4.6 monetary policy

The FOMC (Federal Open Market Committee)

targets the federal funds rate. In a limited-reserves system the Fed hits the target by changing the quantity of reserves.

Monetary policy

A central bank's use of its tools to reach macroeconomic goals such as price stability

Federal funds rate

The rate banks charge other banks for overnight loans of reserves. It is the U.S. policy rate.

Who lends?	A bank with extra reserves
Who borrows?	Another bank that needs reserves
Who sets it?	Determined by banks in the market. The FOMC sets the target.
Role	The policy rate. This is the rate the news means.
Main tool to move it (limited reserves)	Open market operations

Discount rate

The rate the Fed charges banks that borrow from it. Not the federal funds rate.

		Discount rate
Who lends?		The Fed
Who borrows?		A bank
Who sets it?		The Fed sets it directly
Role		A tool that affects banks' cost of borrowing from the Fed
Main tool to move it (limited reserves)		Changing the discount rate itself

Interest on reserves

The rate the Fed pays banks on reserves held at the Fed

Open market operations (OMO)

The Fed buying or selling government bonds

Monetary base

Reserves plus currency.

A1. The chain

Fed action → reserves change → monetary base changes → money supply changes by more than the base (multiplier) → federal funds rate (the policy rate) and other nominal interest rates change → investment and consumption change → AD changes → real GDP and price level change

limited reserves ground rules

• Banks lend out all excess reserves, so they hold no excess reserves.

• No one holds cash outside the banking system. Every loan is redeposited.

• The money multiplier = 1 ÷ required reserve ratio.

The policy rate: what the Fed is aiming at

targeting an overnight interbank lending rate, often called the policy rate. In the United States, this is the federal funds rate .

Open market operations

Bonds held by the Fed

Open market operations: Expansionary move

Buy bonds

Open market operations: Contractionary move

Sell bonds

Required reserve ratio: Expansionary move

Lower it

Required reserve ratio: Contractionary move

Raise it

Discount rate: Expansionary move

Lower it

Discount rate: Contractionary move

Raise it

Ample reserves: contractionary

raise Interest on Reserves/Admin Rates

Ample reserves: Expansionary

lower Interest on Reserves/Admin Rates

reserve market graph