Monetary Policy and the Economy
Using the tools of monetary policy, the Federal Reserve can affect the volume of money and credit and their price-interest rates. In this way, it influences employment, output, and the general level of prices.THE FEDERAL RESERVE ACT LAYS OUT the goals of monetary policy. It specifies that, in conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."Many analysts believe that the central bank should focus primarily on achieving price stability. A stable level of prices appears to be the condition most conducive to maximum sustained output and employment and to moderate long-term interest rates; in such circumstances, the prices of goods, materials, and services are undistorted by inflation and thus can serve as clearer signals and guides for the efficient allocation of resources. Also, a background of stable prices is thought to encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation.
The Federal Reserve is not required to achieve its announced objectives for these financial aggregates, but if it does not, it must ex-plain the reasons to Congress and the public. Indeed, the economy frequently is buffeted by factors affecting aggregate demand for goods and services or aggregate supply. Moreover, many banks fear that their use of discount window credit might become known to private market participants, even though the Federal Reserve treats the identity of such borrowers in a highly confidential manner, and that such borrowing might be viewed as a sign of weakness. The other source of reserve supply is non-borrowed reserves. Production is the first to respond to monetary policy actions; prices and wages respond only later. Countering this threat of inflation with a more restrictive monetary policy could risk small losses of output and employment in the near term but might make it possible to avoid larger losses later should expectations of higher inflation become embedded in the economy. The supply of borrowed reserves depends on the initiative of depository institutions to borrow, though it is influenced by the level of the discount rate and by the terms and conditions for access to discount window credit. Lessened demand resulting from higher interest rates and the stronger dollar tends to reduce production and thereby relieve pressures on resources. Because interest rates paid on many deposits in the money stock adjust only slowly, holding balances in money (that is, in a form counted in the money stock) becomes less attractive. In the early 1990s, the velocity of M2 departed from this pattern and drifted upward. Whereas short-term interest rates are strongly influenced by current reserve provisions of the central bank, longer-term rates are influenced by expectations of future short-term rates and thus by the longer-term effects of monetary policy on inflation and output. Monetary policy in time can offset such shocks in private-sector demand but because of their nature, not as they occur. dollars becomes more appealing, and the demand for dollars in foreign exchange markets increases. Arguing against giving interest rates a key role in guiding monetary policy is the uncertainty about what level or path of interest rates is consistent with the more basic goals. Short- and Long-term Interest RatesInterest rates have frequently been proposed as a guide to policy.
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