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Updated January 21, 2022
Introduction to U.S. Economy: Monetary Policy
The Federal Reserve (Fed), the nation’s central bank, is
are business physical capital investment (e.g., plant and
responsible for monetary policy. This In Focus explains
equipment), consumer durables (e.g., automobiles,
how monetary policy works. Typically, when the Fed wants
appliances), and residential investment (new housing
to stimulate the economy, it makes policy more
construction). All else equal, higher interest rates reduce
expansionary by reducing interest rates. When it wants to
interest-sensitive spending, and lower interest rates increase
make policy more contractionary or tighter, it raises rates.
interest-sensitive spending.
For background on the Fed and its other responsibilities, see
CRS In Focus IF10054, Introduction to Financial Services:
Figure 1. Federal Funds Rate, 2020-2022
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.
Statutory Goals
In 1977, the Fed was mandated to set monetary policy to

Source: Federal Reserve.
promote the goals of “maximum employment, stable prices,
and moderate long-term interest rates” (12 U.S.C. §225a).
Notes: FFR=federal funds rate; IOR=interest rate on bank reserves.
The first two goals are referred to as the dual mandate.
Interest rates also influence the demand for exports and
Since 2012, the FOMC has explained its mandate in its
imports by affecting the value of the dollar. All else equal,
Statement on Longer-Run Goals. It defines stable prices as
higher interest rates increase net foreign capital inflows as
2% inflation, measured as the annual percent change in the
U.S. assets become more attractive relative to foreign
personal consumption expenditures price index. In the
assets. To purchase U.S. assets, foreigners must first
Fed’s view, maximum employment “is not directly
purchase U.S. dollars, pushing up the value of the dollar.
measurable and changes over time owing largely to
When the value of the dollar rises, the price of foreign
nonmonetary factors that affect the structure and dynamics
imports declines relative to U.S. import-competing goods,
of the labor market.” The Fed aims to meet its target on
and U.S. exports become more expensive relative to foreign
average over time, offsetting periods of inflation below 2%
goods. As a result, net exports (exports less imports)
with periods above 2%.
decrease. When interest rates fall, all of these factors work
in reverse and net exports increase, all else equal.
Federal Funds Rate
In normal economic conditions, the Fed’s primary
Business investment, consumer durables, residential
instrument for setting monetary policy is the federal funds
investment, and net exports are all components of gross
rate (FFR), the overnight interest rate in the federal funds
domestic product (GDP). Thus, if expansionary monetary
market, a private market where banks lend to each other.
policy causes interest-sensitive spending to rise, it increases
The FOMC sets a target range for the FFR and uses its tools
GDP in the short run. This increases employment, as more
to keep the actual FFR within that range (see Figure 1).
workers are hired to meet increased demand for goods and
services. Most economists believe that monetary policy
How Does Monetary Policy Affect the
cannot permanently change the level or growth rate of GDP
Economy?
or employment but can permanently change the inflation
Changes in the FFR target lead to changes in interest rates
rate, because long-run GDP is determined by the
economy’s productive capacity (the
throughout the economy, although these changes are mostly
size of the labor force,
less than one-to-one. Changes in interest rates affect overall
capital stock, and so on). If monetary policy pushes demand
economic activity by changing the demand for interest-
above what the economy can produce, then inflation should
sensitive spending (goods and services that are bought on
eventually rise to restore equilibrium. When setting
credit). The main categories of interest-sensitive spending
monetary policy, the Fed must take into account the lags
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Introduction to U.S. Economy: Monetary Policy
between a change in policy and economic conditions, so
conducted through repos. (As noted above, the Fed still
rate changes can be preemptive.
purchases Treasury securities and uses repos, but it no
longer does so to target the FFR.)
The Fed’s Balance Sheet
Like any company, the Fed holds assets on its balance sheet
Before the crisis, the Fed could target the FFR through
that are equally matched by the sum of liabilities and
direct intervention in the federal funds market because
capital. The Fed’s assets are primarily Treasury securities,
reserves were scarce—banks held only enough reserves to
mortgage-backed securities, loans, repurchase agreements
slightly exceed the reserve requirements set by the Fed.
(repos), and other assets acquired from emergency
Now, banks hold trillions of dollars of reserves, despite the
programs. Its liabilities are primarily currency, reverse
fact that the Fed eliminated reserve requirements in 2020.
repos, bank reserves, and money that Treasury holds at the
The overall level of reserves is the result of Fed actions—
Fed. When the Fed purchases assets or makes loans, its
primarily QE—that have increased the Fed’s balance sheet
balance sheet gets larger, which is matched by growth in
(see Figure 2) and are not a choice by banks.
reverse repos and bank reserves. Capital comes from stock
issued to private banks that are “member banks” and the
Figure 2. Selected Assets and Liabilities on Fed’s
funds in its surplus account. As discussed in the next
Balance Sheet, 2008-2022
section, the Fed’s balance sheet grew significantly from
2008 to 2014 and since 2020, in response to the financial
crisis and the pandemic, respectively (see Figure 2).
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),
Source: Federal Reserve.
it has purchased trillions of dollars of Treasury securities
After the Fed ended QE in 2014, it decided to maintain
and mortgage-backed securities in an effort to directly
abundant reserves instead of fully shrinking its balance
lower their yield. Under forward guidance, it has pledged to
sheet and returning to its pre-crisis monetary framework.
keep the FFR low for an extended period of time, with the
With reserves so abundant, adding or removing reserves
hope that reducing investor expectations of future short-
could not raise the FFR above zero in the absence of IOR
term rates will reduce long-term rates today. It has also
and a standing (i.e., on-demand) reverse repo facility. In
used large-scale repos, equivalent to short-term loans, to
2021, the Fed added a standing repo facility to make it
directly pump more liquidity into the financial system.
easier to keep the FFR from exceeding its target.
In addition, the Fed has responded to these crises by using
The Money Supply and Inflation
its lender-of-last-resort powers. For more information on its
Historically, money supply growth has been a predictor of
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.” After the financial crisis the money supply grew at
The Post-Crisis Policy Framework
historically high levels, but inflation had mostly been below
Following the 2007-2009 financial crisis, the Fed changed
target until it rose well above target in 2021. The money
how it conducted monetary policy. The Fed now maintains
supply has grown relatively rapidly since 2008 because of
the FFR target primarily by setting the interest rate it pays
rapid growth in the monetary base, which consists of bank
banks on reserves held at the Fed (IOR) and by using
reserves and currency and is controlled by the Fed.
reverse repos to drain liquidity from the financial system.
Although faster money supply growth would typically
Unlike the FFR, the Fed sets the IOR directly. The IOR
cause inflation to rise, all else equal, IOR gives the Fed a
anchors the FFR because banks will generally deploy their
means to “tie up” bank reserves so that they do not
surplus reserves to earn whichever rate is more attractive.
potentially cause inflation.
Before the crisis, monetary policy was conducted
Congress and Monetary Policy
differently. The Fed did not have authority to pay interest
Congress has delegated responsibility for monetary policy
on bank reserves until 2008, so it could not target the FFR
to the Fed but retains oversight responsibilities. For
by setting the IOR. Instead, the Fed directly intervened in
example, Title 12, Section 225b, of the U.S. Code requires
the federal funds market through open market operations
the Fed to semi-annually produce a written report and
that added or removed reserves from the federal funds
testify on monetary policy to the House Financial Services
market. Open market operations could be conducted by
Committee and the Senate Banking, Housing, and Urban
buying or selling Treasury securities but were typically
Affairs Committee.
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Introduction to U.S. Economy: Monetary Policy

IF11751
Marc Labonte, Specialist in Macroeconomic Policy

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