Operating procedures and the reserve market with a non-penalty discount rate: Section 9.4 from the second edition of Monetary Theory and Policy

Understanding a central bank’s operating procedures is important for two reasons. First, it is important in empirical work to distinguish between endogenous responses to developments in the economy and exogenous shifts in policy. Whether movements in a monetary aggregate or a short-term interest rate are predominantly endogenous responses to disturbances unrelated to policy shifts or are exogenous shifts in policy will depend on the nature of the procedures used to implement policy. Thus, some understanding of operating procedures is required for empirical investigations of the impact of monetary policy. Second, operating procedures, by a¤ecting the automatic adjustment of interest rates and monetary aggregates to economic disturbances, can have implications for the macro equilibrium. For example, operating procedures that lead the monetary authority to smooth interest-rate movements can introduce a unit root into the price level,1 and in the models examined in chapters 2 and 3, the economy’s response to productivity shocks was shown to depend on how the money supply was adjusted (although the e¤ects were small). Analyses of operating procedures are based on the market for bank reserves. In the United States, this is the federal funds market. While the focus in this section will be on the United States and the behavior of the Federal Reserve, similar issues arise in the analysis of monetary policy in other countries, although institutional details can vary considerably. Discussions of operating procedures in major OECD countries can be found in Batten, Blackwell, Kim, Nocera, and Ozeki (1990), Bernanke and Mishkin (1992), Morton and Wood (1993), Kasman (1993), and Borio (1997) .