most important and widely used policy tool is open market operations. Remember the reserve requirement, which necessitates that banks keep 10% of the value of existing deposits on reserve with the Fed. This gives the Fed tremendous amounts of money with which to engage in financial transactions. Open market operations involve the buying and selling of government debt (Treasury Bills, Notes, and Bonds) by the Fed. The Fed makes these debt transactions with banks in order to alter total reserves in the banking system.

At this point, you may be scratching your head. The banks keep required reserves with the Fed. The Fed pays no interest to the banks on these reserves. And in some cases, the Fed then uses these reserves to buy bonds from banks, with the banks’ own money? Yes.

Let us consider a specific example. Assume the Fed wants to use open market operations to increase bank reserves. Note that banks use a portion of customer deposits (liabilities) to buy assets in the form of federal government-issued debt. To increase bank reserves, the Fed buys some of the government bonds from banks. For example, if the Fed buys $10 million in bonds from a bank, the bank’s reserves increase by $10 million, money which the bank will desire to loan out. The $10 million increase in bank reserves yields an equivalent increase in the monetary base.

Finding itself with $10 million in additional reserves from the sale of bonds to the Fed, the bank will rapidly put the money to work earning interest. By creating an additional $10 million in loans, the recipients of the loans will spend the money on goods and services. And through the multiplier process, when the bank makes loans, the money supply will increase by a multiple of the $10 million. The money supply will increase by an amount equal to the change in the money base ($10 million) times the money multiplier. If the reserve requirement is 10% and the money multiplier equals 10 (1/.10), the potential increase in the money supply will equal $100 million ($10 million x 10).

We assume that the businesses and individuals that borrow money from the bank do so with the intention of spending that money. Furthermore, as these businesses and individuals buy goods and services this creates income for businesses, employees, and other individuals. The majority of this income finds its way back into the banking system in the form of deposits.

To summarize thus far:

1. The Fed buys bonds from banks.

We see how the Fed can change the money supply, interest rates, investment, and the growth rate of GDP through open market operations. Unfortunately, Fed policy does not always work as smoothly as the Fed desires in this scenario. Let us examine in greater detail how open market operations actually work.

Using Open Market Operations to Change the Growth Rate of GDP

We begin with the Fed funds Rate. The Fed funds rate is the interest rate the Fed targets with open market operations. This is a very short-term interest rate that depends on the level of excess reserves present in the vaults of banks. By engaging in an expansionary policy, the Fed is using open market operations to buy bonds from the asset portfolios of some banks. As these banks sell bonds to the Fed, their cash reserves increase, creating excess reserves, and expanding the monetary base.

Since banks do not earn any return on excess reserves, they immediately look to loan out the excess reserves. If a bank with excess reserves cannot immediately find a long-term borrower, it can still earn interest. One way for a bank to make a loan is through the Fed Funds market where other banks borrow money for a short-term duration (overnight or a few days).

When the Fed buys bonds from individual banks, it creates excess reserves for those banks. Other banks may need to raise money on a short-term basis if they have fallen below their reserve requirement and/or need to raise money to make a loan to a corporate customer. Or the borrowing banks may desire to engage in other financial transactions and do not want to wait for deposit inflows to raise the necessary money.

We can see the connection between Fed open market operations and short-term interest rates. If the Fed is undertaking an expansionary policy (buying bonds), some banks will find themselves with an increased supply of excess reserves when they sell part of their government bond portfolio to the Fed. As the supply of excess reserves rises, banks will lower the interest rate they charge other banks to borrow short-term in the Fed funds market. As a result, the Fed funds interest rate decreases.

Having succeeded in lowering the Fed funds rate, the Fed assumes that longer-term interest rates will follow. This is a very important point regarding Fed monetary policy. While the Fed can directly control the Fed funds interest rate, it only has indirect control over longer-term interest rates.

The key to attaining the Fed’s goal of changing the growth rate of GDP lies in long-term interest rates. Changes in long-term interest rates create a response in business investment activity and consumer borrowing. Lower interest rates reduce the cost and increase the profitability of borrowing through the present value calculation. The same holds for the consumer, who will see a reduction in monthly payments for new loans taken out or for those loans adjusted to falling market interest rates.

The critical question is how effective is the Fed in translating policy decisions that change the Fed funds rate (short-term) into actual changes in longer-term interest rates? Only if longer-term interest rates adjust to changes in short-term interest rates will business investment and consumer spending react to Fed policy. And it is through changes in investment and consumption that the Fed will influence the growth rate of GDP.

How effective the Fed will be in determining the direction of long-term interest rates depends on changes in the spread or gap between short-term and long-term rates. The historical gap between the 3-month Treasury bill rate and the long-term government Treasury bond is about 2%. The longer the maturity of the debt, the higher is the associated interest rate. If the Fed lowers short-term interest rates by 0.5% (1/2 a basis point), the Fed’s goal is to maintain a constant spread. In this case long-term rates will also fall by 0.5% and investment and consumption activity will increase.

In the early 1990s, the spread between short-term and long-term interest rates reached a new high. This was a consequence of expected inflation in the future caused by the massive federal budget deficits of the 1980s and early 1990s. Long-term interest rates had an additional inflationary premium built in because of expected future inflation relating to the fiscal budget deficit. For our purposes here, we will assume a constant spread between long and short interest rates. In other words, when the Fed changes the Fed funds rate, all other interest rates will move in the same direction and by a similar magnitude. In this way we can base our discussion on a single rate of interest, r.

A restrictive monetary policy is a decision by the Fed to raise interest rates in order to slow the growth rate of GDP. In 1994, the Fed raised the Fed funds rate seven times in order to achieve a soft landing for the U.S. economy.

When open market operations are used to implement a restrictive monetary policy, the Fed sells bonds to banks. By purchasing bonds from the Fed, banks have less money to loan out and the monetary base shrinks. The result is a reduction in the money supply by a factor of the money multiplier. The reduction in the money supply and bank reserves raises the Fed funds rate using the opposite of the process described above. As long-term interest rates increase along with the Fed funds rate, business investment and consumer borrowing both decrease, resulting in slower GDP growth.

Changes in the Reserve Requirement and the Discount Rate

The Fed uses open market operations to carry out the great majority of its policy decisions. On occasion, the Fed will change the percentage of deposits that banks must keep on reserve with the Fed (the reserve requirement). If the Fed lowers the reserve requirement as part of an expansionary monetary policy, banks will have additional money that can be lent out to businesses and consumers. The value of the money multiplier will also increase. The net effect is to increase the money supply, lower interest rates, and increase the GDP growth rate.

A restrictive monetary policy by the Fed involves increasing the reserve requirement to reduce bank lending and decrease the value of the money multiplier. The money supply contracts, raising interest rates and reducing GDP growth as investment and consumption decline due to the higher interest rates.

Due to the dramatic effects on the money multiplier, the Fed seldom changes the reserve requirement. The Fed will only use this policy in circumstances of severe recession or inflation.

The discount rate is the interest rate that the Fed charges banks to borrow directly from the Fed. The discount rate is usually changed after the fact of a policy decision involving open market operations. If the Fed is using open market operations to carry out an expansionary monetary policy, it may follow up on changes in the Fed funds rate with a change in the discount rate. In this way, changes in the discount rate are used to confirm (to the public) the direction of Fed policy.

Monetary Policy

In this section we will take a graphical look at the implementation of Fed policy through open market operations. We will start by examining the impact on the Fed Funds interest rate when the Fed uses open market operations to change the money supply. This in turn will have an effect on investment with a change in a composite long-run interest rate, r. In addition, our analysis will look at the impact on aggregate demand when investment changes. Be aware that consumption activity is also responsive to changing interest rates (e.g. falling interest rates increase consumption), although this relationship will not be modeled explicitly.

We begin by taking a general look at the chain of events which occur when the Fed decides to use open market operations to change economic conditions. Before we look at the sequence keep in mind some important considerations:

• If economic growth is considered to be undesirably rapid, the Fed will undertake a restrictive monetary policy with the goal of slowing economic growth and dampening inflationary pressures.

Direction of Causality of Monetary Policy when the Federal Reserve Decides to Change Interest Rates

»» Open Market Operations, Fed buys or sells bonds »» Change in Bank Reserves »» Change in the Monetary Base »»

»» Change in the Money Supply »» Change in the Fed Funds Interest Rate »» Change in Long-term Interest Rates »»

»» Change in Business Investment »» Change in Aggregate Demand »» Change in GDP Growth, the Inflation and Unemployment Rates.

(1) The spread in interest rates refers to the difference between short-term rates and long-term rates for a debt asset with similar characteristics except for the time until the asset matures. For example, a Treasury bond that matures in 20 years may offer an interest rate 2% higher than a 3 month T-bill. Debt with greater maturities will offer higher interest rates to compensate for the extra risk that interest rates may change unfavorably for the owner of the debt over time.

Restrictive Monetary Policy

When the policy making group at the Fed (the FOMC) gathers, they take a detailed look at current and expected economic conditions. The members of the FOMC will be given forecasts of the likely direction of the economy in the upcoming year or so. To be effective, the FOMC desires to anticipate economic problems rather than reacting to current conditions.

Let us look at the scenario facing the FOMC in January 1994. The U.S. economy had been growing at a rapidly increasing clip during 1993. As 1994 began, several key indicators of the economy were entering the danger area. For example, capacity utilization was reaching a level that could cause an increase in the inflation rate by the later part of 1994 if high economic growth rates continued. Rather than wait for the anticipated inflation to materialize, the Fed initiated a restrictive monetary policy to slow the growth rate of GDP.