Economics #5: Monetary Policy

Ever since the panic of 2008, the federal reserve has been working overtime to patch up holes in the economy. There was QE1, ZIRP, QE2, Operation Twist, QE3, and most recently, an interest rate hike at the end of 2015. In his book The Only Game in Town, Mohamed El-Erian argues that these monetary policy band-aids have reached the limits of their efficacy. El-Erian believes that a pivot to real structural reform is long overdue.

But since the political will to enact real reform is in short supply, it looks like the federal reserve, and the monetary policy that it sets, will continue to be front and center on the world stage. This post will break down how monetary policy works.

The Bank’s Bank

Before we get into the main tools of monetary policy, we should digress to talk about another key role that central banks play: regulating and overseeing a nation’s commercial banks. For example, the Fed sets both capital and reserve requirements that limit the amount of risk banks can take on.

Imagine two banks, Bank A and Bank B. Neither bank knows when a sudden influx of customers will withdraw their deposits from the bank, so they keep a buffer on hand in the form of reserves deposited at the central bank. If a bank wants to live dangerously and ignore the buffer, the central bank can impose a reserve requirement.

Now imagine that during the course of a work day, Bank A has a large influx of withdraws and their reserves fell below the reserve requirement. Bank A would have four options: 1) they could raise capital, 2) they could sell assets, 3) they could borrow reserves from the Fed at the discount window rate, or 4) they could borrow reserves from Bank B at the fed funds rate.

The first two options take time and aren’t practical for hitting daily reserve requirements. The third option can be expensive and signal bank weakness. The fourth option is what usually happens. Bank B will lend Bank A some of their excess reserves in an overnight loan and then the next day that loan will either be rolled over or repaid. This inter-bank lending market is where the monetary policy magic happens.

Open Market Operations

The fed funds rate is the interest rate that banks charge to lend reserves to each other. This is the rate that the Fed targets when they perform monetary policy.

Let’s go back to Bank A and Bank B. Bank B might charge Bank A an annual rate of 5% for its excess reserves. Since Bank B could safely lend at 5% to Bank A, there would be no incentive to lend to customers at any rate lower than 5%. In the same way, Bank A would need to make at least 5% on their borrowed reserves in order to make any profit. Thus the fed funds rate is the base that other interest rates in an economy are set upon.

Now imagine that the Fed wants to stimulate the economy. They figure that lower interest rates will spur the populace to borrow and spend. They can’t force the banks to lower interest rates, but they can increase the supply of money in the economy. Through open market operations, the Fed can print money (electronically) in order to buy treasury securities from the banks.

The way this works is that the banks would give the Fed their treasury securities and the Fed in return would credit their reserve balances. Ultimately, the reserves in the banking system will increase. What happens to our two bank example now? Bank A will have less demand for reserves and Bank B will have more supply of reserves. When the supply increases and the demand decreases, the price of reserves (fed funds rate) decreases.

Since money is cheaper for banks, it should be cheaper for banks customers.

Quantitative Easing

Open market operations works well in normal times, but hit a snag when the fed funds rate is already at zero. This is when non-traditional policies like quantitative easing and negative interest rates might come into play.

Quantitative easing works in the same way as open market operations, but instead of buying short-term treasury securities, the fed buys longer term securities like mortgages. The logic goes that if short-term rates are already at zero, might as well target long-term rates. Quantitative easing also has a second order effect of providing liquidity to markets that might have frozen up, for example the mortgage-backed security market after the great recession.

Imagine Bank A has a bunch of MBSs on its balance sheet and that the value of them are uncertain. Bank A can’t use them as collateral for reserves since no one will take something they are uncertain about, so Bank A is forced to pull credit lines from customers in order to stay solvent. This causes credit markets freeze up, as everyone has to sell assets and stop lending at the same time. The fed, through quantitative easing, can just say give us all your MBSs and we will credit your reserve account with liquid cash. In theory, Bank A will be free of the MBS weight and lend freely again.

No Free Lunch

If all of this can help the economy, why not always be in a state of expansionary monetary policy? Remember that the Fed is effectively creating money out of thin air to buy these assets. When you create more money, money is worth less. This takes time to funnel through the economy, but eventually prices will rise to reflect the increased money supply. If everyone all of a sudden has twice as much money, prices will just double, and no one will be any richer.

This is the magic trick of monetary policy, in the short-run it can stimulate demand but in the long-run it might just lead to increased inflation. Central banks have to perform a balancing act, and take away the punch bowl before things get out of hand.

Real world examples

In the late 1970s, inflation was running rampant. Paul Volcker, the Fed chairman at the time, used open market operations to decrease the money supply and increase interest rates. Volker managed to bring inflation back down, but at the cost of jobs and a recession.

During the great depression, banks were holding onto a bunch of illiquid assets in the form of stocks and bonds (much like the MBS in 2008). This meant that banks could not exchange their assets easily for the cash that their customers were withdrawing. Banks began to fail in mass. Instead of providing emergency liquidity to the banks, the Fed let them fail. Because of this, the Fed is often blamed for prolonging the great depression.


Monetary policy is a short-term tool for controlling the money supply of an economy. It can smooth over periods of panic by keeping markets liquid and functioning. However, too much expansionary monetary policy can led to high inflation and too much contractionary monetary policy can lead to high unemployment.



Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

1 thought on “Economics #5: Monetary Policy”

  1. I have just finished reading “Stress Test”, by Timothy Geithner (quoted at the beginning). During the Financial Melt-Down (4Q07-1Q09), he switched from the Presidency of the New York Federal Reserve Bank to become President Obama’s Secretary of the Treasury, from 2009 to 2012. Besides being intimately involved in saving the Economy, and thereby the Nation, he had previously worked on the Mexican Peso crisis, as well as those of several Asian nations. For a proper reading of the book, it helps to have some grasp of financial concepts.

    I also agree with the premise that Monetary Policy can only do so much by itself, especially when (he Fed Funds) rates descend near zero. That’s why it was enlightening that to read, a few months ago, that the Bank of England and the Exchequer a(Treasury) announced a multi-pronged combination of both Monetary and Fiscal Policy, in order to offset some of the downside of the Brexit.

    As Geithner’s book Stress Test points out, lowering the Funds Rate by 0.25% is meaningless–in jump-starting Consumer Spending–when people are unemployed. But Government Spending (Fiscal Policy) will keep them working, paying taxes and spending.

    Great blog post!

    Liked by 1 person

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