The Mechanics of Monetary Policy
Up to now we have been assuming that the central bank has been determining inflation by appropriate use of its monetary policy instruments. However, we have not specified the relation between inflation and the monetary policy instruments.
As discussed in chapter 12, the two main instruments of monetary policy are the money supply and the nominal interest rate. These two instruments are not independent, but are related through the money demand function. Thus, if the central bank wishes to achieve a given nominal interest rate target, it must be prepared to supply the stock of money (liquidity) demanded at this nominal interest rate. If the central bank wishes to achieve a given target for the stock of money, then it must be prepared to accept the nominal interest rate that equates the demand with the supply of money.
We have already referred to the classic analysis of the appropriate choice of monetary instrument by Poole [1970] and the demonstration by Sargent and Wallace [1975] that, under rational expectations, a noncontingent interest rate target leads to price level indeterminacy and instability. We have also discussed why this problem does not arise in the case of contingent interest rate rules that make the nominal interest rate depend on the price level (McCallum [1981]), or a sufficiently sensitive positive function of inflation in the context of a Wicksell [1898] or Taylor [1993] rule.11
In any case, central banks have been consistently using interest rates as their main monetary policy instrument.12 In the light of this fact, we shall confine our analysis of monetary policy to contingent rules for the nominal interest rate, such as the Taylor [1993] rule.13
Before we analyze such rules, it is worth delving a little deeper into the mechanics of monetary policy.
20.4.1 Financial Markets and Open Market Operations
Monetary policy affects the economy through its effects on conditions in financial markets, mainly nominal and real interest rates.
In particular, conventional monetary policy operates through interventions in money markets, where short-term debt instruments (such as treasury bills and short-term deposits of financial institutions) are traded. Through buying and selling short-term securities, a central bank can affect short-term interest rates in the market. If it wishes to increase short-term interest rates, then it sells treasury bills or other short-term financial instruments, depressing their prices and causing an increase in their interest yield. If it wishes to reduce short-term interest rates, then it buys short-term financial instruments, causing their price to increase and thus reducing their interest yield.Consider a one-period discount bond that pays B at the end of period t. Its price (value) at the beginning of the period is equal to V = B/(1 + i), where i is the nominal interest rate.
Arbitrage in financial markets thus ensures that the rate of return of a one-period bond will be equal to the short-term interest rate i. Hence, a (risk-neutral) investor who could borrow at the short-term interest rate i would be indifferent between (1) borrowing at the interest rate i and investing in the bond or (2) not borrowing and not investing in the bond. It is clear that for a given bond payment at the end of the period, there is an inverse relation between the bond price and the nominal interest rate. Thus, if the central bank buys more short-term securities in the secondary market and increases their price V, it effectively reduces short-term interest rates. Such operations are called open market operations.
For example, the US Federal Reserve aims to affect the so-called federal funds rate, which is an overnight rate. This is the interest rate at which depository institutions, such as commercial banks, trade federal funds (balances held at Federal Reserve Banks) with one another overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances.
In other words, a bank with excess liquidity will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined by the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate. The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.The Federal Open Market Committee meets eight times a year to determine the federal funds target rate. This target rate influences the effective federal funds rate through open market operations. More specifically, the Federal Reserve decreases liquidity by selling treasury bills, thereby raising the federal funds rate, because banks then have less liquidity to trade with other banks. Similarly, the Federal Reserve can increase liquidity by buying treasury bills, decreasing the federal funds rate, because banks then have excess liquidity for interbank trades.
Similar procedures are followed by central banks in the other industrial economies with developed financial markets, such as the European Central Bank, the Bank of Japan, and the Bank of England.
20.4.2 The Term Structure of Interest Rates
The federal funds rate is the central interest rate in the US financial market. It influences other interest rates, such as the prime rate, which is the rate banks charge their customers with higher credit ratings. Additionally, the federal funds rate indirectly influences longer-term interest rates, such as the yield of government bonds, corporate bonds, mortgages, loans, and savings, all of which are very important to the cost of borrowing, consumer wealth, and confidence.
Interest rates on short- and long-term securities are related through the term structure of interest rates. Assume that there are two types of discount bonds, which are perfect substitutes: a short-term bond, which pays an interest rate i1 at the end of one period, and a long-term bond, which lasts for n periods and pays a rate of return nin at the end of n periods.
Here in is the per period interest rate of the n-period bond.Assuming that investors are risk neutral, they will be indifferent between investing in a sequence of one-period bonds for n periods and an n-period bond, if the two types of portfolio investment have the same expected rate of return. Hence, at time t, arbitrage would ensure that
From (20.28), it follows that the per period rate of return of the n-period bond would be equal to the average expected rate of return of one-period bonds between period t and period t + n:
Thus, open market operations that affect short-term rates would cause long-term rates to move in the same direction. If the change in short-term rates is temporary, then a rise in the short-term rate by one percentage point would raise long-term rates by 1/n of a percentage point. If the change is permanent, it will raise long-term rates by one full percentage point as well. If it is expected to persist for m periods, where m < n, then the effect on long-term rates will be m/n of a percentage point as well.
This theory of the term structure of interest rates, which results in long-term rates being the average of the expected future short-term rates, is called the expectations theory of the term structure.
The theory can be extended to allow for risk-averse investors. In that case, (20.29) is modified to
where 
is a positive term premium to holding an n-period bond, reflecting the higher uncertainty about the rate of return of the long-term bond.
Hence, on the basis of the expectations theory of the term structure, open market operations that affect short-term rates (such as the federal funds rate) also affect the whole spectrum of interest rates in the same direction.
20.5