8.1 FM&I Chapter 9,10

PA RT 4 CENTRAL BANKING AND THE
CONDUCT OF MONETARY POLICY
9
C H A P T E R
Central Banks
PREVIEW
Among the most important players in financial In this chapter we look at the institutional
markets throughout the world are central banks, structure of major central banks and focus on the
the government authorities in charge of monetary European Central Bank (ECB), the Federal Reserve
policy. Central banks’ actions affect interest rates, System, and other global central banking systems.
the amount of credit, and the money supply, all We start by focusing on the elements of the European
of which have direct impacts not only on financial Central Bank’s institutional structure that determine
markets but also on aggregate output and inflation. where the true power within the ECB system lies. By
To understand the role that central banks play in understanding who makes the decisions, we will have a
financial markets and the overall economy, we need better idea of how they are made. We then look at the
to understand how these organizations work. Who structure of central banks of other larger economies,
controls central banks and determines their actions? and see how they are organized. With this information,
What motivates their behavior? Who holds the reins we will be better able to comprehend the actual conduct
of power? of monetary policy described in the following chapter.
224
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CHAPTER 9 Central Banks 225
Origins of the Central Banking System

The oldest central bank in the world, the Sveriges Riksbank or the Bank of Sweden,
was established in 1668, with its main function being lending money to the govern-
ment of Sweden. With the increase in the size of global trade and the corresponding
increase of the volume of international payments in the seventeenth century, the
need arose for the creation of more central banks throughout Europe.
The founding of the Bank of England (BoE) in 1694 marks the de facto origin of
central banking since the BoE was the archetype for central banks that were created
in Europe during the eighteenth and nineteenth centuries. In addition to buying
government debt, central banks were primarily concerned at that time with secur-
ing cashless international payments so as to increase the efficiency of international
trade. Gradually, the central banking functions evolved in order to safeguard mon-
etary stability, which required central banks to answer to their parliaments.
Unlike Europeans, who considered central banks pivotal in policing banks,
Americans feared that the concentration of power in the hands of a sole central bank
was apt to be politically hazardous. Thus, the various attempts since the nineteenth
century to establish a European-style central bank in the United States were met with
considerable controversy. This hostility toward the centralization of banking control
dampened after the recurrent banking crises that hit the United States between 1870
and 1907. Ultimately, this led to the establishment of the Federal Reserve bank in 1913.
To avoid the risk of power concentration, the structure of the Federal Reserve bank was
designed so as to distribute power over 12 regional Federal Reserve banks scattered
across the United States. Moreover, it remained privately owned by its member banks.
Most emerging market economies established their central banks after World
War II, namely a few years after their independence from colonialism. The structure
of these banks became very similar to those of European central banks.
Over the last two centuries, the functions of central banks throughout the world
expanded from the exclusive issuance of banknotes, policing banks, and monitoring
international payments to regulating the value of the national currency, financing
the government, and acting as a “lender of last resort” to banks suffering from liquid-
ity and/or credit crises.
While today most central banks around the world are publicly owned, a few still
have private ownership. For example, the Federal Reserve bank and the Bank of
Italy are privately owned by their commercial bank members. The European Central
Bank is owned by the central banks of the member states of the Eurozone. In addi-
tion, the shares of some central banks such as those of Belgium, Greece, Switzerland,
Japan, Turkey, and South Africa, are privately owned. Each of these central banks
has a different shareholding structure comprising government institutions, banks,
financial institutions, cantons, and/or private individuals (see the Global box, “Who
Should Own Central Banks?”).
Variations in the Functions and Structures

of Central Banks
The roles of central banks have grown in importance over time and their activities con-
tinue to evolve. While most central banks of the world share many commons features
and goals, there are a number of differences in the structure and policy tools that each
central bank adopts. These differences depend on the level of sophistication of the
banking and financial sectors as well as changes in the domestic and global economies.
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226 PART 4 Central Banking and the Conduct of Monetary Policy
GLOBAL
Who Should Own Central Banks?
Initially central banks were set up as private or joint On the other hand, advocates of private owner-
stock banks that provided commercial banking ser- ship argue that it guarantees the independence of
vices along with banking services to other banks. the central bank from the government, which in many
Being the sole issuers of currency and legal tender cases is mostly concerned with financing the fiscal
in the economy, central banks held substantial gold budget. To avoid control of capital, every single pri-
reserves to back the issued notes, which allowed them vate shareholder is allowed a small number of shares
to become the repository for banks. After the Great and a restricted number of votes. Another determin-
Depression revealed the scandalous lack of control ing factor is restricting the distribution of dividends
over the imprudent behavior of banks, many central per share. Naturally, dividends are distributed after
banks worldwide were nationalized. In spite of becom- keeping the compulsory portion of profits as reserves
ing public institutions, newly nationalized central with the central bank and transferring the residue
banks were granted autonomy to conduct monetary to the treasury. In the case of losses, private owners
policy. Some other central banks, such as the Federal should be required to recapitalize the central bank,
Reserve bank, remained privately owned in order to which lifts this burden off the fiscal budget. As such,
safeguard full autonomy. This often raises concerns of shareholders of privately owned central banks are not
conflicts of interest since it is challenging for a central given direct participation in policy decision making,
bank that is owned by its member banks to supervise but their rights should be confined to the election of
the very banks that own it. audit committee members to the selection of advisors
If central banks are to strike a balance between and some members of the board of directors.
independence and bank supervision, then should they In conclusion, while private ownership allows
be publicly, rather than privately, owned? The argu- central banks to exercise increased independence,
ment for public ownership is that when central banks public ownership ensures more transparency and
are owned by the government, they act in the ultimate accountability by central bankers. Regardless of own-
public interest. This is because public ownership is ership arrangements of central banks, it is generally
based on the concept of shared community repre- perceived that the broader the governance rules of
sentation and public participation in the oversight of central banks, the more likely they are to efficiently
these central banks. Advocates of this opinion also serve their financial functions and economic roles.
argue that private ownership is apt to bias central As long as the constitution of the nation stipulates
banks toward self-serving profit-making interests, that the central bank is a statutory institution that is
hence increasing risk-taking and balance sheet trou- accountable to the parliament and obliged to meet
bles. Besides, the global financial crisis has indeed the monetary goals of the economy, ensure financial
highlighted concerns that the profit-making target of steadfastness, maintain price stability, and pursue
private shareholders could hamper them from saving economic growth, then central bank ownership does
the financial sector during financial crises. not really matter.
Central banks have also been gradually assigned increasing responsibilities, which has
required that they gain more independence from fiscal authorities and political institu-
tions. As we shall observe in the following sections, the changed circumstances of each
nation have resulted in different functions and structures for each central bank.
The European Central Bank, the Euro System,

and the European System of Central Banks
The European Central Bank (ECB) came into existence on June 1, 1998, in order
to handle the transitional issues of the nations that comprise the Eurozone. The
Eurozone is an economic and monetary union consisting of the member states of the
European Union (EU) that have adopted the euro as their currency. The creation of
the Eurozone and of the new supranational institution, the ECB, was a milestone in
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the long and complex process of European integration. All of the member states of the
European Union have to comply with a set of economic criteria and legal preconditions.
Initially in January 1, 1999, only 11 EU member states had adopted the euro.
This was the date when the responsibility for conducting monetary policy was
transferred from the National Central Banks (NCBs) of these 11 nation-states
to the ECB. All of the Eurozone or euro area countries—i.e., the EU countries
that have adopted the euro—retain their own National Central Banks and their
own banking systems, albeit that the Eurosystem’s rules and monetary policy are
set centrally by the ECB. As of 2017, 19 countries out of the 27 member states
of the European Union have joined the euro area. The Eurosystem comprises
the ECB and the NCBs of those EU member states that have adopted the euro.
Today, the EU is the world’s third largest economy after the United States and
China in terms of GDP. As of 2017, the Eurozone had a population of 341 million
citizens. It comprises the following 19 countries: Austria, Belgium, Cyprus, Estonia,
Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg,
Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. The remaining
member states outside of the Eurozone have either chosen to retain their own national
currency or do not comply with the convergence criteria that allow them to adopt the
euro. It is worth mentioning that in the U.K. referendum of June 23, 2016, 52% of
British voters voted to exit the EU. Accordingly, the United Kingdom is scheduled to
exit the EU in April 2019, a process that has come to be known as “Brexit.” Since the
Brexit was enacted, the EU includes only 27 member states.
Since not all of the EU member states have adopted the euro, the European
System of Central Banks (ESCB) was established alongside the Eurosystem to
comprise the ECB and the NCBs of all EU member states whether or not they are
members of the Eurozone. Figure 9.1 outlines the organizational structure of the ESCB.
The NCBs of the EU member states that have retained their national currencies are
members of the ESCB with a special status, whereby they are allowed to conduct their
own respective national monetary policies. In other words, they do not take decisions
regarding the design and implementation of the monetary policy for the euro area.
The capital stock of the European Central Bank is owned by the central banks of
the current 27 EU member states. Similarly, the balance sheet of the ECB—i.e., its
assets and its liabilities—is held by the National Central Banks. Thus, the 19 NCBs of
the euro area partially function as branches of the ECB. The shares of the National
Central Banks of the 27 EU member states in the ECBs capital stock are calculated
using a key that is weighted according to the shares of the respective member states
in the total population and the GDP of the EU. The bulk of the capital stock of the
ECB is held by the 19 euro area NCBs, while non-Eurozone central banks collectively
hold only around 3.5% of the capital structure of the ECB. The ECB adjusts the shares
every five years and whenever a new country joins the EU. Deutsche Bundesbank
(almost 18%), Banque de France (14.18%), Banca d’Italia (12.31%), and Banco de
España (8.84%) hold the highest capital key percentages of the ECB’s capital.
Decision-Making Bodies of the ECB

The three main decision-making bodies of the European Central Bank are the
Governing Council, the Executive Board, and the General Council. Figure 9.2 displays
the structure of the decision-making bodies and the responsibilities for policy tools
within the ESCB.
The Governing Council is the chief decision-making body of the ECB responsible
for formulating monetary policy in the euro area. It consists of the ECB’s president
and vice-president, four members of the Executive Board as well as the governors
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Iceland
Finland
26
Russia
Norway Sweden 6
27 Estonia
14
Latvia
Lithuania
4 15
Denmark
Belarus
7
Ireland
United 21
Kingdom 19
€ Poland
Netherlands
5 Ukraine
Germany
1
Belgium 3
16 Czech Republic
Luxembourg Slovakia 25
Moldova
20
10 17 2
Austria Hungary
France Liechtenstein Bulgaria
Switzerland Slovenia
24 Croatia 11
Bosnia
and Serbia
Herzegovina 23
San Marino
Romania
Kosovo
12 Montenegro
Andorra Italy Macedonia
Vatican city
9 Albania
22 Turkey
Spain
Portugal 8
Greece
Cyprus
13
18
Malta
FIGURE 9.1 The Organization of the ESCB

he map illustrates the European System of Central Banks (ESCB) and the 27 Participating National
T
Central Banks (NCBs).
Source: Based on information from the ECB Europa Website.
European Central Bank European Central Bank
1 Nationale Bank van Beligié 8 Bank of Greece

2 Bulgarian National Bank 9 Banco de España
3 Czech National Bank 10 Banque de France
4 Danmarks Nationalbank 11 Croatian National Bank (HNB)
5 Deutsche Bundesbank 12 Banca d’Italia
6 Bank of Estonia 13 Central Bank of Cyprus
7 Central Bank of Ireland 14 Latvijas Banka
M09_MISH9547_10_GE_C09.indd 228 06/07/23 2:28 PM

European Central Bank European Central Bank
15 Bank of Lithuania 22 Banco de Portugal

16 Central Bank of Luxembourg 23 National Bank of Romania
17 Hungarian National Bank (MNB) 24 Banka Slovenije
18 Central Bank of Malta 25 National Bank of Slovakia
19 De Nederlandsche Bank 26 Bank of Finland
20 Oesterreichische Nationalbank 27 Sveriges Riksbank
21 Narodowy Bank Polski
of the 19 National Central Banks of the euro-area countries. Various non-council

members are allowed to attend meetings of the governing Council in order to raise
important issues pertaining to the EU, albeit that they do not have voting rights.
Examples of such individuals are presidents of the European Council, the European
Commission, and the Eurogroup president.
The main function of the Governing Council of the ECB is to conduct monetary
policy and its primary objective is to maintain price stability in the euro area. Since the
major monetary and financial decisions in the euro area are taken by the Governing
Council, it is chaired by the ECB president, who is considered its highest represen-
tative and spokesperson. The Governing Council meets in Frankfurt on a fortnightly
basis. At the beginning of each month, the Governing Council decides on the monthly
monetary policy decisions in accordance with the economic and monetary develop-
ments in the Eurozone. Every time after this monthly meeting, the ECB president and
vice president hold a press conference to explicate the ECB’s monetary policy deci-
sions and rationale. At its second meeting, the Governing Council of the ECB discusses
other issues and responsibilities pertaining to the ECB and the Eurosystem.
The Executive Board of the ECB is appointed by the European Council.
Decisions of the ECB’s Governing Council are made based on majority voting. While
the ECB’s Executive Board members hold permanent voting rights, governors
of NCBs take turns holding voting rights in the Governing Council on a monthly-
rotation basis. Euro area countries are divided into groups according to the size of
their economies and the ranking of their financial sectors. The governors from the
five largest countries—Germany, France, Italy, Spain, and the Netherlands—share
four voting rights. The remaining 14 countries share 11 voting rights.
The Executive Board of the ECB is responsible for the day-to-day operations and
management of the ECB and the Eurosystem. It also implements the decisions of the
Governing Council by giving instructions to the corresponding NCBs. The Executive
Board comprises the following six members: the president and the vice-president of
the ECB, and four other members who take decisions in their personal capacity, not
as representatives of a given country or institutions. These four individuals are of high
standing and professional experience in the monetary and/or financial fields. The selec-
tion process that is made by the heads of the governments of the EU member states
is quite meticulous and rests on recommendations and consultations of the European
Parliament, the European Council of Ministers, and the Governing Council of the ECB.
The third decision-making body is the General Council of the ECB, which
comprises the president and the vice-president of the ECB in addition to the gov-
ernors of the NCBs of the 28 EU member states. Without having voting rights, a few
officials are allowed to attend the meetings of the General Council such as members
of the Executive Board of the ECB, the president of the EU Council, and one member
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European System of Central Banks (ESCB)
The ESCB promotes monetary and financial

cooperation among the 27 EU member states.
It comprises the European Central Bank and
19 National Central Banks of the euro area
European Central National Central

Bank (ECB) Banks (NCB)
Governing Executive General

Council Board Council
FIGURE 9.2 Structure and Responsibility for Policy Tools within the ESCB
The figure illustrates the relationships of the European Central Bank (ECB) and the 19 National
Central Banks (NCB) and the three decision-making bodies of the ECB. The Governing Council
consists of governors from the 19 euro area NCBs and members of the Executive Board; the
Executive Board consists of the president and the vice-president of the ECB along with four other
members; and the General Council consists of the president and the vice-president of the ECB
and the governors of the NCBs of the 27 EU member states.
GLOBAL
The Importance of the Bundesbank Within the ECB

Since its establishment in 1998, the European Central Bundesbank have proved to be a burden rather
Bank has been headquartered in Frankfurt, Germany. than an advantage to the largest economy of the
Largely, the structure of the ECB was modeled after EU. During the crises, more than five bailouts were
the German central bank—the Deutsche Bundesbank. offered to the ailing European economies, and govern-
In 1999, member states of the euro area, including ment bonds have been purchased from their govern-
Germany, ceded monetary and currency control to the ments. While the ECB buys public debt according
ECB, which had to formulate monetary policy decisions to the capital key of each NCB, the burden will lie
and oftentimes had to deal with financial crises. the most on the Bundesbank since it is the largest
In theory, the rotation voting system means shareholder of the ECB. Hence, the Bundesbank
that the Bundesbank has similar say on the ECB’s has been increasingly at odds with ECB, accusing
25-member Governing Council over monetary policy it of overstepping its mandate. It protests that the
measures. In practice, however, the Bundesbank’s monetary financing of budget deficits violates the
size makes it an influential actor in crafting Eurozone ECB’s independence from government, political, and
monetary policy at the ECB and maintaining the euro financial influence. Accordingly, the Bundesbank has
area’s financial sector. demanded that large Eurozone states like Germany
However, during the European sovereign debt assume a greater role in the future banking supervi-
crises, the size and historical standing of the sion process at the ECB.
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of the European Commission. The main task of the General Council is to encourage
cooperation between the National Central Banks of the member states of the EU. The
General Council also performs a number of important advisory functions such as col-
lecting statistical information for the ECB, preparing the ECB’s annual reports, and
standardizing the accounting and reporting operations of the NCBs. According to the
Statute of the ESCB and the ECB, the General Council is a transitional body that will
be dissolved once all EU member states have introduced the single currency.
How Monetary Policy Is Conducted Within the ECB

The aims of the ECB are similar to those of any other modern central bank. The
three main objectives of the ECB are to maintain price stability in the economies of
the EU, support the economic policies of the Eurozone nations, and ensure an inde-
pendent and open market economy. Direct macroeconomic stimulation is not on the
mandate of the ECB, which is the task of fiscal policies. Since price stability is very
important in order to attain economic growth and job creation, the ECB endeavors
to maintain its independence from governments.
To achieve its primary objective of price stability, the ECB aims to maintain a
medium-term inflation rate closely below 2%. As mentioned earlier, the Governing
Council of the ECB controls money supply and decides interest rates. The Governing
Council of the ECB sets the following three key policy interest rates:
• Deposit facility rate, which is the rate on tenders to banks. It is the most
important policy rate because it provides the bulk of liquidity to the bank-
ing system and determines how far down the ECB’s quantitative easing
(QE), which refers to asset purchases as one of the tools to support eco-
nomic growth, can push sovereign bond yields
• Refinancing rate, which is the rate on overnight deposits with the
Eurosystem
• Marginal lending facility rate, which is the rate on overnight credit to banks
from the Eurosystem
The ECB’s operational framework consists of the following set of conventional

monetary policy instruments:
• Open market operations

• Standing facilities to provide and absorb overnight liquidity
• Minimum or required reserve requirements for credit institutions
Since the intensification of the global financial crisis in September 2008 and the
series of European debt crises, the ECB has introduced a number of unconventional
or non-standard monetary policy measures to complement the regular operations of
the Eurosystem when standard monetary policy has become ineffective at combating
a falling money supply and economic recessions. The first of these unconventional
monetary policy measures includes emergency liquidity assistance (ELA)—that
provides liquidity and loans exceptionally to solvent banking and financial institu-
tions that are facing temporary liquidity problems. Second, the ECB has pursued
quantitative easing, where central banks buy sovereign bonds and/or other financial
assets from commercial banks and financial institutions to increase money supply
and stimulate the economy. Examples of these are the asset purchase programmes
(APP) and the Securities Market Programme (SMP). The APP includes purchases of
public sector securities, private sector bonds, and asset-backed securities. Therefore,
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GLOBAL
Are Non-Euro Central Banks Constrained by Membership of the EU?
Similar to other traditional currency unions, the 19 euro Undoubtedly, from a pure monetary policy per-
area nations share a common currency, joint monetary spective, by possessing a floating exchange rate and
policy rules and flexible labor mobility. But what the fully independent institutional and monetary policy
Eurozone lacks is intra-country fiscal budgetary trans- frameworks, non-Eurozone EU member states should
fers that are an essential shock absorbing mechanism. be able to absorb external shocks with little impact on
Moreover, the presumable openness of the EU to labor underlying price stability. The rules of the EU prohibit
mobility has not necessarily been prompted by structural the provision of any producer subsidy or aid granted
factors, but more so by personal relocation migration con- by an EU government to promote certain domestic
siderations by the population of EU states. sectors. This is to ensure that competition among EU
In addition to strong sentiments of national member nations is not threatened and that free trade
pride, it is precisely the imperfect labor market condi- is not curtailed in any way.
tions and the infeasibility of fiscal However, EU rulings allow domestic central banks to
integration that have actually impelled many EU freely implement conventional monetary policies. This
nations to refrain from adopting the euro. But the means that the stimulus programs and unconventional
most important disadvantage that non-Eurozone EU monetary policies undertaken by the central banks of
nations, such as the United Kingdom, Denmark, and non-Eurozone EU states during both the global financial
Sweden, wanted to avoid was the loss of their fiscal crisis and the European Sovereign Crisis had to be con-
and/or monetary autonomy. Hence, to insulate their ducted in coordination with the European Central Bank.
economies against external shocks from Eurozone EU, It goes without saying that these are only special cases at
these non-Eurozone EU nations wanted to retain the the unusual times of financial crises. But under normal
ability to freely conduct and implement their home conditions, non-Eurozone EU central banks are hardly
grown fiscal and monetary policies. constrained by their countries’ membership of the EU.
the APP addresses the risks of prolonged periods of deflation. The SMP strictly lim-
its purchases of government bonds by the Eurosystem to secondary markets. All of
these non-traditional monetary policy tools were temporary and aimed at providing
liquidity to financial markets and reducing pressures on interest rates. These mea-
sures are gradually being removed as governments of the ailing EU member states
have made commitments to meet their fiscal targets and adopted fiscal and structural
reforms. Since 2014, the ECB has introduced a negative interest rate policy (NIRP)
on bank deposits in order to reduce the slowdown in the economy.
The ECB itself does not conduct monetary policies, but assigns these tasks to
the central banks. For example, in the case of the quantitative easing program, the
19 National Central Banks are tasked with buying bonds in their respective sover-
eign bond markets. The purchase amounts are based on the Capital Key of each EU
member state. The Deutsche Bundesbank and Banque de France are responsible for
26% and 20% of bonds purchased, respectively.
The Federal Reserve System

The Federal Reserve System is one of the largest and most influential central banks
in the world. As mentioned earlier, Americans wanted to ensure full independence
of the Fed from the government and, hence, ensured that the Fed became an inde-
pendent entity that is privately owned by its member banks. The Fed is subject to
oversight from Congress that periodically reviews its activities, but its decisions are
made totally independent of the U.S. government. Owning the Fed does not mean
that private banks have control over it. In fact, the Fed supervises and regulates
the nation’s financial institutions and simultaneously serves as their banker. There
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are 12 regional Federal Reserve banks that are located in major U.S. cities. These
regional Federal Reserve banks act as the operating arm of the Fed that carry out
most of its activities and implement the Fed’s dual mandate of long-term price
stability and macroeconomic stability through creating jobs. The Federal Reserve
banks generate their income from services provided to member banks and from
interest earned on government securities, foreign currency, and loans to financial
institutions. Any excess income after covering day-to-day operations is funneled
into the U.S. Treasury.
The Federal Reserve System consists of the following entities:
• The Federal Reserve Board of Governors (FRB) which mainly assumes

regulatory and supervisory responsibilities over member banks.
• The Federal Open Market Committee (FOMC) comprises 12 mem-
bers—seven members of the Federal Reserve Board of Governors, president
of the Federal Reserve bank of New York, and four of the regional Federal
Reserve bank presidents. The FOMC convenes eight times a year to decide
on the interest rates and monetary policy. Members of the FOMC base their
decisions on the Green Book, the Blue Book, and the Beige Book, which
are respectively the FRB staff forecasts of the U.S. economy. Starting in
2010, the green and the blue books were combined into the “teal book”; the
FRB staff analysis of monetary policy; and discussions of regional economic
conditions prepared by each of the twelve regional Reserve Banks.
• The 12 regional Federal Reserve banks that are located in major cities
throughout the nation
• Private U.S. member banks
• The Federal Advisory Council
Difference Between the ECB and the Fed

Both the ECB and the Fed are entities that bind a number of regional central banks
together, 19 National Central Banks for the ECB and 12 Regional Federal Reserve
banks for the Fed. Both are independent institutions with a decentralized struc-
ture that employs basic monetary tools such as legal reserve requirements, inter-
est rates, and open market operations. The ECB was designed according to the
German Model, which supports political independence and makes monetary policy
decisions independent of political authorities. This suits the state of affairs of the
ECB where the interference of multiple EU governments is apt to disrupt opera-
tions. Similarly, the Fed is highly independent of the government and reports to the
Congress. Although at face value the structure of the Eurosystem is similar to that
of the Federal Reserve System, some important differences distinguish the two.
First of all, the ECB and the Fed have different mandates or objectives and accord-
ingly adopt different methods to achieve these objectives. As mentioned before, the
primary objective of the ECB is to achieve price stability. On the other hand, the Fed’s
dual mandate and monetary policy objective is to deliver price stability and conse-
quently to support the macroeconomic objectives including those for growth and
employment. Hence, unlike the ECB, the Fed often ignores the temporary effects of
price changes since it considers unemployment to be a much bigger priority.
Second, the budgets of the Federal Reserve banks are controlled by the Board
of Governors, whereas the National Central Banks control their own budgets and
the budget of the ECB in Frankfurt. The ECB in the Eurosystem, therefore, has less
power than does the Board of Governors in the Federal Reserve System.
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Third, the monetary operations of the Eurosystem are conducted by the

National Central Banks in each country, so monetary operations are not centralized
as they are in the Federal Reserve System.
Fourth, in contrast to the Federal Reserve, the ECB is not involved in supervi-
sion and regulation of financial institutions; these tasks are left to the individual
countries in the European Monetary Union.
Finally, in order to finance fiscal budget deficits, the Fed buys government
bonds outright, while the ECB accepts them as collateral for new loans to the
banking system. In this case, governments of weaker economies can use the ECB
to finance their fiscal deficits and externalize the costs of a loss of purchasing
power of the euro onto the entire economies of the Eurozone. Oftentimes this
has prompted popular criticism of the system among nationals of stronger EU
economies.
The Bank of England

The British central bank or the Bank of England (BOE), known as the ‘Old Lady’
of Threadneedle Street, was founded in 1694. Being the second-oldest central
bank in the world, its model has been the basis of most other central banks of
the world. The Bank Act of 1946 gave the government statutory authority over
the Bank of England. The Court of Directors (equivalent to a board of directors)
of the Bank of England is made up of five executive members from the Bank,
including the governor and two deputy governors, and up to nine non-executive
members. It is accountable to the Parliament. All members of the Court are
appointed by the Queen upon the recommendation of the prime minister. One of
the non-executive members is selected by the chancellor to chair the Court of
Directors.
Because the United Kingdom is not a member of the euro area, the Bank of
England makes its monetary policy decisions independently from the European
Central Bank. The Bank’s Monetary Policy Committee (MPC) is responsible for con-
ducting monetary policy. It has nine members, of which five are BoE staff including
the governor, three deputy governors, and the chief economist. Four members of
the Committee are independent experts chosen from outside the Bank, selected
for their experience in economics and monetary policy. The MPC meets over three
days eight times a year to deliberate on macroeconomic changes and goals. The
MPC accordingly sets interest rates to fulfill its mandate and monetary policy objec-
tives: to deliver price stability and to support the government’s economic objectives
including those for growth and employment. Raising and lowering interest rates is
the main policy tool that the BOE uses for controlling growth. The lower the interest
rate, the more people are encouraged to spend and investors to invest. However, as
interest rates were cut close to zero since the global financial crisis, many central
banks including the BOE have used quantitative easing, which is an unconventional
form of monetary policy where a central bank creates new money electronically to
buy financial assets from businesses. Most of these financial assets are government
debt and corporate bonds. Quantitative easing aims to directly increase private sec-
tor spending in the economy and return inflation to target. The government’s infla-
tion target is announced each year by the Chancellor of the Exchequer in the annual
Budget statement. The minutes of the MPC meetings are published simultaneously
with the interest rate decision. This gives the BoE less autonomy in comparison to
the Fed.
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GLOBAL Brexit and the BoE

Brexit refers to the United Kingdom’s intended with- increase to the EU and the United Kingdom. Second,
drawal from the EU in the wake of a 51.9% referendum the BoE and its regulatory arm, the Prudential
vote on June 23, 2016. While media coverage has mostly Regulation Authority, complain that financial firms
portrayed the Brexit decision to be primarily based on restructuring after Brexit could be more difficult and
migration and labor concerns, in reality macroeconomic costly to regulate.
concerns were more manifest. After the slowdown in the The extent of the repercussions of Brexit depends
EU and the European Financial Crisis, weak domestic largely on the kind of future relationship that the United
demand in the euro area weighed on U.K. export perfor- Kingdom will develop with the EU. A hard Brexit arrange-
mance and reduced growth. This is because the euro area ment, or no exit agreement with the EU, would likely
is the United Kingdom’s largest trading partner, account- see the United Kingdom give up full access to the single
ing for around two-fifths of British exports. Also, the euro market. This would give Britain full control over its bor-
area crisis weakened demand in the United Kingdom ders enabling it to increase customs. A hard Brexit would
through movements in asset prices and uncertainty. also no longer enable financial firms to keep their “pass-
Undoubtedly, Brexit will have economic and finan- porting” rights to sell services and operate branches
cial repercussions on the United Kingdom and the EU freely in the United Kingdom without the authorization
alike and the transition process is going to be quite a of the BoE. This is apt to increase operational costs
challenge. First and foremost, the United Kingdom’s and supervision costs as well as magnify the risk of
financial services sector provides 75% of foreign unexpected breaks in the provision of financial services
exchange trading and supports half of all lending for such as loans to firms and consumers. On the other
the EU. Moreover, British investment banks provide hand, a soft Brexit arrangement would leave the United
75% of all hedging products, which help businesses Kingdom’s relationship with the EU as close as possible
ensure against risk when making investments or buy- to the existing arrangements. Hence, before leaving the
ing products. Thus, as the financial services that have EU by March 2019, an adequate implementation period
been conducted in the City of London would fragment is desirable in order to give U.K. and EU firms more time
across other European, financial centers, costs would to make the necessary changes.
Structure of Central Banks of Larger Economies

Here we examine the structure and degree of independence of three other impor-
tant and large central banks: the Bank of Canada, the Bank of Japan, and the People’s
Bank of China.
The Bank of Canada

Canada was late in founding a central bank because its need for a central bank to super-
vise the Canadian financial sector was not apparent till after the Great Depression.
The Bank of Canada (BoC) started its operations in 1935 in Ottawa as a privately
owned financial institution but was turned into public ownership since 1938. There
are five Regional Bank of Canada offices in Vancouver, Calgary, Toronto, Montreal, and
Halifax. The BoC practices regulatory and supervisory responsibilities over Canadian
banks and reports its monetary policy decisions to the House of Commons twice a
year. The Bank of Canada directors are appointed by the Minister of Finance to three-
year terms, and in turn they appoint the governor for a seven-year term.
The Bank Act was amended in 1967 to give the ultimate responsibility for mone-
tary policy to the government. In practice, however, the Bank of Canada does essen-
tially control monetary policy. In the event of a disagreement between the bank and
the government, the minister of finance can issue a directive that the bank must
M09_MISH9547_10_GE_C09.indd 235 06/07/23 2:28 PM

follow. However, because the directive must be in writing and specific and applicable
for a specified period, it is unlikely that such a directive would be issued, and none
has been to date. The goal for monetary policy, a target for inflation, is set jointly by
the Bank of Canada and the government, so the Bank of Canada has less goal inde-
pendence than the Fed.
The main mandate of BoC is to preserve the value of money by keeping inflation
low, stable, and predictable. The Bank of Canada adopts a dual key monetary policy
framework comprising inflation-control target and flexible exchange rate. Decisions are
announced eight times a year in order to install an environment of stability and trust.
The Governing Council of the BoC, consisting of the four deputy governors and
the governor, is the main monetary policy-making body comparable to the FOMC of
the Fed. Other major participants that assist the Governing Council in the monetary
policy decision-making are the Monetary Policy Review Committee (MPRC) and
the four economics departments at the BoC that share their information, analysis,
experience, and judgment. The monetary policy decision-making is a complicated
process that borrows a lot from that of the Bank of England. It goes through the fol-
lowing five intricate key stages.
• The BoC’s staff present their initial projection of monetary policy to the
Governing Council two and a half weeks before the interest rate decision.
This projection uses economic modeling and simulation to produce a base-
case or most likely scenario.
• A second major briefing occurs one week before the decision. It includes an
update on economic developments, risks, business outlook, inflation, credit
conditions, financial market conditions, and monetary policy expectations in
Canada, the United States, and globally.
• Final policy recommendations are presented two days after the major brief-
ing and serve as the starting point for an extensive discussion by the entire
MPRC.
• Deliberations take place Thursdays through Mondays and decisions are
taken on Tuesdays.
• Finally, the Bank of Canada announces its decision on Wednesday and pub-
lishes a press release that explains the reasons behind its decision.
The Bank of Japan

The Bank of Japan (BoJ), Nippon Ginko or Nichigin for short, was founded in 1882
during the Meiji Restoration. It is headquartered in Tokyo and has 32 branches, the
largest being in Osaka. The Bank of Japan was restructured after World War II in
1949. Up until the early nineties, the main monetary policy tool used by the BoJ
was the imposition of bank credit growth quotas on the commercial banks. Until
recently, the Bank of Japan was not formally independent of the government, with
the ultimate power residing with the Ministry of Finance. However, the Bank of
Japan Act of 1997, which took effect in April 1998 and was the first major change
in the powers of the Bank of Japan in 55 years, changed this situation. The two
main mandates of the BoJ are price stability and financial sector stability in order
to achieve stable and sustainable macroeconomic growth. The Bank of Japan Act
granted greater instrument and goal independence to the Bank.
The Policy Board of the Bank of Japan, which is composed of nine members,
determines the monetary policy: the governor; two deputy governors; and six exec-
utive directors appointed by the cabinet and approved by both chambers of the Diet,
M09_MISH9547_10_GE_C09.indd 236 06/07/23 2:28 PM

all of whom serve for five-year terms. The Policy Board makes monetary policy deci-
sions eight times a year, but meets on a weekly basis to decide on other matters
pertinent to the economy and international finance.
Earlier, the government had two voting members on the Policy Board, one from
the Ministry of Finance and the other from the Economic Planning Agency. Now
the government may send two representatives from these agencies to board meet-
ings, but they no longer have voting rights, although they do have the ability to
request delays in monetary policy decisions. As such, the Japanese monetary policy
is regarded as the outcome of a bargaining process between the government and
the Bank of Japan. The Ministry of Finance has lost its authority to oversee many
operations of the BoJ, particularly the right to dismiss senior officials. However, the
Ministry of Finance continues to have control over the part of the Bank’s budget that
is unrelated to monetary policy. More importantly, the BoJ lacks the autonomy to
influence the yen exchange rate and acts on behalf of the Ministry of Finance which
instructs the BoJ to conduct foreign exchange intervention by buying or selling yen
against foreign currencies using government funds as well as BoJ foreign assets.
Thus, the Bank of Japan Act has reduced the scope of action and the independence
of the Bank of Japan in comparison to its European counterparts.
The People’s Bank of China

The Chinese central bank is known as the People’s Bank of China (PBoC). As of
2017, the People’s Bank of China has the largest financial asset holdings and foreign
currency reserves held by any central bank in the world. The PBoC was founded
in 1949 as a result of the merger of three of the largest commercial banks then. Up
till the early eighties, the PBoC was the main entity authorized to conduct banking
operations in that country. Then four state-owned specialized banks were allowed
to conduct banking operations. In its endeavor to gradually liberalize the econ-
omy, the public was allowed to hold minority shares in banks since the nineties.
Now China has dozens of joint-stock, commercial, and rural banks. Foreign banks
are also allowed to open branches in China. Since the global financial crisis, the
Chinese banking sector has had the largest assets among other nations of the world.
The main mandate of the People’s Bank of China is to maintain the stability of
the value of the currency, reduce overall risk and promote stability of the financial
system to enhance economic growth. The PBoC reports to the Standing Committee
of the National People’s Congress. The Monetary Policy Committee (MPC) consists
of 13 members comprising of the PBoC’s governor, two deputy governors, and key
representatives of various government institutions. This reduces the independence
of the PBoC from the government.
The MPC convenes on a quarterly basis to make monetary policy decisions.
Interest rates and reserve requirements are the main policy tools used by the
MPC. In terms of reserve requirements, the PBoC has a notoriously high reserve
requirement that sometimes reaches 18–20%. It is set that high to wipe up liquid-
ity in the market and to avoid inflationary pressures. Interest rates have histori-
cally been regulated and lending rates were held artificially low in order to pro-
vide cheap credit to Chinese investors. The PBoC held a three-percentage point
gap between deposit and lending rates, guaranteeing banks easy profits when
turning deposits into loans. But the PBoC has been slowly liberalizing interest
rates since the turn of the century. While it still continues to publish benchmark
deposit and lending rates, the People’s Bank of China has now set banks free and
allowed them to pay depositors whatever interest they like. This will increase
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competition and incentives to the banking sector to create new products in order
to increase their profits. While this is expected to take the Chinese banking sec-
tor a step closer to Western banks, the PBoC remains one of the least indepen-
dent central banks.
Structure and Independence of Central Banks

of Emerging Market Economies
Emerging markets economies (EMEs) are those economies of Asia, Latin
America, and Eastern Europe that are growing at a fast rate and are experiencing
booming industrialization and increased exports. To cater to their rapid macro-
economic growth, the financial markets and banking sectors of EMEs are swiftly
maturing. For this reason, central banks of EMEs assume a more complex role
in comparison to their counterparts in industrial nations. In addition to the tra-
ditional central banking functions discussed earlier in this chapter—monetary
policy, bank supervision and regulation, and overseeing the payments system—
central banks of EMEs vigorously build and reform the financial infrastructure of
their countries, continuously develop their financial markets, and directly help
with macroeconomic development. Moreover, central banks of EMEs manage for-
eign exchange reserves and implement policies that also help promote growth and
exports. Thus, most of the foreign exchange decisions are taken in collaboration
with the government.
Among the largest and most successful central banks in EMEs are the Reserve
Bank of India (RBI), the South African Reserve Bank, Banco do Brasil, and Bank
Negara Malaysia. In the wake of the banking crises that occurred in most of these
nations at the end of the last century, these central banks have managed to success-
fully reform their banking sectors and supervise them to avoid any further banking
crises. Indeed, such reforms from the central banks have sheltered EMEs from con-
tagion during the global financial crisis.
The main developmental roles that central banks of EMEs assume are enhanc-
ing credit flow to productive fast-growing export-oriented industries and employ-
ment intensive sectors, mainly agriculture and small and micro and enterprises.
They also subsidize banks when they make affordable housing and education loans.
Since the agricultural sectors of EMEs are underbanked, their central banks try to
increase access to affordable financial services, promote financial education and lit-
eracy, and support small local, rural, and cooperative banks. All of these strategies
are known as financial inclusion policies. To achieve these development roles,
often the central banks coordinate monetary policy decisions with fiscal agents.
As such, central banks in EMEs have less independence because many decisions
regarding foreign exchange, developing financial institutions and markets, and
extending loans to priority regions and sectors need to be made jointly with the
government.
Central Banks Independence

During the last four decades, both theory and empirical evidence have suggested
that the more independent a central bank the more effective monetary policy is.
There are two key dimensions of central bank independence. The first dimension
M09_MISH9547_10_GE_C09.indd 238 06/07/23 2:28 PM

is goal independence, the ability of the central bank to set the goals of monetary
policy. The second dimension is instrument independence, the ability of the cen-
tral bank to set monetary policy instruments. The degree of independence of central
banks depends largely on the preferences and circumstances of each nation.
The Case for Independence

The strongest argument for an independent central bank rests on the view that sub-
jecting it to more political pressures, mainly before elections, would impart an infla-
tionary bias to monetary policy. This is apt to lead to a political business cycle, in
which these expansionary monetary policies are reversed after the election to limit
inflation, unnecessarily leading to macroeconomic instability or booms and busts.
Another argument for central bank independence is that the public not only
generally distrusts politicians in regard to making politically motivated decision, but
also due to their lack of expertise in conducting monetary policy. According to the
principal-agent problem that we discussed in Chapter 7, both politicians and the
central bank have incentives to act in their own interest rather than that of the pub-
lic. Yet, the principal–agent problem is worse for politicians who have fewer incen-
tives to act in favor of public interest.
Third, politicians often opt for more central bank independence, especially when
there is disagreement between policymakers regarding unpopular macroeconomic
decisions. In this case, politicians can grant more independence to the central bank
in order to avoid public criticism. This was the case in many EMEs that were forced
to float or liberalize their domestic currencies in order to gain integration with global
financial markets. While this was definitely in the long-run public interest, central
banks took the blame for the massive inflationary pressures due to higher costs of
imported commodities.
The Case Against Independence

The main argument against central bank independence is that macroeconomic sta-
bility can be best achieved if monetary policy is properly coordinated with fiscal
policy. Since the government is generally responsible for the macroeconomic per-
formance of the country, opponents of independence argue that it must have some
degree of control over monetary policy.
Opponents also argue that central banks are not necessarily immune from politi-
cal pressures. The theory of bureaucratic behavior suggests that the objective of
a bureaucracy is to maximize its own welfare, akin to consumer’s behavior that aims
at maximizing personal welfare. Thus, the central bank can pursue a course of nar-
row self-interest to increase its power and prestige at the expense of public interest.
The Trend Toward Greater Independence

The high correlation between macroeconomic and price stability on the one hand
and central bank independence on the other hand has led to a remarkable trend
to enhance central bank independence globally. Many of the aforementioned draw-
backs have been tackled. In order to ensure that central banks do not deviate from
the overall socioeconomic goals of the nation, most central banks have been made
accountable to their parliaments and are required to become more transparent
M09_MISH9547_10_GE_C09.indd 239 06/07/23 2:28 PM

about their operations by publishing minutes of their decisive meetings and commu-
nicating their policies to the public. Also, after the Global Financial Crisis, fiscal and
monetary agents are increasingly coordinating their policies and decisions.
While the Federal Reserve has historically been more independent than
almost all other central banks, the structure and the level of political indepen-
dence of the European Central Bank make it even more independent. Even cen-
tral banks that have been traditionally subject to the intervention of the ministry
of finance, such as the Bank of England and the Bank of Japan, have been granted
more independence in the nineties of last century.
As for the central banks’ functions of bank regulation and supervision, the
Bank of England is among the most independent central banks in the world.
The Bank of England has formed the Financial Policy Committee and has simply
invited a nonvoting member from the U.K. Treasury. Conversely, the US Financial
Stability Oversight Council comprises all of the principal regulators as members
and the Secretary of the Treasury as chairman.
SUMMARY
1. The oldest central bank in the world, the Sveriges 5. Brexit refers to the United Kingdom’s intended
Riksbank or the Bank of Sweden, was established withdrawal from the EU in the wake of a 51.9%
in 1668. The establishment of the Bank of England referendum vote on June 23, 2016. A hard Brexit
(BoE) in 1694 marks the de facto origin of central arrangement—or no exit agreement with the
banking since the BoE was the architype for central EU—would likely see the United Kingdom give
banks that were created in Europe during the eigh- up full access to the single market and would
teenth and nineteenth centuries. also no longer enable financial firms to keep their
2. The European Central Bank (ECB) came into exis- “passporting” rights to sell services and operate
tence on June 1, 1998 in order to handle the tran- branches freely in the United Kingdom without
sitional issues of the nations that comprise the the authorization of BoE. A soft Brexit arrange-
Eurozone. The euro area or zone is an economic ment would leave the United Kingdom’s relation-
and monetary union comprising of the member states ship with the EU as close as possible to the exist-
of the European Union (EU) that have adopted the ing arrangements.
euro as their currency. As of 2017, 19 countries out 6. The Federal Reserve System (the Fed) is the
of the 28 member states of the European Union have most influential central bank in the world. It con-
joined the euro area. The Eurosystem comprises the sists of The Federal Reserve Board of Governors,
ECB and the National Central Banks (NCBs) of those the Federal Open Market Committee (FOMC), 12
EU member states that have adopted the euro. regional Federal Reserve banks, member banks,
3. The three main decision-making bodies of the ECB the Board of Governors, and the Federal Advisory
are the Governing Council, the Executive Board, Council.
and the General Council. The Governing Council is 7. Emerging markets economies (EMEs) are fast
the chief decision-making body of the ECB respon- growing export-oriented economies in Asia, Latin
sible for formulating monetary policy. The Executive America, and Eastern Europe. Their financial
Board is responsible for the day-to-day operations markets and banking sectors are swiftly matur-
and management of the ECB and the Eurosystem. ing. Central banks of EMEs assume more com-
The main task of the General Council is to encourage plex roles: monetary policy, bank supervision and
cooperation between the NCBs of the EU. regulation, and overseeing the payments system,
4. The Bank of England is governed by the Court of building reform the financial infrastructure of
Directors. The Monetary Policy Committee (MPC) their countries, developing the financial mar-
is responsible for conducting monetary policy in the kets, and directly helping with macroeconomic
United Kingdom. development.
M09_MISH9547_10_GE_C09.indd 240 06/07/23 2:28 PM

8. Both theory and empirical evidence have suggested goal independence and instrument independence.
that the more independent the central bank the bet- The structure and the charter of the ECB make it the
ter the effectiveness of monetary policy. There are most independent bank of the world.
two key dimensions of central bank independence:
KEY TERMS
Brexit, p. 227 Federal Reserve System (FRS), quantitative easing, p. 231
emerging market economies, p. 238 p. 232 the Executive Board of the ECB,
Euro area or zone, p. 240 financial inclusion policies, p. 238 p. 230
European System of Central Banks goal independence, p. 239 the General Council of the ECB, p. 230
(ESCB), p. 227 instrument independence, p. 239 the Governing Council of the ECB,
Eurosystem, p. 227 political business cycle, p. 239 p. 229
QUESTIONS AND PROBLEMS

1. Should central banks be privately or publicly owned? a central bank. Do you think that the interest rate
Explain. should be set based on judgment or by increased use
2. How will growth impact the structure of the of formal econometric analysis?
European Central Bank’s (ECB) decision-making 10. Usually people welcome actions that maintain
bodies? effective communication and promote transparency,
3. In what ways can the national central banks influ- particularly when these involve public or quasi-
ence the conduct of monetary policy? public institutions. When would a more transparent
communication strategy be detrimental to central
4. Why is the European Central Bank (ECB) governed
banks objectives?
by three different bodies?
5. Why have some countries rejected the single c urrency 11. Why might eliminating the central bank’s indepen-
despite being full members of the European Union? dence lead to a more pronounced political business
cycle?
6. Compare the structure and independence of the
European System of Central Banks and the Federal 12. William does not feel comfortable with the current
Reserve System. level of the European Central Bank’s independence.
Put yourself in William’s shoes and state an argument
7. What are the expected consequences of Brexit on against the current level of the European Central
the Bank of England? Bank’s independence.
8. The structure and the policy of the People’s Bank of
13. How would you argue in favor of the current trend
China (PBoC) differentiate it from traditional models
toward central banks’ independence?
of central banking systems. What are the main dif-
ferences? What are the consequences of the PBoC 14. The independence of the central bank has meant
system for other economies? that it takes the long view and not the short view.
9. To what extent should an interest rate be modified Is this statement true, false, or uncertain? Explain
to restore equilibrium is an important decision for your answer.
WEB EXERCISES
Structures of the Federal Reserve System and the 2. Go to https://www.ecb.europa.eu/ecb/orga/
European System of Central Banks independence/html/index.en.html. What is the
main argument used to defend the ECB’s political
1. Go to https://www.federalreserve.gov/aboutthefed.
independence?
htm. Find biographical data of members of the Board
of Governors by following the link on their names.
Are there currently seven members appointed, or
are there empty seats?
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10
CHAPTER
Conduct of Monetary Policy
PREVIEW
Understanding the conduct of monetary policy is detail how the Fed and other central banks use the
important because it affects not only interest rates tools of monetary policy and what goals they establish
but also the level of economic activity and hence our for monetary policy. Then we look at how central
well-being. To explore this subject, we look first at banks conduct monetary policy to achieve these
how the Fed affects liquidity in the banking system, goals, with the hope that it will give us some clues to
thereby affecting interest rates. Then we examine in where monetary policy may head in the future.
242
M10_MISH9547_10_GE_C10.indd 242 06/07/23 11:32 AM

Chapter 10 Conduct of Monetary Policy 243
ow Fed Actions Affect Reserves

H
in the Banking System
All banks have an account at the Fed in which they hold deposits. Reserves con-
sist of deposits at the Fed plus currency that is physically held by banks (called
vault cash because it is stored in bank vaults). Reserves are assets for the banks but
liabilities for the Fed because the banks can demand payment on them at any time
and the Fed is obliged to satisfy its obligation by paying with Federal Reserve notes.
The amount of reserves in the banking system is important because these reserves
can be lent out, and thus when the Fed takes actions to increase these reserves, it
increases liquidity in the banking system.
Total reserves can be divided into two categories: reserves that the Fed requires
banks to hold (required reserves) and any additional reserves the banks choose to
hold (excess reserves). For example, the Fed imposes regulations, called reserve
requirements, making it obligatory for banking institutions to keep a certain frac-
tion of their deposits as reserves with the Fed. For example, the Fed might require
that for every dollar of deposits at a depository institution, a certain fraction (say,
10 cents) must be held as reserves. This fraction (10%) is called the required
reserve ratio.
The Fed injects reserves into the banking system in two ways, through open
market operations, the central bank’s purchase or sale of securities in the open
market, or by making loans to banks, which are referred to as discount loans.
Open Market Operations

Open market operations are the primary determinant of changes in reserves in the
banking system. Federal Reserve purchases and sales of bonds are always done
with primary dealers, government securities dealers who operate out of private
banking institutions. To see how open market operations work, we need to look at
what happens to the Fed’s balance sheet, its holdings of assets and liabilities. To
understand how these actions affect the Fed’s balance sheet, we use a tool called a
T-account. A T-account is a simplified balance sheet, with lines in the form of a T,
that lists only the changes that occur in balance sheet items starting from some ini-
tial balance sheet position. Let’s use T-accounts to examine what happens when the
Fed conducts an open market purchase in which $100 million of bonds are bought
from primary dealers.
When the primary dealer sells the $100 million of bonds to the Fed, the Fed
adds $100 million to the dealer’s deposit account at the Fed, so that reserves in the
banking system go up by $100 million. The banking system’s T-account after this
transaction is
Banking System
Assets Liabilities
Securities −$100 m
Reserves +$100 m
(deposits at the Fed)
M10_MISH9547_10_GE_C10.indd 243 06/07/23 11:32 AM

The effect on the Fed’s balance sheet is that it has gained $100 million of securi-
ties in its assets column, whereas reserves have increased by $100 million, as shown
in its liabilities column:
Federal Reserve System

Assets Liabilities
Securities +$100 m Reserves +$100 m
As you can see, the result of the Fed’s open market purchase is an expansion
of the Fed’s balance sheet with an increase in both its holdings of securities and
reserves. The size of the banking system’s balance sheet has not changed, with total
assets remaining the same. However, the banking system’s holdings of deposits at
the Fed has increased, and since these can be lent out, liquidity in the banking sys-
tem has increased.
Another way of looking at what has happened is to recognize that open market
purchases of bonds expand reserves because the central bank pays for the bonds
with reserves. An open market purchase leads to an expansion of reserves
in the banking system.
Similar reasoning indicates that when a central bank conducts an open mar-
ket sale, reserves in the banking system fall because primary dealers pay for these
bonds with their deposits held at the Fed (reserves). Thus, an open market sale
leads to a contraction of reserves in the banking system.
GO
ONLINE
Discount Lending
Access www.federalreserve. Open market operations are not the only way the Federal Reserve can affect the
gov/releases/h3/ and view amount of reserves.
historic and current data on
the aggregate reserves of
Reserves are also changed when the Fed makes a discount loan to a bank, also
depository institutions and the referred to as borrowings from the Fed, or alternatively, as borrowed reserves.
monetary base. During normal times, the Fed makes loans only to banking institutions and the
interest rate charged banks for these loans is called the discount rate. (As we will
discuss later in the chapter, during the recent financial crisis, the Fed made loans to
other financial institutions.)
For example, suppose that the Fed makes a $100 million discount loan to
the First National Bank. The Fed then credits $100 million to the bank’s reserve
account. The effects on the balance sheets of the banking system and the Fed are
illustrated by the following T-accounts:
Banking System Federal Reserve System

Assets Liabilities Assets Liabilities
Reserves +$100 m Loans (borrowings Discount Reserves +$100 m

from the loans +$100 m
Fed) +$100 m
We thus see that a discount loan leads to an expansion of reserves,

which can be lent out, thereby leading to an expansion of liquidity in
M10_MISH9547_10_GE_C10.indd 244 06/07/23 11:32 AM

the banking system. Similar reasoning indicates that when a bank repays its
discount loan and so reduces the total amount of discount lending, the
amount of reserves decreases along with liquidity in the banking system.
he Market for Reserves and the

T
Federal Funds Rate
We have just seen how open market operations and Federal Reserve lending affect
the balance sheet of the Fed and the amount of reserves. Now we will analyze
the market for reserves to see how the resulting changes in reserves affect the
federal funds rate, the interest rate on overnight loans of reserves from one
bank to another. The federal funds rate is particularly important in the conduct
of monetary policy because it is the interest rate that the Fed tries to influence
directly. Thus, it is indicative of the Fed’s stance on monetary policy.
Demand and Supply in the

Market for Reserves
The analysis of the market for reserves proceeds in a similar fashion to the analysis
of the bond market we conducted in Chapter 4. We derive a demand and supply
curve for reserves. Then the market equilibrium in which the quantity of reserves
demanded equals the quantity of reserves supplied determines the federal funds
rate, the interest rate charged on the loans of these reserves.
Demand Curve To derive the demand curve for reserves, we need to ask what
happens to the quantity of reserves demanded, holding everything else constant, as
the federal funds rate changes. Recall from the earlier section that the amount of
reserves can be split into two components: (1) required reserves, which equal the
required reserve ratio times the amount of deposits on which reserves are required,
and (2) excess reserves, the additional reserves banks choose to hold. Therefore,
the quantity of reserves demanded equals required reserves plus the quantity of
excess reserves demanded. Excess reserves are insurance against deposit outflows,
and the cost of holding these excess reserves is their opportunity cost, the interest
rate that could have been earned on lending these reserves out, minus the interest
rate that is earned on these reserves, ioer .
Before 2008 the Federal Reserve did not pay interest on reserves, but since the
autumn of 2008 the Fed has paid interest on excess reserves at a level that is set
at a fixed amount below the federal funds rate target and therefore changes when
the target changes. When the federal funds rate is above the rate paid on excess
reserves, ioer , as the federal funds rate decreases, the opportunity cost of holding
excess reserves falls. Holding everything else constant, including the quantity of
required reserves, the quantity of reserves demanded rises.
Consequently, the demand curve for reserves, R d , slopes downward when
the federal funds rate is above ioer , as Figure 10.1 shows. If, however, the federal
funds rate begins to fall below the interest rate paid on excess reserves ioer , banks
would not lend in the overnight market at a lower interest rate. Instead, they would
just keep on adding to their holdings of excess reserves indefinitely. The result is
that the demand curve for reserves, R d , becomes flat (infinitely elastic) at ioer in
Figure 10.1.
M10_MISH9547_10_GE_C10.indd 245 06/07/23 11:32 AM

Federal
With excess supply of
Funds Rate reserves, the federal
funds rate falls to i *ff .
id Rs
2
i ff
i ff* 1
i ff1
With excess demand

ioer for reserves, the Rd
federal funds rate
rises to i *ff .
NBR Quantity of
Reserves, R
FIGURE 10.1 Equilibrium in the Market for Reserves

Equilibrium occurs at the intersection of the supply curve R s and the demand curve R d at
point 1 and an interest rate of i ff* .
upply Curve The supply of reserves, R s , can be broken into two components:
S
the amount of reserves that are supplied by the Fed’s open market operations,
nonborrowed reserves (NBR), and the amount of reserves borrowed from the
Fed, called borrowed reserves (BR). The primary cost of borrowing from the Fed
is the interest rate the Fed charges on these loans, the discount rate ( id ). Because
borrowing federal funds from other banks is a substitute for borrowing (taking out
discount loans) from the Fed, if the federal funds rate i ff is below the discount
rate id , then banks will not borrow from the Fed and borrowed reserves will be
zero because borrowing in the federal funds market is cheaper. Thus, as long as i ff
remains below id , the supply of reserves will just equal the amount of nonborrowed
reserves supplied by the Fed, NBR, and so the supply curve will be vertical, as shown
in Figure 10.1. However, if the federal funds rate were to rise even infinitesimally
above the discount rate, banks would want to keep borrowing more and more at id
and then lending out the proceeds in the federal funds market at the higher rate,
i ff . The result is that the federal funds rate can never rise above the discount rate
and the supply curve becomes flat (infinitely elastic) at id , as shown in Figure 10.1.
Market Equilibrium Market equilibrium occurs when the quantity of reserves

demanded equals the quantity supplied, R s = R d . Equilibrium therefore occurs at
the intersection of the demand curve R d and the supply curve R s at point 1, with
an equilibrium federal funds rate of i *ff . When the federal funds rate is above the
equilibrium rate at i 2ff , more reserves are supplied than demanded (excess supply)
and so the federal funds rate falls to i *ff , as shown by the downward arrow. When the
federal funds rate is below the equilibrium rate at i 1ff , more reserves are demanded
than supplied (excess demand) and so the federal funds rate rises, as shown by the
upward arrow. (Note that Figure 10.1 is drawn so that id is above i *ff because the
M10_MISH9547_10_GE_C10.indd 246 06/07/23 11:32 AM

Federal Reserve typically keeps the discount rate substantially above the target for
the federal funds rate.)
How Changes in the Tools of Monetary

Policy Affect the Federal Funds Rate
GO Now that we understand how the federal funds rate is determined, we can examine
ONLINE how changes in the four tools of monetary policy—open market operations, discount
Access https://www.
federalreserve.gov/ lending, reserve requirements, and the interest rate paid on excess reserves—affect
monetarypolicy/ the market for reserves and the equilibrium federal funds rate. The first two tools,
openmarket.htm. This site open market operations and discount lending, affect the federal funds rate by inject-
lists historical federal funds
ing reserves into the banking system, thereby changing the supply of reserves, while
rates and discusses Federal
Reserve targets. the third tool, reserve requirements, affects the federal funds rate by changing the
demand for reserves, and the fourth tool affects the federal funds rate by changing
the interest rate paid on excess reserves.
Open Market Operations The effect of an open market operation depends on

whether the supply curve initially intersects the demand curve in its downward-
sloped section versus its flat section. Panel (a) of Figure 10.2 shows what happens
if the intersection initially occurs on the downward-sloped section of the demand
curve. We have already seen that an open market purchase leads to a greater quantity
of reserves supplied; this is true at any given federal funds rate because of the higher
Federal Step 1. An open Federal Step 1. An open

Funds Rate market purchase Funds Rate market purchase
shifts the supply shifts the supply
curve to the right . . . curve to the right . . .
id id
R1s R2s R1s R2s
1 Step 2. but the

i ff1
Step 2. federal funds
causing rate cannot fall
the federal below the interest
funds rate i ff2 2 rate paid on
to fall. reserves.
1 2
i oer R1d 1 2
i ff 5 i ff 5 ioer R1d
NBR1 NBR 2 Quantity of NBR1 NBR 2 Quantity of

Reserves, R Reserves, R
(a) Supply curve initially intersects (b) Supply curve initially intersects
demand curve in its demand curve in its flat section
downward-sloping section
FIGURE 10.2 Response to an Open Market Operation

An open market purchase increases nonborrowed reserves and hence the reserves supplied, and shifts the supply
curve from R1s to R 2s . In panel (a), the equilibrium moves from point 1 to point 2, lowering the federal funds rate from
i ff1 to i ff2 . In panel (b), the equilibrium moves from point 1 to point 2, but the federal funds rate remains unchanged,
i ff1 = i ff2 = i oer .
M10_MISH9547_10_GE_C10.indd 247 06/07/23 11:32 AM

amount of nonborrowed reserves, which rises from NBR1 to NBR2 . An open market
purchase therefore shifts the supply curve to the right from R1s to R2s and moves
the equilibrium from point 1 to point 2, lowering the federal funds rate from i 1ff to
i 2ff . The same reasoning implies that an open market sale decreases the quantity of
nonborrowed reserves supplied, shifts the supply curve to the left, and causes the
federal funds rate to rise. Because this is the typical situation—since the Fed usually
keeps the federal funds rate target above the interest rate paid on excess reserves—
the conclusion is that an open market purchase causes the federal funds rate
to fall, whereas an open market sale causes the federal funds rate to rise.
GO However, if the supply curve initially intersects the demand curve on its flat
ONLINE section, as in panel (b) of Figure 10.2, open market operations have no effect on
Access www.
frbdiscountwindow.org/ and
the federal funds rate. To see this, let’s again look at an open market purchase that
find detailed information on raises the quantity of reserves supplied, which shifts the supply curve from R1s to
the operation of the discount R2s , but now where initially i 1ff = ioer . The shift in the supply curve moves the equi-
window and data on current
and historical interest rates.
librium from point 1 to point 2, but the federal funds rate remains unchanged at ioer
because the interest rate paid on excess reserves, ioer , sets a floor for the
federal funds rate.1
Discount Lending The effect of a discount rate change depends on whether

the demand curve initially intersects the supply curve in its vertical section versus
its flat section. Panel (a) of Figure 10.3 shows what happens if the intersection
occurs in the vertical section of the supply curve so there is no discount lending
and borrowed reserves, BR, are zero. In this case, when the discount rate is lowered
by the Fed from id1 to id2 , the horizontal section of the supply curve falls, as in R2s ,
but the intersection of the supply and demand curves remains at point 1. Thus, in
this case, no change occurs in the equilibrium federal funds rate, which remains
at i 1ff . Because this is the typical situation—since the Fed now usually keeps the
discount rate above its target for the federal funds rate—the conclusion is that most
changes in the discount rate have no effect on the federal funds rate.
However, if the demand curve intersects the supply curve on its flat section, so
there is some discount lending (i.e., BR > 0), as in panel (b) of Figure 10.3, changes
in the discount rate do affect the federal funds rate. In this case, initially discount
lending is positive and the equilibrium federal funds rate equals the discount rate,
i 1ff = id1 . When the discount rate is lowered by the Fed from id1 to id2 , the horizontal
section of the supply curve R2s falls, moving the equilibrium from point 1 to point 2,
and the equilibrium federal funds rate falls from i 1ff to i 2ff ( = id2 ) in panel (b).
Reserve Requirements When the required reserve ratio increases, required

reserves increase and hence the quantity of reserves demanded increases for any
given interest rate. Thus, a rise in the required reserve ratio shifts the demand curve
to the right from R1d to R2d in Figure 10.4, moves the equilibrium from point 1 to
1
The federal funds rate can be slightly below the floor set by the interest rate paid on excess reserves
because some big lenders in the federal funds market, particularly Fannie Mae and Freddie Mac, are not
banking institutions and so cannot keep deposits in the Federal Reserve and get paid the Fed’s inter-
est rate on excess reserves. Thus if they have excess funds to lend in the federal funds market, they
may have to accept a federal funds rate lower than the interest rate the Fed pays on excess reserves.
To make sure that the federal funds rate does not fall much below the floor set by the interest rate on
excess reserves, the Federal Reserve has set up another borrowing facility, the reverse repo facility, in
which these nonbank lenders can lend to the Fed and earn an interest rate that is close to the interest
rate the Fed pays on excess reserves.
M10_MISH9547_10_GE_C10.indd 248 06/07/23 11:32 AM

Federal Federal
Step 1. Lowering
Funds Rate Funds Rate
the discount rate
shifts the supply
curve down . . .
i d1 R1s Step 1. Lowering

the discount rate
2
shifts the supply
id R2s curve down . . .
1 1
Step 2. but
i ff1
Step 2. and i ff1 5 i d1 R1s
does not lower lowers the
the federal federal
funds rate. funds rate. 2
i ff 5 i d
2 2
R2s
ioer R1d ioer BR1 R d1
BR2
NBR Quantity of NBR Quantity of
(a) No discount lending (BR 5 0) (b) Some discount lending (BR > 0)
FIGURE 10.3 Response to a Change in the Discount Rate

In panel (a) when the discount rate is lowered by the Fed from i d1 to i d2 , the horizontal section of the supply curve
falls, as in R 2s , and the equilibrium federal funds rate remains unchanged at i ff1 . In panel (b) when the discount
rate is lowered by the Fed from i d1 to i d2 , the horizontal section of the supply curve R 2s falls, and the equilibrium federal
funds rate falls from i ff1 to i ff2 as borrowed reserves increase.
Federal
Funds Rate
id R1s
Step 1. Increasing
2 the reserve require-
Step 2. and i ff2
ment causes the
the federal
demand curve to
funds rate
1 1 shift to the right . . .
rises. i ff
R2d
ioer
R1d
NBR Quantity of
Reserves, R
FIGURE 10.4 Response to a Change in Required Reserves

When the Fed raises reserve requirements, required reserves increase, which increases the
demand for reserves. The demand curve shifts from R1d to R 2d , the equilibrium moves from
point 1 to point 2, and the federal fund rate rises from i ff1 to i ff2 .
M10_MISH9547_10_GE_C10.indd 249 06/07/23 11:32 AM

point 2, and in turn raises the federal funds rate from i 1ff to i 2ff . The result is that
when the Fed raises reserve requirements, the federal funds rate rises.
Conversely, a decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left, and causes the federal funds rate to
fall. When the Fed decreases reserve requirements, the federal funds rate
falls.
Interest on Excess Reserves The effect of a change in the interest rate the Fed
pays on excess reserves depends on whether the supply curve intersects the demand
curve in its downward-sloping versus its flat section. Panel (a) of Figure 10.5 shows
what happens if the intersection occurs on the demand curve’s downward-sloping
section, where the equilibrium federal funds rate is above the interest rate paid on
excess reserves. In this case, when the interest rate on excess reserves is raised
from ioer1 2 , the horizontal section of the demand curve rises, as in R d, but the
to ioer 2
intersection of the supply and demand curves remains at point 1. However, if the
supply curve intersects the demand curve on its flat section, where the equilibrium
federal funds rate is at the interest rate paid on excess reserves, as in panel (b) of
Figure 10.5, a rise in the interest rate on excess reserves from ioer
1 to i 2 moves the
oer
equilibrium to point 2, where the equilibrium federal funds rate rises from i 1ff = ioer
1
to i 2ff = ioer
2 . When the federal funds rate is at the interest rate paid on
excess reserves, a rise in the interest rate on excess reserves raises the
federal funds rate. Conversely, in this situation, a fall in the interest rate paid
on excess reserves lowers the federal funds rate.
Federal Federal
Funds Rate Funds Rate
id Rs id Rs
Step 1. A rise in Step 1. A rise in
the interest rate the interest rate
on reserves from on reserves from
1 2 1 2
ioer to ioer ... ioer to ioer ...
Step 2. leaves Step 2. raises
the federal the federal 2 2 2
i ff1 1 iff = ioer R2d
funds rate funds rate to
2
unchanged. i oer R2d 2 2 .
iff 5 ioer
1 1
1 iff = ioer R1d
ioer R1d 1
NBR Quantity of NBR Quantity of

1 1 1 1
(a) Initial iff > ioer (b) Initial iff = ioer
FIGURE 10.5 Response to a Change in the Interest Rate on Excess Reserves

In panel (a) when the equilibrium federal funds rate is above the interest rate paid on excess reserves, a rise in the
interest rate on excess reserves from i oer
1 to i 2 raises the horizontal section of the demand curve, as in R d , but
oer 2
the equilibrium federal funds rate remains unchanged at i ff1 . In panel (b) when the equilibrium federal funds rate
is at the interest rate paid on excess reserves, a rise in the interest rate on excess reserves from i oer
1 to i 2 raises the
oer
equilibrium federal funds rate i ff = i oer to i ff = i oer .
1 1 2 2
M10_MISH9547_10_GE_C10.indd 250 06/07/23 11:32 AM

CASE
How the Federal Reserve’s Operating Procedures Limit Fluctuations in

the Federal Funds Rate
An important advantage of the Fed’s current procedures for operating the discount
window and paying interest on excess reserves is that they limit fluctuations in the
federal funds rate. We can use our supply-and-demand analysis of the market for
reserves to see why.
Suppose that initially the equilibrium federal funds rate is at the federal funds
rate target of i *ff in Figure 10.6. If the demand for reserves has a large unexpected
increase, the demand curve would shift to the right to R d ″, where it now intersects
the supply curve for reserves on the flat portion where the equilibrium federal funds
rate, i ″ff , equals the discount rate, id . No matter how far the demand curve shifts to
the right, the equilibrium federal funds rate, i ″ff , will stay at id because borrowed
reserves will just continue to increase, matching the increase in demand. Similarly, if
the demand for reserves has a large unexpected decrease, the demand curve would
shift to the left to R d′ , and the supply curve intersects the demand curve on its flat
portion where the equilibrium federal funds rate, i ′ff , equals the interest rate paid
on excess reserves ioer . No matter how far the demand curve shifts to the left, the
equilibrium federal funds rate i ′ff will stay at ioer because excess reserves will just
Step 1. A rightward shift

of the demand curve
Federal raises the federal funds
Funds Rate R d′ R d* R d″ rate to a maximum of
the discount rate.
i ″ff 5 id Rs
Step 2. A leftward
shift of the demand
curve lowers the
federal funds rate
to a minimum of i ff*
the interest rate on
reserves.
i ′ff 5 ioer
NBR* Quantity of
Reserves, R
FIGURE 10.6 How the Federal Reserve’s Operating Procedures Limit Fluctuations
in the Federal Funds Rate
A shift to the right in the demand curve for reserves to R d ″ will raise the equilibrium
federal funds rate to a maximum of i ff″ = i d while a shift to the left of the demand curve
to R d ′ will lower the federal funds rate to a minimum of i ff′ = i oer .
M10_MISH9547_10_GE_C10.indd 251 06/07/23 11:33 AM

keep on increasing so that the quantity demanded of reserves equals the quantity of
nonborrowed reserves supplied.2
Our analysis therefore shows that the Federal Reserve’s operating proce-
dures limit the fluctuations of the federal funds rate to between i oer and
i d . If the range between ioer and id is kept narrow enough, then the fluctuations
around the target rate will be small.
Conventional Monetary Policy Tools

During normal times, the Federal Reserve uses four tools of monetary policy—
open market operations, discount lending, reserve requirements, and paying
interest on excess reserves—to control the interest rates, and these are referred
to as conventional monetary policy tools. We will look at each of them in turn
to see how the Fed wields them in practice and how relatively useful each tool is.

Before the global financial crisis, open market operations were the primary mone-
tary policy tool used by the Fed to set interest rates before the global financial crisis
of 2007–2009. Open market operations are of two types: Dynamic open market
operations are intended to change the level of reserves and defensive open
market operations are intended to offset movements in other factors that affect
reserves. The Fed conducts open market operations in U.S. Treasury and govern-
ment agency securities, especially U.S. Treasury bills. The Fed conducts most of its
open market operations in Treasury securities because the market for these secu-
rities is the most liquid and has the largest trading volume. It has the capacity to
absorb the Fed’s substantial volume of transactions without experiencing excessive
price fluctuations that would disrupt the market.
GO As we saw in Chapter 9, the decision-making authority for open market opera-
ONLINE tions is the Federal Open Market Committee (FOMC), which sets a target for the
Access www.federalreserve.
gov/fomc for a discussion
federal funds rate. The actual execution of these operations, however, is conducted
about the Federal Open Market by the trading desk at the Federal Reserve Bank of New York. The best way to see
Committee, list of current how these transactions are executed is to look at a typical day at the trading desk,
members, meeting dates, and
located in a newly built trading room on the ninth floor of the Federal Reserve Bank
other current information.
of New York, whose operations are described by the Inside the Fed box “A Day at
the Trading Desk.”
Temporary open-market operations are the main way the Fed affects reserves in
the banking system, and they are of two basic types. In a repurchase agreement
(often called a repo), the Fed purchases securities with an agreement that the
seller will repurchase them in a short period of time, anywhere from one to fifteen
days from the original date of purchase. Because the effects on reserves of a repo
are reversed on the day the agreement matures, a repo is actually a temporary open
market purchase and is an especially desirable way of conducting a defensive open
market purchase that will be reversed shortly. When the Fed wants to conduct a
2
Note that, as discussed in footnote 1, the federal funds rate can be slightly below the floor of the inter-
est rate paid on excess reserves.
M10_MISH9547_10_GE_C10.indd 252 06/07/23 11:33 AM

INSIDE THE FED

A Day at the Trading Desk
The manager of domestic open market operations trade in over the course of the day. They also call the
supervises the analysts and traders who execute the Treasury to get updated information on the expected
purchases and sales of securities in the drive to hit the level of Treasury balances at the Fed to refine their
federal funds rate target. To get a grip on what might estimates of the supply of reserves.
happen in the federal funds market that day, her Members of the Monetary Affairs Division at the
workday starts early in the morning, around 7:30 a.m., Board of Governors are then contacted, and the New
when her staff begins with a review of developments in York Fed’s forecasts of reserve supply and demand are
the federal funds market the previous day and with an compared with the Board’s. On the basis of these pro-
update on the actual amount of reserves in the bank- jections and the observed behavior of the federal funds
ing system the day before. Then her staff produces market, the desk will formulate and propose a course
updated reports that contain detailed forecasts of what of action to be taken that day, which may involve plans
will be happening to some of the short-term factors to add reserves to or drain reserves from the banking
affecting the supply and demand of reserves. system through open market operations. If an opera-
This information will help the manager of domestic tion is contemplated, the type, size, and maturity will
open market operations and her staff decide how large be discussed.
a change in nonborrowed reserves is needed to reach About 9 a.m., a daily conference call takes place
the federal funds rate target. If the amount of reserves linking the desk with the Office of the Director of
in the banking system is too large, many banks will Monetary Affairs at the Board of Governors and with
have excess reserves to lend that other banks may one of the four voting Reserve Bank presidents outside
have little desire to hold, and the federal funds rate of New York. During the call, a member of the open
will fall. If the level of reserves is too low, banks market operations unit will outline the desk’s proposed
seeking to borrow reserves from the few banks that reserve management strategy for the day. After the
have excess reserves to lend may push the funds rate plan is approved, it is announced to the markets at
higher than the desired level. Also during the morn- 9:30 a.m. and the desk is instructed to execute im-
ing, the staff will monitor the behavior of the federal mediately any temporary open market operations that
funds rate and contact some of the major participants were planned for that day.
in the funds market, which may provide independent At times, the desk may see the need to address
information about whether a change in reserves is a persistent reserve shortage or surplus and wish to
needed to achieve the desired level of the federal arrange an operation that will have a more perma-
funds rate. nent impact on the supply of reserves. This opera-
Members of the manager’s staff also contact tion, referred to as an outright operation, involves a
several representatives of the primary dealers that the straightforward purchase or sale of securities that is
open market desk trades with. Her staff finds out how not self-reversing, and it is traditionally executed later
the dealers view market conditions to get a feel for in the day when temporary operations are not being
what may happen to the prices of the securities they conducted.
temporary open market sale, it engages in a matched sale–purchase transaction

(sometimes called a reverse repo), in which the Fed sells securities and the buyer
agrees to sell them back to the Fed in the near future.
Discount Policy and the Lender of Last Resort

The facility at which banks can borrow reserves from the Federal Reserve is called
the discount window. The easiest way to understand how the Fed affects the vol-
ume of borrowed reserves is by looking at how the discount window operates.
M10_MISH9547_10_GE_C10.indd 253 06/07/23 11:33 AM

Operation of the Discount Window The Fed’s discount loans to banks are
of three types: primary credit, secondary credit, and seasonal credit.3 Primary
credit is the discount lending that plays the most important role in monetary
policy. Healthy banks are allowed to borrow all they want at very short maturities
(usually overnight) from the primary credit facility, and it is therefore referred to
as a standing lending facility. The interest rate on these loans is the discount
rate, and as we mentioned before, it is set higher than the federal funds rate target,
usually by 100 basis points (one percentage point) because the Fed prefers that
banks borrow from each other in the federal funds market so that they continually
monitor each other for credit risk. As a result, in most circumstances the amount of
discount lending under the primary credit facility is very small. If the amount is so
small, why does the Fed have this facility?
The answer is that the facility is intended to be a backup source of liquidity for
sound banks so that the federal funds rate never rises too far above the federal funds
target set by the FOMC. We have already seen how this works in Figure 10.6. When
the demand for reserves has a large unexpected increase, no matter how far the
demand curve shifts to the right, the equilibrium federal funds rate i ″ff will stay at id
because borrowed reserves will just continue to increase, and the federal funds rate
can rise no further. The primary credit facility has thus put a ceiling on the federal
funds rate at id .
Secondary credit is given to banks that are in financial trouble and are expe-
riencing severe liquidity problems. The interest rate on secondary credit is set at
50 basis points (0.5 percentage point) above the discount rate. The interest rate on
these loans is set at a higher, penalty rate to reflect the less-sound condition of these
borrowers. Seasonal credit is given to meet the needs of a limited number of small
banks in vacation and agricultural areas that have a seasonal pattern of deposits.
The interest rate charged on seasonal credit is tied to the average of the federal
funds rate and certificate of deposit rates. The Federal Reserve has questioned the
need for the seasonal credit facility because of improvements in credit markets and
is thus contemplating eliminating it in the future.
Lender of Last Resort In addition to its use as a tool to influence the amount of
reserves and interest rates, discounting is important in preventing and coping with
financial panics. When the Federal Reserve System was created, its most important
role was intended to be lender of last resort; to prevent bank failures from spinning
out of control, it was to provide reserves to banks when no one else would, thereby
preventing bank and financial panics. Discounting is a particularly effective way to
provide reserves to the banking system during a banking crisis because reserves are
immediately channeled to the banks that need them most.
Using the discount tool to avoid financial panics by performing the role of lender
of last resort is an extremely important requirement of successful monetary policy
making. Financial panics can severely damage the economy because they interfere
3
The procedures for administering the discount window were changed in January 2003. The primary
credit facility replaced an adjustment credit facility whose discount rate was typically set below market
interest rates, so banks were restricted in their access to this credit. In contrast, now healthy banks
can borrow all they want from the primary credit facility. The secondary credit facility replaced the
extended credit facility, which focused somewhat more on longer-term credit extensions. The seasonal
credit facility remains basically unchanged.
M10_MISH9547_10_GE_C10.indd 254 06/07/23 11:33 AM

with the ability of financial intermediaries and markets to move funds to people with
productive investment opportunities (as discussed in Chapter 8).
Unfortunately, the discount tool has not always been used by the Fed to prevent
financial panics, as the massive failures during the Great Depression attest. The Fed
learned from its mistakes of that period and has performed admirably in its role of
lender of last resort in the post–World War II period. The Fed has used its discount
lending weapon several times to avoid bank panics by extending loans to troubled
banking institutions, thereby preventing further bank failures.
At first glance, it might seem that the presence of the FDIC, which insures
depositors up to a limit of $250,000 per account from losses due to a bank’s failure,
would make the lender-of-last-resort function of the Fed superfluous. This is not
the case for two reasons. First, it is important to recognize that the FDIC’s insur-
ance fund amounts to about 1% of the amount of these deposits outstanding. If a
large number of banks failed, the FDIC would not be able to cover all the deposi-
tors’ losses. Indeed, the large number of bank failures in the 1980s and early 1990s
led to large losses and a shrinkage in the FDIC’s insurance fund, which reduced
the FDIC’s ability to cover depositors’ losses. This fact has not weakened the confi-
dence of small depositors in the banking system because the Fed has been ready to
stand behind the banks to provide whatever reserves are needed to prevent bank
panics. Second, the $1.7 trillion of large-denomination deposits in the banking sys-
tem are not guaranteed by the FDIC because they exceed the $250,000 limit. A
loss of confidence in the banking system could still lead to runs on banks from the
large-denomination depositors, and bank panics could still occur despite the exis-
tence of the FDIC. The importance of the Federal Reserve’s role as lender of last
resort is, if anything, more important today because of the high number of bank
failures experienced in the 1980s and early 1990s and during the financial crisis of
2007–2009. Not only can the Fed be a lender of last resort to banks, but it can also
play the same role for the financial system as a whole. The existence of the Fed’s
discount window can help prevent and cope with financial panics that are not trig-
gered by bank failures, as was the case during the global financial crisis from 2007
through 2009.
Although the Fed’s role as the lender of last resort has the benefit of preventing
bank and financial panics, it does have a cost. If a bank expects that the Fed will
provide it with discount loans when it gets into trouble, it will be willing to take on
more risk knowing that the Fed will come to the rescue. The Fed’s lender-of-last-
resort role has thus created a moral hazard problem similar to the one created by
deposit insurance (discussed in Chapter 18): Banks take on more risk, thus expos-
ing the deposit insurance agency, and hence taxpayers, to greater losses. The moral
hazard problem is most severe for large banks, which may believe that the Fed and
the FDIC view them as “too big to fail”; that is, they will always receive Fed loans
when they are in trouble because their failure would be likely to precipitate a bank
panic.
Similarly, Federal Reserve actions to prevent financial panic may encourage
financial institutions other than banks to take on greater risk. They, too, expect
the Fed to ensure that they could get loans if a financial panic seems imminent.
When the Fed considers using the discount weapon to prevent panics, it therefore
needs to consider the trade-off between the moral hazard cost of its role as lender
of last resort and the benefit of preventing financial panics. This trade-off explains
why the Fed must be careful not to perform its role as lender of last resort too
frequently.
M10_MISH9547_10_GE_C10.indd 255 06/07/23 11:33 AM

Reserve Requirements
Changes in reserve requirements affect the demand for reserves: A rise in reserve
requirements means that banks must hold more reserves, and a reduction means
that they are required to hold less. The Depository Institutions Deregulation
and Monetary Control Act of 1980 provided a simpler scheme for setting reserve
requirements. All depository institutions, including commercial banks, savings
and loan associations, mutual savings banks, and credit unions, are subject to the
same reserve requirements: Up until March 2020, required reserves on all check-
able deposits—including non–interest-bearing checking accounts, NOW accounts,
super-NOW accounts, and automatic transfer savings (ATS) accounts—were equal
to zero for the first $16.9 million of a bank’s checkable deposits, 3% on check-
able deposits from $16.9 to $127.5 million, and 10% on checkable deposits over
$127.5 million. However, since March 2020, reserve requirements have been
reduced to zero.
Interest on Excess Reserves

Because the Fed only started paying interest on excess reserves in 2008, this tool
of monetary policy does not have a long history. For the same reason that the Fed
sets the discount rate above the federal funds target—that is, to encourage bor-
rowing and lending in the federal funds market so that banks monitor each other—
the Fed to date generally has set the interest rate on excess reserves as a floor
under the federal funds target. In the aftermath of the global financial crisis, and
again following the Covid pandemic, banks accumulated huge quantities of excess
reserves, and in this situation, to increase the federal funds rate would require mas-
sive amounts of open market operations to remove these reserves from the banking
system. The interest-on-excess reserves tool came to the rescue because raising
this interest rate can instead be used to raise the federal funds rate, as is illustrated
in panel (b) of Figure 10.5. Indeed, this tool of monetary policy has become the
primary tool to control the federal funds rate.
Nonconventional Monetary Policy Tools

and Quantitative Easing
Although in normal times, conventional monetary policy tools, which raise or lower
interest rates, are enough to stabilize the economy, when the economy experiences
a full-scale financial crisis like the one we have recently experienced, conventional
monetary policy tools cannot do the job for two reasons. First, the financial system
seizes up to such an extent that it becomes unable to allocate capital to productive
uses, and so investment spending and the economy collapse along the lines we
discussed in Chapter 8. Second, the negative shock to the economy can lead to the
effective-lower-bound problem, in which the central bank is unable to lower the
policy interest rate (the federal funds rate for the Fed) much below zero. A nega-
tive federal funds rate well below zero would imply that banks are willing to earn
a much lower return by lending in the federal funds market than they could earn
by holding cash in their vaults, with its zero rate of return, as occurred at the end
M10_MISH9547_10_GE_C10.indd 256 06/07/23 11:33 AM

of 2008. For both of these reasons, central banks needed non–interest-rate tools,
known as nonconventional monetary policy tools, to stimulate the economy
in the wake of the global financial crisis and the Covid pandemic. These noncon-
ventional monetary policy tools take four forms: (1) liquidity provision, (2) asset
purchases, (3) forward guidance, and (4) negative interest rates on bank deposits
at a central bank.
Liquidity Provision
Because conventional monetary policy actions were not sufficient to bolster finan-
cial markets during recent financial crises and the Covid pandemic, the Federal
Reserve implemented unprecedented increases in its lending facilities to provide
liquidity to the financial markets.
1. D
iscount window expansion At the outset of the crisis in mid-August
2007 the Fed lowered the discount rate (the interest rate on loans it makes
to banks) to 50 basis points (0.50 percentage point) above the federal funds
rate target from the normal 100 basis points. It then lowered it further in
March 2008 to only 25 basis points above the federal funds rate target.
However, because bank borrowing from the discount window has a “stigma”
because it suggests that the borrowing bank may be desperate for funds and
thus in trouble, use of the discount window has proved insufficient during
crises.
2. Term auction facility To encourage borrowing by banking institutions
that avoided the stigma problem, in December 2007 the Fed set up a
temporary Term Auction Facility (TAF), in which it made loans at a rate
determined through competitive auctions. It was more widely used than
the discount window facility because it enabled banks to borrow at a rate
lower than the discount rate, and it was determined competitively, rather
than being set at a penalty rate. The TAF auctions started at amounts of
$20 billion, but as the crisis worsened, the Fed raised the amounts dra-
matically, with a total outstanding of over $400 billion. (The European
Central Bank conducted similar operations, with one auction in June 2008
of over 400 billion euros.)
3. New lending programs During the global financial crisis, the Fed broad-
ened its provision of liquidity to the financial system well outside its tra-
ditional lending to banking institutions. These actions included lending to
investment banks, as well as lending to promote purchases of commercial
paper, mortgage-backed securities, and other asset-backed securities. In
addition, the Fed engaged in lending to J.P. Morgan to assist in its purchase of
Bear Stearns and to AIG to prevent its failure. The enlargement of the Fed’s
lending programs during the 2007–2009 financial crisis was indeed remark-
able, expanding the Fed’s balance sheet by over $1 trillion by the end of
2008. During the Covid crisis, the Fed went even further in extending credit
to nonfinancial institutions. With the backing of the U.S. Treasury, it set up
facilities to lend to small businesses, corporations, and state and local gov-
ernments. The number of new programs introduced over the course of the
crisis spawned a whole new set of abbreviations, including the TAF, TSLF,
M10_MISH9547_10_GE_C10.indd 257 06/07/23 11:33 AM

PDCF, AMLF, MMIFF, CPFF, TALF, PMCCF, SMCCF, PPPLF, MLF, MSNLF,
and MSELF. These facilities are described in more detail in the Inside the Fed
box “Fed Lending Facilities During the Global Financial and Covid Crises.”
INSIDE THE FED
Fed Lending Facilities During the Global Financial and Covid Crises
During the global financial crisis and the Covid restore liquidity to different parts of the financial sys-
pandemic, the Federal Reserve became very creative tem. The new facilities, the dates they were created,
in assembling a host of new lending facilities to help and their functions are listed in the table below.
Lending Facility Date Established Function
Term Auction Facility December 12, 2007 Made borrowing from the Fed more widely used;
(TAF) extended loans of fixed amounts to banks at interest
rates that were determined by competitive auction
rather than being set by the Fed, as with normal
discount lending
Term Securities Lending March 11, 2008 Provided sufficient Treasury securities to act as
Facility (TSLF) collateral in credit markets; lent Treasury securities
to primary dealers for terms longer than overnight
against a broad range of collateral
Central Bank Liquidity March 11, 2008, and Lent dollars to foreign central banks in exchange for
Swaps March 13, 2020 foreign currencies so that these central banks can in
turn make dollar loans to their domestic banks
Loans to J.P. Morgan to buy March 14, 2008 Bought $30 billion of Bear Stearns assets through
Bear Stearns nonrecourse loans to J.P. Morgan to facilitate its
purchase of Bear Stearns
Primary Dealer Credit March 16, 2008, and Lent to primary dealers (including investment banks)
Facility (PDCF) March 17, 2020 so that they could borrow on similar terms to banks
using the traditional discount window facility
Loans to AIG September 16, 2008 Loaned $85 billion to AIG
Asset-Backed Commercial September 19, 2008 Lent to primary dealers so that they could purchase
Paper Money Market Mutual asset-backed commercial paper from money market
Fund Liquidity Facility mutual funds so that these funds could sell this paper
(AMLF) to meet redemptions from their investors
Commercial Paper Funding October 7, 2008, and Finances purchase of commercial paper from issuers
Facility (CPFF) March 23, 2020
Money Market Investor October 21, 2008 Lent to special-purpose vehicles so that they could
Funding Facility (MMIFF) buy a wider range of money market mutual fund assets
Term Asset-Backed November 25, 2008, Lent to issuers of asset-backed securities against
Securities Loan Facility and March 23, 2020 these securities as collateral to improve functioning of
(TALF) this market
Money Market Mutual Fund March 18, 2020 Lent to banks that buy money market mutual fund
Liquidity Facility (MMLF) assets
Primary Market Credit March 23, 2020 Made loans to investment-grade companies
Facility (PMCCF)
M10_MISH9547_10_GE_C10.indd 258 06/07/23 11:33 AM

Lending Facility Date Established Function
Secondary Market March 23, 2020 Purchased secondary market, investment-grade cor-
Corporate Credit Facility porate bonds
(SMCCF)
Paycheck Protection April 9, 2020 Provided credit to financial institutions that origi-
Program Liquidity Facility nate the Small Business Administration Paycheck
(PPPLF) Protection Program loans to small businesses
Municipal Liquidity Facility April 9, 2020 Purchased up to $500 billion of state and local gov-
(MLF) ernment bonds
Main Street Lending April 9, 2020 Purchased 95% participations in loans made by
Program, which includes financial institutions to small and medium-sized busi-
Main Street New Loan nesses, with the financial institution retaining 5% of
Facility (MSNLF) and Main the loan
Street Expanded Loan
Facility (MSELF)
Temporary Foreign and March 31, 2020 Provided repurchase agreements in which interna-
International Monetary tional monetary authorities temporarily exchange U.S.
Authorities (FIMA) Repo Treasury securities for U.S. dollars
Facility
Large-Scale Asset Purchases

The Fed’s open market operations normally involve only purchase of government
securities, particularly those that are short-term. However, during the crisis the Fed
started three new large-scale asset purchase programs (often referred to as LSAPs)
to lower interest rates for particular types of credit. Because, as we have seen
earlier in the chapter, a central bank’s asset purchases lead to an expansion of its bal-
ance sheet, these asset purchase programs have been given the name quantitative
easing (QE).
1. I n November 2008 the Fed set up a Government Sponsored Entities Purchase

Program, more commonly referred to as QE1, in which the Fed eventually
purchased $1.25 trillion of mortgage-backed securities (MBS) guaranteed
by Fannie Mae and Freddie Mac. Through these purchases, the Fed hoped to
prop up the MBS market and to lower interest rates on residential mortgages
to stimulate the housing market.
2. In November 2010 the Fed announced that it would purchase $600 billion
of long-term Treasury securities at a rate of about $75 billion per month.
This purchase program, which became known as QE2 (which stands for
Quantitative Easing 2, not the Cunard cruise ship) was intended to lower
long-term interest rates. Although short-term interest rates on Treasury
securities hit a floor of zero during the global financial crisis, long-term
interest rates did not. Since investment projects have a long life, long-
term interest rates are more relevant than short-term ones to investment
decisions. The Fed’s purchase of long-term Treasuries to lower long-term
M10_MISH9547_10_GE_C10.indd 259 06/07/23 11:33 AM

interest rates could therefore help stimulate investment spending and the
economy.
3. In September 2012 the Federal Reserve announced a third
large-scale-asset-purchase program, which has become known as QE3, which
combined elements of QE1 and QE2 by conducting purchases of $40 billion
of mortgage-backed securities and $45 billion of long-term Treasuries.
However, QE3 differed in one major way from the previous QE programs in
that it was not for a fixed dollar amount but instead was open-ended, with
the purchase plan continuing “if the outlook for the labor market does not
improve substantially.”
4. At the March 15, 2020, FOMC meeting, the Fed opened a new round of
large-scale asset purchases, authorizing the purchases by at least $500 billion
of Treasury securities and $200 billion of mortgage-backed securities.
These liquidity-provision and large-scale-asset-purchase programs led to an

unprecedented quadrupling of the Federal Reserve’s balance sheet from 2008 to
2014 and then a further sharp increase in the Fed’s balance sheet starting in March
2020 (shown in Figure 10.7).
Quantitative Easing Versus Credit Easing

These quantitative easing programs resulted in an unprecedented expansion of the
Federal Reserve’s balance sheet from about $900 billion to over $4 trillion by 2015.
Then the Fed instituted similar programs in response to the Covid pandemic, lead-
ing to a further expansion to over $7 trillion in June 2020, with a further increase to
Total Federal Reserve

assets ($ trillions)
10
9
8
7
6
5
4
3
2
1
0
2007 2009 2011 2013 2015 2017 2019 2021
FIGURE 10.7 The Expansion of the Federal Reserve’s Balance Sheet During and After the
Global Financial Crisis: Total Federal Reserve Assets, 2007–2022
The size of the Federal Reserve’s balance sheet more than quadrupled in the aftermath of the global
financial crisis and then shot up again during the Covid pandemic.
Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/WALCL.
M10_MISH9547_10_GE_C10.indd 260 06/07/23 11:33 AM

nearly $9 trillion by 2022. Because this increase in reserves increases liquidity in the
banking system, enabling banks to lend more, it could be a powerful force to stimu-
late the economy and possibly produce inflation down the road.
There are reasons to be very skeptical. First, because the federal funds rate
had already hit the effective-lower-bound when it fell to zero, the expansion of the
balance sheet and the monetary base could not lower short-term interest rates any
further and thereby stimulate the economy. Second, the increase in reserves did not
result in an increase in lending because banks just added to their holdings of excess
reserves instead of making loans. A similar phenomenon seems to have occurred
when the Bank of Japan engaged in quantitative easing after the bubble burst in the
stock and real estate markets; yet not only did the economy not recover, but infla-
tion even turned negative.
Does skepticism about quantitative easing mean that the Fed’s nonconventional
monetary policy actions would be ineffective at stimulating the economy? The Fed
chair at the time, Ben Bernanke, argued that the answer is no because the Fed’s
policies were directed not at expanding the Fed’s balance sheet but rather at credit
easing—that is, altering the composition of the Fed’s balance sheet in order to
improve the functioning of particular segments of the credit markets. Indeed, Chair
Bernanke was adamant that the Fed’s policies should not be characterized as quan-
titative easing.
Altering the composition of the Fed’s balance sheet can stimulate the econ-
omy in several ways. First, when the Fed provides liquidity to a particular seg-
ment of the credit markets that has seized up, it can help unfreeze the market
and thereby enable it to allocate capital to productive uses and consequently
stimulate the economy. Second, when the Fed purchases particular securities,
it increases the demand for those securities, and as we saw in Chapter 5, it can
lower the interest rates on those securities relative to other securities. Thus, even
if short-term interest rates have hit a floor of zero, asset purchases can lower
interest rates for borrowers in particular credit markets and thereby stimulate
spending. For example, purchases of mortgage-backed securities appear to have
lowered their interest rates on these securities and led to a substantial decline in
residential mortgage rates. Purchase of long-term government securities could
also lower their interest rates relative to short-term interest rates, and because
long-term interest rates are likely to be more relevant to investment decisions,
these asset market purchases could boost investment spending. Recent research
appears to support this viewpoint, with estimates of the decline in long-term
interest rates from the Fed’s asset purchase programs on the order of 100 basis
points (one percentage point).4
Forward Guidance
Although short-term interest rates could not be driven much below zero in the after-
math of the global financial crisis, the Federal Reserve could take another route to
lower long-term interest rates, which, as we have mentioned above, would stimulate
the economy. This route involved a commitment by the Fed to keep the federal
4
See, for example, Joseph Gagnon, Mathew Raskin, Julie Remache, and Brian Sack, “Large Scale Asset
Purchases by the Federal Reserve: Did They Work?” Federal Reserve Bank of New York Economic
Policy Review, 17, no. 1 (May 2011): 41–59.
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funds rate at zero for a long period of time in order to lower the market’s expecta-
tions of future short-term interest rates, thereby causing the long-term interest rate
to fall. This strategy is referred to as forward guidance.
The Fed pursued this forward guidance strategy when it announced after its
FOMC meeting on December 16, 2008, that not only would it lower the federal funds
rate target to between zero and 0.25%, but also that “the Committee anticipates
that weak economic conditions are likely to warrant exceptionally low levels of the
federal funds rate for some time.” The Fed then continued to use this language in its
FOMC statements for several years afterward and then moved to announcing spe-
cific dates, eventually with the statement that “the exceptionally low levels of the
federal funds rate are likely to be warranted until mid-2015.” Although long-term
interest rates on Treasury securities did subsequently fall with these announce-
ments, it is not clear how much of this decline was due to the Fed’s forward guid-
ance versus weakness in the economy.
There are two types of commitments to future policy actions: conditional and
unconditional. The commitment to keep the federal funds rate at zero for an extended
period starting in 2008 was conditional because it mentioned that the decision was
predicated on a weak economy going forward. If economic circumstances changed,
the FOMC was indicating that it might abandon the commitment. Alternatively, the
Fed could have made an unconditional commitment by just stating that it would
keep the federal funds rate at zero for an extended period without indicating that
this decision was based on the state of the economy. An unconditional commitment
has the advantage of being stronger than a conditional commitment because it does
not suggest that the commitment will be abandoned and so is likely to have a larger
effect on long-term interest rates. Unfortunately, it has the disadvantage that even if
circumstances change in such a way that it would be better to abandon the commit-
ment, the Fed may feel it cannot go back on its word and do so.
The problem of an unconditional commitment is illustrated by the Fed’s experi-
ence in the 2003–2006 period. In 2003 the Fed became worried that inflation was
too low and that the probability of a deflation was significant. At the August 12,
2003, FOMC meeting, the FOMC stated, “In these circumstances, the Committee
believes that policy accommodation can be maintained for a considerable period.”
Then when the Fed started to tighten policy at its June 30, 2004, FOMC meeting, it
changed its statement to “policy accommodation can be removed at a pace that is
likely to be measured.” Then for the next ten FOMC meetings through June 2006,
the Fed raised the federal funds rate target by exactly a ¼ percentage point at every
meeting. The market interpreted the FOMC’s statements as indicating an uncon-
ditional commitment, and this is why the Fed may have been constrained not to
deviate from ¼ percentage point moves at every FOMC meeting. In retrospect, this
commitment led to monetary policy that was too easy for too long, with inflation
subsequently rising to well above desirable levels, and as discussed in Chapter 8, it
may have helped promote the housing bubble whose bursting led to such devastat-
ing consequences for the economy.
When the Fed announced a specific date for exiting from exceptionally low
rates, many market participants viewed this announcement as an unconditional
commitment, despite the Federal Reserve’s objections. To avoid the problems with
an unconditional commitment, in December 2012 the Fed changed its statement to
M10_MISH9547_10_GE_C10.indd 262 06/07/23 11:33 AM

be more clearly conditional by indicating that the “exceptionally low range for the
federal funds rate will be appropriate at least as long as the unemployment rate
remains above 6 ½ percent, inflation between one and two years ahead is pro-
jected to be no more than a half percentage point above the Committee’s 2 percent
longer-run goal, and longer-term inflation expectations continue to be well
anchored.” With the unemployment rate approaching the 6½% mark, at its March
2014 meeting the FOMC dropped forward guidance based on unemployment and
inflation thresholds. Subsequently, it announced that it would determine the tim-
ing and size of changes in the target for the federal funds rate taking “into account
a wide range of information, including measures of labor market conditions, indi-
cators of inflation pressures and inflation expectations, and readings on financial
and international developments.”
Negative Interest Rates on Banks’ Deposits

With inflation very low and their economies weak after the global financial cri-
sis, central banks in Europe and Japan recently began experimenting with a new
nonconventional monetary policy tool, setting interest rates on deposits held by
banks at their central banks to be negative. In other words, banks now had to
pay their central bank to keep deposits in the central bank. The central bank of
Sweden was the first to set negative interest rates on bank deposits in July 2009,
followed by the central bank of Denmark in July 2012, the ECB in June 2014,
the central bank of Switzerland in December 2014, and the Bank of Japan in
January 2016.
Setting negative interest rates on banks’ deposits is supposed to work to stimu-
late the economy by encouraging banks to lend out the deposits they were keeping
at the central bank, thereby encouraging households and businesses to spend more.
However, there are doubts that negative interest rates on deposits will have the
intended, expansionary effect.
First, banks might not lend out their deposits at the central bank, but instead
move them into cash. There would be some cost to doing so because banks would
have to build more vaults and hire security guards to protect the cash. Nonetheless,
they still might prefer to do this rather than lend them out.
Second, charging banks interest on their deposits might be very costly
to banks if they still have to pay positive interest rates to their depositors.
In this case, bank profitability would fall. The result might then make banks
less likely to lend. So instead of being expansionary, negative interest rates
on banks’ deposits could cause banks to cut back on lending and therefore be
contractionary.
The jury is still out on whether negative interest rates on bank deposits held
at central banks will stimulate the economy as intended. Indeed, doubts about the
effectiveness of this nonconventional monetary policy tool led Janet Yellen, the chair
of the Board of Governors of the Federal Reserve, to announce in 2016 that the Fed
was not considering using this tool to stimulate the economy. However, the Federal
Reserve’s views could change if the structure of the U.S. economy evolves, and if the
experience with negative interest rates in other countries suggested that this tool is
effective in stimulating spending.
M10_MISH9547_10_GE_C10.indd 263 06/07/23 11:33 AM

Monetary Policy Tools of the

European Central Bank
Like the Federal Reserve, the European System of Central Banks (which is usually
referred to as the European Central Bank) signals the stance of its monetary policy
by setting a target financing rate, which in turn sets a target for the overnight
cash rate. Like the federal funds rate, the overnight cash rate is the interest rate for
very short-term interbank loans. The monetary policy tools used by the European
Central Bank are similar to those used by the Federal Reserve and involve open mar-
ket operations, lending to banks, and reserve requirements.
GO
ONLINE
Access www.federalreserve. Like the Federal Reserve, the European Central Bank uses open market operations
gov/aboutthefed/. The Federal as its primary tool for conducting monetary policy and setting the overnight cash
Reserve provides links to other
central bank Web pages.
rate at the target financing rate. Main refinancing operations are the predomi-
nant form of open market operations and are similar to the Fed’s repo transactions.
They involve weekly reverse transactions (purchase or sale of eligible assets
under repurchase or credit operations against eligible assets as collateral) that
are reversed within two weeks. Credit institutions submit bids, and the European
Central Bank decides which bids to accept. Like the Federal Reserve, the European
Central Bank accepts the most attractively priced bids and makes purchases or
sales to the point where the desired amount of reserves is supplied. In contrast to
the Federal Reserve, which conducts open market operations in one location at the
Federal Reserve Bank of New York, the European Central Bank decentralizes its
open market operations by having them be conducted by the individual national
central banks.
A second category of open market operations is the longer-term refinancing
operations, which are a much smaller source of liquidity for the euro-area bank-
ing system and are similar to the Fed’s outright purchases or sales of securities.
These operations are carried out monthly and typically involve purchases or sales
of securities with a maturity of three months. They are not used for signaling the
monetary policy stance but are aimed at providing euro-area banks with additional
longer-term refinancing.
Lending to Banks
As for the Fed, the next most important tool of monetary policy for the European
Central Bank involves lending to banking institutions, which is carried out by the
national central banks, just as discount lending is performed by the individual
Federal Reserve Banks. This lending takes place through a standing lending
facility called the marginal lending facility. There, banks can borrow (against
eligible collateral) overnight loans from the national central banks at the mar-
ginal lending rate, which is set at 100 basis points above the target financing
rate. The marginal lending rate provides a ceiling for the overnight market inter-
est rate in the European Monetary Union, just as the discount rate does in the
United States.
M10_MISH9547_10_GE_C10.indd 264 06/07/23 11:33 AM

Interest on Excess Reserves

As in the United States, Canada, Australia, and New Zealand, the Eurosystem has
another standing facility, the deposit facility, in which banks are paid an interest
rate on excess reserves that is typically 100 basis points below the target financing
rate. The prespecified interest rate on the deposit facility provides a floor for the
overnight market interest rate, while the marginal lending rate sets a ceiling. The
interest rate on excess reserves set by the European Central Bank is not always
positive. As discussed above, the European Central Bank set the interest rate on
excess reserves to negative values starting in June 2014.
Reserve Requirements
Like the Federal Reserve, the European Central Bank imposes reserve require-
ments such that all deposit-taking institutions are required to hold 2% of the total
amount of checking deposits and other short-term deposits in reserve accounts with
national central banks. All institutions that are subject to minimum reserve require-
ments have access to the European Central Bank’s standing lending facilities and
participate in open market operations.
The Price Stability Goal and the Nominal Anchor

Over the past few decades, policy makers throughout the world have become
increasingly aware of the social and economic costs of inflation and more con-
cerned with maintaining a stable price level as a goal of economic policy. Indeed,
price stability, which central bankers define as low and stable inflation, is
increasingly viewed as the most important goal of monetary policy. Price stabil-
ity is desirable because a rising price level (inflation) creates uncertainty in the
economy, and that uncertainty might hamper economic growth. For example,
when the overall level of prices is changing, the information conveyed by the
prices of goods and services is harder to interpret, which complicates decision
making for consumers, businesses, and government, thereby leading to a less effi-
cient financial system.
Not only do public opinion surveys indicate that the public is hostile to inflation,
but a growing body of evidence also suggests that inflation leads to lower economic
growth.5 The most extreme example of unstable prices is hyperinflation, such as
Argentina, Brazil, and Russia have experienced in the recent past. Hyperinflation
has proved to be very damaging to the workings of the economy.
Inflation also makes it difficult to plan for the future. For example, it is more
difficult to decide how much to put aside to provide for a child’s college educa-
tion in an inflationary environment. Furthermore, inflation can strain a country’s
social fabric: Conflict might result because each group in the society may com-
pete with other groups to make sure that its income keeps up with the rising level
of prices.
5
For example, see Stanley Fischer, “The Role of Macroeconomic Factors in Growth,” Journal of
Monetary Economics 32 (1993): 485–512.
M10_MISH9547_10_GE_C10.indd 265 06/07/23 11:33 AM

The Role of a Nominal Anchor

Because price stability is so crucial to the long-run health of an economy, a central
element in successful monetary policy is the use of a nominal anchor, a nominal
variable such as the inflation rate or the money supply, which ties down the price
level to achieve price stability. Adherence to a nominal anchor that keeps the nomi-
nal variable within a narrow range promotes price stability by directly promoting
low and stable inflation expectations. A more subtle reason for a nominal anchor’s
importance is that it can limit the time-inconsistency problem, in which mon-
etary policy conducted on a discretionary, day-by-day basis leads to poor long-run
outcomes.6
The Time-Inconsistency Problem

The time-inconsistency problem is something we deal with continually in everyday
life. We often have a plan that we know will produce a good outcome in the long run,
but when tomorrow comes, we just can’t help ourselves and we renege on our plan
because doing so has short-run gains. For example, we make a New Year’s resolution
to go to bed earlier, but soon thereafter we can’t resist binge-watching one more
episode of our latest favorite show—and then another episode, and then another
episode—and the sleep deficit begins to pile back on. In other words, we find our-
selves unable to consistently follow a good plan over time; the good plan is said to
be time-inconsistent and will soon be abandoned.
Monetary policy makers also face the time-inconsistency problem. They are
always tempted to pursue a discretionary monetary policy that is more expansion-
ary than firms or people expect because such a policy would boost economic output
(or lower unemployment) in the short run. The best policy, however, is not to pur-
sue expansionary policy because decisions about wages and prices reflect workers’
and firms’ expectations about policy; when they see a central bank pursuing expan-
sionary policy, workers and firms will raise their expectations about inflation, driving
wages and prices up. The rise in wages and prices will lead to higher inflation but
will not result in higher output on average.
A central bank will have better inflation performance in the long run if it does
not try to surprise people with an unexpectedly expansionary policy but instead
keeps inflation under control. However, even if a central bank recognizes that dis-
cretionary policy will lead to a poor outcome (high inflation with no gains in output),
it still may not be able to pursue the better policy of inflation control because poli-
ticians are likely to apply pressure on the central bank to try to boost output with
overly expansionary monetary policy.
A clue to how we should deal with the time-inconsistency problem comes from
how-to books on parenting. Parents know that giving in to a child to keep him from
acting up will produce a very spoiled child. Nevertheless, when a child throws a
6
The time-inconsistency problem was first outlined in papers by Nobel Prize winners Finn Kydland
and Edward Prescott, “Rules Rather Than Discretion: The Inconsistency of Optimal Plans,” Journal of
Political Economy 85 (1977): 473–491; Guillermo Calvo, “On the Time Consistency of Optimal Policy
in the Monetary Economy,” Econometrica 46 (November 1978): 1411–1428; and Robert J. Barro and
David Gordon, “A Positive Theory of Monetary Policy in a Natural Rate Model,” Journal of Political
Economy 91 (August 1983): 589–610.
M10_MISH9547_10_GE_C10.indd 266 06/07/23 11:33 AM

tantrum, many parents give him what he wants just to shut him up. Because parents
don’t stick to their “do not give in” plan, the child expects that he will get what he
wants if he behaves badly, so he will throw tantrums over and over again. Parenting
books suggest a solution to the time-inconsistency problem (although they don’t call
it that): Parents should set behavior rules for their children and stick to them.
A nominal anchor is like a behavior rule. Just as rules help to prevent the
time-inconsistency problem in parenting by helping adults resist pursuing the discre-
tionary policy of giving in, a nominal anchor can help prevent the time-inconsistency
problem in monetary policy by providing an expected constraint on discretionary
policy.
Other Goals of Monetary Policy

Although price stability is the primary goal of most central banks, five other goals
are continually mentioned by central bank officials when they discuss the objec-
tives of monetary policy: (1) high employment, (2) economic growth, (3) stability
of financial markets, (4) interest-rate stability, and (5) stability in foreign exchange
markets.
High Employment and Output Stability

High employment is a worthy goal for two main reasons: (1) The alternative situa-
tion—high unemployment—causes much human misery, and (2) when unemploy-
ment is high, the economy has both idle workers and idle resources (closed factories
and unused equipment), resulting in a loss of output (lower GDP).
Although it is clear that high employment is desirable, how high should it be?
At what point can we say that the economy is at full employment? At first, it might
seem that full employment is the point at which no worker is out of a job—that is,
when unemployment is zero. But this definition ignores the fact that some unem-
ployment, called frictional unemployment, which involves searches by workers
and firms to find suitable matchups, is beneficial to the economy. For example, a
worker who decides to look for a better job might be unemployed for a while dur-
ing the job search. Workers often decide to leave work temporarily to pursue other
activities (raising a family, travel, returning to school), and when they decide to
reenter the job market, it may take some time for them to find the right job.
Another reason that unemployment is not zero when the economy is at full
employment is structural unemployment, a mismatch between job require-
ments and the skills or availability of local workers. Clearly, this kind of unem-
ployment is undesirable. Nonetheless, it is something that monetary policy can
do little about.
This goal for high employment is not an unemployment level of zero but a level
above zero consistent with full employment at which the demand for labor equals
the supply of labor. This level is called the natural rate of unemployment.
Although this definition sounds neat and authoritative, it leaves a troublesome
question unanswered: What unemployment rate is consistent with full employment?
In some cases, it is obvious that the unemployment rate is too high: The unemploy-
ment rate in excess of 20% during the Great Depression, for example, was clearly far
too high. In the early 1960s, on the other hand, policy makers thought that a reason-
able goal was 4%, a level that was well below more recent estimates of the natural
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rate of unemployment of around 6% for that period, with the result that when the
unemployment rate fell to 4% in the late 1960s, inflation accelerated. The natural
rate of unemployment has fallen since then, and current estimates of the natural
rate of unemployment place it around 4%. Even this estimate is subject to much
uncertainty and disagreement. It is possible, for example, that appropriate govern-
ment policy, such as the provision of better information about job vacancies or job
training programs, could decrease the natural rate of unemployment.
The high employment goal can be thought of in another way. Because the level
of unemployment is tied to the level of economic activity in the economy, a level of
output is produced at the natural rate of unemployment, which naturally enough is
referred to as the natural rate of output but is more often referred to as poten-
tial output.
Trying to achieve the goal of high employment thus means that central banks
should try to move the level of output toward the natural rate of output. In other
words, they should try to stabilize the level of output around its natural rate.
Economic Growth
The goal of steady economic growth is closely related to the high employment goal
because businesses are more likely to invest in capital equipment to increase pro-
ductivity and economic growth when unemployment is low. Conversely, if unem-
ployment is high and factories are idle, it does not pay for a firm to invest in addi-
tional plants and equipment. Although the two goals are closely related, policies can
be specifically aimed at promoting economic growth by directly encouraging firms
to invest or by encouraging people to save, which provides more funds for firms
to invest. In fact, this approach is the stated purpose of supply-side economics
policies, which are intended to spur economic growth by providing tax incentives
for businesses to invest in facilities and equipment and for taxpayers to save more.
Active debate continues over what role monetary policy can play in boosting growth.
Stability of Financial Markets

Financial crises can interfere with the ability of financial markets to channel funds
to people with productive investment opportunities and lead to a sharp contrac-
tion in economic activity. The promotion of a more stable financial system in which
financial crises are avoided is thus an important goal for a central bank. Indeed, as
discussed in Chapter 9, the Federal Reserve System was created in response to the
bank panic of 1907 to promote financial stability.
Interest-Rate Stability
Interest-rate stability is desirable because fluctuations in interest rates can create
uncertainty in the economy and make it harder to plan for the future. Fluctuations
in interest rates that affect consumers’ willingness to buy houses, for example, make
it more difficult for consumers to decide when to purchase a house and for construc-
tion firms to plan how many houses to build. A central bank may also want to reduce
upward movements in interest rates for the reasons we discussed in Chapter 9:
Upward movements in interest rates generate hostility toward central banks and
lead to demands that their power be curtailed.
The stability of financial markets is also fostered by interest-rate stability
because fluctuations in interest rates create great uncertainty for financial institu-
tions. An increase in interest rates produces large capital losses on long-term bonds
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and mortgages, losses that can cause the failure of the financial institutions hold-
ing them. In recent years, more pronounced interest-rate fluctuations have been a
particularly severe problem for savings and loan associations and mutual savings
banks, many of which got into serious financial trouble in the 1980s and early 1990s.
Stability in Foreign Exchange Markets

With the increasing importance of international trade to the U.S. economy, the value
of the dollar relative to other currencies has become a major consideration for the
Fed. A rise in the value of the dollar makes American industries less competitive
with those abroad, and declines in the value of the dollar stimulate inflation in the
United States. In addition, preventing large changes in the value of the dollar makes
it easier for firms and individuals purchasing or selling goods abroad to plan ahead.
Stabilizing extreme movements in the value of the dollar in foreign exchange mar-
kets is thus an important goal of monetary policy. In other countries, which are even
more dependent on foreign trade, stability in foreign exchange markets takes on
even greater importance.
hould Price Stability Be the Primary Goal

S
of Monetary Policy?
In the long run, no inconsistency exists between the price stability goal and the
other goals mentioned earlier. The natural rate of unemployment is not lowered
by high inflation, so higher inflation cannot produce lower unemployment or more
employment in the long run. In other words, there is no long-run trade-off between
inflation and employment. In the long run, price stability promotes economic growth
as well as financial and interest-rate stability. Although price stability is consistent
with the other goals in the long run, in the short run price stability often conflicts
with the goals of high employment and interest-rate stability. For example, when
the economy is expanding and unemployment is falling, the economy may become
overheated, leading to a rise in inflation. To pursue the price stability goal, a central
bank would prevent this overheating by raising interest rates, an action that would
initially lower employment and increase interest-rate instability. How should a cen-
tral bank resolve this conflict among goals?
Hierarchical Versus Dual Mandates

Because price stability is crucial to the long-run health of the economy, many
countries have decided that price stability should be the primary, long-run goal for
central banks. For example, the Maastricht Treaty, which created the European
Central Bank, states, “The primary objective of the European System of Central
Banks [ESCB] shall be to maintain price stability. Without prejudice to the objec-
tive of price stability, the ESCB shall support the general economic policies in the
Community,” which include objectives such as “a high level of employment” and
“sustainable and noninflationary growth.” Mandates of this type, which put the goal
of price stability first and then say that as long as it is achieved other goals can be
pursued, are known as hierarchical mandates. They are the directives governing
the behavior of central banks such as the Bank of England, the Bank of Canada, and
the Reserve Bank of New Zealand, as well as for the European Central Bank.
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In contrast, the legislation defining the mission of the Federal Reserve states,
“The Board of Governors of the Federal Reserve System and the Federal Open
Market Committee shall maintain long-run growth of the monetary and credit aggre-
gates commensurate with the economy’s long-run potential to increase production,
so as to promote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates.” Because, as we learned in Chapter 4, long-term
interest rates will be high if inflation is high, to achieve moderate long-term inter-
est rates, inflation must be low. Thus, in practice, the Fed has a dual mandate to
achieve two co-equal objectives: price stability and maximum employment.
Is it better for an economy to operate under a hierarchical mandate or a dual
mandate?
Price Stability as the Primary, Long-Run

Goal of Monetary Policy
Because no inconsistency exists between achieving price stability in the long run
and the natural rate of unemployment, these two types of mandates are not very
different if maximum employment is defined as the natural rate of unemployment.
In practice, however, a substantial difference between these two mandates could
exist because the public and politicians may believe that a hierarchical mandate
puts too much emphasis on inflation control and not enough on reducing business
cycle fluctuations.
Because low and stable inflation rates promote economic growth, central bank-
ers have come to realize that price stability should be the primary, long-run goal of
monetary policy. Nevertheless, because output fluctuations should also be a concern
of monetary policy, the goal of price stability should be seen as primary only in the
long run. Attempts to keep inflation at the same level in the short run no matter
what would likely lead to excessive output fluctuations.
As long as price stability is a long-run but not short-run goal, central banks
can focus on reducing output fluctuations by allowing inflation to deviate from the
long-run goal for short periods and, therefore, can operate under a dual mandate.
However, if a dual mandate leads a central bank to pursue short-run expansionary
policies that increase output and employment without worrying about the long-run
consequences for inflation, the time-inconsistency problem may recur. Concerns
that a dual mandate might lead to overly expansionary policy is a key reason why
central bankers often favor hierarchical mandates in which the pursuit of price sta-
bility takes precedence. Hierarchical mandates can also be a problem if they lead
to a central bank behaving as what the former Governor of the Bank of England,
Mervyn King, referred to as an “inflation nutter”—that is, a central bank that focuses
solely on inflation control, even in the short run, and so undertakes policies that
lead to large output fluctuations. The choice of which type of mandate is better for
a central bank ultimately depends on the subtleties of how it will work in practice.
Either type of mandate is acceptable as long as it operates to make price stability
the primary goal in the long run, but not the short run.
In the following section, we examine the most prominent monetary policy strat-
egy that monetary policymakers use today to achieve price stability: inflation target-
ing. This strategy features a strong nominal anchor and has price stability as the
primary, long-run goal of monetary policy.
M10_MISH9547_10_GE_C10.indd 270 06/07/23 11:33 AM

Inflation Targeting
The recognition that price stability should be the primary long-run goal of mon-
etary policy and the value of having a nominal anchor to achieve this goal have led
to a monetary policy strategy known as inflation targeting. Inflation targeting
involves several elements: (1) public announcement of medium-term numerical
targets for inflation; (2) an institutional commitment to price stability as the pri-
mary, long-run goal of monetary policy and a commitment to achieve the inflation
goal; (3) an information-inclusive approach in which many variables are used in
making decisions about monetary policy; (4) increased transparency of the mon-
etary policy strategy through communication with the public and markets about
the plans and objectives of monetary policy makers; and (5) increased account-
ability of the central bank for attaining its inflation objectives. New Zealand was the
first country to formally adopt inflation targeting in 1990, followed by Canada in
1991, the United Kingdom in 1992, Sweden and Finland in 1993, and Australia and
Spain in 1994. Israel, Chile, and Brazil, among others, have also adopted a form of
inflation targeting.7
One country that was late to the party of inflation targeting was the United
States, but this changed in January 2012, as is discussed in the Inside the Fed box
“Ben Bernanke and the Federal Reserve’s Adoption of Inflation Targeting.”
Advantages of Inflation Targeting

Inflation targeting has the key advantage that it is readily understood by the public
and is thus highly transparent. Also, because an explicit numerical inflation target
increases the accountability of the central bank, inflation targeting has the potential
to reduce the likelihood that the central bank will fall into the time-inconsistency
trap of trying to expand output and employment in the short run by pursuing overly
expansionary monetary policy. A key advantage of inflation targeting is that it can
help focus the political debate on what a central bank can do in the long run, that
is, control inflation, rather than what it cannot do, permanently increase economic
growth and the number of jobs through expansionary monetary policy. Thus, infla-
tion targeting has the potential to reduce political pressures on the central bank
to pursue inflationary monetary policy and thereby to reduce the likelihood of the
time-inconsistency problem.
The performance of inflation-targeting regimes has been quite good.
Inflation-targeting countries seem to have significantly reduced both the rate of
inflation and inflation expectations beyond what would likely have occurred in the
absence of inflation targets. Furthermore, once down, inflation in these countries
has been more likely to stay down. However, in the period from 2008 to 2020, infla-
tion had been running below the Federal Reserve’s 2% inflation objective, so the
Fed became concerned that the persistent inflation undershoots of the 2% target
7
If you are interested in a more detailed discussion of experiences with inflation targeting in these
and other countries, see Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen,
Inflation Targeting: Lessons from the International Experience (Princeton, N.J.: Princeton
University Press, 1999).
M10_MISH9547_10_GE_C10.indd 271 06/07/23 11:33 AM

INSIDE THE FED
Ben Bernanke and the Federal Reserve’s

Adoption of Inflation Targeting
Ben Bernanke, a former professor at Princeton Univer- After becoming Fed chairman, Bernanke made it
sity, became the Federal Reserve chairman in February clear that any movement toward inflation targeting
2006, after serving as a member of the Board of Gov- must result from a consensus within the Federal Re-
ernors from 2002 to 2005 and then as the chairman serve and be consistent with the dual mandate given
of the president’s Council of Economic Advisors. Ber- to the Fed by Congress. After Chairman Bernanke
nanke is a world-renowned expert on monetary policy set up a subcommittee to discuss Federal Reserve
and, while serving as an academic, wrote extensively communication, which included discussions about an-
on inflation targeting, including articles and a book nouncing a specific numerical inflation objective, the
written with the author of this text.8 FOMC made partial steps in the direction of inflation
Bernanke’s writings indicated that he was a strong targeting with its new communication strategy first
proponent of inflation targeting and increased transpar- outlined in November 2007 (with an amendment in
ency in central banks. In an important speech given at a January 2009) that provided FOMC participants’ infla-
conference at the Federal Reserve Bank of St. Louis in tion projections for one, two, and three years ahead as
2004 he described how the Federal Reserve might move well as for the longer term. The inflation projections
toward inflation targeting by announcing a numerical val- for the longer term are produced under an assumption
ue for its long-run inflation goal.9 Bernanke emphasized of “appropriate policy” and so reflect each partici-
that announcing a numerical objective for inflation would pant’s long-run inflation objective. Because the long-
be completely consistent with the Fed’s dual mandate run inflation projections of all the FOMC participants
of achieving price stability and maximum employment. ended up being close to 2%, the FOMC finally moved
Therefore, it might be called a mandate-consistent infla- to inflation targeting in January 2012 by agreeing to a
tion objective because the goal for measured inflation single numerical value of the inflation objective, 2%
would be set above zero to avoid deflations that have on the PCE deflator. However, the FOMC also made
harmful effects on employment and because measured it clear that it would be pursuing a flexible form of
inflation is likely to be biased upward. In addition, it inflation targeting consistent with its dual mandate
would not be intended to be a short-run target that because it not only would seek to achieve its inflation
might lead to control of inflation that is too tight at the target but would also focus on promoting maximum
expense of overly high employment fluctuations. sustainable employment.
could lead to inflation expectations declining below 2%. As a result, in August 2020,
after the Fed had conducted a study of its monetary policy strategy, Jerome Powell
announced that the Fed was modifying its inflation target to be a 2% average rather
than a 2% annual target. How the modification changes the Fed’s monetary policy
strategy is described in the Inside the Fed box “The Fed’s New Monetary Policy
Strategy: Average Inflation Targeting.”
8
Ben S. Bernanke and Frederic S. Mishkin, “Inflation Targeting: A New Framework for Monetary
Policy,” Journal of Economic Perspectives, 11, no. 2 (1997); Ben S. Bernanke, Frederic S. Mishkin,
and Adam S. Posen, “Inflation Targeting: Fed Policy After Greenspan,” Milken Institute Review
(Fourth Quarter, 1999): 48–56; Ben S. Bernanke, Frederic S. Mishkin, and Adam S. Posen, “What
Happens When Greenspan Is Gone,” Wall Street Journal (January 5, 2000): A22; and Ben S.
Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, Inflation Targeting: Lessons
from the International Experience (Princeton, N.J.: Princeton University Press, 1999).
9
Ben S. Bernanke, “Inflation Targeting,” Federal Reserve Bank of St. Louis, Review, 86, no. 4
(July/August 2004): 165–168.
M10_MISH9547_10_GE_C10.indd 272 06/07/23 11:33 AM

INSIDE THE FED

The Fed’s New Monetary Policy Strategy:
Average Inflation Targeting
The Federal Reserve’s original 2% point-target for in- because past undershoots of the target would be made
flation was one in which bygones are bygones: that is, up over time by pursuing easier monetary policy. The
it would continue to try to achieve a 2% annual infla- second advantage of this new monetary policy strategy
tion rate no matter what had happened to inflation in is that it would generate an automatic stabilizer for the
the past. The Fed announcement in August 2020 that economy. When a negative shock that causes inflation to
it would now target an average inflation rate of 2% fall below the 2% target occurs, average inflation target-
meant that bygones were no longer bygones because ing would commit the Fed to temporarily raise inflation
past inflation would affect its target in the short run. to above 2%. Inflation expectations would then likely
If inflation had been running below the 2% target level, rise above the 2% level temporarily, thus lowering the
as it had prior to 2020, then average inflation would real interest rate automatically even if the Fed did not
fall below 2%, and so to raise the average back to 2%, or could not lower the federal funds rate.
the Fed would seek to achieve an inflation rate above There is one major objection to this new monetary
2% for a short period of time. This would require the policy strategy. If the Fed allowed inflation to temporari-
Fed to pursue easier monetary policy than it would ly rise above the 2% level, there might be concerns that
have otherwise. If, on the other hand, inflation had the Fed is no longer committed to keep inflation at the
been running above 2%, then the Fed would temporar- 2% level in the long run. To avoid this problem, the Fed
ily shoot for an inflation rate below 2% and pursue a would need to convince the public that an overshoot of
tighter monetary policy. the 2% inflation objective would not weaken the Fed’s
There are two major advantages to this new monetary commitment to stabilize inflation at the 2% level in the
policy strategy. First, it would make it less likely that in- long run. Indeed, these concerns have been amplified
flation expectations would drift down below the 2% level by the very high inflation rates that arose during 2022.
Disadvantages of Inflation Targeting

Critics of inflation targeting cite four disadvantages of this monetary policy strategy:
delayed signaling, too much rigidity, the potential for increased output fluctuations,
and low economic growth. We look at each in turn and examine the validity of these
criticisms.
Delayed Signaling Inflation is not easily controlled by the monetary authorities,

and because of the long lags in the effects of monetary policy, inflation outcomes
are revealed only after a substantial lag. Thus, an inflation target is unable to send
immediate signals to both the public and markets about the stance of monetary policy.
oo Much Rigidity Some economists have criticized inflation targeting because

T
they believe it imposes a rigid rule on monetary policy makers and limits their
ability to respond to unforeseen circumstances. However, useful policy strategies
exist that are “rule-like,” in that they involve forward-looking behavior that limits
policy makers from systematically engaging in policies with undesirable long-run
consequences. Such policies avoid the time-inconsistency problem and would best
be described as “constrained discretion.”
Indeed, inflation targeting can be described exactly in this way. Inflation target-
ing, as actually practiced, is far from rigid and is better described as “flexible infla-
tion targeting.” First, inflation targeting does not prescribe simple and mechanical
instructions on how the central bank should conduct monetary policy. Rather, it
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requires the central bank to use all available information to determine which policy
actions are appropriate to achieve the inflation target. Unlike simple policy rules,
inflation targeting never requires the central bank to focus solely on one key vari-
able. Second, inflation targeting as practiced contains a substantial degree of policy
discretion. Inflation targets have been modified depending on economic circum-
stances, as we have seen. Moreover, central banks under inflation-targeting regimes
have left themselves considerable scope to respond to output growth and fluctua-
tions through several devices.
Potential for Increased Output Fluctuations An important criticism of inflation

itargeting is that a sole focus on inflation may lead to monetary policy that is too tight
when inflation is above target and thus may lead to larger output fluctuations. Inflation
targeting does not, however, require a sole focus on inflation—in fact, experience has
shown that inflation targeters display substantial concern about output fluctuations.
Inflation targeters have chosen inflation targets above zero (typically around 2%),
and this reflects the concern of monetary policy makers that particularly low inflation
can have substantial negative effects on real economic activity. Deflation (negative
inflation in which the price level actually falls) is especially to be feared because of the
possibility that it may promote financial instability and precipitate a severe economic
contraction (Chapter 8). The deflation in Japan in recent years has been an important
factor in the weakening of the Japanese financial system and economy. Targeting infla-
tion rates of above zero makes periods of deflation less likely. This is one reason why
economists, both within and outside Japan, called for the Bank of Japan to adopt an
inflation target at levels of 2%, which finally occurred in 2013.
Inflation targeting also does not ignore traditional stabilization goals. Central
bankers in inflation-targeting countries continue to express their concern about
fluctuations in output and employment, and the ability to accommodate short-run
stabilization goals to some degree is built into all inflation-targeting regimes. All
inflation-targeting countries have been willing to minimize output declines by gradu-
ally lowering medium-term inflation targets toward the long-run goal.
Low Economic Growth Another common concern about inflation targeting is that
it will lead to low growth in output and employment. Although inflation reduction has
been associated with below-normal output during disinflationary phases in inflation-
targeting regimes, once low inflation levels were achieved, output and employment
returned to levels at least as high as they were before. A conservative conclusion
is that once low inflation is achieved, inflation targeting is not harmful to the real
economy. Given the strong economic growth after disinflation in many countries (such
as New Zealand) that have adopted inflation targets, a case can be made that inflation
targeting promotes real economic growth, in addition to controlling inflation.
Should Central Banks Respond to Asset-Price

Bubbles? Lessons from the Global Financial Crisis
Over the centuries, economies have been periodically subject to asset-price bub-
bles, pronounced increases in asset prices that depart from fundamental values,
which eventually burst resoundingly. The story of the 2007–2009 financial crisis, dis-
cussed in Chapter 8, indicates how costly these bubbles can be. The bursting of the
asset-price bubble in the housing market severely disrupted the financial system,
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leading to an economic downturn, a rise in unemployment, distressed communities,

and direct hardship for families forced to leave their homes after foreclosures.
The high cost of asset-price bubbles raises a key question for monetary policy
strategy: What should central banks do about them? Should they use monetary pol-
icy to try to pop bubbles? Are there regulatory measures they can take to rein in
asset-price bubbles? To answer these questions, we need to ask whether different
bubbles require different responses.
Because asset prices affect business and household spending and hence eco-
nomic activity, monetary policy certainly needs to respond to asset prices in order
to stabilize the economy. Hence, the issue of how monetary policy should respond
to asset-price movements is not whether it should respond at all, but whether it
should respond at a level over and above that called for in terms of the objectives of
stabilizing inflation and employment. Another way of defining the issue is whether
monetary policy should try to pop, or slow, the growth of possibly developing
asset-price bubbles to minimize later damage to the economy when these bubbles
burst. Alternatively, rather than respond directly to possible asset-price bubbles,
should the monetary authorities respond to asset-price declines only after a bubble
bursts, to stabilize both output and inflation? These opposing positions have been
characterized as leaning against asset-price bubbles versus cleaning up after the
bubble bursts, and so the debate over what to do about asset-price bubbles is often
referred to as the “lean versus clean” debate.
Two Types of Asset-Price Bubbles

There are two types of asset-price bubbles: one that is driven by credit and a second
that is driven purely by overly optimistic expectations (which former chairman of
the Fed, Alan Greenspan, referred to as “irrational exuberance”).
Credit-Driven Bubbles When a credit boom begins, it can spill over into an asset-
price bubble: Easier credit can be used to purchase particular assets and thereby
raise their prices. The rise in asset values, in turn, encourages further lending for
these assets, either because it increases the value of collateral, making it easier to
borrow, or because it raises the value of capital at financial institutions, which gives
them more capacity to lend. The lending for these assets can then increase demand
for them further and hence raise their prices even more. This feedback loop—in
which a credit boom drives up asset prices, which in turn fuels the credit boom,
which drives asset prices even higher, and so on—can generate a bubble in which
asset prices rise well above their fundamental values.
Credit-driven bubbles are particularly dangerous, as the recent global finan-
cial crisis has demonstrated. When asset prices come back down to Earth and the
bubble bursts, the collapse in asset prices then leads to a reversal of the feed-
back loop in which loans go sour, lenders cut back on credit supply, the demand
for assets declines further, and prices drop even more. These were exactly the
dynamics in housing markets during the global financial crisis. Driven by a credit
boom in subprime lending, housing prices rose way above fundamental values, but
when housing prices crashed, credit shriveled up and housing prices plummeted.
The resulting losses on subprime loans and securities eroded the balance sheets
of financial institutions, causing a decline in credit (deleveraging) and a sharp fall
in business and household spending, and therefore in economic activity. As we saw
during the 2007–2009 financial crisis, the interaction between housing prices and
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the health of financial institutions following the collapse of the housing price bubble
endangered the operation of the financial system as a whole and had dire conse-
quences for the economy.
Bubbles Driven Solely by Irrational Exuberance Bubbles that are driven

solely by overly optimistic expectations, but that are not associated with a credit
boom, pose much less risk to the financial system. For example, the bubble in
technology stocks in the late 1990s described in Chapter 6 was not fueled by credit,
and the bursting of the tech-stock bubble was not followed by a marked deterioration
in financial institutions’ balance sheets. The bursting of the tech-stock bubble thus
did not have a very severe impact on the economy, and the recession that followed
was quite mild. Bubbles driven solely by irrational exuberance are therefore far less
dangerous than those driven by credit booms.
The Debate over Whether Central Banks

Should Try to Pop Bubbles
Whether central banks should try to pop, or prick, bubbles was actively debated
before the crisis. Alan Greenspan argued against, and his position held great sway
in central banking circles before the global financial crisis. However, the crisis led
to re-evaluation of this viewpoint, and we look at the pro and con arguments below.
Con: Why Central Banks Should Not Try to Pop Bubbles Alan Greenspan’s
arguments that central banks should not take actions to prick bubbles became
known as the “Greenspan doctrine.” His position reflected five arguments.
1. Asset-price bubbles are nearly impossible to identify. If central banks or gov-

ernment officials knew that a bubble was in progress, why wouldn’t market
participants know as well? If so, then a bubble would be unlikely to develop
because market participants would know that prices were getting out of line
with fundamentals. Unless central bank or government officials are smarter
than market participants, which is unlikely given the especially high wages
that savvy market participants garner, they will be unlikely to identify when
bubbles of this type are occurring.
2. Although some economic analysis suggests that raising interest rates can
diminish rises in asset prices, raising interest rates may be very ineffec-
tive in restraining the bubble because market participants expect such
high rates of return from buying bubble-driven assets. Furthermore, rais-
ing interest rates has often been found to cause a bubble to burst more
severely, thereby increasing damage to the economy. Another way of saying
this is that bubbles are departures from normal behavior, and it is unreal-
istic to expect that the usual tools of monetary policy will be effective in
abnormal conditions.
3. Many different asset prices exist, and at any one time a bubble may be present
in only a fraction of assets. Monetary policy actions are a very blunt instru-
ment in such a case, as such actions would be likely to affect asset prices in
general, rather than the specific assets that are experiencing a bubble.
4. Monetary policy actions to prick bubbles can have harmful effects on the
aggregate economy. If interest rates are raised significantly to curtail a bub-
ble, the economy will slow, people will lose jobs, and inflation can fall below
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its desirable level. Indeed, as the first two arguments suggest, the rise in
interest rates necessary to prick a bubble may be so high that it can only
be done at great cost to workers and the economy. This is not to say that
monetary policy should not respond to asset prices per se. The level of asset
prices does affect household and business spending and thus the evolution of
the economy. Monetary policy should react to fluctuations in asset prices to
the extent that they affect inflation and economic activity.
5. As long as the central bank responds in a timely fashion, by easing mon-
etary policy aggressively after an asset bubble bursts, the harmful effects
of a bursting bubble could be kept at a manageable level. Indeed, the
Greenspan Fed acted exactly in this way after the stock market crash of
1987 and the bursting of the tech bubble in the stock market in 2000.
Aggressive easing after the stock market bubbles burst in 1987 and 2000
was highly successful. The economy did not enter a recession after the
stock market crash of 1987, whereas the recession was very mild after the
tech bubble burst in 2000.
Pro: Why Central Banks Should Try to Pop Bubbles In contrast to the
Greenspan doctrine, the recent crisis has clearly demonstrated that the bursting of
credit-driven bubbles can be not only extremely costly but also very hard to clean
up after. The global financial crisis has therefore provided a much stronger case for
trying to pop potential bubbles.
However, the distinction between the two types of bubbles, one of which
(credit-driven) is much more costly than the other, suggests that the lean ver-
sus clean debate may have been miscast. Rather than leaning against poten-
tial asset-price bubbles, which would include both credit-driven and irrational
exuberance-type bubbles, the case is much stronger for leaning against credit
bubbles, which would involve leaning against credit-driven asset-price bubbles
but not irrational exuberance asset-price bubbles. In addition, it is much easier
to identify credit bubbles than asset-price bubbles. When asset-price bubbles are
rising rapidly at the same time that credit is booming, the likelihood is greater
that asset prices are deviating from fundamentals because laxer credit standards
are driving asset prices upward. In this case, central bank or government offi-
cials have a greater likelihood of identifying that a bubble is in progress; this was
indeed the case during the housing market bubble in the United States because
these officials did have information that lenders had weakened lending stan-
dards and that credit extension in the mortgage markets was rising at abnor-
mally high rates.
The case for leaning against credit bubbles seems strong, but what policies will
be most effective in restraining credit bubbles?
Macroprudential Policies First, it is important to recognize that the key

principle to consider in designing effective policies to lean against credit bubbles
is to curb excessive risk taking. Only when this risk taking is excessive are credit
bubbles likely to develop, and so it is natural to look to prudential regulatory
measures to constrain credit bubbles. Regulatory policy to affect what is happening
in credit markets in the aggregate is referred to as macroprudential regulation,
and it does seem to be the right tool for reigning in credit-driven bubbles.
Financial regulation and supervision, either by central banks or by other govern-
ment entities, with the usual elements of a well-functioning prudential regulatory
M10_MISH9547_10_GE_C10.indd 277 06/07/23 11:33 AM

and supervisory system, as described in Chapter 18, can prevent excessive risk tak-
ing that can trigger a credit boom, which in turn leads to an asset-price bubble.
These elements include adequate disclosure and capital requirements, prompt cor-
rective action, close monitoring of financial institutions’ risk management proce-
dures, and close supervision to enforce compliance with regulations. More generally,
regulation should focus on preventing leverage cycles. As the global financial crisis
demonstrated, the rise in asset prices that accompanied the credit boom resulted in
higher capital buffers at financial institutions, supporting further lending in the con-
text of unchanging capital requirements, which led to higher asset prices, and so on;
in the bust, the value of the capital dropped precipitously, leading to a cut in lend-
ing. Capital requirements that are countercyclical, that is, adjusted upward during
a boom and downward during a bust, might help eliminate the pernicious feedback
loops that promote credit-driven bubbles.
A rapid rise in asset prices accompanied by a credit boom provides a signal
that market failures or poor financial regulation and supervision might be causing a
bubble to form. Central banks and other government regulators could then consider
implementing policies to rein in credit growth directly or implement measures to
make sure credit standards are sufficiently high.
Monetary Policy The fact that the low interest-rate policies of the Federal
Reserve from 2002 to 2005 were followed by excessive risk taking suggests to
many that overly easy monetary policy might promote financial instability, as was
discussed in Chapter 8. Although it is far from clear that the Federal Reserve is
primarily to blame for the housing bubble, research does suggest that low interest
rates can encourage excessive risk taking in what has been called the “risk-taking
channel of monetary policy.” Low interest rates may increase the incentives for asset
managers in financial institutions to search for yield and hence increase risk taking.
Low interest rates may also increase the demand for assets, raising their prices and
leading to increased valuation of collateral, which in turn encourages lenders to lend
to riskier borrowers.
The risk-taking channel of monetary policy suggests that monetary policy should
be used to lean against credit bubbles. However, many of the objections to using
monetary policy to prick bubbles behind the Greenspan doctrine are still valid, so
wouldn’t it be better to use macroprudential supervision to constrain credit bubbles,
leaving monetary policy to focus on price and output stability?
This argument would be quite strong if macroprudential policies were able
to do the job. However, there are doubts on this score. Prudential supervision
is subject to more political pressure than monetary policy because it affects the
bottom line of financial institutions more directly. Thus they have greater incen-
tives to lobby politicians to discourage macroprudential policies that would rein
in credit bubbles, particularly during a credit bubble when they are making the
most money. In addition, financial institutions are often very good at finding loop-
holes to avoid regulation and so macroprudential supervision may not be effective.
The possibility that macroprudential policies may not be implemented sufficiently
well to constrain credit bubbles suggests that monetary policy may have to be
used instead.
An important lesson from the global financial crisis is that central banks and
other regulators should not have a laissez-faire attitude and let credit-driven bub-
bles proceed without any reaction. How to do this well, however, is indeed a daunt-
ing task.
M10_MISH9547_10_GE_C10.indd 278 06/07/23 11:33 AM

THE PRACTICING MANAGER
Using a Fed Watcher

As we have seen, the most important player in the determination of the U.S. interest
rates is the Federal Reserve. When the Fed wants to inject reserves into the system,
it conducts open market purchases of bonds, which cause their prices to increase
and their interest rates to fall, at least in the short term. To withdraw reserves from
the system, the Fed sells bonds, thereby depressing their price and raising their
interest rates. From a longer-run perspective, if the Fed pursues an expansionary
monetary policy with low interest rates initially, inflation will eventually rise and
interest rates will eventually rise as well. Contractionary monetary policy is likely to
lower inflation in the long run and lead to lower long-run interest rates.
GO Knowing what actions the Fed might be taking can thus help financial institution
ONLINE managers predict the future course of interest rates with greater accuracy. Because,
Access https://www.
federalreserve.gov/
as we have seen, changes in interest rates have a major impact on a financial insti-
aboutthefed/the-fed- tution’s profitability, the managers of these institutions are particularly interested
explained.htm and review in scrutinizing the Fed’s behavior. To help in this task, managers hire so-called Fed
what the Federal Reserve
watchers, experts on Federal Reserve behavior who may have worked in the Federal
reports as its primary
purposes and functions. Reserve System and so have an insider’s view of Federal Reserve operations.
Divining what the Fed is up to is by no means easy. The Fed does not disclose
the content of the minutes of FOMC meetings at which it decides the course of
monetary policy until three weeks after each meeting. In addition, the Fed does not
provide information on the amount of certain transactions and frequently tries to
obscure from the market whether it is injecting reserves into the banking system by
making open market purchases and sales simultaneously.
Fed watchers, with their specialized knowledge of the ins and outs of the Fed,
scrutinize the public pronouncements of Federal Reserve officials to get a feel for
where monetary policy is heading. They also carefully study the data on past Federal
Reserve actions and current events in the bond markets to determine what the Fed
is up to.
If a Fed watcher tells a financial institution manager that Federal Reserve con-
cerns about inflation are high and the Fed will pursue a tight monetary policy and
raise short-term interest rates in the near future, the manager may decide immedi-
ately to acquire funds at the currently low interest rates in order to keep the cost
of funds from rising. If the financial institution trades foreign exchange, the rise
in interest rates and the attempt by the Fed to keep inflation down might lead the
manager to instruct traders to sell foreign currencies and purchase dollars in the
foreign exchange market. As we will see in Chapter 15, these actions by the Fed
would be likely to cause the value of the dollar to appreciate, so the purchase of dol-
lars by the financial institution should lead to substantial profits.
If, conversely, the Fed watcher thinks that the Fed is worried about a weak
economy and will thus pursue an expansionary policy and lower interest rates, the
financial institution manager will take very different actions. Now the manager might
instruct loan officers to make as many loans as possible so as to lock in the higher
interest rates that the financial institution can earn currently. Or the manager might
buy bonds, anticipating that interest rates will fall and their prices will rise, giving
the institution a nice profit. The more expansionary policy is also likely to lower
the value of the dollar in the foreign exchange market, so the financial institution
M10_MISH9547_10_GE_C10.indd 279 06/07/23 11:33 AM

manager might tell foreign exchange traders to buy foreign currencies and sell dol-
lars in order to make a profit when the dollar falls in the future.
A Fed watcher who is right is a very valuable commodity to a financial institu-
tion. Successful Fed watchers are actively sought out by financial institutions and
often earn high salaries, well into the six-figure range.
SUMMARY
1. Central banks affect the amount of reserves in the the economy, but changing the composition of the
banking system through either open market opera- balance sheet, which is what liquidity provision and
tions or discount lending. Conduct of monetary policy asset purchases accomplished and is referred to as
involves actions that affect the Federal Reserve’s bal- credit easing, can have a large impact by improving
ance sheet. Open market purchases lead to an expan- the function of credit markets. Negative interest rates
sion of reserves and liquidity in the banking system. An on banks’ deposits at the central bank might help
increase in discount loans also leads to an expansion of stimulate the economy by encouraging banks to lend
reserves and liquidity in the banking system. out their reserves. However, this expansionary effect
2. A supply-and-demand analysis of the market for might not occur because banks choose to move their
reserves yields the following results: When the Fed deposits at the central bank into cash or because
makes an open market purchase or lowers reserve negative interest rates might hurt bank profitability,
requirements, the federal funds rate declines. When thereby discouraging banks from lending.
the Fed makes an open market sale or raises reserve 5. The monetary policy tools used by the European Central
requirements, the federal funds rate rises. Changes in Bank are similar to those used by the Federal Reserve
the discount rate and the interest rate paid on excess System and involve open market operations, lend-
reserves may also affect the federal funds rate. ing to banks, interest on excess reserves, and reserve
3. Conventional monetary policy tools include open requirements. Main financing operations—open market
market operations, discount policy, reserve require- operations in repos that are typically reversed within
ments, and interest on excess reserves. Open mar- two weeks—are the primary tool to set the overnight
ket operations were the primary tool used by the cash rate at the target financing rate. The European
Fed to implement monetary policy before the global Central Bank also operates standing lending facilities
financial crisis. Discount policy has the advantage of that ensure that the overnight cash rate remains within
enabling the Fed to perform its role of lender of last 100 basis points of the target financing rate.
resort. Reserve requirements have rarely been used 6. The six basic goals of monetary policy are price sta-
as a monetary policy tool. Raising interest rates on bility (the primary goal), high employment, economic
excess reserves to increase the federal funds rate growth, interest-rate stability, stability of financial
has the advantage that it avoids the need to conduct markets, and stability in foreign exchange markets.
massive open market operations to reduce reserves 7. A nominal anchor is a key element in monetary pol-
when banks have accumulated large amounts of icy strategy. It helps promote price stability by tying
excess reserves. down inflation expectations and limiting the time-
4. Conventional monetary policy tools are ineffective inconsistency problem, in which monetary policy
when the effective-lower-bound problem occurs, in makers conduct monetary policy in a discretionary
which the central bank is unable to lower interest way that might provide short-term benefits but pro-
rates much below zero. In this situation, central banks duces poor long-run outcomes.
use nonconventional monetary policy tools, which 8. Inflation targeting has several advantages: (1) It is
involve liquidity provision, asset purchases, forward readily understood by the public and is highly trans-
guidance, and negative interest rates on banks’ parent; (2) it increases accountability of the cen-
deposits at the central bank. Liquidity provision and tral bank; (3) it makes it less likely the central bank
asset purchases lead to an expansion of the central will fall into the time-inconsistency trap of pursuing
bank balance sheet, which is referred to as quantita- overly expansionary monetary policy; (4) it helps
tive easing. Expansion of the central bank balance focus the debate on what central banks can do in the
sheet by itself is unlikely to have a large impact on long run, that is control inflation; and (5) it appears
M10_MISH9547_10_GE_C10.indd 280 06/07/23 11:33 AM

to ameliorate the effects of inflationary shocks. It 9. The lessons from the global financial crisis suggest
does have some disadvantages, however: (1) Inflation that monetary policy should lean against credit
is not easily controlled by the monetary authorities, booms but not asset-price bubbles.
so that an inflation target is unable to send immediate 10. B
ecause predicting the Federal Reserve’s actions can
signals to both the public and markets; (2) it might help managers of financial institutions predict the
impose a rigid rule on policy makers, although this course of interest rates, which has a major impact
has not been the case in practice; and (3) a sole focus on financial institutions’ profitability, such managers
on inflation may lead to larger output fluctuations, value the services of Fed watchers, who are experts
although this has also not been the case in practice. on Federal Reserve behavior.
KEY TERMS
balance sheet, p. 243 forward guidance, p. 262 open market operations, p. 243
bubbles, p. 276 hierarchical mandates, p. 269 overnight cash rate, p. 264
conventional monetary policy tools, inflation targeting, p. 271 potential output, p. 268
p. 252 lender of last resort, p. 254 price stability, p. 265
credit easing, p. 261 longer-term refinancing operations, primary dealers, p. 243
defensive open market operations, p. 264 repurchase agreement (repo),
p. 252 macroprudential regulation, p. 277 p. 252
deposit facility, p. 265 main refinancing operations, p. 264 required reserve ratio, p. 243
discount loans, p. 243 marginal lending facility, p. 264 required reserves, p. 243
discount rate, p. 244 marginal lending rate, p. 264 reserve requirements, p. 243
discount window, p. 253 matched sale–purchase transaction, reserves, p. 243
dual mandate, p. 270 p. 253 reverse repo, p. 253
dynamic open market operations, natural rate of output, p. 268 reverse transactions, p. 264
p. 252 natural rate of unemployment, p. 267 standing lending facility, p. 254
effective-lower-bound problem, p. 256 nominal anchor, p. 266 T-account, p. 243
excess reserves, p. 243 nonconventional monetary policy target financing rate, p. 264
federal funds rate, p. 245 tools, p. 257 time-inconsistency problem, p. 266
QUESTIONS
1. A
commercial banking system is usually regulated by appeared in the United States in 2007, when real
central banks. For instance, the European Central estate prices began to collapse and sub-prime mort-
Bank (ECB) requires holding minimum reserves for gages began to spike, which contributed to financial
banks located in the euro area. Branches located out- panic during September and October of 2008. Why
side the euro area are subject to minimum reserve do the Fed and other central banks worry about
requirements. How do central banks affect reserves in financial panics? In addition to reserve requirements
a banking system? Which actions are recommended and interest rates, what tool does the Fed use to pre-
and when? Can reserve requirements influence vent financial panic? Has the Fed always effectively
money supply and, hence, inflation in the economy? used these tools?
2. In which economic conditions would a central bank 5. Why was the Term Auction Facility more widely used
want to use a “forward guidance” strategy? Based by financial institutions than the discount window
on your previous answer, can we easily measure the during the global financial crisis?
effects of such a strategy? 6. What are the advantages and disadvantages of quan-
3. “Discounting is no longer needed because the pres- titative easing as an alternative to conventional
ence of the FDIC eliminates the possibility of bank monetary policy when short-term interest rates are
panics.” Is this statement true, false, or uncertain? at the effective-lower-bound?
Explain your answer. 7. Can interest rates on bank deposits be negative?
4. One risk facing financial institutions is losing reputa- Explain the reasons for your answer. Can nega-
tion, and a key contributor to it is financial panic. For tive interest rates on deposit have an expansionary
instance, the first signs of impending financial crises effect?
M10_MISH9547_10_GE_C10.indd 281 06/07/23 11:33 AM

8. How do the monetary policy tools of the European 14. Why might inflation targeting increase support for
System of Central Banks compare to the monetary the independence of the central bank to conduct
policy tools of the Fed? Does the ECB have a dis- monetary policy?
count lending facility? Does the ECB pay banks 15. “Because inflation targeting focuses on achieving the
interest on their deposits? inflation target, it will lead to excessive output fluc-
9. In many countries, especially with expected inflation, tuations.” Is this statement true, false, or uncertain?
inflation targeting is the objective of central banks. Do Explain your answer.
you think this is always a good idea? Why or why not? 16. “A central bank with a dual mandate will achieve lower
10. What is the main rationale behind paying negative unemployment in the long run than a central bank with
interest rates to banks for keeping their deposits at a hierarchical mandate in which price stability takes
central banks in Sweden, Switzerland, and Japan? precedence.” Is this statement true, false, or uncertain?
What could happen to these economies if banks 17. A central bank decides to issue a statement declaring
decide to loan their excess reserves, but no good that it will not try to eliminate asset-price bubbles.
investment opportunities exist? Can you think of a negative consequence of this
11. Give an example of the time-inconsistency problem statement for the central bank’s ability to conduct
that you experience in your everyday life. monetary policy?
12. What incentives arise for a central bank to fall into 18. If higher inflation is bad, then why might it be more
the time-inconsistency trap of pursuing overly advantageous to have a higher inflation target than a
expansionary monetary policy? lower target closer to zero?
19. Why aren’t most central banks more proactive at try-
13. Suppose your boss asks you to write reports with
ing to use monetary policy to eliminate asset-price
two conditions: The report has to be clear (i.e., well
bubbles?
written), and it has to be completed by the end of the
day. Do these instructions constitute a dual mandate 20. Why would it be better to lean against credit-driven
or a hierarchical mandate? Suppose that in the short bubbles and clean after other types of asset bubbles
run (during the first month) you fail to meet one of crash?
the conditions (you either write a proper report or 21. Describe in your own terms the concept of macro-
are late, or vice versa). Do you see a conflict between prudential regulation. Why might this approach be
these two conditions in the long run? an important element in preventing credit bubbles?
Q U A N T I TAT I V E P R O B L E M S
1. Consider a central bank policy to maintain 9% re- 10% (so this bank holds no excess reserves). If there
serves on deposits held by commercial banks. A bank, is a deposit outflow (i.e., someone withdraws funds
ALFA, currently has $10 million in deposits and holds from her account) for $5,000, would this bank still
$1 million in reserves at the central bank. What is the comply with the Fed’s requirement of keeping 10%
excess reserve ratio? What will be the requirements if of its deposits in the form of reserves? What would
the bank is to add $500,000 additional deposits? be the cost for this bank to comply with this regula-
2. Estimates of unemployment for the upcoming year tion if the bank decides to borrow from another bank
have been developed as follows: to eliminate its reserve shortage? Assume a federal
funds rate of 0.25%.
Unemployment
Economy Probability Rate (%) 4. Refer to the previous problem. What would be
the cost for this bank to comply with its required
Bust 0.15 20 reserves if the bank decides to borrow from the Fed
Average 0.50 10 at a discount rate of 0.75%? Can you now explain
why excess reserves serve as insurance against
Good 0.20 5 deposit outflows?
Boom 0.15 1
5. The short-term nominal interest rate is 5%, with an
What is the expected unemployment rate? The stan- expected inflation rate of 2%. Economists forecast
dard deviation? that next year’s nominal rate will increase by 100
3. Suppose a bank currently has $150,000 in deposits basis points, but inflation will fall to 1.5%. What is
and $15,000 in reserves. The required reserve ratio is the expected change in real interest rates?
M10_MISH9547_10_GE_C10.indd 282 06/07/23 11:33 AM

WEB EXERCISES
Conduct of Monetary Policy: Tools, Goals, Strategy, b. Review the press release from the last meeting.
and Tactics What did the committee decide to do about short-
term interest rates?
1. Go to https://www.federalreserve.gov/releases/
h15/. Define the federal funds rate. What is the cur- c. Review the most recently published meeting
rent federal funds rate? Define the discount rate. minutes. What areas of the economy seemed to
What is the current Federal Reserve discount rate? be of most concern to the committee members?
Have short-term rates increased or decreased since (See the section on Participants Views on Current
the end of 2022? Conditions and the Economic Outlook.)
3. It is possible to access other central bank Web sites
2. The Federal Open Market Committee (FOMC) meets
to learn about their structure. One example is the
about every six weeks to assess the state of the
European Central Bank. Go to www.ecb.int. On the
economy and to decide what actions the central
ECB home page, find information about the ECB’s
bank should take. The minutes of this meeting are
strategy for monetary policy.
released three weeks after the meeting; however,
a brief press release is made available immediately. 4. Many countries have central banks that are responsi-
Find the schedule of minutes and press releases at ble for their nation’s monetary policy. Go to www.bis.
https://www.federalreserve.gov/monetarypolicy/ org/cbanks.htm and select one of the central banks
fomccalendars.htm. (for example, Norway). Review that bank’s Web site
to determine its policies regarding application of
a. When was the last scheduled meeting of the monetary policy. How does this bank’s policies com-
FOMC? When is the next meeting? pare to those of the U.S. central bank?
M10_MISH9547_10_GE_C10.indd 283 06/07/23 11:33 AM

8.1 FM&I Chapter 9,10

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PA RT 4 CENTRAL BANKING AND THE

CONDUCT OF MONETARY POLICY

M09_MISH9547_10_GE_C09.indd 224 06/07/23 2:28 PM

Origins of the Central Banking System

Variations in the Functions and Structures

M09_MISH9547_10_GE_C09.indd 225 06/07/23 2:28 PM

The European Central Bank, the Euro System,

M09_MISH9547_10_GE_C09.indd 226 06/07/23 2:28 PM

Decision-Making Bodies of the ECB

M09_MISH9547_10_GE_C09.indd 227 06/07/23 2:28 PM

FIGURE 9.1 The Organization of the ESCB

European Central Bank European Central Bank

1 Nationale Bank van Beligié 8 Bank of Greece

M09_MISH9547_10_GE_C09.indd 228 06/07/23 2:28 PM

European Central Bank European Central Bank

15 Bank of Lithuania 22 Banco de Portugal

of the 19 National Central Banks of the euro-area countries. Various non-council

M09_MISH9547_10_GE_C09.indd 229 06/07/23 2:28 PM

European System of Central Banks (ESCB)

The ESCB promotes monetary and financial

European Central National Central

Governing Executive General

The Importance of the Bundesbank Within the ECB

M09_MISH9547_10_GE_C09.indd 230 06/07/23 2:28 PM

How Monetary Policy Is Conducted Within the ECB

The ECB’s operational framework consists of the following set of conventional

• Open market operations

M09_MISH9547_10_GE_C09.indd 231 06/07/23 2:28 PM

The Federal Reserve System

M09_MISH9547_10_GE_C09.indd 232 06/07/23 2:28 PM

• The Federal Reserve Board of Governors (FRB) which mainly assumes

Difference Between the ECB and the Fed

M09_MISH9547_10_GE_C09.indd 233 06/07/23 2:28 PM

Third, the monetary operations of the Eurosystem are conducted by the

The Bank of England

M09_MISH9547_10_GE_C09.indd 234 06/07/23 2:28 PM

GLOBAL Brexit and the BoE

Structure of Central Banks of Larger Economies

The Bank of Canada

M09_MISH9547_10_GE_C09.indd 235 06/07/23 2:28 PM

The Bank of Japan

M09_MISH9547_10_GE_C09.indd 236 06/07/23 2:28 PM

­The People’s Bank of China

M09_MISH9547_10_GE_C09.indd 237 06/07/23 2:28 PM

Structure and Independence of Central Banks

Central Banks Independence

M09_MISH9547_10_GE_C09.indd 238 06/07/23 2:28 PM

The Case for Independence

The Case Against Independence

The Trend Toward Greater Independence

M09_MISH9547_10_GE_C09.indd 239 06/07/23 2:28 PM

M09_MISH9547_10_GE_C09.indd 240 06/07/23 2:28 PM

QUESTIONS AND PROBLEMS

M09_MISH9547_10_GE_C09.indd 241 06/07/23 2:28 PM

Conduct of Monetary Policy

M10_MISH9547_10_GE_C10.indd 242 06/07/23 11:32 AM

­ ow Fed Actions Affect Reserves

Open Market Operations

M10_MISH9547_10_GE_C10.indd 243 06/07/23 11:32 AM

Federal Reserve System

The People’s Bank of China

ow Fed Actions Affect Reserves

he Market for Reserves and the

Open Market Operations

1. I n November 2008 the Fed set up a Government Sponsored Entities Purchase

The Time-Inconsistency Problem

High Employment and Output Stability