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The Implementation of Monetary Policy

The Federal Reserve exercises considerable control over the demand for and supply of balances that depository institutions hold at the Reserve Banks. In so doing, it influences the federal funds rate and, ultimately, employment, output, and prices.
The Federal Reserve implements U.S. monetary policy by affecting conditions in the market for balancesthat depository institutions hold at the Federal Reserve Banks. The operating objectives or targets that it has used to effect desired conditions in this market have varied over the years. At one time, the FOMC sought to achieve a specific quantity of balances, but now it sets a target for the interest rate at which those balances are traded between depository institutions—the federal funds rate.(See “Operational Approaches over the Years” on page 28.) By conducting open market operations, imposing reserve requirements, permitting depository institutions to hold contractual clearing balances, and extending credit through its discount window facility, the Federal Reserve exercises considerable control over the demand for and supply of Federal Reserve balances and the federal funds rate.Through its control of the federal funds rate, the Federal Reserve is able to foster financial and monetary conditions consistent with its monetary policy objectives.

The Market for Federal Reserve Balances
The Federal Reserve inf luences the economy through the market for balances that depository institutions maintain in their accounts at Federal Reserve Banks. Depository institutions make andreceive payments on behalf of their customers or themselves in these accounts. The end-ofday balances in these accounts are used to meet reserve and other balance requirements. If a depository institution anticipates that it will end the day with a larger balance than it needs, it can reduce that balance in several ways, depending on how long it expects the surplus to persist. For example, if itexpects the surplus to be temporary, the institution can lend excess balances in financing markets, such as the market for repurchase agreements or the market for federal funds.

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The Federal Reserve System: Purposes and Functions

Operational Approaches over the Years
The Federal Reserve can try to achieve a desired quantity of balances at the Federal Reserve Banks or a desired price ofthose balances (the federal funds rate), but it may not be able to achieve both at once. The greater the emphasis on a quantity objective, the more short-run changes in the demand for balances will inf luence the federal funds rate. Conversely, the greater the emphasis on a funds-rate objective, the more shifts in demand will inf luence the quantity of balances at the Federal Reserve. Over theyears, the Federal Reserve has used variations of both of these operational approaches. During most of the 1970s, the Federal Reserve targeted the price of Federal Reserve balances. The FOMC would choose a target federal funds rate that it thought would be consistent with its objective for M1 growth over short intervals of time. The funds-rate target would be raised or lowered if M1 growthsignificantly exceeded or fell short of the desired rate. At times, large rate movements were needed to bring money growth back in line with the target, but the extent of the necessary policy adjustment was not always gauged accurately. Moreover, there appears to have been some reluctance to permit substantial variation in the funds rate. As a result, the FOMC did not have great success in combating theincrease in inf lationary pressures that resulted from oil-price shocks and excessive money growth over the decade. By late 1979, the FOMC recognized that a change in tactics was necessary. In October, the Federal Reserve began to target the quantity of reserves—the sum of balances at the Federal Reserve and cash in the vaults of depository institutions that is used to meet reserve requirements—to...