formation about the economy becomes available only with a lag and may be imperfect.
2
Monetary Policy and the Economy
The Federal Reserve sets the nations monetary policy to
promote the objectives of maximum employment, stable prices,
and moderate long-term interest rates. The challenge for policy
makers is that tensions among the goals can arise in the short
run and that information about the economy becomes available
only with a lag and may be imperfect.
Goals of Monetary Policy
The goals of monetary policy are spelled out in the Federal Reserve Act,
which specifies that the Board of Governors and the Federal Open Mar-
ket Committee should seek to promote effectively the goals of maxi-
mum employment, stable prices, and moderate long-term interest rates.
Stable prices in the long run are a precondition for maximum sustainable
output growth and employment as well as moderate long-term interest
rates. When prices are stable and believed likely to remain so, the prices
of goods, services, materials, and labor are undistorted by inf lation and
serve as clearer signals and guides to the efficient allocation of resources
and thus contribute to higher standards of living. Moreover, stable prices
foster saving and capital formation, because when the risk of erosion of
asset values resulting from inf lationand the need to guard against such
lossesare minimized, households are encouraged to save more and busi-
nesses are encouraged to invest more.
Although price stability can help achieve maximum sustainable output
growth and employment over the longer run, in the short run some ten-
sion can exist between the two goals. Often, a slowing of employment
is accompanied by lessened pressures on prices, and moving to counter
the weakening of the labor market by easing policy does not have adverse
inf lationary effects. Sometimes, however, upward pressures on prices are
developing as output and employment are softeningespecially when
an adverse supply shock, such as a spike in energy prices, has occurred.
Then, an attempt to restrain inf lation pressures would compound the
weakness in the economy, or an attempt to reverse employment losses
would aggravate inf lation. In such circumstances, those responsible for
monetary policy face a dilemma and must decide whether to focus on
defusing price pressures or on cushioning the loss of employment and
output. Adding to the difficulty is the possibility that an expectation of
15 The Federal Reserve System: Purposes and Functions
Depository
institutions have
accounts at their
Reserve Banks, and
they actively trade
balances held in
these accounts in the
federal funds market
at an interest rate
known as the federal
funds rate.
increasing inf lation might get built into decisions about prices and wages,
thereby adding to inf lation inertia and making it more difficult to achieve
price stability.
Beyond inf luencing the level of prices and the level of output in the near
term, the Federal Reserve can contribute to financial stability and better
economic performance by acting to contain financial disruptions and pre-
venting their spread outside the financial sector. Modern financial systems
are highly complex and interdependent and may be vulnerable to wide-
scale systemic disruptions, such as those that can occur during a plunge
in stock prices. The Federal Reserve can enhance the financial systems
resilience to such shocks through its regulatory policies toward banking
institutions and payment systems. If a threatening disturbance develops,
the Federal Reserve can also cushion the impact on financial markets and
the economy by aggressively and visibly providing liquidity through open
market operations or discount window lending.
How Monetary Policy Affects the Economy
The initial link in the chain between monetary policy and the economy
is the market for balances held at the Federal Reserve Banks. Depository
institutions have accounts at their Reserve Banks, and they actively trade
balances held in these accounts in the federal funds market at an interest
rate known as the federal funds rate. The Federal Reserve exercises con-
siderable control over the federal funds rate through its inf luence over the
supply of and demand for balances at the Reserve Banks.
The FOMC sets the federal funds rate at a level it believes will foster
financial and monetary conditions consistent with achieving its monetary
policy objectives, and it adjusts that target in line with evolving economic
developments. A change in the federal funds rate, or even a change in
expectations about the future level of the federal funds rate, can set off a
chain of events that will affect other short-term interest rates, longer-term
interest rates, the foreign exchange value of the dollar, and stock prices.
In turn, changes in these variables will affect households and businesses
spending decisions, thereby affecting growth in aggregate demand and the
economy.
Short-term interest rates, such as those on Treasury bills and commercial
paper, are affected not only by the current level of the federal funds rate
but also by expectations about the overnight federal funds rate over the
duration of the short-term contract. As a result, short-term interest rates
could decline if the Federal Reserve surprised market participants with
a reduction in the federal funds rate, or if unfolding events convinced
participants that the Federal Reserve was going to be holding the federal
funds rate lower than had been anticipated. Similarly, short-term inter-
16 Monetary Policy and the Economy
est rates would increase if the Federal Reserve surprised market partici-
pants by announcing an increase in the federal funds rate, or if some event
prompted market participants to believe that the Federal Reserve was
going to be holding the federal funds rate at higher levels than had been
anticipated.
It is for these reasons that market participants closely follow data releases
and statements by Federal Reserve officials, watching for clues that the
economy and prices are on a different trajectory than had been thought,
which would have implications for the stance of monetary policy.
Changes in short-term interest rates will inf luence long-term interest
rates, such as those on Treasury notes, corporate bonds, fixed-rate mort-
gages, and auto and other consumer loans. Long-term rates are affected
not only by changes in current short-term rates but also by expectations
about short-term rates over the rest of the life of the long-term contract.
Generally, economic news or statements by officials will have a greater
impact on short-term interest rates than on longer rates because they typi-
cally have a bearing on the course of the economy and monetary policy
over a shorter period; however, the impact on long rates can also be con-
siderable because the news has clear implications for the expected course
of short-term rates over a long period.
Changes in long-term interest rates also affect stock prices, which can
have a pronounced effect on household wealth. Investors try to keep their
investment returns on stocks in line with the return on bonds, after allow-
ing for the greater riskiness of stocks. For example, if long-term inter-
est rates decline, then, all else being equal, returns on stocks will exceed
returns on bonds and encourage investors to purchase stocks and bid up
stock prices to the point at which expected risk-adjusted returns on stocks
are once again aligned with returns on bonds. Moreover, lower interest
rates may convince investors that the economy will be stronger and profits
higher in the near future, which should further lift equity prices.
Furthermore, changes in monetary policy affect the exchange value of
the dollar on currency markets. For example, if interest rates rise in the
United States, yields on dollar assets will look more favorable, which will
lead to bidding up of the dollar on foreign exchange markets. The higher
dollar will lower the cost of imports to U.S. residents and raise the price of
U.S. exports to those living outside the United States. Conversely, lower
interest rates in the United States will lead to a decline in the exchange
value of the dollar, prompting an increase in the price of imports and a
decline in the price of exports.
Changes in the value of financial assets, whether the result of an actual or
expected change in monetary policy, will affect a wide range of spending
decisions. For example, a drop in interest rates, a lower exchange value of
Lower interest rates
in the United States
will lead to a decline
in the exchange
value of the dollar,
prompting an
increase in the price
of imports and a
decline in the price
of exports.
17 The Federal Reserve System: Purposes and Functions
If the economy slows
and employment
softens, policy
makers will be
inclined to ease
monetary policy to
stimulate aggregate
demand.
the dollar, and higher stock prices will stimulate various types of spend-
ing. Investment projects that businesses believed would be only margin-
ally profitable will become more attractive with lower financing costs.
Lower consumer loan rates will elicit greater demand for consumer goods,
especially bigger-ticket items such as motor vehicles. Lower mortgage
rates will make h