Most of the ingredients of the standard intro econ class have been pretty stable for a long time: opportunity cost and budget constraints, supply and demand, perfect and imperfect competition, externalities and public goods, unemployment and inflation, growth and business cycles, benefits and costs of international trade. In contrast, the topic of how the central bank conducts monetary policy has shifted substantially more than decade ago, in a way that makes earlier textbooks literally obsolete. Jane Ihrig and Scott Wolla offer an overview of the changes in \”Monetary Policy Had Changed, Has Your Instruction?\” (Teaching Resources for Economics at Community Colleges Newsletter, March 2021). For a more in-depth discussion, Ihrig and Wolla wrote: “Let’s close the gap: Revising teaching materialsto reflect how the Federal Reserve implements monetary policy” (October 2020, Federal Reserve Finance and Economics Discussion Series 2020-092)
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As Ihrig and Wolla point out, the traditional pedagogy of how monetary policy works focuses on how the Federal Reserve can raise or lower a specific targeted interest rate: the \”federal funds\” rate. It goes like this:
One big change is in the \”policy implementation\” arrow. When I was taking intro econ in the late 1970s or when I was teaching big classes in the late 1980s and into the 1990s, the textbooks all discussed three tools for conducting monetary policy: open market operations, changing the reserve requirement, or changing the discount rate.
This shift in framework was spurred on by actions during the global financial crisis. Between 2008 and 2014 the Fed conducted a series of large-scale asset purchase programs to lower longer-term interest rates, ease broader financial market conditions, and thus support economic activity and job creation. These purchases not only increased the Fed\’s level of securities holdings but also increased the total level of reserves in the banking system from around $15 billion in 2007 to about $2.7 trillion in late 2014. At this point, reserves were no longer limited but instead became quite plentiful, or \”ample.\”
Bank reserves expanded enormously, as shown in this figure. In turn, this shift from \”limited reserves\” to the new era of \”ample reserves\” opened up the possibility for a new tool of monetary policy: the Fed could pay interest on these bank reserves.
In short, the primary tool that the Fed now uses for the conduct of monetary policy is \”interest on reserves,\” often abbreviated as IOR. This isn\’t hard to explain. Reserves go up and down for two reasons: one is if the Fed is using quantitative easing to buy Treasury debt or mortgage-backed securities directly, or not; the other is if banks prefer to hold reserves at the Fed and receive the IOR payments, or not. By moving the IOR up or down, the Fed still seeks to target the federal funds interest rate. For example, that rise in the fed funds rate from about 2016-2018, shown above, was a result of a rise in the interest rate paid on reserves.
For example, during both crises, the Fed conducted large-scale asset purchases to either deliberately push down longer-term interest rates (the motive during the 2007-2009 financial crisis and subsequent recession) or aid market functioning and help foster accommodative financial conditions (the motive during the COVID-19 pandemic). As a traditional open market operation, when the Fed also made adjustments to existing lending facilities and introduced new, emergency lending facilities to help provide short-term liquidity to banks and other financial institutions. For example, the Fed expanded its currency swap program where it loans dollars to foreign central banks to alleviate dollar funding stresses abroad. It also introduced the Primary Dealer Credit Facility during both stress events, which provided overnight loans to primary dealers and helped foster improved conditions in financial markets.
The current standard practice for teaching the conduct of monetary policy at the intro level is still emerging. At present, my own take is to discuss the shift from limited reserves too ample reserves to give some sense of how these issues have evolved, but as time passes, it will eventually be time to drop the old limited-reserves approach entirely. Instead, for the current time, the tools of monetary policy to teach at the intro level would be interest on reserves, quantitative easing, forward guidance, and emergency (but temporary) lending facilities.