Academic journal article Federal Reserve Bank of New York Economic Policy Review

Divorcing Money from Monetary Policy

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Divorcing Money from Monetary Policy

Article excerpt


Monetary policy has traditionally been viewed as the process by which a central bank uses its influence over the supply of money to promote its economic objectives. For example, Milton Friedman (1959, p. 24) defined the tools of monetary policy to be those "powers that enable the [Federal Reserve] System to determine the total amount of money in existence or to alter that amount." In fact, the very term monetary policy suggests a central bank's policy toward the supply of money or the level of some monetary aggregate.

In recent decades, however, central banks have moved away from a direct focus on measures of the money supply. The primary focus of monetary policy has instead become the value of a short-term interest rate. In the United States, for example, the Federal Reserve's Federal Open Market Committee (FOMC) announces a rate that it wishes to prevail in the federal funds market, where overnight loans are made among commercial banks. The tools of monetary policy are then used to guide the market interest rate toward the chosen target. For this reason, we follow the common practice of using the term monetary policy to refer to a central bank's interest rate policy.

It is important to realize, however, that the quantity of money and monetary policy remain fundamentally linked under this approach. Commercial banks hold money in the form of reserve balances at the central bank; these balances are used to meet reserve requirements and make interbank payments. The quantity of reserve balances demanded by banks varies inversely with the short-term interest rate because this rate represents the opportunity cost of holding reserves. The central bank aims to manipulate the supply of reserve balances--for example, through open market operations that exchange reserve balances for bonds--so that the marginal value of a unit of reserves to the banking sector equals the target interest rate. The interbank market for short-term funds will then clear with most trades taking place at or near the target rate. In other words, the quantity of money (especially reserve balances) is chosen by the central bank in order to achieve its interest rate target.

This link between money and monetary policy can generate tension with central banks' other objectives because bank reserves play other important roles in the economy. In particular, reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank's desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

Recent experience has shown that central banks perform this balancing act well most of the time. Nevertheless, it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.

The tension is clearest during times of acute stress in financial markets. In the days following September 11, 2001, for example, the Federal Reserve provided an unusually large quantity of reserves in order to promote the efficient functioning of the payments system and financial markets more generally. As a result of this action, the fed funds rate fell substantially below the target level for several days. …

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