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Abstract
The topic of the Federal Reserve’s (the Fed’s) implementation of monetary policy has a significant presence in economics textbooks. Unfortunately, as the Fed purposefully shifted the way it implements monetary policy to an environment with ample reserves in the banking system, many textbooks have not kept up. The authors walk through the key policy tools the Fed uses to implement policy in the ample-reserves regime. Next, they contrast the current framework with the pre-2009 regime to highlight that there are substantial differences in the policy tools and concepts that should be taught in the classroom. Finally, they review six, 2020 or 2021 edition, principles of economics textbooks and quantify how well they cover the key concepts associated with the way the Fed implements policy.
Acknowledgments
The authors thank Ellen Meade, Ed Nelson, Mary Suiter, Gretchen Weinbach, and David Wheelock for their useful comments. The views expressed in this article are those of the authors and not necessarily those of the Federal Reserve Board, the Federal Reserve Bank of St. Louis, or the Federal Reserve System.
Notes
1 See the Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization. https://www.federalreserve.gov/newsevents/pressreleases/monetary20190130c.htm
2 High school teachers also must consider teaching to standards and guidelines. See Ihrig and Wolla (Citation2020b) for a discussion of how national standards and Advanced Placement guidelines are out of date and the authors’ recommendations for updates.
3 Banks and a few other government-sponsored entities bilaterally conduct federal funds trades at different rates and quantities. The FRBNY publishes the effective FFR, the volume-weighted median of all fed funds trades, each day. When the FOMC sets a target for the FFR, its goal is to have trades occur near the target so that the effective FFR is within the target range.
4 Prior to July 29, 2021, the Federal Reserve set interest rates on required reserves and excess reserves. Because reserve requirements do not serve as an important tool for implementing monetary policy with ample reserves, beginning in March 2020, required reserves were set to zero and all reserve balances effectively began earning the interest rate on excess reserves, which was renamed the IORB rate. For more information on reserve balances see: https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
5 Board of Governors of the Federal Reserve System, “Overnight Reverse Repurchase Agreement Facility.” https://www.federalreserve.gov/monetarypolicy/overnight-reverse-repurchase-agreements.htm
6 Federal Reserve Bank of New York. “Reverse Repo Counterparties.” https://www.newyorkfed.org/markets/rrp_counterparties
7 Board of Governors of the Federal Reserve System. “Overnight Reverse Repurchase Agreement Facility.” https://www.federalreserve.gov/monetarypolicy/overnight-reverse-repurchase-agreements.htm
8 The discount window offers three types of credit to depository institutions: primary credit, secondary credit, and seasonal credit, each with its own interest rate. Most credit is done at the primary credit rate.
9 The Fed introduced a standing repo facility for select large financial institutions and a foreign and international monetary authorities repo facility for a subset of these organizations that have accounts at the Fed.
10 Demand for currency grows at a rate of about 6 percent per year. When a bank requests currency for its customers, an armored truck comes to a regional Federal Reserve Bank, picks up the cash that was ordered, and delivers it to the ordering bank. The Fed decreases the ordering bank’s reserve account to take payment for the cash. See Ihrig, Senyuz and Weinbach (2020b) for a discussion of key factors that naturally drain reserves from the banking system.
11 Some call the Fed’s purchases of securities a standard or traditional OMO. The ON RRP facility, which was fully established in 2015, is another form of an OMO. The traditional OMO is where the Fed determined the quantity of government securities it wants to buy (or sell) from primary dealers (i.e., securities dealers who are active in the market for U.S. government securities and have agreed to do operations with the Fed). When the Fed initiates a purchase, it pays for the securities by crediting the reserve accounts of the banks used by the primary dealers and, hence, boosts reserves in the banking system. The ON RRP facility, on the other hand, stands ready to purchase the quantity of securities that a broader set of counterparties determine they want to place at the Fed.
12 For more discussion of how changes in the federal funds rate affect the broader economy, see this overview on the Board’s website: https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm
13 In the 1970s and 1980s, money supply growth was seen as a key factor influencing economic activity and the price level. As a result, the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act, required the Federal Reserve to set one-year target ranges for money supply growth and to report to Congress on the behavior of the money supply relative to those target ranges. However, because the historical relationships among these variables were not stable, the FOMC gradually shifted away from a focus on the monetary aggregates as a key guide for monetary policy over time. By the mid-1990s, the FOMC increasingly focused on adjusting a target for the level of short-term interest rates with the goal of influencing overall financial conditions in a way that would attain the Committee’s dual mandate.
14 Many textbooks present the limited-reserves framework where the Fed uses OMOs to achieve a desired level of the money supply to move market interest rates to the FOMC’s target and ultimately steer the economy toward the Committee’s dual mandate. Today, in an ample-reserves regime, the Fed must ensure the quantity of reserves is ample, but targeting a particular level of reserves (or money supply) is not the focus for policy implementation.
15 When central banks provide forward guidance, individuals and businesses will use this information in making decisions about spending and investments. Thus, forward guidance about future policy can influence financial and economic conditions today. A timeline of the FOMC’s setting of the policy rate and use of forward guidance is found here: https://www.federalreserve.gov/monetarypolicy/timeline-forward-guidance-about-the-federal-funds-rate.htm
16 In an emergency, the Federal Reserve has the power to provide liquidity to depository institutions using standard traditional tools, like open market operations and discount window lending. Under section 13(3) of the Federal Reserve Act, the U.S. central bank also has authority to provide liquidity to nondepository institutions in “unusual and exigent circumstances.” Since the passage of the Dodd-Frank Act in 2010, the Board’s authority to engage in emergency lending has been limited to programs and facilities with “broad-based eligibility” that have been established with the approval of the Secretary of the Treasury. For a detailed discussion of the Federal Reserve’s response to the 2007–9 financial crisis see: https://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm
Similarly, the extensive measures taken by the Fed during the COVID-19 pandemic are found here: https://www.federalreserve.gov/covid-19.htm
17 See Ihrig, Weinbach, and Wolla (Citation2020) for a discussion of the Fed’s early monetary policy response to the COVID-19 shock.
18 Section 13.3 of the Federal Reserve Act lays out actions the Fed can take in unusual and exigent circumstances. And, the Dodd-Frank Act of 2010 includes additional requirements, including the approval of the Secretary of the Treasury.
19 The FOMC has made statements through the years that it wants, in the longer run, to hold no more securities than necessary to implement monetary policy efficiently and effectively. Holding other parts of the Fed’s balance sheet constant, an increase (decrease) in securities will increase (decrease) reserves. So a statement about “holding no more securities than necessary” is also saying the Fed plans to hold no more reserves than necessary to implement policy efficiently and effectively. More information about the Federal Reserve’s discussion of efficient and effective is summarized at the following link: https://www.federalreserve.gov/monetarypolicy/policy-normalization-discussions-communications-history.htm
20 Over the years the FOMC has released multiple statements related to policy normalization. A summary of these communications is found here: https://www.federalreserve.gov/monetarypolicy/policy-normalization.htm
21 Before the 2007–9 Global Financial Crisis the Fed operated with limited reserves in the banking system. The Fed conducted large-scale asset purchases aimed at lowering longer-term interest rates to help boost the economy during this crisis and the subsequent recession. This action boosted reserves to unprecedented levels. For a detailed discussion of how the Fed moved from the limited- to ample-reserves regime, see the St Louis Federal Reserve Bank’s Economic Lowdown webinar “Monetary Policy in Ordinary and Extraordinary Times,” at https://www.stlouisfed.org/education/econ-lowdown-webinar-series/monetary-policy-in-ordinary-and-extraordinary-times
22 Although these scores reflect the specific metric used in the evaluation, another metric would provide a similar ranking of the textbooks.
23 Mateer and Coppock’s (2021) figure 31.1 (1004) and Mankiw’s (2021) figure 3 (726) examine the effect of the Fed buying bonds on the money supply and how that translates into the economy. McConnell, Brue, and Flynn’s (2021) Figure 36.3 (720) shows an increase in the money supply, although it does not explicitly note the Fed action that boosted the supply.
24 For example, McConnell, Brue, and Flynn (Citation2021) state “The Fed has, however, shown an eagerness in recent years to alter the rate of interest on excess reserves (IOER) as a way of managing bank reserves and the supply of money” (714). Mankiw (Citation2021, 604) says, “The higher the interest rate on reserves, the more reserves banks will choose to hold. Thus, an increase in the interest rate on reserves will tend to increase the reserve ratio, lower the money multiplier, and lower the money supply” (604). Mateer and Coppock (Citation2021) say, “This historic change in policy means that banks now have less incentive to loan out each dollar above the required reserve threshold. The Fed put this policy in place to reduce the opportunity cost of excess reserves. The increase in excess reserves means that the money multiplier is much smaller than our earlier analysis implied. When banks hold more dollars on reserve, fewer are loaned out and multiplied throughout the economy” (995).
25 OMOs have been used quite often in 2019 and 2020 as the Fed addressed different stresses. The authors might consider adjusting their words about OMOs being a historical lesson.
26 For example, they refer to the limited-reserves tools in the past tense “traditionally the Fed had three tools available to it to control the interest rate via changing the money supply: open market operations, changing the reserve requirement ratio, and changing the discount rate that banks pay to the Fed to borrow reserves” (526).
27 We award Hubbard and O’Brien (Citation2021) a point for saying IORB is the primary tool, although this is only implied by the text on page 880. This point could be brought out more forcefully in their next edition.
28 In 2020, many additional education resources were posted on the Federal Reserve System’s Web sites, including “The Fed’s New Monetary Policy Tools” (Page One Economics, St. Louis Fed), “How Does the Fed Influence Interest Rates Using Its New Tools” (Open Vault Blog, St. Louis Fed), and “Closing the Monetary Policy Curriculum Gap: A Primer for Educators Making the Transition to Teaching the Fed’s Ample-Reserves Framework” (FEDS Notes, Federal Reserve Board of Governors). Ihrig, Senyuz, and Weinbach (Citation2020a) have a primer that presents most of the key concepts of an ample regime. However, they do not walk through an interest rate adjustment. Also, their discussion is quite detailed in some areas, making it a good resource for money and banking courses that dive into more details than discussed in a principles textbook.