FREE ESSAY ON MONETARY POLICY AND THE ECONOMY

MONETARY POLICY AND THE ECONOMY

Monetary Policy and the Economy
Using the tools of monetary policy, the Federal Reserve can affect the volume of money
and credit and their price-interest rates. In this way, it influences employment, output,
and the general level of prices.
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THE FEDERAL RESERVE ACT LAYS OUT the goals of monetary policy. It specifies that, in
conducting monetary policy, the Federal Reserve System and the Federal Open Market
Committee should seek "to promote effectively the goals of maximum employment, stable
prices, and moderate long-term interest rates."
GOALS OF MONETARY POLICY
Many analysts believe that the central bank should focus primarily on achieving price
stability. A stable level of prices appears to be the condition most conducive to maximum
sustained output and employment and to moderate long-term interest rates; in such
circumstances, the prices of goods, materials, and services are undistorted by inflation
and thus can serve as clearer signals and guides for the efficient allocation of
resources. Also, a background of stable prices is thought to encourage saving and,
indirectly, capital formation because it prevents the erosion of asset values by
unanticipated inflation. 
However, policymakers must consider the long- and short-term effects of achieving any one
goal. For example, in the long run, price stability complements efforts to achieve
maximum output and employment; but in the short run, some tension can arise between
efforts to reduce inflation and efforts to maximize employment and output. At times, the
economy is faced with adverse supply shocks, such as a bad agricultural harvest or a
disruption in the supply of oil, which put upward pressure on prices and downward
pressure on output and employment. In these circum-stances, makers of monetary policy
must decide the extent to which they should focus on defusing price pressures or on
cushioning the loss of output and employment. At other times, policymakers may be
concerned that the public's expectation of more inflation will get built into decisions
about wages and prices, become a self-fulfilling prophecy, and result in temporary losses
of output and employment. Countering this threat of inflation with a more restrictive
monetary policy could risk small losses of output and employment in the near term but
might make it possible to avoid larger losses later should expectations of higher
inflation become embedded in the economy. 
Beyond influencing the level of prices and the level of output in the near term, the
Federal Reserve can contribute to financial stability and better economic performance by
limiting the scope of financial disruptions and preventing their spread outside the
financial sector. Modern financial systems are highly complex and interdependent and
potentially vulnerable to wide-scale systemic disruptions, such as those that can occur
during a plunge in stock prices. The Federal Reserve can help to establish for the U.S.
banking system and, more broadly, for the financial system a framework that reduces the
potential for systemic disruptions. More-over, if a threatening disturbance develops, the
central bank can cushion its effects on financial markets and the economy by pro-viding
liquidity through its monetary policy tools. 
MONETARY POLICY AND THE RESERVES MARKET
The initial link between monetary policy and the economy occurs in the market for
reserves. The Federal Reserve's policies influence the demand for or supply of reserves
at banks and other depository institutions, and through this market, the effects of
monetary policy are transmitted to the rest of the economy. Therefore, to understand how
monetary policy is related to the economy, one must first understand what the reserves
market is and how it works.
Demand for Reserves
The demand for reserves has two components: required reserves and excess reserves. All
depository institutions-commercial banks, saving banks, savings and loan associations,
and credit unions-must retain a percentage of certain types of deposits to be held as
reserves. The Federal Reserve under the Depository Institutions Deregulation and Monetary
Control Act of 1980 sets the reserve requirements. At the end of 1993, 4,148 member
banks, 6,042 nonmember banks, 495 branches and agencies of foreign banks, 61 Edge Act and
agreement corporations, and 3,238 thrift institutions were subject to reserve
requirements. 
Since the early 1990s, reserve requirements have been applied only to transaction
deposits (basically, interest-bearing and non-interest-bearing checking accounts).
Required reserves are a fraction of such deposits; the Board of Governors within limits
prescribed by law sets the fraction-the required reserve ratio-. Thus, total required
reserves expand or contract with the level of transaction deposits and with the required
reserve ratio set by the Board; in practice, however, the required reserve ratio has been
adjusted only infrequently. Depository institutions hold required re-serves in one of two
forms: vault cash (cash on hand at the bank) or, more important for monetary policy,
required reserve balances in accounts with the Reserve Bank for their Federal Reserve
District. 
Depositories use their accounts at Federal Reserve Banks not only to satisfy their
reserve requirements but also to clear many financial transactions. Given the volume and
unpredictability of trans-actions that clear through their accounts every day,
depositories need to maintain a cushion of funds to protect themselves against debits
that could leave their accounts overdrawn at the end of the day and subject to penalty.
Depositories that find their required reserve balances insufficient to provide such
protection may open supplemental accounts for required clearing balances. These
additional balances earn interest in the form of credits that can be used to defray the
cost of services, such as check clearing and wire transfers of funds and securities that
the Federal Reserve provides. 
Some depository institutions choose to hold reserves even beyond those needed to meet
their reserve and clearing requirements. These additional balances, which provide extra
protection against overdrafts and deficiencies in required reserves, are called excess
reserves; they are the second component of the demand for re-serves (a third component if
required clearing balances are included). In general, depositories hold few excess
reserves because these balances do not earn interest; nonetheless, the demand for these
reserves can fluctuate greatly over short periods, complicating the Federal Reserve's
task of implementing monetary policy.
Supply of Reserves
The Federal Reserve supplies reserves to the banking system in two ways:
? Lending through the Federal Reserve discount window
? Buying government securities (open market operations).
Reserves obtained through the first channel are called borrowed reserves. The Federal
Reserve supplies these directly to depository institutions that are eligible to borrow
through the discount window. Access to such credit by banks and thrift institutions is
established by rules set by the Board of Governors, and loans are made at a rate of
interest-the discount rate-set by the Reserve Banks and approved by the Board. The supply
of borrowed reserves depends on the initiative of depository institutions to borrow,
though it is influenced by the level of the discount rate and by the terms and conditions
for access to discount window credit. 
In general, banks are expected to come to the discount window to meet liquidity needs
only after drawing on all other reasonably available sources of funds, which limits
considerably the use of this source of funds. Moreover, many banks fear that their use of
discount window credit might become known to private market participants, even though the
Federal Reserve treats the identity of such borrowers in a highly confidential manner,
and that such borrowing might be viewed as a sign of weakness. As a consequence, the
amount of reserves supplied through the discount window is generally a small portion of
the total supply of reserves. 
The other source of reserve supply is non-borrowed reserves. Al-though the supply of
non-borrowed reserves depends on a variety of factors, many of them outside the
day-to-day control of the Federal Reserve, the System can exercise control over this
supply through open market operations-the purchase or sale of securities by the Domestic
Trading Desk at the Federal Reserve Bank of New York. When the Federal Reserve buys
securities in the open market, it creates reserves to pay for them, and the supply of
non-borrowed reserves increases. Conversely, when it sells securities, it absorbs
reserves in exchange for the securities, and the supply of non-borrowed reserves falls.
In other words, the Federal Reserve adjusts the supply of non-borrowed reserves by
purchasing or selling securities in the open market, and the purchases are effectively
paid for by additions to or subtractions from a depository institution's reserve balance
at the Federal Reserve. 
Trading of Reserves
Depository institutions actively trade reserves held at the Federal Reserve among them,
usually overnight. Those with surplus balances in their accounts transfer reserves to
those in need of boosting their balances. The benchmark rate of interest charged for the
short-term use of these funds is called the federal funds rate. Changes in the federal
funds rate reflect the basic supply and demand conditions in the market for reserves. 
Equilibrium exists in the reserves market when the demand for required and excess
reserves equals the supply of borrowed plus non-borrowed reserves. Should the demand for
reserves rise-say, because of a rise in checking account deposits-disequilibrium will
occur, and upward pressure on the federal funds rate will emerge. Equilibrium may be
restored by open market operations to supply the added reserves, in which case the
federal funds rate will be unchanged. It may also be restored as the supply of re-serves
increases through greater borrowing from the discount window; in this case, interest
rates would tend to rise, and over time the demand for reserves would contract as reserve
market pressures are translated, through the actions of banks and their depositors, into
lower deposit levels and smaller required re-serves. Conversely, should the supply of
reserves expand-say, because the Federal Reserve purchases securities in the open market-
the resulting excess supply will put downward pressure on the federal funds rate. A lower
federal funds rate will set in motion equilibrating forces through the creation of more
deposits and larger required reserves and lessened borrowing from the discount window.
EFFECTS OF MONETARY POLICY ON THE ECONOMY
As the preceding discussion illustrates, monetary policy works through the market for
reserves and involves the federal funds rate. A change in the reserves market will
trigger a chain of events that affect other short-term interest rates, foreign exchange
rates, long-term interest rates, the amount of money and credit in the economy, and
levels of employment, output, and prices. For ex-ample, if the Federal Reserve reduces
the supply of reserves, the resulting increase in the federal funds rate tends to spread
quickly to other short-term market interest rates, such as those on Treasury bills and
commercial paper. Because interest rates paid on many deposits in the money stock adjust
only slowly, holding balances in money (that is, in a form counted in the money stock)
becomes less attractive. As the public pursues higher yields available in the market (for
example, on Treasury bills), the money stock declines. Moreover, as bank reserves and
deposits shrink, the amount of money available for lending may also decline. Higher costs
of borrowing and possible restraints on credit supply will damp growth of both bank
credit and broader credit measures. 
A change in short-term interest rates will also translate into changes in long-term rates
on such financial instruments as home mortgages, corporate bonds, and Treasury bonds,
especially if the change in short-term rates is expected to persist. Thus, a rise in
short-term rates that is expected to continue will lead to a rise (though typically a
smaller one) in long-term rates. 
Higher long-term interest rates will reduce the demand for items that are most sensitive
to interest cost, such as residential housing, business investment, and durable consumer
goods (for example, automobiles and large household appliances). Higher mortgage interest
rates depress the demand for housing. Higher corporate bond rates increase the cost of
borrowing for businesses and, thus, restrain the demand for additions to plants and
equipment; and tighter supplies of bank credit may constrain the demand for investment
goods by those firms particularly dependent on bank loans. Furthermore, higher rates on
loans for motor vehicles reduce consumers' demand for cars and light trucks. Beyond these
effects, consumption demand is lowered by a reduction in the value of household
assets-such as stocks, bonds, and land-that tends to result from higher long-term
interest rates. 
The implications of changes in interest rates extend beyond domestic money and credit
markets. Continuing with the example, when interest rates in the United States move
higher in relation to those abroad, holding assets denominated in U.S. dollars becomes
more appealing, and the demand for dollars in foreign exchange markets increases. A
result is upward pressure on the exchange value of the dollar. With flexible exchange
rates (rates that fluctuate as the supply of and demand for national currencies vary),
the dollar strengthens, the cost of imported goods to Americans de-clines, and the price
of U.S.-produced goods to people abroad rises. As a consequence, demands for U.S. goods
are reduced as Americans are induced to substitute goods from abroad for those produced
in the United States and people abroad are induced                                       
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
                                                                                         
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renegotiated, and other adjustments occur. As a consequence, price and wage levels adjust
to the slower rate of expansion of aggregate demand, and the economy gravitates toward
full employment of resources. 
LIMITATIONS OF MONETARY POLICY
Monetary policy is not the only force affecting output and prices. Indeed, the economy
frequently is buffeted by factors affecting aggregate demand for goods and services or
aggregate supply. On the demand side, the government influences the economy through
changes in tax and spending programs. Such fiscal policy actions receive a lot of public
attention and typically can be anticipated well in advance. In fact, their effect on the
economy may precede their implementation to the degree that some businesses and
households may alter their spending in anticipation of the policy change. Also,
forward-looking financial markets may build such fiscal events into the level and
structure of interest rates and thus further influence spending decisions before the
government action. 
Other changes in demand or supply can be totally unpredictable and can influence the
economy in unforeseen ways. Examples of such "shocks" on the demand side are changes in
households' propensity to consume and shifts in consumer and business confidence.
Monetary policy in time can offset such shocks in private-sector demand but because of
their nature, not as they occur. On the supply side, matters can be even more
complicated. Natural disasters, disruptions in the supply of oil, and agricultural losses
are examples of adverse supply shocks. Because such events tend to raise prices and
reduce output, monetary policy can attempt to counter the losses of output or the higher
prices, but cannot completely offset both. 
In practice, monetary policymakers do not have up-to-the-minute, reliable information
about the state of the economy and prices. Information is limited because of lags in the
publication of data and because of later revisions in data. Also, policy-makers have a
less-than-perfect understanding of the way the economy works, including the knowledge of
when and to what extent policy actions will affect aggregate demand. The operation of the
economy changes over time, and with it the response of the economy to policy measures.
These limitations add to uncertainties in the policy process and make determining the
appropriate setting of monetary policy instruments more difficult. 
The central bank will have an easier time reaching its goals if the public understands
them and believes the Federal Reserve will take the steps necessary to reach them. For
example, a believable anti-inflation policy, implemented through a deceleration of
aggregate demand, will more quickly lead the public to expect lower inflation, and such
an expectation will itself help bring down inflation. In that case, workers will not feel
the need to demand large wage increases to protect themselves against expected price
hikes, and businesses will be less aggressive in raising their prices, knowing that doing
otherwise would result in losses in sales. In these circumstances, inflation will come
down more or less in line with the slowing of aggregate demand, with much less slack
emerging in resource markets than if workers and businesses continued to act as if
inflation were not going to slow.
GUIDES FOR MONETARY POLICY
The goals of monetary policy are spelled out in law. But how will the Federal Reserve
know whether or not its current operations in the reserves market are consistent with
those goals or whether it needs to be more restrictive or more accommodative? The actions
taken in the reserves market affect the economy with considerable lags. If the Federal
Reserve waits to adjust rates until it sees an undesirable change in employment or
prices, it will be too late to achieve its objectives. Consequently, people have
suggested that the Federal Reserve pay particularly close attention to guides to policy
that are intermediate between operations in the reserves market and effects in the
economy. Among those frequently mentioned are monetary and credit aggregates, interest
rates, and the foreign exchange value of the dollar. Some suggest that one or the other
of these measures be used as an intermediate target-that is, one with a specific formal
objective. Others suggest that they be used less formally as indicators of the
longer-term effects of monetary policy on the economy, to be judged in conjunction with a
variety of other financial and economic information. 
Monetary and Credit Aggregates
The Humphrey-Hawkins Act has something to say about the guides for monetary policy: It
specifies that each February the Federal Reserve must announce publicly its objectives
for growth in money and credit and that at midyear it must review its objectives and
revise them if appropriate. This provision of the act was based on the presumption of a
reasonably stable relation between growth of money and credit, on the one hand, and the
goals of monetary policy, on the other-a relation that could be fruitfully exploited in
achieving those goals. Control over the money stock, it was thought, could in effect
anchor the price level in much the same way that the former gold standard was thought to
have anchored the price level. 
Nonetheless, the law foresaw that revision might be appropriate should, for example, the
relation between the monetary or credit aggregates and the economy-the velocity of money
or credit-change unpredictably (see the box for a description of the content of the
monetary and credit aggregates). In these circumstances, adherence to the initial
objectives for money or credit growth would lead to an undesirable outcome for output or
prices. The Federal Reserve is not required to achieve its announced objectives for these
financial aggregates, but if it does not, it must ex-plain the reasons to Congress and
the public. 
The usefulness of the monetary aggregates for indicating the state of the economy and for
stabilizing the level of prices has been called into question by frequent departures of
their velocities from historical patterns. As can be seen in chart 2.1, the velocity of
M2 had until recently been fairly stable over long periods, although it did vary over
shorter periods in ways related to the interest-rate cycle. In the early 1990s, the
velocity of M2 departed from this pattern and drifted upward. This upward drift occurred
even as market interest rates were moving down, a change that should have added to the
attractiveness of deposits in M2 and lowered its velocity. Such departures from
historical experience have made forecasting velocity, and thus the rate of monetary
growth needed to achieve economic objectives, more difficult. 
Many observers believe that the recent unusual monetary behavior is due to the growing
variety of new financial assets offered to the public, such as new kinds of mutual funds
and mutual fund services, and to changes in the way people manage their financial
portfolios. Some analysts expect that rapid financial change will continue and will
further undermine the value of the monetary aggregates as guides to policy. Others expect
the process to settle down as people complete their shifts of investment-type balances to
assets outside M2. In this view, once the shift is fairly complete, M2-perhaps measured
somewhat differently-will again behave in a reliable way and can again be used
effectively as a guide for monetary policy.
Short- and Long-term Interest Rates
Interest rates have frequently been proposed as a guide to policy. Surely, some argue,
changes in the provision of reserves by the Federal Reserve can influence interest rates,
and changes in interest rates affect various spending decisions. Moreover, information on
interest rates is available on a real-time basis. 
Arguing against giving interest rates a key role in guiding monetary policy is the
uncertainty about what level or path of interest rates is consistent with the more basic
goals. The appropriate level or path will vary with the stance of fiscal policy, changes
in pat-terns of business and household spending, the productivity of capital, and
economic developments abroad. It is difficult not only to gauge the strength of these
various forces at any time but also to translate them into an appropriate level of
interest rates. More-over, real interest rates-that is, interest rates net of expected
inflation-drive spending decisions. Expected inflation is not readily measured; thus,
assessing what the level of real interest rates hap-pens to be is difficult. However,
failing to account for inflation expectations can result in misleading signals coming
from nominal interest rates. For example, if the public expected more inflation, nominal
interest rates would tend to rise, as investors sought protection for the greater loss of
purchasing power, and might lead to the belief that monetary policy had become tighter
and more disinflationary when, in fact, just the reverse had occurred. 
Alternatively, the yield curve-the difference between the interest rate on longer-term
securities and the interest rate on short-term instruments-has been proposed. Whereas
short-term interest rates are strongly influenced by current reserve provisions of the
central bank, longer-term rates are influenced by expectations of future short-term rates
and thus by the longer-term effects of monetary policy on inflation and output. For
example, a steep positive yield curve (that is, long-term rates far above short-term
rates) may be a signal that participants in the bond market believe that monetary policy
has become too expansive and thus, without a monetary policy correction, more
inflationary. Such a curve would be telling the central bank to provide fewer reserves.
Conversely, an inverted yield curve (short-term rates above long-term rates) may be an
indication that policy is restrictive, perhaps overly so. However, various other
influences, such as uncertainty about the course of interest rates, affect long-term
interest rates. Thus, a steepening of the yield curve may indicate not that the thrust of
monetary policy is too expansive, but that market participants have become more uncertain
about the outlook for interest rates. In other words, liquidity premiums embodied in
long-term interest rates may have risen. More generally, interest rates can vary for a
variety of reasons, especially over short periods, and the Federal Reserve must exercise
considerable caution in interpreting and re-acting to their fluctuations.
Foreign Exchange Rates
Exchange rate movements are an important channel through which monetary policy affects
the economy, and they tend to respond promptly to a change in the provision of reserves
and in interest rates. Information on exchange rates, like that on interest rates, is
available almost continuously throughout each day. 
Interpreting the m