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make decisions without
criteria”thus keeping monetary policy out of the “political thicket.” Without this inde-
political interference.
pendence, they argued, politicians with short time horizons might try to force the central
bank to expand the money supply too rapidly, especially before elections, thereby con-
tributing to chronic inflation and undermining faith in the country™s financial system.
They pointed to historical evidence showing that countries with more independent
central banks have, on average, experienced lower inflation.
Opponents of this view countered that there is something profoundly undemocratic
about letting a group of unelected bankers and economists make decisions that affect
every citizen™s well-being. Monetary policy, they argued, should be formulated by the
elected representatives of the people, just as fiscal policy is.
The high inflation of the 1970s and early 1980s helped resolve this issue by convincing
many governments around the world that an independent central bank was essential to
controlling inflation. Thus, one country after another has made its central bank indepen-
dent over the past 20 to 25 years. For example, the Maastricht Treaty (1992), which com-
mitted members of the European Union to both low inflation and a single currency (the
euro), required each member state to make its central bank independent. All did so, even
though several have still not joined the monetary union. Japan also decided to make its
central bank independent in 1998. In Latin America, several formerly high-inflation




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Chapter 13 265
Managing Aggregate Demand: Monetary Policy



countries like Brazil and Mexico found that giving their central banks more independence
helped them control inflation. And some of the formerly socialist countries of Europe,
finding themselves saddled with high inflation and “unsound” currencies, made their
central banks more independent for similar reasons. Thus, for practical purposes, the
debate over central bank independence is now all but over.
The new debate is over how to hold such independent and powerful institutions
accountable to the political authorities and to the broad public. For example, most central
banks have now abandoned their former traditions of secrecy and have become far
more open to public scrutiny. Some, the “inflation targeters,” even announce specific
numerical targets for inflation, thereby making it easy for outside observers to judge the
central bank™s success or failure. The Federal Reserve does not do this explicitly, but it
reveals enough information in its long-run forecast that people pretty much know its
inflation target.



IMPLEMENTING MONETARY POLICY: OPEN-MARKET OPERATIONS
When it wants to change interest rates, the Fed normally relies on open-market operations, Open-market
operations refer to the
which is the tool it relied upon when it lowered interest rates in response to the financial
Fed™s purchase or sale of
crisis of 2007“2008. Open-market operations either give banks more reserves or take
government securities
reserves away from them, thereby triggering the sort of multiple expansion or contraction
through transactions in
of the money supply described in the previous chapter. the open market.
How does this process work? If the Federal Open Market Committee decides to lower
interest rates, it can bring them down by providing banks with more reserves. Specifically,
the Federal Reserve System would normally purchase a particular kind of short-term U.S.
government security called a Treasury bill from any individual or bank that wished to sell
them, paying with newly created bank reserves. To see how this open-market operation
affects interest rates, we must understand how the market for bank reserves, which is
F I GU R E 1
depicted in Figure 1, works.
The Market for Bank
Reserves
The Market for Bank Reserves
The main sources of supply and demand in the market on which S
D
bank reserves are traded are straightforward. On the supply
side, the Fed decides how many dollars of reserves to provide.
Thus the label on the supply curve in Figure 1 indicates that the
position of the supply curve depends on Federal Reserve policy. The For given
Interest Rate




Fed policy
Fed™s decision on the quantity of bank reserves is the essence of E
monetary policy, and we are about to consider how the Fed
makes that decision. For given Y
and P
On the demand side of the market, the main reason why
banks hold reserves is something we learned in the previous
chapter: Government regulations require them to do so. In Chap-
ter 12, we used the symbol m to denote the required reserve ratio
D
(which is 0.1 in the United States). So if the volume of transaction S
deposits is D, the demand for required reserves is simply m 3 D.
The demand for reserves thus reflects the demand for transac- Quantity of Bank Reserves
tions deposits in banks.
The demand for bank deposits depends on many factors, but the principal determinant
is the dollar value of transactions. After all, people and businesses hold bank deposits in
order to conduct transactions. Real GDP (Y) is typically used as a convenient indicator of
the number of transactions, and the price level (P) is a natural measure of the average price
per transaction. So the volume of bank deposits, D, and therefore the demand for bank reserves,
depends on both Y and P”as indicated by the label on the demand curve in Figure 1.




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Part 3
266 Fiscal and Monetary Policy



There is more to the story, however, for we have not yet explained why the the demand
curve DD slopes down and the supply curve SS slopes up. The interest rate measured along
the vertical axis of Figure 1 is called the federal funds rate. It is the rate that applies when
The federal funds rate is
the interest rates that banks banks borrow and lend reserves to one another. When you hear on the evening news that
pay and receive when they “the Federal Reserve today cut interest rates by 1„4 of a point today,” it is the federal funds
borrow reserves from one
rate that the reporter is talking about.
another.
Now where does this borrowing and lending come from? As we mentioned in the
previous chapter, banks sometimes find themselves with either insufficient or excess
reserves. Neither situation leaves bankers happy. Keeping actual reserves below the
required level is not allowed. Holding reserves in excess of requirements is perfectly
legal, but since reserves pay no interest, a bank can put excess reserves to better use by
lending them out rather than keeping them idle. So banks have developed an active mar-
ket in which those with excess reserves lend them to those with reserve deficiencies. These
F I GU R E 2 bank-to-bank loans provide an additional source of both supply and demand”and one
The Effects of an Open- that (unlike required reserves) is interest sensitive.
Market Purchase
Any bank that wants to borrow reserves must pay the federal
funds rate for the privilege. Naturally, as the funds rate rises, bor-
rowing looks more expensive and so fewer reserves are de-
S0 S1
D
manded. In a word, the demand curve for reserves (DD) slopes
downward. Similarly, the supply curve for reserves (SS) slopes
upward because lending reserves becomes more attractive as the
federal funds rate rises.
The equilibrium federal funds rate is established, as usual, at
Interest Rate




E
point E in Figure 1”where the demand and supply curves cross.
Now suppose the Federal Reserve wants to push the federal
A
funds rate down. It can provide additional reserves to the market
by purchasing Treasury bills (often abbreviated as T-bills) from
banks.3 This open-market purchase would shift the supply curve of
bank reserves outward, from S0S0 to S1S1, in Figure 2. Equilibrium
would therefore shift from point E to point A, which, as the
D
S0 S1
diagram shows, implies a lower interest rate and more bank
reserves. That is precisely what the Fed does when it wants to
Quantity of Bank Reserves
reduce interest rates.4


The Mechanics of an Open-Market Operation
The bookkeeping behind such an open-market purchase is illustrated by Table 1, which
imagines that the Fed purchases $100 million worth of T-bills from commercial banks.
When the Fed buys the securities, the ownership of the T-bills shifts from the banks to the
Fed”as indicated by the black arrows in Table 1. Next, the Fed makes payment by giving the
banks $100 million in new reserves, that is, by adding $100 million to the bookkeeping entries
that represent the banks™ accounts at the Fed”called “bank reserves” in the table. These re-
serves, shown in blue in the table, are liabilities of the Fed and assets of the banks.
You may be wondering where the Fed gets the money to pay for the securities. It could
pay in cash, but it normally does not. Instead, it manufactures the funds out of thin air or,
more literally, by punching a keyboard. Specifically, the Fed pays the banks by adding the
appropriate sums to the reserve accounts that the banks maintain at the Fed. Balances
held in these accounts constitute bank reserves, just like cash in bank vaults. Although this
process of adding to bookkeeping entries at the Federal Reserve is sometimes referred to
as “printing money,” the Fed does not literally run any printing presses. Instead, it simply



It is not important that banks be the buyers. Test Yourself Question 3 at the end of the chapter shows that the ef-
3

fect on bank reserves and the money supply is the same if bank customers purchase the securities.
There are many interest rates in the economy, but they all tend to move up and down together. So, in a first
4

course in economics, we need not distinguish one interest rate from another.




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Licensed to:

Chapter 13 267
Managing Aggregate Demand: Monetary Policy



TA BL E 1
Effects of an Open-Market Purchase of Securities on the Balance Sheets of Banks and the Fed

Banks Federal Reserve System
Assets Liabilities Assets Liabilities
Reserves 1 $100 million U.S. government Bank
U.S. government securities 1 $100 million reserves 1 $100 million
securities 2 $100 million

Banks get reserves
Addendum: Changes
in Reserves
Actual Fed gets securities
reserves 1 $100 million
Required
reserves No Change
Excess
reserves 1 $100 million




trades its IOUs for an existing asset (a T-bill). But unlike other IOUs, the Fed™s IOUs con-
stitute bank reserves and thus can support a multiple expansion of the money supply just
as cash does. Let™s see how this works.
It is clear from Table 1 that bank deposits have not increased at all”yet. So required re-
serves are unchanged by the open-market operation. But actual reserves are increased by
$100 million. So, if the banks held only their required reserves initially, they now have
$100 million in excess reserves. As banks rid themselves of these excess reserves by making
more loans, a multiple expansion of the banking system is set in motion”as described in the
previous chapter. It is not difficult for the Fed to estimate the ultimate increase in the money
supply that will result from its actions. As we learned in the previous chapter, each dollar of
newly created bank reserves can support up to 1/m dollars of checking deposits, if m is the
required reserve ratio. In the example in the last chapter, m 5 0.20; hence, $100 million in new
reserves would support $100 million 4 0.2 5 $500 million in new money.
But estimating the ultimate monetary expansion is a far cry from knowing it with
certainty. We know from the previous chapter that the oversimplified money multiplier
formula is predicated on two assumptions: that people will want to hold no more cash,
and that banks will want to hold no more excess reserves, as the monetary expansion pro-
ceeds. In practice, these assumptions are unlikely to be literally true. So to predict the
eventual effect of its action on the money supply, the Fed must estimate both the amount
that firms and individuals will add to their currency holdings and the amount that banks
will add to their excess reserves. Neither of these can be estimated with utter precision. In
summary:
When the Federal Reserve wants lower interest rates, it purchases U.S. government
securities in the open market. It pays for these securities by creating new bank reserves,
which lead to a multiple expansion of the money supply. Because of fluctuations in peo-
ple™s desires to hold cash and banks™ desires to hold excess reserves, the Fed cannot pre-
dict the consequences of these actions for the money supply with perfect accuracy. But
the Fed can always put the federal funds rate where it wants by buying just the right
volume of securities.5
For this reason, in this and subsequent chapters, we will simply proceed as if the Fed
controls the federal funds rate directly.


Why? Because the federal funds rate is observable in the market every minute and hence need not be estimated.
5

If interest rates do not fall as much as the Fed wants, it can simply purchase more securities. If interest rates fall
too much, the Fed can purchase less. And these adjustments can be made very quickly.




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Licensed to:
Part 3
268 Fiscal and Monetary Policy


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