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February 2, 2021
Introduction to U.S. Economy: Monetary Policy
The Federal Reserve (Fed), the nation’s central bank, is
The FOMC sets a target range for the FFR and uses its tools
responsible for monetary policy. This In Focus explains
to keep the actual FFR within that range (see Figure 1).
how monetary policy works. Typically, when the Fed wants
to stimulate the economy, it makes policy more
Figure 1. Federal Funds Rate
expansionary by reducing interest rates. When it wants to
2020-2021
make policy more contractionary or tighter, it raises rates.
For background on the Fed and its other responsibilities, see
CRS In Focus IF10054, Introduction to Financial Services:
The Federal Reserve.
Federal Open Market Committee
Monetary policy decisions are made by the Federal Open
Market Committee (FOMC), whose voting members are the
Fed’s seven governors, the New York Federal Reserve
Bank president, and four other Reserve Bank presidents,
who vote on a rotating basis. The FOMC is chaired by the
Fed chair. FOMC meetings are regularly scheduled every
six weeks, but the chair sometimes calls unscheduled
meetings. After these meetings, the FOMC statement

announcing any changes to monetary policy is released.
Source: Federal Reserve.
Notes: FFR=federal funds rate; IOR=interest rate on bank reserves.
Statutory Goals
In 1977, the Fed was mandated to set monetary policy to
How Does Monetary Policy Affect the
promote the goals of “maximum employment, stable prices,
Economy?
and moderate long-term interest rates” (12 U.S.C. §225a).
Changes in the FFR target lead to changes in interest rates
The first two goals are referred to as the dual mandate.
throughout the economy, although these changes are mostly
less than one-to-one. Changes in interest rates affect overall
Statement on Longer-Run Goals
economic activity by changing the demand for interest-
Since 2012, the FOMC has explained its mandate in the
sensitive spending (goods and services that are bought on
Statement on Longer-Run Goals. It defines stable prices as
credit). The main categories of interest-sensitive spending
2% inflation, measured as the annual percent change in the
are business physical capital investment (e.g., plant and
personal consumption expenditures price index. In the
equipment), consumer durables (e.g., automobiles,
Fed’s view, maximum employment “is not directly
appliances), and residential investment (new housing
measurable and changes over time owing largely to
construction). All else equal, higher interest rates reduce
nonmonetary factors that affect the structure and dynamics
interest-sensitive spending, and lower interest rates increase
of the labor market.”
interest-sensitive spending.
In response to the low inflation and low growth
Interest rates also influence the demand for exports and
environment that dates back to the 2007-2009 financial
imports by affecting the value of the dollar. All else equal,
crisis, the FOMC made significant changes to the statement
higher interest rates increase net foreign capital inflows as
in 2020. First, monetary policy would aim to make up for
U.S. assets become more attractive relative to foreign
periods of inflation below 2% with periods of inflation
assets. To purchase U.S. assets, foreigners must first
above 2%, so that inflation would average 2% over time.
purchase U.S. dollars, pushing up the value of the dollar.
Second, monetary policy would respond only if
When the value of the dollar rises, the price of foreign
unemployment is high, not if it is low. For more
imports declines relative to U.S. import-competing goods,
information, see CRS Insight IN11499, The Federal
and U.S. exports become more expensive relative to foreign
Reserve’s Revised Monetary Policy Strategy Statement.
goods. As a result, net exports (exports less imports)
decrease. When interest rates fall, all of these factors work
Federal Funds Rate
in reverse and net exports increase, all else equal.
In normal economic conditions, the Fed’s primary
instrument for setting monetary policy is the federal funds
Business investment, consumer durables, residential
rate (FFR), the overnight interest rate in the federal funds
investment, and net exports are all components of gross
market, a private market where banks lend to each other.
domestic product (GDP). Thus, if expansionary monetary
policy causes interest sensitive spending to rise, it increases
GDP in the short run. This increases employment, as more
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Introduction to U.S. Economy: Monetary Policy
workers are hired to meet increased demand for goods and
Now, banks hold trillions of dollars of reserves, despite the
services. Most economists believe that monetary policy
fact that the Fed eliminated reserve requirements in 2020.
cannot permanently change the level or growth rate of GDP
The overall level of reserves is the result of Fed actions—
or employment but can permanently change the inflation
primarily QE—that have increased the assets held on the
rate, because long-run GDP is determined by the
Fed’s balance sheet (see Figure 2) and are not a choice by
economy’s productive capacity (the size of the labor force,
banks. The Fed acquires assets by increasing bank reserves.
capital stock, and so on). If monetary policy pushes demand
above what the economy can produce, then inflation should
Figure 2. Fed Assets, Bank Reserves, and Money
eventually rise to restore equilibrium. When setting
Supply Growth
monetary policy, the Fed must take into account the lags
2003-2021
between a change in policy and economic conditions.
Unconventional Tools at the Zero Lower
Bound
Twice in its history—during the 2007-2009 financial crisis
and the current COVID-19 pandemic—the Fed has lowered
the FFR target range to 0-0.25% (called the zero lower
bound) in response to unusually serious economic
disruptions. In both cases, the zero lower bound prevented
the Fed from providing as much conventional stimulus as
desired to mitigate these crises, so it turned to
unconventional monetary policy tools in an effort to reduce
longer-term interest rates. Under quantitative easing (QE),
it has purchased trillions of dollars of Treasury securities

and mortgage-backed securities in an effort to directly
Source: Federal Reserve.
lower their yield. Under forward guidance, it has pledged to
Notes: Money supply growth is measured by annual % change in M2.
keep the FFR low for an extended period of time, with the
hope that that will reduce long-term rates today by reducing
After the Fed ended QE in 2014, it decided to maintain
investor expectations of future short-term rates. It has also
abundant reserves instead of shrinking its balance sheet and
used large-scale repurchase agreements (known as repos),
returning to its pre-crisis monetary framework. With
which are temporary purchases and sales of securities, to
reserves so abundant, adding or removing reserves could
directly pump more liquidity into the financial system.
not raise the FFR above zero in the absence of IOR.
In addition, the Fed has responded to these crises by using
The Money Supply and Inflation
its powers as lender of last resort. For more information on
Historically, money supply growth has been a predictor of
its actions in the pandemic, see CRS Report R46411, The
the inflation rate. The logic behind this relationship is that
Federal Reserve’s Response to COVID-19: Policy Issues.
inflation is caused by “too much money chasing too few
goods.” Another difference since the financial crisis is that
The Post-Crisis Policy Framework
the money supply has grown at his torically high levels (see
Following the 2007-2009 financial crisis, the Fed changed
Figure 2), but inflation has mostly been below target. The
how it conducted monetary policy. The Fed now maintains
money supply has grown relatively rapidly since 2008
the FFR target primarily by setting the interest rate it pays
because of rapid growth in the monetary base, which
banks on reserves held at the Fed (IOR). Unlike the FFR,
consists of bank reserves and currency and is controlled by
the Fed sets the IOR directly. The IOR anchors the FFR,
the Fed. Although faster money supply growth would
because banks will generally deploy their surplus reserves
typically cause inflation to rise, all else equal, the economy
to earn whichever of the two rates is most attractive.
has also faced significant offsetting deflationary pressures
caused by the financial crisis and the pandemic. In addition,
Before the crisis, monetary policy was conducted
IOR gives the Fed a means to effectively “tie up” bank
differently. The Fed did not have authority to pay interest
reserves so that they do not contribute to inflation. Another
on bank reserves until 2008, so it could not target the FFR
reason inflation has been contained is because individuals
by setting the IOR. Instead, the Fed directly intervened in
have low inflation expectations—a virtuous cycle that may
the federal funds market through open market operations
persist as long as individuals believe that the Fed is
that added or removed reserves from the federal funds
committed to price stability.
market. Open market operations could be conducted by
buying or selling Treasury securities but were typically
Congress and Monetary Policy
conducted through repos. (As noted above, the Fed still
Congress has delegated responsibility for monetary policy
purchases Treasury securities and uses repos, but it no
to the Fed but retains oversight responsibilities. For
longer does so to target the FFR.)
example, statute requires the Fed chair to semi-annually
produce a written report and testify on monetary policy to
Before the crisis, the Fed could target the FFR through
the House Financial Services Committee and the Senate
direct intervention in the federal funds market because
Banking, Housing, and Urban Affairs Committee.
reserves were scarce—banks held only enough reserves to
slightly exceed the reserve requirements set by the Fed.
Marc Labonte, Specialist in Macroeconomic Policy
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Introduction to U.S. Economy: Monetary Policy

IF11751


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