Monetary
Policy
A journey through the Monetary Policy
Introduction: What is Monetary Policy
Monetary policy refers to the actions undertaken by a nation's central
bank (like the Federal Reserve in the U.S., the European Central Bank in
the Eurozone, or Banko Sentral in the Philippines) to control the money
supply and achieve macroeconomic goals that promote a stable economy.
These primary goals are:
Price Stability: Controlling inflation.
Maximum Employment: Promoting low unemployment.
Moderate Long-Term Interest Rates: Which are a byproduct of a
healthy economy.
Financial System Stability.
The central bank is the key institution that formulates and implements
this policy.
Mechanics of
Monetary Policy
What “reserves” are: Bank deposits at the central bank + vault cash. These are
assets for banks and liabilities for the central bank. More reserves = more
liquidity in the banking system.
How the central bank changes reserves:
Open market operations (OMO): Buying securities adds reserves; selling
drains reserves. Conducted with primary dealers; can be shown with simple T-
accounts.
Discount lending: Central bank loans to banks increase reserves; the
discount rate is the interest on these loans.
Reserve requirements: Rules on the fraction of deposits banks must hold;
rarely used because abrupt changes can create liquidity stress.
Interest on reserves (IOR): Paying interest on reserves helps put a floor under
the policy rate; after the crisis it became a practical tool to lift rates without
massive OMOs.
Mechanics of
Monetary Policy Part 2
Market for reserves → policy rate: Supply–demand for
reserves determines the federal funds rate; OMOs and
requirements shift these curves and move the rate.
Reference: Mishkin & Eakins (2018), Financial Markets and Institutions, Part
Four, Chapter 10: Conduct of Monetary Policy.
Implementing
Monetary Policy
Conventional toolkit (day-to-day implementation):
OMO to steer the overnight rate toward the target.
Discount policy to backstop funding (lender of last
resort).
Reserve requirements (used sparingly).
Interest on reserves to set a rate floor—used
heavily when excess reserves are large (e.g., liftoff
in Dec 2015).
When rates hit (near) zero→ nonconventional tools: Needed at the
zero lower bound and during severe financial stress. Four forms: (1)
liquidity provision, (2) asset purchases, (3) forward guidance, (4)
negative rates on bank deposits at the central bank.
Quantitative vs. credit easing: Expanding the balance sheet (QE)
vs. changing its composition to repair credit markets (credit
easing).
Implementing
Monetary Policy Part 2
International implementation (ECB example): Similar
toolkit—OMOs, lending facilities, IOR, and reserve
requirements—adapted to the euro area’s framework.
Reference: Mishkin & Eakins (2018), Financial Markets and Institutions, Part Four, Chapter 10:
Conduct of Monetary Policy.
Trade-Off in Monetary
Policy
[Link]-run trade-offs:
Inflation vs. employment/output: In the short run,
tightening to cool inflation can raise unemployment
and create interest-rate volatility; easing to support
jobs can risk higher inflation.
[Link]-run perspective:
No long-run trade-off between inflation and
employment (natural-rate view). Stable prices
support growth and financial/interest-rate stability
[Link] and time-inconsistency:
Hierarchical vs. dual mandates: Some central banks
put price stability first (hierarchical); the Fed
operates with a dual mandate (price stability &
maximum employment). Poorly designed incentives
risk time-inconsistent (overly expansionary) policy.
Trade-Off in Monetary
Policy Part 2
[Link] choice (inflation targeting)
Pros: Transparent, anchors expectations, reduces
political pressure for inflationary policy.
Cons (criticisms): Delayed signaling, perceived
rigidity, potential for output volatility—mitigated in
practice by flexible inflation targeting (“constrained
discretion”).
[Link]-stability trade-offs:
Risk-taking channel: Prolonged low rates can
encourage excessive risk-taking; question of
whether to “lean against” credit/asset bubbles with
policy vs. rely on macroprudential tools.
Lender of last resort: Prevents panics but creates
moral hazard (too-big-to-fail concerns).
Policymakers weigh panic prevention vs. future risk-
taking.
Reference: Mishkin & Eakins (2018), Financial Markets and Institutions, Part
Four, Chapter 10: Conduct of Monetary Policy.
