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Running head: Monetary Policy and Its Effects
Monetary Policy and Its Effects
University of Phoenix
October 27, 2007
Monetary policy has two basic goals: to promote "maximum" sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act. (Federal Reserve Bank of San Francisco, 2007)
The Federal government uses various tools to control money. The Federal Reserve cannot control inflation or influence output and employment directly; instead it affects them indirectly, mainly by raising or lowering a short-term interest rate called the "federal funds" rate. Most often, it does this through open market operations in the market for bank reserves, known as the federal funds market. Banks and other depository institutions keep a certain amount of funds in reserve to meet unexpected outflows. Banks can keep these reserves as cash in their vaults or as deposits with the Federal Reserve. In fact, banks are required to hold a certain amount in reserves. But typically, they hold even more than they are required to in order to clear overnight checks, restock ATMs, and make other payments. (FRBSF, 2007)
The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand for goods and services. Policy actions affect real interest rates, which in turn affect demand and ultimately output, employment, and inflation. The Federal Reserve operates only in the market for bank reserves. Because they are the sole supplier of reserves, the Federal Reserve can set the nominal funds rate. The Federal Reserve cannot set real interest rates directly because it cannot set inflation ex ...