Monetary policy is the control of the quantity of money available in an economy

and the channels by which new money is supplied. It refers to the use of monetary
instruments under the control of the central bank to regulate magnitudes such as
interest rates, money supply and availability of credit with a view to achieving the
ultimate objective of economic policy. Broadly speaking, monetary policy is either
expansionary or contractionary. An expansionary policy aims to increase spending
by businesses and consumers by making it cheaper to borrow. A contractionary
policy forces spending lower by making it more expensive to borrow money.
Depending on which is needed at the time, these policies bring inflation into an
acceptable range, keep unemployment at acceptable levels & maintain the value of
the currency.
Difference b/w Monetary & Fiscal Policy
Monetary policy is enacted by a central bank with the mandate to keep the
economy on an even keel. The aim is to keep unemployment low, protect the value
of the currency, and maintain economic growth at a steady pace. It achieves this
mostly by manipulating interest rates, which in turn raises or lowers borrowing,
spending, and savings rates. Inflation targeting monetary policy is adopted by all
central banks. Price stability goal of low & stable inflation is adopted by central
banks of emerging economies and developed countries because most frontier
economies are struggling to fight high inflation
Fiscal policy is enacted by the national government. It involves spending taxpayer
dollars in order to spur economic recovery. It sends money, directly or indirectly, to
increase spending and turbo-charge growth.
Central Bank’s Balance Sheet
The conduct of monetary policy by the Central Banks involves actions that affect its
balance sheet (holdings of assets and liabilities).

Liabilities
The two liabilities on the balance sheet are
● Currency in circulation
● Reserves
These are referred to as the monetary liabilities of the Central Bank. They are an
important part of the money supply story because increases in either or both will
lead to an increase in the money supply (everything else being constant). The sum
of the Central Bank’s monetary liabilities (currency in circulation & reserves) and the
Treasury’s monetary liabilities (Treasury currency in circulation are primarily coins) is
called the monetary base. The monetary liabilities of the Treasury account for less
than 10% of the base.
Currency in circulation
The Central Bank issues currency. Currency in circulation is the amount of
currency in the hands of the public (outside banks), an important component of
money supply. Currency held by depository institutions is also a liability of the
Central Bank but is counted as part of its reserves. These notes are IOUs from the
Central Bank to the bearer & are also liabilities, but unlike most, they promise to pay
back the bearer solely with Central Bank notes; that is, they pay off IOUs with other
IOUs. People are more willing to accept IOUs from the Central Bank because these
notes are a recognized medium of exchange, accepted as a means of payment and
functions as money.
Reserves
All banks have an account at the Central Bank in which they hold deposits.
Reserves consist of their deposits at the Central Bank plus currency physically
held by banks (called vault cash because it is stored in bank vaults). Reserves are
assets for the banks but liabilities for the Central Bank because banks can demand
payment on them any time. The Central Bank is obliged to satisfy its obligation by
paying Central Bank notes. An increase in reserves leads to an increase in the level
of deposits and hence in the money supply.
The total reserves can be divided into two categories:
● Required Reserves: The Central Bank requires banks to hold. The Central
Bank might require that for every deposit at a depository institution, a certain
fraction must be held as reserves. This fraction is called the required reserve
ratio.
● Additional Reserves: The banks choose to hold (excess reserves). Banks
need to invest in their surplus position from time to time. For this, they invest
their excess funds with the Central Bank if the Money Market rates are low.
The currency item on the central bank’s balance sheet refers only to currency in
circulation. Currency that has been printed is not automatically a liability of the
central bank.
Assets
The two assets on the Central Bank’s balance sheet are:
● Government Securities
 ● Discount Loans
The assets on the Central Bank’s balance sheet are important because, firstly, the
changes in the asset items lead to changes in reserves and consequently to
changes in the money supply. Secondly, because these assets (government
securities & discount loans) earn interest while the liabilities (currency in circulation
& reserves) do not, the Central Bank makes billions of rupees each year. Although it
returns most of its earnings to the central government, it does spend some of it on
“worthy causes,” such as supporting economic research.
● Government securities: This category of assets covers the Central Bank’s
holdings of securities issued by the Government Treasury. The Central Bank
provides reserves to the banking system by purchasing securities, thereby
increasing its holdings of these assets. An increase in government securities
held by the Central Bank leads to an increase in the money supply.
● Discount loans: The Central Bank can provide reserves to the banking
system by making discount loans to banks. An increase in discount loans is
another source of an increase in the money supply. The interest rate charged
for these loans is called the discount rate.
How Fed Actions Affect Reserves in the Banking System
All banks have an account at the Fed in which they hold deposits. Reserves consist
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 & thus when the Fed takes actions to increase these reserves, it
increases liquidity in the banking system. The total reserves can be divided into two
categories:
● Required reserves: Reserves that the Fed requires banks to hold.
● Excess reserves: Any additional reserves the banks choose to hold.
The Fed imposes regulations, called reserve requirements, making it obligatory for
banking institutions to keep a certain fraction of their deposits as reserves with the
Fed. The Fed might require that for every deposit at a depository institution, a
certain fraction must be held as reserves. This fraction 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
● 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. The Federal Reserve’s purchases and sales of bonds are always
done with primary dealers, government securities dealers who operate out of private
banking institutions.
When the primary dealer sells bonds to the Fed, the Fed adds to the dealer’s
deposit account at the Fed, so that reserves in the banking system go up.

The effect on the Fed’s balance sheet is that it has gained securities in its assets
column, whereas reserves have increased, as shown in its liabilities column.

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 have
increased, and since these can be lent out, liquidity in the banking system has
increased.
Open market purchases of bonds expand reserves in the banking system because
the central bank pays for the bonds with reserves. When a central bank conducts an
open market 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.
Discount Lending
Reserves are also changed when Fed makes a discount loan to the bank, referred
to as borrowed reserves. Interest rate charged by banks for these loans is called
the discount rate.
When the Fed makes a discount loan to the bank, the Fed then credits to the bank’s
reserve account. The effects on the balance sheets of the banking system and the
Fed are:
Thus, discount loans lead to expansion of reserves, which can be lent out,
thereby leading to expansion of liquidity in the banking system.
Conversely, when a bank repays its discount loan & so reduces the total
amount of discount lending, the amount of reserves decreases along with
liquidity in the banking system.
The Market for Reserves and the Federal Funds Rate
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 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

The amount of reserves can be split into two components:

● Required reserves, which equal the required reserve ratio times the amount
of deposits on which reserves are required
● 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.
The Fed has paid interest on 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 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 slopes
downward when the federal funds rate is above. If the federal funds rate begins to
fall below the interest rate paid on reserves, 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 becomes flat (infinitely elastic), causing the “floor rate”.
Supply curve

The supply of reserves can be broken into two components:

● The amount of reserves that are supplied by the Fed’s open market
operations, nonborrowed reserves (NBR)
● 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. Because borrowing federal funds from other banks is
a substitute for borrowing (taking out discount loans) from the Fed, if the federal
funds rate is below the discount rate, the banks will not borrow from the Fed and
borrowed reserves will be zero because borrowing in the federal funds market is
cheaper. Thus, the supply of reserves will just equal the amount of nonborrowed
reserves supplied by the Fed, NBR & so the supply curve will be vertical.
However, if the federal funds rate were to rise even infinitesimally above the
discount rate, banks would want to keep borrowing more and more and then lending
out the proceeds in the federal funds market at the higher rate. The result is that the
federal funds rate can never rise above the discount rate and the supply curve
becomes flat (infinitely elastic). This causes the “ceiling rate”.
Market Equilibrium
Market equilibrium occurs when the quantity of reserves demanded equals the
quantity supplied. Equilibrium therefore occurs at the intersection of the demand
curve and the supply curve, with an equilibrium federal funds rate. When the federal
funds rate is above the equilibrium rate, more reserves are supplied than demanded
(excess supply) and so the federal funds rate falls. When the federal funds rate is
below the equilibrium rate, more reserves are demanded than supplied (excess
demand) and so the federal funds rate rises.
How Changes in the Tools of Monetary Policy Affect the Federal Funds Rate
● Open market operations
● Discount lending
● Reserve requirements
● Interest rate paid on reserves
Open market operations and discount lending affect the federal funds rate by
injecting reserves into the banking system, thereby changing the supply of reserves,
while the reserve requirements affect the federal funds rate by changing the
demand for reserves and the interest rate paid on reserves affects the federal funds
rate by changing the interest rate paid on reserves.
Open Market Operations
The effect of an OMO depends on whether the supply curve initially intersects the
demand curve in its downward sloped section versus its flat section.
An open market purchase leads to a greater quantity of reserves supplied at any
given federal funds rate, because of the higher amount of nonborrowed reserves. An
open market purchase therefore shifts the supply curve to the right and moves the
equilibrium, and the ff rate is lowered.
An open market sale decreases the quantity of nonborrowed reserves supplied,
shifts the supply curve to the left, and causes the ff rate to rise, since the Fed usually
keeps the federal funds rate target above the interest rate paid on reserves. (Floor
rate)
The conclusion is that an open market purchase causes the ff rate to fall, whereas
an open market sale causes the ff rate to rise, if it initially intersects the demand
curve on its downward slope.
However, if the supply curve initially intersects demand curve on its flat section,
OMO has no effect on the ff rate.
To see this, let’s again look at an open market purchase that raises the quantity of
reserves supplied, which shifts the supply curve.
The shift in the supply curve moves the equilibrium, but the ff rate remains
unchanged because the interest rate paid on reserves sets a floor for the ff rate.
Discount Lending

Effect of a discount rate change depends on whether demand curve initially

intersects supply curve in its vertical section versus its flat section. If the intersection
occurs in the vertical section of the supply curve, there is no discount lending and
borrowed reserves are zero. In this case, when the discount rate is lowered by the
Fed, the horizontal section of the supply curve falls, but the intersection of the supply
& demand curves remains. Thus, in this case, no change occurs in the equilibrium ff
rate, which remains.
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 (Ceiling Rate)
However, if the demand curve intersects supply curve on its flat section, so there is
some discount lending, 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.
When the discount rate is lowered by the Fed, the horizontal section of the supply
curve falls, moving the equilibrium & the equilibrium ff rate falls.
Reserve Requirements

When required reserve ratio increases, required reserves increase & 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, moves
the equilibrium, and in turn raises the federal funds rate. The result is that when the
Fed raises reserve requirements, the ff rate rises.
Conversely, decline in the required reserve ratio lowers the quantity of reserves
demanded, shifts the demand curve to the left & causes the ff rate to fall. When the
Fed decreases reserve requirements, the ff rate falls.
 Interest on Reserves

The effect of a change in the interest rate on reserves that Fed pays depends on
whether the supply curve intersects the demand curve in its downward-sloping
versus its flat section. If the intersection occurs on the demand curve’s
downward-sloping section, the equilibrium federal funds rate is above the interest
rate paid on reserves.
In this case, when the interest rate on reserves is raised, the horizontal section of
the demand curve rises, but the intersection of the supply and demand curves
remains.
However, if the supply curve intersects the demand curve on its flat section, where
the equilibrium ff rate is at the interest rate paid on reserves, a rise in the interest
rate on reserves moves the equilibrium, where the equilibrium ff rate rises.
When the ff rate is at the interest rate paid on reserves, a rise in the interest rate on
reserves raises the ff rate. Conversely, a fall in the interest rate paid on reserves
lowers the ff rate.
Conventional Monetary Policy Tools
The Federal Reserve uses four tools of monetary policy to control the interest rates
● Open market operations
● Discount lending
● Reserve requirements and
● Paying interest on reserves
These are referred to as conventional monetary policy tools.
Open Market Operations
Open market operations were the primary monetary 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 which are intended to change the level of
reserves and
● Defensive open market operations which are intended to offset movements
in other factors that affect reserves.
The Fed conducts most of its open market operations in Treasury securities because
the market for these securities 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. The
decision-making authority for OMO is the Federal Open Market Committee (FOMC),
which sets a target for the federal funds rate. The actual execution of these
operations, however, is conducted by the trading desk. The best way to see how
these transactions are executed is to look at a typical day at the trading desk, given
below:

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
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.
Operation of the Discount Window
The Fed’s discount loans to banks are of three types:
● Primary credit
● Secondary credit
● Seasonal credit
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 FOMC.
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 will stay at id
because borrowed reserves will just continue to increase, and the ff rate can rise no
further. The primary credit facility has thus put a ceiling on the ff rate at id.
Secondary credit is given to banks that are in financial trouble and are
experiencing 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 &
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 with the ability of financial
intermediaries and markets to move funds to people with productive investment
opportunities.
Unfortunately, the discount tool has not always been used by the Fed to prevent
financial panics, as the massive failures during the Great Depression. 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. 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: Banks take on more risk, thus exposing 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, Fed’s actions to prevent financial panic may encourage FIs 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 often.
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. All depository institutions, including commercial
banks, savings and loan associations, mutual savings banks, and credit unions, are
subject to the same reserve requirements. In extraordinary circumstances, the
percentage can be raised as high as 18%. Reserve requirements have rarely been
used as a monetary policy tool because raising them can cause immediate liquidity
problems for banks with low excess reserves. When the Fed increased these
requirements in the past, it usually softened the blow by conducting open market
purchases or by making the discount loan window more available, thereby providing
reserves to banks that needed them. Continually fluctuating reserve requirements
would also create more uncertainty for banks & make liquidity management more
difficult.
Interest on Reserves
Because the Fed only started paying interest on 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 borrowing
and lending in the federal funds market so that banks monitor each other—the Fed
typically sets the interest rate on reserves to be below the federal funds target.
In this case interest on reserves will not be used as a tool of monetary policy but
instead will just help provide a floor under the federal funds rate. However, in the
aftermath of the global financial crisis, banks have accumulated huge quantities of
excess reserves, and in this situation, to increase the federal funds rate would
require massive amounts of open market operations to remove these reserves from
the banking system.

The interest-on-reserves tool can come to the rescue because raising this interest
rate can instead be used to raise the federal funds rate. Indeed, this tool of monetary
policy was extensively used when the Fed wanted to raise the federal funds rate and
exit from maintaining it at zero in December 2015.