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The Federal Reserve (“the Fed”) has a multi-part mission. One of its functions, as detailed in the chapter on The Market for Money, is to ensure the stability of the banking system by exercising oversight and also by acting as a “bank for banks.” Another function, however, is conducting monetary policy. This is the task specifically of the Fed’s Open Market Committee, consisting of the Fed’s seven-member board of directors, the president of the Fed’s New York branch, and a rotating set of four of the eleven presidents of the other regional banks.
If fiscal policy influences the macroeconomy through the use of tax and spending practices, then monetary policy influences the macroeconomy by increasing or decreasing the freedom with which money flows through the economy. The law establishing the Fed assigns it three goals to promote through monetary policy: “maximum employment, stable prices, and moderate long-term interest rates.” This is often simplified by saying that the Fed has a dual mandate, to fight both unemployment and inflation. But remember the Phillips curve (from the chapter on Unemployment and Inequality): unemployment and inflation have a generally inverse relationship. The most the Fed can hope to accomplish, therefore, is to keep inflation and unemployment in balance and within acceptable limits.
In carrying out its mission, the Fed keeps a close eye on the federal funds rate, which is the rate at which banks in the United States borrow money from each other and from certain other entities for short periods. (The other entities part matters, as we will see.) The federal funds rate influences the interest rates at which banks will offer loans to households and firms, and therefore the federal funds rate is an indicator of how freely loan money is available for consumption spending and for investment.
The details of how the Fed conducts monetary policy have evolved considerably since the Fed’s founding. In this chapter, we look first at a historical picture of the Fed’s work and then at a more up-to-date picture that reflects the Fed’s current practices.
