Introduction to U.S. Economy: Monetary Policy
Updated January 9, 2023
Introduction to U.S. Economy: Monetary Policy
The Federal Reserve (Fed), the nation’s central bank, is
How Does Monetary Policy Affect the
responsible for monetary policy. This In Focus explains
Economy?
how monetary policy works. Typically, when the Fed wants
Changes in the FFR target lead to changes in interest rates
to stimulate the economy, it makes policy more
throughout the economy, although these changes are mostly
expansionary by reducing short-term interest rates. When it
less than one-to-one. Changes in interest rates affect overall
wants to make policy more contractionary or tighter, it
economic activity by changing the demand for interest-
raises rates. Since March 2022, the Fed has been raising
sensitive spending (goods and services that are bought on
interest rates in an attempt to reduce inflation. For
credit). The main categories of interest-sensitive spending
background on the Fed and its other responsibilities, see
are business physical capital investment (e.g., plant and
CRS In Focus IF10054, Introduction to Financial Services:
equipment), consumer durables (e.g., automobiles,
The Federal Reserve.
appliances), and residential investment (new housing
construction). All else equal, higher interest rates reduce—
Federal Open Market Committee
and lower rates increase—interest-sensitive spending.
Monetary policy decisions are made by the Federal Open
Market Committee (FOMC), whose voting members are the
Interest rates also influence the demand for exports and
Fed’s seven governors, the New York Federal Reserve
imports by affecting the value of the dollar. All else equal,
Bank president, and four other Reserve Bank presidents,
higher interest rates increase net foreign capital inflows as
who vote on a rotating basis. The FOMC is chaired by the
U.S. assets become more attractive relative to foreign
Fed chair. FOMC meetings are regularly scheduled every
assets. To purchase U.S. assets, foreigners must first
six weeks, but the chair sometimes calls unscheduled
purchase U.S. dollars, pushing up the value of the dollar.
meetings. After these meetings, the FOMC statement
When the value of the dollar rises, the price of foreign
announcing any changes to monetary policy is released.
imports declines relative to U.S. import-competing goods,
and U.S. exports become more expensive relative to foreign
Statutory Goals
goods. As a result, net exports (exports less imports)
In 1977, the Fed was mandated to set monetary policy to
decrease. When interest rates fall, all of these factors work
promote the goals of “maximum employment, stable prices,
in reverse and net exports increase, all else equal.
and moderate long-term interest rates” (12 U.S.C. §225a).
The first two goals are referred to as the dual mandate. The
Business investment, consumer durables, residential
dual mandate provides the Fed with discretion on how to
investment, and net exports are all components of gross
interpret maximum employment and stable prices and how
domestic product (GDP). Thus, if expansionary monetary
to set monetary policy to achieve those goals. There are no
policy causes interest-sensitive spending to rise, it increases
formal repercussions when goals are not met.
GDP in the short run. This increases employment, as more
workers are hired to meet increased demand for goods and
Since 2012, the FOMC has explained its mandate in its
services. An increase in spending also puts upward pressure
Statement on Longer-Run Goals. It defines stable prices as
on inflation. Contractionary monetary policy has the
2% inflation, measured as the annual percent change in the
opposite effect on GDP, employment, and inflation. Most
personal consumption expenditures price index. In the
economists believe that although monetary policy can
Fed’s view, maximum employment “is not directly
permanently change the inflation rate, it cannot
measurable and changes over time owing largely to
permanently change the level or growth rate of GDP,
nonmonetary factors that affect the structure and dynamics
because long-run GDP is determined by the economy’s
of the labor market.” The Fed aims to meet its target on
productive capacity (the size of the labor force, capital
average over time, offsetting periods of inflation below 2%
stock, and so on). If monetary policy pushes demand above
with periods above 2%.
what the economy can produce, then inflation should
eventually rise to restore equilibrium. When setting
Federal Funds Rate
monetary policy, the Fed must take into account the lags
In normal economic conditions, the Fed’s primary
between a change in policy and its effect on economic
instrument for setting monetary policy is the federal funds
conditions so that rate changes can be made preemptively.
rate (FFR), the overnight interest rate in the federal funds
market, a private market where banks lend to each other.
The Fed’s Balance Sheet
The FOMC sets a target range for the FFR that is 0.25
Like any company, the Fed holds assets on its balance sheet
percentage points wide and uses its tools to keep the actual
that are equally matched by the sum of liabilities and
FFR within that range.
capital. The Fed’s assets are primarily Treasury securities,
mortgage-backed securities, loans, repurchase agreements
(repos), and other assets acquired from emergency
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Introduction to U.S. Economy: Monetary Policy
programs. Its liabilities are primarily currency, reverse
liquidity from the financial system. Unlike the FFR, the Fed
repos, bank reserves, and money that Treasury holds at the
sets the IOR and the reverse repo rate directly. The IOR and
Fed. When the Fed purchases assets or makes loans, its
repo rate anchor the FFR because these short-term funding
balance sheet gets larger, which is matched by growth in
sources are relatively substitutable.
reverse repos and bank reserves. Capital comes from stock
Before the crisis, monetary policy was conducted
issued to private banks that are “member banks” and the
differently. The Fed did not have authority to pay interest
funds in its surplus account. As discussed in the next
section, the Fed’s balance sheet grew significantly from
on bank reserves until 2008, so it could not target the FFR
by setting the IOR. Instead, the Fed directly intervened in
2008 to 2014 and from 2020 to 2022 in response to the
the federal funds market through open market operations
financial crisis and the pandemic, respectively (see Figure
that added or removed reserves from the federal funds
1). Since June 2022, the balance sheet has been gradually
market. Open market operations could be conducted by
shrinking. For more information, see CRS In Focus
buying or selling Treasury securities but were typically
IF12147, The Federal Reserve’s Balance Sheet and
conducted through repos. (As noted above, the Fed still
Quantitative Easing.
purchases Treasury securities and uses repos, but it no
Figure 1. Selected Assets and Liabilities on Fed’s
longer does so to target the FFR. Whereas previously the
Balance Sheet, 2008-2022
Fed would offer the amount of repos needed to meet its
FFR target, market participants now choose how many
repos to enter into with the Fed.)
Before the crisis, the Fed could target the FFR through
direct intervention in the federal funds market because
reserves were scarce—banks held only enough reserves to
slightly exceed the reserve requirements set by the Fed.
Now, banks hold trillions of dollars of reserves, despite the
fact that the Fed eliminated reserve requirements in 2020.
The overall level of reserves is the result of Fed actions—
primarily QE—that have increased the Fed’s balance sheet
(see Figure 1) and are not a choice by banks.
After the Fed ended QE in 2014, it decided to maintain
abundant reserves instead of fully shrinking its balance
Source: Federal Reserve.
sheet and returning to its pre-crisis monetary framework.
With reserves so abundant, adding or removing reserves
Unconventional Tools at the
could not raise the FFR above zero in the absence of IOR
Zero Lower Bound
and the reverse repo facility. In 2021, the Fed added a
Twice in its history—during the 2007-2009 financial crisis
standing repo facility to make it easier to keep the FFR
and the COVID-19 pandemic—the Fed lowered the FFR
from exceeding its target.
target range to 0-0.25% (called the zero lower bound) in
The Money Supply and Inflation
response to unusually serious economic disruptions.
Historically, money supply growth has been a predictor of
Because the zero lower bound prevented the Fed from
the inflation rate. The logic behind this relationship is that
providing as much conventional stimulus as desired to
inflation is caused by “too much money chasing too few
mitigate these crises, it turned to unconventional monetary
goods.” Since the financial crisis the money supply grew at
policy tools in an effort to reduce longer-term interest rates.
historically high levels, but inflation had mostly been below
Under quantitative easing (QE), it purchased trillions of
target until it rose well above target in 2021. The money
dollars of Treasury securities and mortgage-backed
supply has grown relatively rapidly since 2008 because of
securities in an effort to directly lower their yield. Under
rapid growth in the monetary base, which consists of bank
forward guidance, it pledged to keep the FFR low for an
reserves and currency and is controlled by the Fed.
extended period of time, with the hope that reducing
Although faster money supply growth would typically
investor expectations of future short-term rates will reduce
cause inflation to rise, all else equal, IOR gives the Fed a
long-term rates today. It also used large-scale repos,
means to “tie up” bank reserves so that they do not
equivalent to short-term loans, to directly pump more
potentially cause inflation.
liquidity into the financial system.
Congress and Monetary Policy
In addition, the Fed has responded to these crises by using
Congress has delegated responsibility for monetary policy
its lender-of-last-resort powers. For more information on its
to the Fed but retains oversight responsibilities. For
actions in the pandemic, see CRS Report R46411, The
example, Title 12, Section 225b, of the U.S. Code requires
Federal Reserve’s Response to COVID-19: Policy Issues.
the Fed to semi-annually produce a written report and
testify on monetary policy to the House Financial Services
The Post-Crisis Policy Framework
Committee and the Senate Banking, Housing, and Urban
Following the 2007-2009 financial crisis, the Fed changed
Affairs Committee.
how it conducted monetary policy. The Fed now maintains
the FFR target primarily by setting the interest rate it pays
Marc Labonte, Specialist in Macroeconomic Policy
banks on reserves held at the Fed (IOR) and by using a
IF11751
standing (i.e., on demand) reverse repo facility to drain
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Introduction to U.S. Economy: Monetary Policy
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