responsible for its content.
The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.
3
The Implementation of Monetary Policy
The Federal Reserve exercises considerable control over the
demand for and supply of balances that depository institutions
hold at the Reserve Banks. In so doing, it influences the federal
funds rate and, ultimately, employment, output, and prices.
The Federal Reserve implements U.S. monetary policy by affecting con-
ditions in the market for balances that depository institutions hold at the
Federal Reserve Banks. The operating objectives or targets that it has
used to effect desired conditions in this market have varied over the years.
At one time, the FOMC sought to achieve a specific quantity of balances,
but now it sets a target for the interest rate at which those balances are
traded between depository institutionsthe federal funds rate. (See Op-
erational Approaches over the Years on page 28.) By conducting open
market operations, imposing reserve requirements, permitting depository
institutions to hold contractual clearing balances, and extending credit
through its discount window facility, the Federal Reserve exercises con-
siderable control over the demand for and supply of Federal Reserve bal-
ances and the federal funds rate. Through its control of the federal funds
rate, the Federal Reserve is able to foster financial and monetary condi-
tions consistent with its monetary policy objectives.
The Market for Federal Reserve Balances
The Federal Reserve inf luences the economy through the market for
balances that depository institutions maintain in their accounts at Federal
Reserve Banks. Depository institutions make and receive payments on
behalf of their customers or themselves in these accounts. The end-of-
day balances in these accounts are used to meet reserve and other bal-
ance requirements. If a depository institution anticipates that it will end
the day with a larger balance than it needs, it can reduce that balance in
several ways, depending on how long it expects the surplus to persist. For
example, if it expects the surplus to be temporary, the institution can lend
excess balances in financing markets, such as the market for repurchase
agreements or the market for federal funds.
27 The Federal Reserve System: Purposes and Functions
Operational Approaches over the Years
The Federal Reserve can try to achieve a desired quantity of bal-
ances at the Federal Reserve Banks or a desired price of those
balances (the federal funds rate), but it may not be able to achieve
both at once. The greater the emphasis on a quantity objective,
the more short-run changes in the demand for balances will inf lu-
ence the federal funds rate. Conversely, the greater the emphasis
on a funds-rate objective, the more shifts in demand will inf luence
the quantity of balances at the Federal Reserve. Over the years,
the Federal Reserve has used variations of both of these operational
approaches.
During most of the 1970s, the Federal Reserve targeted the price
of Federal Reserve balances. The FOMC would choose a target
federal funds rate that it thought would be consistent with its ob-
jective for M1 growth over short intervals of time. The funds-rate
target would be raised or lowered if M1 growth significantly ex-
ceeded or fell short of the desired rate. At times, large rate move-
ments were needed to bring money growth back in line with the
target, but the extent of the necessary policy adjustment was not
always gauged accurately. Moreover, there appears to have been
some reluctance to permit substantial variation in the funds rate.
As a result, the FOMC did not have great success in combating
the increase in inf lationary pressures that resulted from oil-price
shocks and excessive money growth over the decade.
By late 1979, the FOMC recognized that a change in tactics was
necessary. In October, the Federal Reserve began to target the
quantity of reservesthe sum of balances at the Federal Reserve
and cash in the vaults of depository institutions that is used to
meet reserve requirementsto achieve greater control over M1
and bring down inf lation. In particular, the operational objective
for open market operations was a specific level of nonborrowed
reserves, or total reserves less the quantity of discount window
borrowing. A predetermined target path for nonborrowed reserves
was based on the FOMCs objectives for M1. If M1 grew faster
than the objective, required reserves, which were linked to M1
through the required reserve ratios, would expand more quickly
than nonborrowed reserves. With the fixed supply of nonbor-
rowed reserves falling short of demand, banks would bid up the
28 The Implementation of Monetary Policy
federal funds rate, sometimes sharply. The rise in short-term inter-
est rates would eventually damp M1 growth, and M1 would be
brought back toward its targeted path.
By late 1982, it had become clear that the combination of interest
rate deregulation and financial innovation had weakened the his-
torical link between M1 and the economic objectives of monetary
policy. The FOMC began to make more discretionary decisions
about money market conditions, using a wider array of economic
and financial variables to judge the need for adjustments in short-
term interest rates. In the day-to-day implementation of open
market operations, this change was manifested in a shift of focus
from a nonborrowed-reserve target to a borrowed-reserve
target. The Federal Reserve routinely supplied fewer nonbor-
rowed reserves than the estimated demand for total reserves, thus
forcing depository institutions to meet their remaining need for
reserves by borrowing at the discount window. The total amount
borrowed was limited, however, even though the discount rate was
generally below the federal funds rate, because access to discount
window credit was restricted. In particular, depository institutions
were required to pursue all other reasonably available sources of
funds, including those available in the federal funds market, before
credit was granted. During the time it was targeting borrowed
reserves, the Federal Reserve inf luenced the level of the federal
funds rate by controlling the extent to which depository institu-
tions had to turn to the discount window. When it wanted to ease
monetary policy, it would reduce the borrowed-reserve target and
supply more nonborrowed reserves to meet estimated demand.
With less pressure to borrow from the discount window, deposi-
tory institutions would bid less aggressively for balances at the
Federal Reserve and the federal funds rate would fall.
Beginning in the mid-1980s, spreading doubts about the financial
health of some depository institutions led to an increasing reluc-
tance on the part of many institutions to borrow at the discount
window, thus weakening the link between borrowing and the
federal funds rate. Consequently, the Federal Reserve increasingly
sought to attain a specific level of the federal funds rate rather than
a targeted amount of borrowed reserves. In July 1995, the FOMC
began to announce its target for the federal funds rate.
29 DEMAND
SUPPLY
The Federal Reserve System: Purposes and Functions
In the federal funds market, depository institutions actively trade balances
held at the Federal Reserve with each other, usually overnight, on an
uncollateralized basis. Institutions with surplus balances in their accounts
lend those balances to institutions in need of larger balances. The federal
funds ratethe interest rate at which these transactions occuris an im-
portant benchmark in financial markets. Daily f luctuations in the federal
funds rate ref lect demand and supply conditions in the market for Federal
Reserve balances.
Demand for Federal Reserve Balances
The demand for Federal Reserve balances has three components: required
reserve balances, contractual clearing balances, and excess reserve balances.
Required Reserve Balances
Required reserve balances are balances that a depository institution must
hold with the Federal Reserve to satisfy its reserve requirement. Reserve
requirements are imposed on all depository institutionswhich include
commercial banks, savings banks, savings and loan associations, and credit
unionsas well as U.S. branches and agencies of foreign banks and other
The Market for Balances at the Federal Reserve

Contractual clearing balances
held to meet contractually



Autonomous factors
other items on the Federal
Reserve float
can add or drain balances
Loans

window

Securities portfolio



Excess reserves
held to provide additional
protection against overnight
overdrafts and reserve or clearing
balance deficiencies
agreed-upon amount
generate earnings credits that
defray cost of Federal Reserve
priced services
Required reserve balances
held to satisfy reserve
requirements
do not earn interest
Reserves balance sheet such
as Federal Reserve notes,
Treasurys balance at the
Federal Reserve, and Federal
credit extended to depository
institutions